Profitability Analysis

Appendix B

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Appendix B-2

Absolute Profitability
Absolute profitability measures the impact on the organizations overall profits of adding or dropping a particular segment such as a product or customer without making any other changes.

Appendix B-3

Computing Absolute Profitability

For an Existing Segment Compare the revenues that would be lost from dropping that segment to the costs that would be avoided.

For a New Segment Compare the additional revenues from adding that segment to the costs that would be incurred.

Appendix B-4

Learning Objective 1
Compute the profitability index and use it to select from among possible actions.

Appendix B-5

Relative Profitability
Relative profitability is concerned with ranking products, customers, and other business segments to determine which should be emphasized in an environment of scarce resources.

Appendix B-6

Relative Profitability
Managers are interested in ranking segments if a constraint forces them to make trade-offs among segments. In the absence of a constraint, all segments that are absolutely profitable should be pursued.

Appendix B-7

Relative Profitability
Incremental profit from the segment is the absolute profitability of the segment.

Incremental profit from the segment Profitability = index Amount of the constrained resources required by the segment

Appendix B-8

Profitability Index
Management of Matrix, Inc. developed the following information concerning its two segments:
Segment A Incremental profit (a) Amount of constrained resource required (b) Profitability index (a) (b) $ $ 100,000 100 hours 1,000 $ Segment B $ 200,000 400 hours 500

Appendix B-9

Project Profitability Index

From Chapter 13

Project profitability index

Net present value of the project Amount of investment required by the project

The project profitability index is used when a company has more long-term projects with positive net present values than it can fund.

Appendix B10

Project Profitability Index

From Chapter 13

Project profitability index

Net present value of the project Amount of investment required by the project

The net present value of the project goes in the numerator since it represents the incremental profit from the segment.

Appendix B11

Project Profitability Index

From Chapter 13

Project profitability index

Net present value of the project Amount of investment required by the project

The investment funds are the constraint, so the amount of investment required by a project goes in the denominator.

Appendix B12

Quality Kitchen Design An Example

Incremental Profit (a) Project A Project B Project C Project D Project E Project F Project G Project H Project I Project J $ 9,180 7,200 7,040 5,680 5,330 4,280 4,160 3,720 3,650 2,940 Constrained Resource Required (b) 17 hours 9 hours 16 hours 8 hours 13 hours 4 hours 13 hours 12 hours 5 hours 3 hours 100 hours $ Profitability Index (a) (b) 540 per hour 800 per hour 440 per hour 710 per hour 410 per hour 1,070 per hour 320 per hour 310 per hour 730 per hour 980 per hour

Appendix B13

Quality Kitchen Design An Example

Incremental Profit (a) Project A Project B Project C Project D Project E Project F Project G Project H Project I Project J $ 9,180 7,200 7,040 5,680 Constrained Resource Required (b) 17 hours 9 hours 16 hours $ Profitability Index (a) (b) 540 per hour 800 per hour 440 per hour

If management 8 hours 710 per hour only 5,330 has 46 hours 13 hoursavailable, 410 per hour 4,280 projects 4 hours 1,070 per hour which should 4,160 13 hours 320 per hour be accepted?
3,720 3,650 2,940 12 hours 5 hours 3 hours 100 hours 310 per hour 730 per hour 980 per hour

Appendix B14

Ranking Based on Profitability Index

Incremental Profit (a) Project F Project J Project B Project I Project D Project A Project C Project E Project G Project H $ 4,280 2,940 7,200 3,650 5,680 9,180 7,040 5,330 4,160 3,720 Constrained Resource Required (b) 4 hours 3 hours 9 hours 5 hours 8 hours 17 hours 16 hours 13 hours 13 hours 12 hours 100 hours $ Profitability Index (a) (b) 1,070 980 800 730 710 540 440 410 320 310 4 hours 7 hours 16 hours 21 hours 29 hours 46 hours 62 hours 75 hours 88 hours 100 hours $ $ 4,280 2,940 7,200 3,650 5,680 9,180 32,930 Cumulative Hours Incremental Profit

Appendix B15

Ranking Based on Profitability Index

Incremental Profit (a) Project F Project J Project B Project I Project D Project A Project C Project E Project G Project H $ 4,280 2,940 7,200 3,650 5,680 9,180 7,040 5,330 4,160 3,720 Constrained Resource Required (b) 4 hours 3 hours 9 hours 5 hours 8 hours 17 hours 16 hours 13 hours 13 hours 12 hours 100 hours $ Profitability Index (a) (b) 1,070 980 800 730 710 540 440 410 320 310 4 hours 7 hours 16 hours 21 hours 29 hours 46 hours 62 hours 75 hours 88 hours 100 hours $ $ 4,280 2,940 7,200 3,650 5,680 9,180 32,930 Cumulative Hours Incremental Profit

The optimal profit

Appendix B16

Learning Objective 2
Compute and use the profitability index in volume trade-off decisions.

Appendix B17

Volume Trade-Off Decisions

Volume trade-off decisions need to be made when a company must produce less than the market demands for some products due to the existence of a constraint.

Appendix B18

Volume Trade-Off Decisions

Volume trade-off decisions need to be made when a company must produce less than the market demands for some products due to the existence of a constraint.

Profitability index for a volume = trade-off decision

Unit contribution margin Amount of the constrained resource required by one unit

Appendix B19

Volume Trade-Off Decisions An Example

Matrix, Inc. produces the following three products:
Unit contribution margin Demand per week in units Contrained resource required per unit RX200 $ 15 300 5 minutes Products VB30 $ 10 400 2 minutes SQ500 $ 16 100 4 minutes

Appendix B20

Volume Trade-Off Decisions An Example

Matrix, Inc. produces the following three products:
Unit contribution margin Demand per week in units Contrained resource required per unit RX200 $ 15 300 5 minutes Products VB30 $ 10 400 2 minutes SQ500 $ 16 100 4 minutes

RX200 Demand per week in units (a) Contrained resource required per unit (b) Total time required to meet demand (a) (b) 300 5 minutes 1,500 minutes

Products VB30 400 2 minutes 800 minutes

SQ500 100 4 minutes 400 minutes

A total of 2,700 minutes

Appendix B21

Volume Trade-Off Decisions An Example

Matrix, Inc. produces the following three products: If only 2,200 minutes of machine constraint Products RX200 VB30should SQ500 time are available, which products Unit contribution margin $ 15 $ 10 $ 16 be produced in what quantities? Demand per week in units 300 400 100
Contrained resource required per unit 5 minutes 2 minutes 4 minutes

RX200 Demand per week in units (a) Contrained resource required per unit (b) Total time required to meet demand (a) (b) 300 5 minutes 1,500 minutes

Products VB30 400 2 minutes 800 minutes

SQ500 100 4 minutes 400 minutes

A total of 2,700 minutes

Appendix B22

Volume Trade-Off Decisions An Example

First, we calculate the profitability index for each product.

RX200 Contribution margin per unit (a) Contrained resource required per unit (b) Profitabiltiy index (a) (b) $ 15 5 minutes $3 per minute $

Products VB30 10 2 minutes $5 per minute $

SQ500 16 4 minutes $4 per minute

Most profitable

Next most profitable

Appendix B23

Volume Trade-Off Decisions An Example

Next, we prepare the optimal production plan.

Total minutes of constrained resource Less: Minutes needed to produce 400 VB30 Available minutes Less: Minutes needed to produce 100 SQ500 Available minutes Less: Minutes needed to produce 200 RX200 Full utilization of machine time

2,200 800 1,400 400 1,000 1,000 -

Appendix B24

Volume Trade-Off Decisions An Example

Last, we compute the total contribution margin earned under the optimal production plan.
Products VB30 $ 10 400 $ 4,000

Unit contribution margin Production per week in units Total contribution

RX200 $ 15 200 $ 3,000

SQ500 $ 16 100 $ 1,600

Maximum contribution is $8,600 per week.

Appendix B25

Learning Objective 3

Compute and use the profitability index in other business decisions.

Appendix B26

Sales Commissions
RX200 Unit selling price $ 40 Unit variable cost 25 Unit contribution margin (a) $ 15 Contrained resource required per unit (b) 5 minutes Profitability index per minute (a) (b) $ 3.00 Products VB30 $ 30 20 $ 10 2 minutes $ 5.00 SQ500 $ 35 19 $ 16 4 minutes $ 4.00

Sales commissions are based on gross selling price. If you were a salesperson at Matrix, which product would you prefer to sell?

RX200

Appendix B27

Sales Commissions
RX200 Unit selling price $ 40 Unit variable cost 25 Unit contribution margin (a) $ 15 Contrained resource required per unit (b) 5 minutes Profitability index per minute (a) (b) $ 3.00 Products VB30 $ 30 20 $ 10 2 minutes $ 5.00 SQ500 $ 35 19 $ 16 4 minutes $ 4.00

However, RX200 is the least profitable product, given the current machine constraint. It might be a better idea to base sales commissions on the profitability index for each product.

Appendix B28

Pricing New Products

The price of a new product should at least cover the variable cost of producing it plus the opportunity cost of displacing the production of existing products to make it.
Amount of the Opportunity cost constrained per unit of the resource required constrained by a unit of the resource new product

Selling price of new product

Variable cost of the new + product

Appendix B29

Pricing New Products

Matrix, Inc. is planning to introduce a new product WR6000. The variable cost of production is $30 per unit and requires six minutes of constrained machine time per unit. What is the minimum selling price Matrix should charge for product WR6000?

Appendix B30

Pricing New Products

The first step is to recognize that the price of WR6000 must cover its $30 variable cost per unit.

Selling price of new product

$30

Amount of the Opportunity cost constrained per unit of the resource required constrained by a unit of the resource new product

Appendix B31

Pricing New Products

The second step is to recognize that producing WR6000 will require displacing production of RX200, VB30, or SQ500.

Since RX200 has the lowest profitability index of $3 per minute it should be displaced first.

Appendix B32

Pricing New Products

The third step is to compute the opportunity cost per unit associated with displacing production of RX200 ($18 per unit).

Selling price of new product

$30

$3 per minute

6 minutes per unit

Appendix B33

Pricing New Products

The fourth step is to add the variable cost per unit ($30) to the opportunity cost per unit ($18) to arrive at the minimum selling price ($48).

$48

$30

$3 per minute

6 minutes per unit

Appendix B34

End of Appendix B