Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Appendix B Profitability Analysis

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-4 Learning Objective 1 Compute the profitability index and use it to select from among possible actions.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-7 Relative Profitability Profitability Index Incremental profit from the segment Amount of the constrained resources required by the segment = Incremental profit from the segment is the absolute profitability of the segment.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-8 Profitability Index Management of Matrix, Inc. developed the following information concerning its two segments:

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-9 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. From Chapter 14

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-10 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. From Chapter 14

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-11 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. From Chapter 14

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-12 Quality Kitchen Design: An Example

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-13 Quality Kitchen Design: An Example If management only has 46 hours available, which projects should be accepted?

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-14 Ranking Based on Profitability Index

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-15 Ranking Based on Profitability Index The optimal profit

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-16 Learning Objective 2 Compute and use the profitability index in volume trade-off decisions.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-17 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-18 Volume Trade-Off Decisions Profitability index for a volume trade-off decision Unit contribution margin Amount of the constrained resource required by one unit = 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-19 Volume Trade-Off Decisions – Example Matrix, Inc. produces the following three products:

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-20 Volume Trade-Off Decisions – Example Matrix, Inc. produces the following three products: A total of 2,700 minutes

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-21 Volume Trade-Off Decisions – Example Matrix, Inc. produces the following three products: A total of 2,700 minutes If only 2,200 minutes of machine constraint time are available, which products should be produced in what quantities?

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-22 First we calculate the profitability index for each product. Most profitable Next most profitable Volume Trade-Off Decisions – Example

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-23 Volume Trade-Off Decisions – Example Next we prepare the optimal production plan.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-24 Maximum contribution is $8,600 per week. Volume Trade-Off Decisions – Example Last, we compute the total contribution margin earned under the optimal production plan.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-25 Learning Objective 3 Compute and use the profitability index in other business decisions.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-26 Sales Commissions Sales commissions are based on gross selling price. If you were a salesperson at Matrix, which product would you prefer to sell? RX200

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-27 Sales Commissions 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-28 Pricing New Products The price of a new product should cover at least 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 Opportunity cost per unit of the constrained resource Amount of the constrained resource required by a unit of the new product ≥≥++××

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-29 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?

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-30 Pricing New Products Selling price of new product $30 Opportunity cost per unit of the constrained resource Amount of the constrained resource required by a unit of the new product ≥≥++×× The first step is to recognize that the price of WR6000 must cover its $30 variable cost per unit.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-31 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.

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-32 Pricing New Products Selling price of new product $30 ≥≥++×× The third step is to compute the opportunity cost per unit associated with displacing production of RX200 ($18 per unit). $3 per minute 6 minutes per unit

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-33 Pricing New Products $30 ≥≥++×× 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). $3 per minute 6 minutes per unit $48

Copyright © 2008, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin B-34 End of Appendix B