1. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 11 th Edition Appendix B

2. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Profitability Analysis Appendix B

3. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

4. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

5. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Relative Profitability Key Concepts Relative profitability is concerned with ranking products, customers, and other business segments to determine which should be emphasized in an environment of scarce resources.

6. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Relative Profitability Key Concepts 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.

7. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Profitability Index Incremental profit from the segment Amount of the constrained resources required by the segment = Key Concepts In general, the profitability of segments should be measured by the profitability index.

8. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Relative Profitability Here is information developed by the management of Matrix, Inc. concerning its two segments:

9. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The 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.

10. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Project Profitability Index The project profitability index is used when a company has more long-term projects with positive net present values than it can fund. 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.

11. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Project Profitability Index The project profitability index is used when a company has more long-term project with positive net present values than it can fund. 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.

12. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Project Profitability Index The management of Quality Kitchen Design is considering ten projects with incremental profits, constraint requirements, and profitability indexes as shown here. If all projects were accepted they would require a total of 100 hours.

13. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Project Profitability Index If the management of Quality Kitchen Design only has 46 hours available, which projects should be accepted?

14. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Ranking Based on Profitability Index

15. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Ranking Based on Profitability Index The optimal plan

16. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

17. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Trade-Off Decisions Profitability index for a volume trade-off decision Unit contribution margin Amount of the constrained resource required by one unit. = In volume trade-off decisions where fixed costs are irrelevant, the profitability index takes the special form shown below:

18. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Trade-Off Decisions Matrix, Inc. produces the following three products: We have been provided with information about the unit contribution margin, weekly demand, and constrained resource required per unit for its three products.

19. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Trade-Off Decisions Given the assumption of the previous screen, satisfying demand for all three products would require 2,700 minutes of constraint time. Here is how we calculate the 2,700 minutes of weekly demand of machine time. 2,700 minutes

20. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Trade-Off Decisions If only 2,200 minutes of machine constraint time are available, which products should be produced in what quantities?

21. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Volume Trade-Off Decisions Most profitable Next most profitable The first step is to compute the profitability index for each product as shown below.

22. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Optimal Plan

23. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Optimal Plan Optimal contribution is $8,600 per week.

24. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Managerial Implications Other applications of the profitability index include: 1.Sales commissions, 2.Pricing new products.

25. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Sales Commissions Matrix has assigned the following selling price to its three products: If sales persons are paid commissions based on sales, they will try hardest to sell RX200, with its unit selling price of $40.

26. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

27. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 ≥≥++××

28. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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?

29. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Pricing New Products The first step is to recognize that the price of WR6000, our new product, must cover its $30 variable cost per unit.

30. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

31. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Pricing New Products The third step is to compute the opportunity cost per unit associated with displacing production of RX200. ($3 per minute × 6 minutes) = $18 per unit

32. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Pricing New Products The fourth, and final, step is to add the variable cost per unit of our new product, WR6000, to the opportunity cost per unit we just calculated to arrive at the minimum selling price. Selling price ≥≥ $30 + ($3 per minute × 6 minutes) = $48 per unit

33. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Appendix B