Appendix B: Profitability analysis. This appendix provides a coherent framework for measuring profitability, bringing together relevant materials from several chapters. After studying this appendix you should have a firm grasp of the principles underlying profitability analysis. The first step is to distinguish between absolute profitability and relative profitability. | Profitability Analysis Appendix B 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. 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. 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 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. 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. 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 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 13 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 13 Quality Kitchen Design – An Example Quality Kitchen Design – An Example If management only has 46 hours available, which projects should be accepted? Ranking Based on Profitability Index Organize projects from highest profitability index to lowest profitability index. There are only 48 hours available. Ranking Based on Profitability Index The optimal profit Pursue these projects. 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 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. 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 ≥ + × End of Appendix B
