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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
Copyright2012byTheMcGrawHillCompanies,Inc.Allrightsreserved.
Appendix B-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.
Appendix B-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 toto 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.
Appendix B-4

Learning Objective 1

Compute the profitability


index and use it to select
from among possible
actions.
Appendix B-5

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.
Appendix B-6

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 ofof aa constraint,
constraint, all
all segments
segments that
that are
are
absolutely
absolutely profitable should be pursued.
Appendix B-7

Relative Profitability

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

Profitability Incremental profit from the segment


=
index Amount of the constrained
resources required by the segment
Appendix B-8

Profitability Index
Management
Management of of Matrix,
Matrix, Inc.
Inc. developed
developed the
the following
following
information
information concerning
concerning its
its two
two segments:
segments:
Appendix B-9

Project Profitability Index


From Chapter 13

Project Net present value of the project


profitability =
index Amount of investment
required by the project

The
The project
project profitability
profitability index
index is
is used
used
when
when aa company
company hashas more
more long-term
long-term projects
projects
with
with positive
positive net
net present
present values
values than
than itit can
can fund.
fund.
Appendix B-
10

Project Profitability Index


From Chapter 13

Project Net present value of the project


profitability =
index Amount of investment
required by the project

The
The net
net present
present value
value ofof the
the project
project
goes
goes inin the
the numerator
numerator since
since itit represents
represents
the
the incremental
incremental profit
profit from
from the
the segment.
segment.
Appendix B-
11

Project Profitability Index


From Chapter 13

Project Net present value of the project


profitability =
index Amount of investment
required by the project

The
The investment
investment funds
funds areare the
the
constraint,
constraint, soso the
the amount
amount of of investment
investment
required
required by
by aa project
project goes
goes in
in the
the denominator.
denominator.
Appendix B-
12

Quality Kitchen Design An Example


Appendix B-
13

Quality Kitchen Design An Example

If management
only has 46 hours available,
which projects should
be accepted?
Appendix B-
14

Ranking Based on Profitability Index


Appendix B-
15

Ranking Based on Profitability Index

The optimal profit


Appendix B-
16

Learning Objective 2

Compute and use the


profitability index in
volume trade-off
decisions.
Appendix B-
17

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 lessless 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.
Appendix B-
18

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 lessless 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 Unit contribution margin


for a volume = Amount of the constrained resource
trade-off decision required by one unit
Appendix B-
19

Volume Trade-Off Decisions An


Example
Matrix, Inc. produces the following three products:
Appendix B-
20

Volume Trade-Off Decisions An


Example
Matrix, Inc. produces the following three products:

A total of 2,700 minutes


Appendix B-
21

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


Appendix B-
22

Volume Trade-Off Decisions An


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

Next
Next most
most
Most
Most profitable
profitable profitable
profitable
Appendix B-
23

Volume Trade-Off Decisions An


Example
Next, we prepare the optimal production plan.
Appendix B-
24

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.

Products
RX200 VB30 SQ500
Unit contribution margin $ 15 $ 10 $ 16
Production per week in units 200 400 100
Total contribution $ 3,000 $ 4,000 $ 1,600

Maximum contribution is $8,600 per week.


Appendix B-
25

Learning Objective 3

Compute and use the


profitability index in
other business decisions.
Appendix B-
26

Sales Commissions
Products
RX200 VB30 SQ500
Unit selling price $ 40 $ 30 $ 35
Unit variable cost 25 20 19
Unit contribution margin (a) $ 15 $ 10 $ 16
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Profitability index per minute (a) (b) $ 3.00 $ 5.00 $ 4.00

Sales commissions are based on gross selling


price. If you were a salesperson at Matrix, which
product would you prefer to sell?

RX200
Appendix B-
27

Sales Commissions
Products
RX200 VB30 SQ500
Unit selling price $ 40 $ 30 $ 35
Unit variable cost 25 20 19
Unit contribution margin (a) $ 15 $ 10 $ 16
Contrained resource required per unit (b) 5 minutes 2 minutes 4 minutes
Profitability index per minute (a) (b) $ 3.00 $ 5.00 $ 4.00

However,
However, RX200
RX200 is is the
the least
least profitable
profitable product,
product,
given
given the
the current
current machine
machine constraint.
constraint. ItIt might
might be
be
a better idea
idea to base sales
sales commissions
commissions on on the
the
profitability
profitability index
index for
for each
each product.
Appendix B-
28

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.

Amount of the
Opportunity cost
Selling price Variable cost constrained
per unit of the
of new of the new + constrained
resource required
product product by a unit of the
resource
new product
Appendix B-
29

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?
Appendix B-
30

Pricing New Products


The
The first
first step
step is
is to
to recognize
recognize that
that the
the price
price of
of
WR6000
WR6000 must
must cover
cover its
its $30
$30 variable
variable cost
cost per
per unit.
unit.

Amount of the
Opportunity cost
Selling price constrained
per unit of the
of new $30 + constrained
resource required
product by a unit of the
resource
new product
Appendix B-
31

Pricing New Products


The
The second
second step
step is
is to
to recognize that producing
WR6000
WR6000 will
will require
require displacing
displacing production
production of
of
RX200,
RX200, VB30,
VB30, oror SQ500.
SQ500.

Since RX200 has thethe lowest


lowest profitability
profitability index
index
of $3 per minute
minute itit should
should be
be displaced
displaced first.
first.
Appendix B-
32

Pricing New Products


The
The third
third step
step is
is to
to compute
compute the
the opportunity
opportunity cost
cost per
per unit
unit
associated
associated with
with displacing
displacing production
production of
of RX200
RX200 ($18
($18 per
per unit).
unit).

Selling price
$3 6
of new $30 + per minutes
product
minute per unit
Appendix B-
33

Pricing New Products


The
The fourth
fourth step
step is
is to
to add
add the
the variable
variable cost
cost per
per unit
unit ($30)
($30) to
to the
the
opportunity
opportunity cost
cost per
per unit
unit ($18)
($18) to
to arrive
arrive at
at the
the minimum
minimum selling
selling
price
price ($48).
($48).

$3 6
$48 $30 + per minutes
minute per unit
Appendix B-
34

End of Appendix B