Appendix B Homework The Optimal Profit 32930 Would Computed Shown

1

Appendix B

Lecture Notes

Main theme: Perhaps more than any other information,

managers would like to know the profitability of their

I. Absolute profitability

A. Key concepts

i. 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. For example:

ii. Computing absolute profitability

1. For an existing segment, compare the

2

328

5

2. For a potential new segment, compare the

3. In practice, figuring out what costs would

change and what costs would not change if a

segment were dropped or added can be very

difficult.

a. Activity-based costing can be helpful

in this regard, but care must be

exercised to ensure that a given cost

II. Relative profitability

Learning Objective 1: Compute the profitability index

and use it to select from among possible actions.

A. Key concepts

3

4

329

7

ii. Managers are interested in ranking segments

if a constraint forces them to make trade-

offs among the segments.

iii. In general, the profitability of segments

should be measured by the profitability

index as shown. Notice:

B. Relative profitability: an example

i. Assume that Segments A and B earn the

incremental profit and have the constraint

requirements as shown.

C. The project profitability index

i. We have already encountered examples of the

profitability index in previous chapters. For

example, in Chapter 13, the project

profitability index was defined as shown.

9

6

330

14

3. The investment funds are the constraint,

so the amount of investment required by a

project goes in the denominator.

ii. Quality Kitchen Design: an example

1. Assume that management is considering ten

short-term projects with incremental

2. If management only has 46 hours

available, which projects should be

accepted?

a. The projects should be ranked as

shown using the project profitability

index. Notice:

11

13

17

20

III. Volume trade-off decisions

Learning Objective 2: Compute and use the

profitability index in volume trade-off decisions.

A. Key concepts

ii. In volume trade-off decisions where fixed

costs are irrelevant, the profitability index

takes the special form as shown. Notice:

B. Volume trade-off decisions: an example

i. Assume that a company makes three

products with unit contribution margins,

weekly demand, and machine constraint

requirements as shown.

19

16

332

23

26

1. The first step is to compute the profitability

index for each product as shown. Notice:

2. The second step is to compute the optimal

production plan as shown. Notice:

3. The third step is to compute the total

contribution margin earned under the

optimal plan ($8,600) as shown. Notice:

a. There is no other combination of

production that will earn a higher total

contribution.

IV. Managerial implications

Learning Objective 3: Compute and use the

profitability index in other business decisions.

A. Other applications of the profitability index

i. Sales commissions

24

25

28

27

a. If salespersons are paid commissions

based on sales, they will try hardest to

sell RX200 (unit selling price = $40).

ii. Pricing new products

1. The price of a new product should at least

cover the variable cost of producing it plus

the opportunity cost of displacing the

2. For purposes of illustration, assume that the

company mentioned in the prior example

has designed a new product, WR6000, with

a variable cost per unit and constraint

requirements as shown. What is the

minimum price that should be charged

for this new product?

29

26

30

(1). Since RX200 has the lowest

profitability index of $3 per

minute it should be displaced

first.