Appendix B

1. Appendix B Profitability Analysis

2. 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.

3. Computing Absolute Profitability For 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.

4. Learning Objective 1 Compute the profitability index and use it to select from among possible actions.

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.

6. 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.

7. Incremental profit from the segment ProfitabilityIndex = Incremental profit from the segment isthe absolute profitability of the segment. Amount of the constrained resources required by the segment Relative Profitability

8. Profitability Index Management of Matrix, Inc. developed the following information concerning its two segments:

9. ProjectProfitabilityIndex Net present value of the project = Amount of investmentrequired by the project Project Profitability Index From Chapter 14 The project profitability index is used when a company has more long-term projects with positive net present values than it can fund.

10. ProjectProfitabilityIndex Net present value of the project = Amount of investmentrequired by the project Project Profitability Index From Chapter 14 The net present value of the project goes in the numerator since it represents the incremental profit from the segment.

11. ProjectProfitabilityIndex Net present value of the project = Amount of investmentrequired by the project Project Profitability Index From Chapter 14 The investment funds are theconstraint, so the amount of investmentrequired by a project goes in the denominator.

12. Quality Kitchen Design: An Example

13. Quality Kitchen Design: An Example If managementonly has 46 hours available,which projects should be accepted?

14. Ranking Based on Profitability Index

15. The optimal profit Ranking Based on Profitability Index

16. Learning Objective 2 Compute and use the profitability index in volume trade-off decisions.

17. 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.

18. Profitability indexfor a volumetrade-off decision Unit contribution marginAmount of the constrained resourcerequired by one unit = 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.

19. Volume Trade-Off Decisions – Example Matrix, Inc. produces the following three products:

20. Volume Trade-Off Decisions – Example Matrix, Inc. produces the following three products: A total of 2,700 minutes

21. Volume Trade-Off Decisions – Example Matrix, Inc. produces the following three products: If only 2,200 minutes of machine constrainttime are available, which products shouldbe produced in what quantities? A total of 2,700 minutes

22. Most profitable Next mostprofitable Volume Trade-Off Decisions – Example First we calculate the profitability index for each product.

23. Volume Trade-Off Decisions – Example Next we prepare the optimal production plan.

24. Volume Trade-Off Decisions – Example Last, we compute the total contribution marginearned under the optimal production plan. Maximum contribution is $8,600 per week.

25. Learning Objective 3 Compute and use the profitability index in other business decisions.

26. Sales Commissions Sales commissions are based on gross selling price. If you were a salesperson at Matrix, which product would you prefer to sell? RX200

27. Sales Commissions However, RX200 is the least profitable product,given the current machine constraint. It might bea better idea to base sales commissions on theprofitability index for each product.

28. Amount of theconstrainedresource requiredby a unit of thenew product Opportunity costper unit of theconstrainedresource Selling priceof newproduct Variable costof the newproduct ≥ + × Pricing New Products The price of a new product should cover at least the variable cost of producing it plus the opportunity cost of displacing the production of existing products to make it.

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?

30. Amount of theconstrainedresource requiredby a unit of thenew product Opportunity costper unit of theconstrainedresource Selling priceof newproduct $30 ≥ + × Pricing New Products The first step is to recognize that the price ofWR6000 must cover its $30 variable cost per unit.

31. Pricing New Products The second step is to recognize that producing WR6000 will require displacing production of RX200, VB30, or SQ500. Since RX200 has the lowest profitability indexof $3 per minute it should be displaced first.

32. Selling priceof newproduct $30 ≥ + × Pricing New Products The third step is to compute the opportunity cost per unit associated with displacing production of RX200 ($18 per unit). $3perminute 6minutesper unit

33. Pricing New Products The fourth step is to add the variable cost per unit ($30) to the opportunity cost per unit ($18) to arrive at the minimum selling price ($48). $3perminute 6minutesper unit $30 $48 ≥ + ×

34. End of Appendix B