© 2012 McGraw-Hill Education (Asia) Profitability Analysis Appendix B

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 4 Learning Objective 1 Compute the profitability index and use it to select from among possible actions.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 8 Profitability Index Management of Matrix, Inc. developed the following information concerning its two segments:

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 9 Project Profitability Index 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

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 10 Project Profitability Index The net present value of the project goes in the numerator since it represents the incremental profit from the segment. Project profitability index Net present value of the project Amount of investment required by the project = From Chapter 14

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 11 Project Profitability Index The investment funds are the constraint, so the amount of investment required by a project goes in the denominator. Project profitability index Net present value of the project Amount of investment required by the project = From Chapter 14

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 12 Quality Kitchen Design – An Example

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 13 Quality Kitchen Design – An Example If management only has 46 hours available, which projects should be accepted?

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 14 Ranking Based on Profitability Index

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 15 Ranking Based on Profitability Index The optimal profit

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 16 Learning Objective 2 Compute and use the profitability index in volume trade-off decisions.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 19 Volume Trade-Off Decisions – An Example Matrix, Inc. produces the following three products:

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 20 Volume Trade-Off Decisions – An Example Matrix, Inc. produces the following three products: A total of 2,700 minutes

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 21 Volume Trade-Off Decisions – An Example Matrix, Inc. produces the following three products: If only 2,200 minutes of machine constraint time are available, which products should be produced in what quantities? A total of 2,700 minutes

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 22 First we calculate the profitability index for each product. Most profitable Next most profitable Volume Trade-Off Decisions – An Example

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 23 Volume Trade-Off Decisions – An Example Next we prepare the optimal production plan.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 24 Maximum contribution is $8,600 per week. Volume Trade-Off Decisions – An Example Last, we compute the total contribution margin earned under the optimal production plan.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 25 Learning Objective 3 Compute and use the profitability index in other business decisions.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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 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 ≥ ≥ + + × ×

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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?

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 30 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 ≥ ≥ + + × × Pricing New Products The first step is to recognize that the price of WR6000 must cover its $30 variable cost per unit.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 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.

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 32 Selling price of new product $30 $3 per minute 6 minutes per unit ≥ ≥ + + × × Pricing New Products The third step is to compute the opportunity cost per unit associated with displacing production of RX200 ($18 per unit).

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 33 $48 $30 $3 per minute 6 minutes per unit ≥ ≥ + + × × 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).

McGraw-Hill Education (Asia) Garrison, Noreen, Brewer, Cheng & Yuen Slide 34 End of Appendix B