Profitability Analysis Appendix B: Profitability Analysis Perhaps more than any other information, managers would like to know the profitability of their products, customers, and other business segments. Accordingly, this appendix provides a coherent framework for measuring profitability. It distinguishes between absolute profitability and relative profitability. Appendix B McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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. 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. For example, if Coca Cola were considering closing down its operations in the African country of Zimbabwe, managers would be interested in the absolute profitability of those operations. App B-2

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. For an existing segment, compare the revenues that would be lost from dropping the segment to the costs that would be avoided. For a potential new segment, compare the additional revenues from adding the segment to the additional costs that would be incurred. In practice, figuring out what costs would change and what costs would not change if a segment were dropped or added can be very difficult. Activity-based costing can be helpful in this regard, but care must be exercised to ensure that a given cost will really change. For examples of the measurement of absolute profitability see: “Decentralization and Segment Reporting” in Chapter 12. “Adding and Dropping Product Lines and Other Segments” in Chapter 13. App B-3

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. Relative profitability is concerned with ranking products, customers, and other business segments to determine which should be emphasized. App B-4

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. Managers are interested in ranking segments if a constraint forces them to make trade-offs among the segments. In the absence of a constraint, all segments that are absolutely profitable should be pursued. App B-5

Relative Profitability Incremental profit from the segment is the absolute profitability of the segment. Profitability index Incremental profit from the segment Amount of the constrained resources required by the segment = In general, the profitability of segments should be measured by the profitability index as shown. Notice that the term “incremental profit from the segment” in the numerator of this equation is synonymous with the absolute profitability of the segment. App B-6

Profitability Index Management of Matrix, Inc. developed the following information concerning its two segments: Part I. Matrix, Inc. has two segments, A and B. Each segment earns an incremental profit and has the constraint requirements as shown. Part II. The profitability indexes for Segments A ($1,000 per hour) and B ($500 per hour) suggest that Segment A makes a more profitable use of the constraining resource than Segment B. App B-7

Project Profitability Index From Chapter 14 Project profitability index Net present value of the project Amount of investment required by the project = We have already encountered examples of the profitability index in previous chapters. For example, in Chapter 14, the project profitability index was defined as shown. The project profitability index is used when a company has more long-term projects with positive net present values than it can fund. The project profitability index is used when a company has more long-term projects with positive net present values than it can fund. App B-8

Project Profitability Index From Chapter 14 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. The net present value of the project goes in the numerator since it represents the incremental profit from the segment. App B-9

Project Profitability Index From Chapter 14 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.   The investment funds are the constraint, so the amount of investment required by a project goes in the denominator. App B-10

Quality Kitchen Design – An Example Assume that management of Quality Kitchen Design is considering ten short-term projects with incremental profits, constraint requirements, and profitability indexes as shown. Notice that if all ten projects were accepted, they would require a total of 100 hours. App B-11

Quality Kitchen Design – An Example If management only has 46 hours available, which projects should be accepted? If management only has 46 hours available, which projects should be accepted? App B-12

Ranking Based on Profitability Index The optimal profit of $32,930 is the sum of the incremental profits of each project accepted within the 46-hour constraint. The optimal profit App B-13

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. Volume trade-off decisions need to be made when a company must produce less than the market demands of some products due to the existence of a constraint. App B-14

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. Profitability index for a volume trade-off decision Unit contribution margin Amount of the constrained resource required by one unit = When volume trade-off decisions need to be made and fixed costs are irrelevant, the profitability index takes the special form as shown. Notice that this equation mirrors the “contribution margin per unit of the “constrained resource” concept that was introduced in Chapter 13. App B-15

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 ≥ + × 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 (this approach assumes that fixed cost remain unchanged). In equation form, the minimum selling price is computed as shown. App B-16

End of Appendix B End of Appendix B. App B-17