1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Profitability Analysis Appendix B McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. AppB-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.

3. AppB-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.

4. AppB-4 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.

5. AppB-5 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.

6. AppB-6 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.

7. AppB-7 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 13

8. AppB-8 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.

9. AppB-9 Volume Trade-Off Decisions – An Example Matrix, Inc. produces the following three products: A total of 2,700 minutes

10. AppB-10 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

11. AppB-11 First, we calculate the profitability index for each product. Most profitable Next most profitable Volume Trade-Off Decisions – An Example

12. AppB-12 Volume Trade-Off Decisions – An Example Next, we prepare the optimal production plan.

13. AppB-13 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.

14. AppB-14 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 ≥ ≥ + + × ×

15. AppB-15 End of Appendix B