Profitability Analysis
Appendix B
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Absolute Profitability
Absolute profitability measures the impact on the
organization’s overall profits of adding or dropping
a particular segment such as a product or
customer – without making any other changes.
App B-2
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.
App B-3
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.
App B-4
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.
App B-5
Relative Profitability
Incremental profit from the segment is
the absolute profitability of the segment.
Profitability Incremental profit from the segment
=
index Amount of the constrained
resources required by the segment
App B-6
Profitability Index
Management of Matrix, Inc. developed the following
information concerning its two segments:
Segment A Segment B
Incremental profit $ 100,000 $ 200,000
Amount of constrained resource required 100 hours 400 hours
Segment A Segment B
Incremental profit $ 100,000 $ 200,000
Amount of constrained resource required 100 hours 400 hours
Profitability index $ 1,000 $ 500
App B-7
Project Profitability Index
From Chapter 14
Project Net present value of the project
profitability =
index 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.
App B-8
Project Profitability Index
From Chapter 14
Project Net present value of the project
profitability =
index 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.
App B-9
Project Profitability Index
From Chapter 14
Project Net present value of the project
profitability =
index 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.
App B-10
Quality Kitchen Design – An Example
Constrained
Incremental Resource
Profit Required Profitability Index
(a) (b) (a) ÷ (b)
Project A $ 9,180 17 hours $ 540 per hour
Project B 7,200 9 hours 800 per hour
Project C 7,040 16 hours 440 per hour
Project D 5,680 8 hours 710 per hour
Project E 5,330 13 hours 410 per hour
Project F 4,280 4 hours 1,070 per hour
Project G 4,160 13 hours 320 per hour
Project H 3,720 12 hours 310 per hour
Project I 3,650 5 hours 730 per hour
Project J 2,940 3 hours 980 per hour
100 hours
App B-11
Quality Kitchen Design – An Example
Constrained
Incremental Resource
Profit Required Profitability Index
(a) (b) (a) ÷ (b)
Project A $ 9,180 17 hours $ 540 per hour
Project B 7,200 9 hours 800 per hour
Project C 7,040 16 hours 440 per hour
Project D
If management
5,680 8 hours 710 per hour
Project E only has
5,330 46 hours available,410
13 hours per hour
Project F which
4,280 projects should 1,070
4 hours per hour
Project G 4,160 13 hours 320 per hour
be accepted?
Project H 3,720 12 hours 310 per hour
Project I 3,650 5 hours 730 per hour
Project J 2,940 3 hours 980 per hour
100 hours
App B-12
Ranking Based on Profitability Index
Constrained
Incremental Resource Profitability Cumulative Incremental
Profit Required Index Hours Profit
(a) (b) (a) ÷ (b)
Project F $ 4,280 4 hours $ 1,070 4 hours $ 4,280
Project J 2,940 3 hours 980 7 hours 2,940
Project B 7,200 9 hours 800 16 hours 7,200
Project I 3,650 5 hours 730 21 hours 3,650
Project D 5,680 8 hours 710 29 hours 5,680
Project A 9,180 17 hours 540 46 hours 9,180
Project C 7,040 16 hours 440 62 hours $ 32,930
Project E 5,330 13 hours 410 75 hours
Project G 4,160 13 hours 320 88 hours
Project H 3,720 12 hours 310 100 hours
100 hours
The optimal profit
App B-13
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.
App B-14
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 Unit contribution margin
for a volume = Amount of the constrained resource
trade-off decision required by one unit
App B-15
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
Selling price Variable cost constrained
per unit of the
of new ≥ of the new + constrained
× resource required
product product by a unit of the
resource
new product
App B-16
End of Appendix B
App B-17