Appendix B

PROFITABILITY ANALYSIS

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA McGraw-Hill/Irwin

Copyright ÂŠ 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Appendix B-2 2

Absolute Profitability Absolute profitability measures the impact on the organizationâ€™s overall profits of adding or dropping a particular segment such as a product or customer â€“ without making any other changes.

Appendix B-3 3

Computing Absolute Profitability For For an an Existing Existing Segment Segment Compare Compare the the revenues revenues that that would would be be lost lost from from dropping dropping that that segment segment to to the the costs costs that that would would be be avoided. avoided. For For aa New New Segment Segment Compare Compare the the additional additional revenues revenues from from adding adding that that segment segment to to the the costs costs that that would would be be incurred. incurred.

Appendix B-4 4

Learning Objective 1

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

Appendix B-5 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 6

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

Appendix B-7 7

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

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

Appendix B-8 8

Profitability Index Management Management of of Matrix, Matrix, Inc. Inc. developed developed the the following following information information concerning concerning its its two two segments: segments: Segment A Incremental profit

$

Amount of constrained resource required

Incremental profit

100,000

$ 200,000

100 hours

400 hours

Segment A

Segment B

$

$

Amount of constrained resource required Profitability index

Segment B

100,000 100 hours

$

1,000

200,000 400 hours

$

500

Appendix B-9 9

Project Profitability Index From Chapter 14

Project profitability index

=

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

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

Appendix B-10 10

Project Profitability Index From Chapter 14

Project profitability index

=

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

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

Appendix B-11 11

Project Profitability Index From Chapter 14

Project profitability index

=

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

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

Appendix B-12 12

Quality Kitchen Design – An Example

Project A

Incremental Profit

Constrained Resource Required

(a)

(b)

$

Profitability Index (a) ÷ (b)

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 100 hours

980 per hour

Appendix B-13 13

Quality Kitchen Design – An Example

Project A

Incremental Profit

Constrained Resource Required

(a)

(b)

(a) ÷ (b)

9,180

17 hours

Project B

7,200

9 hours

800 per hour

Project C

7,040

16 hours

440 per hour

Project D Project E Project F Project G Project H

$

Profitability Index $

540 per hour

If management 8 hours 710 only has available,410 5,330 46 hours 13 hours 4,280 projects 4 hours which should 1,070 4,160 13 hours 320 be accepted? 3,720 12 hours 310 5,680

per hour per hour per hour per hour per hour

Project I

3,650

5 hours

730 per hour

Project J

2,940

3 hours 100 hours

980 per hour

Appendix B-14 14

Ranking Based on Profitability Index

Project F

Incremental Profit

Constrained Resource Required

Profitability Index

(a)

(b)

(a) รท (b)

$

4,280

4 hours

Project J

2,940

Project B

$

Cumulative Hours

Incremental Profit

1,070

4 hours

$

4,280

3 hours

980

7 hours

2,940

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

Project E

5,330

13 hours

410

75 hours

Project G

4,160

13 hours

320

88 hours

Project H

3,720

12 hours 100 hours

310

100 hours

Appendix B-15 15

Ranking Based on Profitability Index

Project F

Incremental Profit

Constrained Resource Required

Profitability Index

(a)

(b)

(a) รท (b)

$

4,280

4 hours

Project J

2,940

Project B

$

Cumulative Hours

Incremental Profit

1,070

4 hours

$

3 hours

980

7 hours

2,940

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 Project C

9,180 7,040

17 hours 16 hours

540 440

46 hours 62 hours

9,180 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 100 hours

310

100 hours

$

4,280

The optimal profit

Appendix B-16 16

Learning Objective 2

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

Appendix B-17 17

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

Appendix B-18 18

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

Profitability index for a volume = trade-off decision

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

Appendix B-19 19

Volume Trade-Off Decisions â€“ 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 B-20 20

Volume Trade-Off Decisions â€“ 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

RX200 Demand per week in units (a) Contrained resource required per unit (b) Total time required to meet demand (a) Ă— (b)

300 5 minutes 1,500 minutes

A total of 2,700 minutes

Products VB30 $ 10 400 2 minutes

Products VB30 400 2 minutes 800 minutes

SQ500 $ 16 100 4 minutes

SQ500 100 4 minutes 400 minutes

Appendix B-21 21

Volume Trade-Off Decisions â€“ An Example Matrix, Inc. produces the following three products: If only 2,200 minutes of machineProducts constraint RX200 VB30should SQ500 time are available, which products Unit contribution margin $ 15 $ 10 $ 16 be inproduced in what 300 quantities? Demand per week units 400 100 Contrained resource required per unit

5 minutes

RX200 Demand per week in units (a) Contrained resource required per unit (b) Total time required to meet demand (a) Ă— (b)

300 5 minutes 1,500 minutes

A total of 2,700 minutes

2 minutes

Products VB30 400 2 minutes 800 minutes

4 minutes

SQ500 100 4 minutes 400 minutes

Appendix B-22 22

Volume Trade-Off Decisions â€“ An Example First we calculate the profitability index for each product.

Products VB30

RX200 Contribution margin per unit (a) Contrained resource required per unit (b) Profitabiltiy index (a) Ăˇ (b)

$

15 5 minutes $3 per minute

$

10 2 minutes $5 per minute

Most Most profitable profitable

SQ500 $

16 4 minutes $4 per minute

Next Next most most profitable profitable

Appendix B-23 23

Volume Trade-Off Decisions â€“ 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 B-24 24

Volume Trade-Off Decisions â€“ An Example Last, Last, we we compute compute the the total total contribution contribution margin margin earned earned under under the the optimal optimal production production plan. plan.

Unit contribution margin Production per week in units Total contribution

RX200 $ 15 200 $ 3,000

Products VB30 $ 10 400 $ 4,000

SQ500 $ 16 100 $ 1,600

Maximum Maximum contribution contribution is is $8,600 $8,600 per per week. week.

Appendix B-25 25

Learning Objective 3

Compute and use the profitability index in other business decisions.

Appendix B-26 26

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) รท (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-27 27

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) รท (b) $ 3.00

Products VB30 $ 30 20 $ 10 2 minutes $ 5.00

SQ500 $ 35 19 $ 16 4 minutes $ 4.00

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

Appendix B-28 28

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

â‰Ľ

Variable cost of the new + product

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

Appendix B-29 29

Pricing New Products Matrix, Inc. is planning to introduce a new product â€“ 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-30 30

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

Selling price of new product

â‰Ľ

$30

+

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

Appendix B-31 31

Pricing New Products The The second second step step is is to to recognize that producing WR6000 WR6000 will will require require displacing displacing production production of of RX200, RX200, VB30, VB30, or or SQ500. SQ500. Since RX200 has the the lowest lowest profitability profitability index index of $3 per minute minute itit should should be be displaced displaced first. first.

Appendix B-32 32

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

Selling price of new product

â‰Ľ

$30

+

$3 per minute

Ă—

6 minutes per unit

Appendix B-33 33

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

$48

â‰Ľ

$30

+

$3 per minute

Ă—

6 minutes per unit

Appendix B-34 34

End of Appendix B

Advertisement