Appendix B: Profitability Analysis

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.

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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 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 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 ProfitabilityProfitability indexIncremental profit from the segmentAmount of the constrained resources required by the segment=Incremental profit from the segment is the absolute profitability of the segment.Project Profitability IndexProject profitability indexNet present value of the projectAmount 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 13Project Profitability IndexThe net present value of the project goes in the numerator since it represents the incremental profit from the segment.Project profitability indexNet present value of the projectAmount of investment required by the project=From Chapter 13Project Profitability IndexThe investment funds are the constraint, so the amount of investment required by a project goes in the denominator.Project profitability indexNet present value of the projectAmount of investment required by the project=From Chapter 13Quality Kitchen Design – An ExampleQuality Kitchen Design – An ExampleIf management only 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 index for a volume trade-off decisionUnit 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 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 price of new productVariable cost of the new productOpportunity cost per unit of the constrained resourceAmount of the constrained resource required by a unit of the new product≥+×End of Appendix B
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