1. 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 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Appendix B-22 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.

3. Appendix B-33 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.

4. Appendix B-44 Learning Objective 1 Compute the profitability index and use it to select from among possible actions.

5. Appendix B-55 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.

6. Appendix B-66 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.

7. Appendix B-77 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.

8. Appendix B-88 Profitability Index Management of Matrix, Inc. developed the following information concerning its two segments:

9. Appendix B-99 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

10. Appendix B-1010 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

11. Appendix B-1111 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

12. Appendix B-1212 Quality Kitchen Design – An Example

13. Appendix B-1313 Quality Kitchen Design – An Example If management only has 46 hours available, which projects should be accepted?

14. Appendix B-1414 Ranking Based on Profitability Index

15. Appendix B-1515 Ranking Based on Profitability Index The optimal profit

16. Appendix B-1616 Learning Objective 2 Compute and use the profitability index in volume trade-off decisions.

17. Appendix B-1717 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.

18. Appendix B-1818 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.

19. Appendix B-1919 Volume Trade-Off Decisions – An Example Matrix, Inc. produces the following three products:

20. Appendix B-2020 Volume Trade-Off Decisions – An Example Matrix, Inc. produces the following three products: A total of 2,700 minutes

21. Appendix B-2121 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

22. Appendix B-2222 First we calculate the profitability index for each product. Most profitable Next most profitable Volume Trade-Off Decisions – An Example

23. Appendix B-2323 Volume Trade-Off Decisions – An Example Next we prepare the optimal production plan.

24. Appendix B-2424 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.

25. Appendix B-2525 Learning Objective 3 Compute and use the profitability index in other business decisions.

26. Appendix B-2626 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

27. Appendix B-2727 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.

28. Appendix B-2828 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 ≥ ≥ + + × ×

29. Appendix B-2929 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?

30. Appendix B-3030 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.

31. Appendix B-3131 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.

32. Appendix B-3232 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).

33. Appendix B-3333 $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).

34. Appendix B-3434 End of Appendix B