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 © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Appendix B-2
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.
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 B-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
Segment B
$
100 hours
$
1,000
200,000
400 hours
$
500
Appendix B-9
Project Profitability Index
From Chapter 8
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 B-10
Project Profitability Index
From Chapter 8
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 B-11
Project Profitability Index
From Chapter 8
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 B-12
Learning Objective B-2
Compute and use the
profitability index in volume
trade-off decisions.
Appendix 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.
Appendix 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
=
for a volume
trade-off decision
Unit contribution margin
Amount of the constrained resource
required by one unit
Appendix B-15
Learning Objective B-3
Compute and use the
profitability index in other
business decisions.
Appendix B-16
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 B-17
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 B-18
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.
Selling price
of new
product
≥
Variable cost
of the new +
product
Amount of the
Opportunity cost
constrained
per unit of the
× resource required
constrained
by a unit of the
resource
new product
Appendix B-19
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 B-20
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 B-21
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 B-22
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 B-23
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 B-24
End of Appendix B