Appendix B: Profitability Analysis

Profitability AnalysisAppendix B Absolute ProfitabilityAbsolute 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 ProfitabilityFor an Existing SegmentCompare the revenues that would be lost fromdropping that segment to the costs that would be avoided.For a New SegmentCompare the additional revenues from addingthat segment to the costs that would be incurred.Relative ProfitabilityRelative profitability is concerned with ranking products, customers, and other business segments to determine which should be emphasized in an environment of scarce resources.Relative ProfitabilityManagers 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 ProfitabilityProfitabilityindexIncremental profit from the segmentAmount of the constrained resources required by the segment=Incremental profit from the segment isthe absolute profitability of the segment.Project Profitability IndexProjectprofitabilityindexNet present value of the projectAmount of investmentrequired 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 13Project Profitability IndexThe net present value of the project goes in the numerator since it represents the incremental profit from the segment.ProjectprofitabilityindexNet present value of the projectAmount of investmentrequired by the project=From Chapter 13Project Profitability IndexThe investment funds are theconstraint, so the amount of investmentrequired by a project goes in the denominator.ProjectprofitabilityindexNet present value of the projectAmount of investmentrequired by the project=From Chapter 13Quality Kitchen Design – An ExampleQuality Kitchen Design – An ExampleIf managementonly has 46 hours available,which projects should be accepted?Ranking Based on Profitability IndexOrganize projects from highest profitability index to lowest profitability index. There are only 48 hours available. Ranking Based on Profitability IndexThe optimal profitPursue these projects. Volume Trade-Off DecisionsVolume 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 DecisionsProfitability indexfor a volumetrade-off decisionUnit contribution marginAmount of the constrained resourcerequired 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 ProductsThe 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 priceof newproductVariable costof the newproductOpportunity costper unit of theconstrainedresourceAmount of theconstrainedresource requiredby a unit of thenew product≥+×End of Appendix B