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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
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

AppB-2

Absolute Profitability
Absolute profitability measures the impact on the
organizations overall profits of adding or dropping
a particular segment such as a product or
customer without making any other changes.

AppB-3

Computing Absolute Profitability


For
For an
an Existing
Existing Segment
Segment
Compare
Compare the
the revenues
revenues that
that would
would be
be lost
lost from
from
dropping
dropping that
that segment
segment to
to the
the costs
costs that
that
would
would be
be avoided.
avoided.
For
For aa New
New Segment
Segment
Compare
Compare the
the additional
additional revenues
revenues from
from adding
adding
that
that segment
segment to
to the
the costs
costs that
that would
would be
be incurred.
incurred.

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.

AppB-5

Relative Profitability
Managers
Managers are
are interested in
in ranking
ranking segments
segments ifif aa
constraint
constraint forces
forces them
them to
to make
make trade-offs
trade-offs among
among
segments.
segments.
In
In the
the absence
absence of
of aa constraint,
constraint, all
all segments
segments that
that are
are
absolutely
absolutely profitable should be pursued.

AppB-6

Relative Profitability
Incremental
Incremental profit
segment is
is
profit from
from the
the segment
the
the absolute
absolute profitability
profitability of
of the
the segment.
segment.

Incremental profit from the segment


Profitability
=
index
Amount of the constrained
resources required by the segment

AppB-7

Project Profitability Index


From Chapter 13

Project
profitability
index

Net present value of the project


Amount of investment
required by the project

The
project profitability
profitability index
index is
is used
used
The project
when
when aa company
company has
has more
long-term projects
projects
more long-term
with
with positive
positive net
net present
present values
values than
than itit can
can fund.
fund.

AppB-8

Volume Trade-Off Decisions


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

Profitability index
for a volume =
trade-off decision

Unit contribution margin


Amount of the constrained resource
required by one unit

AppB-9

Volume Trade-Off Decisions An


Example
Matrix, Inc. produces the following three products:

A total of 2,700 minutes

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

AppB-11

Volume Trade-Off Decisions An


Example
First, we calculate the profitability index for each product.

Most
Most profitable
profitable

Next
Next most
most
profitable
profitable

AppB-12

Volume Trade-Off Decisions An


Example
Next, we prepare the optimal production plan.

AppB-13

Volume Trade-Off Decisions An


Example
Last,
Last, we
we compute
compute the
the total
total contribution
contribution margin
margin
earned
earned under
under the
the optimal
optimal production
production plan.
plan.

Unit contribution margin


Production per week in units
Total contribution

RX200
$
15
200
$ 3,000

Products
VB30
$
10
400
$ 4,000

SQ500
$
16
100
$ 1,600

Maximum contribution is $8,600 per week.

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

Amount of the
Opportunity cost
constrained
per unit of the
resource required
constrained
by a unit of the
resource
new product

AppB-15

End of Appendix B

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