Appendix B

Profitability Analysis

Solutions to Questions
B-1 Absolute profitability measures the impact on overall profits of adding or dropping a particular segment, such as a product or customer, without making any other changes. B-2 Relative profitability involves ranking segments, each of which may be absolutely profitable, for the purpose of making trade-offs among the segments. Such trade-offs are necessary when a constraint exists. Otherwise, they are not necessary. B-3 very business that seeks to maximi!e profits has a constraint. "o business ever has had or ever will have infinite profits. #hatever prevents a business from attaining more profits is its constraint. $he constraint might be a production constraint, it might be managerial time or talent, or it might be some internal policy that prevents the firm from progressing, but every profit-seeking organi!ation faces at least one constraint. $he same is true for almost all nonprofit organi!ations, which generally seek more of something%be it more health care, more land preserved from development, more art, or some other ob&ective. B-4 $he absolute profitability of a segment is measured by the difference between the incremental revenues from the segment and the incremental 'avoidable( costs of the segment. )onse*uently, to measure absolute profitability, one would need the . , $he -c.raw-/ill )ompanies, +nc., 0121. All rights reserved. 020 -anagerial Accounting, 23th dition incremental revenues and costs of the segment. B-5 $he relative profitability of a segment is measured by the profitability index, which is computed by dividing the incremental profit from the segment by the amount of the constrained resource re*uired by the segment. )onse*uently, to measure relative profitability, one would need the incremental profit from the segment and the amount of the constrained resource re*uired by the segment. B-6 A volume trade-off decision involves trading off units of one product for another. +n such decisions fixed costs are usually irrelevant and the products can be ranked by dividing their unit contribution margins by the amount of the constrained resource re*uired by one unit of the product. B-7 $he selling price of a new product should at least cover its variable costs and opportunity costs. $he opportunity costs can be determined by multiplying the opportunity cost per unit of the constrained resource by the amount of the constrained resource re*uired by a unit of the new product. +n addition, the selling price should cover any avoidable fixed costs of the product. xactly how much of the avoidable fixed costs should be covered by each unit is difficult to determine a priori because the future unit sales volume of a product is not known with certainty.

Exercise B-1 '31 minutes( 2. $his exercise can be solved by first computing the profitability index of each new ride and then ranking the rides based on that profitability index4 Safety Enginee Net r Time Present Require Value d (A) (B) 52,067,01 381 1 52,2:0,11 361 1 568;,611 301 5688,211 2;1 5:81,111 0:1 5:3;,011 261 5860,111 221 58:9,011 361 5813,011 271 5379,:11 0:1

Ride 2..... Ride 0..... Ride Ride Ride Ride Ride Ride Ride Ride 3..... 8..... :..... 6..... 9..... 7..... ;..... 21. . .

Profitabili ty Inde (A) ! (B) 53,931 53,011 50,131 53,3;1 50,261 53,391 58,011 52,091 50,081 52,::1 "umulati #e Amount of Safety Engineer Time Required 221 8:1 681 711 2,261 2,381 2,:;1 2,;21 0,261
-anagerial Accounting, 23th dition

Ride Ride Ride Ride Ride Ride Ride Ride Ride

023

9..... 2..... 8..... 6..... 0..... ;..... :..... 3..... 21. . .

Profitabili ty Inde 58,011 53,931 53,3;1 53,391 53,011 50,081 50,261 50,131 52,::1

Safety Enginee r Time Require d 221 381 2;1 261 361 271 0:1 301 0:1

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Ride 7.....

52,091

361

0,:01

.iven the 2,:;1 hours of safety engineer time available, the seven rides above the line in the above table should be built.

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Exercise B-1 'continued( 0. $he total net present value for the seven new rides to be built is computed as follows4 Ride 9...... Ride 2...... Ride 8...... Ride 6...... Ride 0...... Ride ;...... Ride :...... 5 860,11 1 2,067,01 1 688,211 :3;,011 2,2:0,11 1 813,011 :81,11 1 5:,117,9 11

"otes4 'a( =oth the safety engineer>s time and the individual pro&ects would have to be #ery carefully scheduled to make sure that all pro&ects are completed on time. #e have assumed that the 2,:;1 hours of available safety engineer time does not include hours that have been set aside as a buffer to provide protection from inevitable disruptions in the schedule. 'b( +f the cumulative amount of safety engineer time re*uired did not exactly consume the total amount of time available, some ad&ustment might be re*uired in which pro&ects are accepted to ensure that the best plan is selected.

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Exercise B-2 '31 minutes( 2. $here is not enough capacity in the bottleneck operation to satisfy demand for all four products. $he total amount of time available in the bottleneck operation is 2,711 hours, but 0,911 hours would be re*uired to satisfy demand as shown below4 Adironda $% Annual demand in units 'a(. . 71 /ours re*uired in the bottleneck operation per unit 'b(............................. : $otal hours re*uired in the bottleneck operation 'a( ? 'b(........................... 811 &a%e 'uron 201 8 871 (ysterma n Voyageur 211 281 9 911 7 2,201 0,911 Total

0. $he profitability index should be used to rank the products. Adironda $% 587: : 5;9 &a%e 'uron 5067 8 569 (ysterma n Voyageur 537: 5611 9 5:: 7 59:

@nit contribution margin 'a( /ours re*uired in the bottleneck operation per unit 'b(............................ <rofitability index 'a( A 'b(. .

$he most profitable use of the bottleneck operation 'the constraint( is the Adirondack model, followed by the Boyageur model and then the Cake /uron and Oysterman models. =ecause no fixed costs would be affected by this decision, the optimal plan would be4

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Exercise B-2 'continued( Amount of constrained resource available............ Cess4 )onstrained resource re*uired for production of 71 units of the Adirondack model Remaining constrained resource available............ Cess4 )onstrained resource re*uired for production of 281 units of the Boyageur model. Remaining constrained resource available............ Cess4 )onstrained resource re*uired for production of 91 units of the Cake /uron model Remaining constrained resource available............ 2,711 hours 811 hours 2,811 hours 2,201 hours 071 hours 071 hours 1 hours

3. $he total contribution margin under the above plan would be 5282,:614 Adironda $% 587: 71 537,71 1 &a%e 'uron 5067 91 527,961 (ysterma n Voyageur 537: 5611 1 281 578,11 51 1 Total 5282,: 61

@nit contribution margin 'a(. Optimal production plan 'b(. $otal contribution margin 'a( ? 'b(.............................

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Exercise B-3 '21 minutes( $he selling price of the new praline cappuccino product should at least cover its variable cost and its opportunity cost. $he variable cost of the new product is 51.31 and its opportunity cost can be computed by multiplying the opportunity cost of 50.91 per minute of order filling time by the amount of time re*uired to fill an order for the new product4 Selling price of Bariable cost of D the new product the new product Amount of the constrained Opportunity cost per unit of the ? resource re*uired by a unit constrained resource of the new product Selling price of 51.31 D the new product 81 seconds 50.91 per minute ? 61 seconds per minute

Selling price of 51.31 D 50.91 per minute ? 0E3 minute ( ) the new product Selling price of 51.31 D 52.71 F 50.21 the new product /ence, the selling price of the new product should at least cover both its variable cost of 51.31 and its opportunity cost of 52.71, for a total of 50.21.

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Problem B-4 '61 minutes( 2. $here is not enough kiln capacity to satisfy demand for all four products. $he total amount of time available is 0,111 hours, but 0,611 hours would be re*uired to satisfy demand as shown below4 Tradition al Bri$% ;1 7 "inde Te ture r Roman d )a$ing Blo$% Bri$% 221 7 211 8 201 :

Annual demand in pallets 'a(......... /ours re*uired in the drying kiln per pallet 'b(.... $otal hours re*uired in the drying kiln 'a( ? 'b(...........

Total

901

771

811

611

0,611

0. $he profitability index should be used to rank the products. Tradition al Bri$% 5890 7 5:; "inde Te ture r Roman d )a$ing Blo$% Bri$% 5630 7 59; 5396 8 5;8 5881 : 577

)ontribution margin per pallet 'a(.......... /ours re*uired in drying kiln per pallet 'b(................ <rofitability index 'a( A 'b(.................

$he most profitable use of the bottleneck operation 'the constraint( is the )inder =lock product, followed by the Roman =rick product and then the $extured Gacing and $raditional =rick products. =ecause no fixed costs would be affected by this decision, the optimal plan would be4

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Problem B-4 'continued( Amount of constrained resource available....................................... Cess4 )onstrained resource re*uired for production of 211 pallets of )inder =lock.................................. Remaining constrained resource available....................................... Cess4 )onstrained resource re*uired for production of 201 pallets of Roman =rick.................................. Remaining constrained resource available....................................... Cess4 )onstrained resource re*uired for production of 221 pallets of $extured Gacing............................. Remaining constrained resource available....................................... Cess4 )onstrained resource re*uired for production of 2: pallets of $raditional =rick............................. Remaining constrained resource available....................................... 0,111 hours 811 hours 2,611 hours 611 hours 2,111 hours 771 hours 201 hours 201 hours 1 hours

3. $he total contribution margin under the above plan would be 5269,1114 Tradition al Bri$% 5890 2: Te ture d )a$ing 5630 221 56;,:0 1 "inder Blo$% 5396 211 Roman Bri$% 5881 201 5269,1 11 Total

)ontribution margin per pallet 'a(.... Optimal production plan 'b(...... $otal contributio n margin 'a( ? 'b(.....

59,171

539,61 5:0,71 1 1

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8. $he company should be willing to pay up to 5:; per hour to operate the kiln until demand is satisfied for traditional bricks.

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Problem B-4 'continued( :. $he selling price for the new product should at least cover its variable cost and opportunity cost4 Selling price of Bariable cost of D the new product the new product Amount of the constrained Opportunity cost per unit of the ? resource re*uired by a unit constrained resource of the new product Selling price of 5701 D 5:; per hour ? 21 hours ( ) the new product F 5701 D 5:;1 F 52,821 6. Salespersons who are paid a commission of :H of gross revenues will naturally prefer to sell a customer a pallet of anything other than cinder blocks because they have the lowest gross revenues. /owever, given the company>s constraint, they are in fact the company>s most profitable product. $he rankings of the products in terms of their gross sales and profitability indexes are given below4 Tradition al Bri$% 59:6 3 5:; 8 "inde Te ture r Roman d )a$ing Blo$% Bri$% 52,3:6 2 59; 3 5:7; 8 5;8 2 57:9 0 577 0

.ross revenues per pallet...................... Ranking based on gross revenues....... <rofitability index....... Ranking based on profitability index...

$o align the salespersons> incentives with the interests of the company, the salespersons should be compensated based on the profitability index of the products sold or on the total contribution margin generated by the sales.

, $he -c.raw-/ill )ompanies, +nc., 0121. All rights reserved. Solutions -anual, <rofitability Analysis Appendix 000

Problem B-5 '8: minutes( 2. $he relative profitability of segments should be measured by the profitability index as follows4 <rofitability indexF +ncremental profit from the segment Amount of the constrained resource used by the segment

/owever, the hospital measures profitability using the following ratio4 <rofitabilityF Segment margin Segment revenue

$he segment margin 'i.e., revenue less fully allocated costs( should not be used in the numerator when measuring profitability because it does not represent the incremental profit from the segment. $he incremental profit from a segment is its revenue less its a#oidable costs. Gully allocated costs include avoidable costs plus other costs that are not avoidable, but are nevertheless allocated to the segment. $hese unavoidable costs are completely irrelevant when considering the profitability of a segment because they would be unaffected even if the segment were eliminated. +ncluding unavoidable costs in the numerator of the profitability measure distorts the measure and may result in incorrect rankings of the segments. 0. +t is appropriate to use the segment revenue in the denominator of the profitability measure only if total re#enue is t*e organi+ation,s $onstraint. +n that case, the revenue of the segment would be the amount of the constrained resource used by the segment. Otherwise, segment revenue should not be used as the denominator when measuring the relative profitability of segments. #hen would total revenue be the organi!ation>s constraintI +n truth, it is difficult to imagine situations in which total revenue would be the constraint. One possibility is that the organi!ation>s customers have a fixed total budget for spending on the organi!ation>s products and services and the
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organi!ation has excess productive capacity. +n that case, total revenue would indeed be the organi!ation>s constraint. /owever, this situation would rarely arise.

, $he -c.raw-/ill )ompanies, +nc., 0121. All rights reserved. Solutions -anual, <rofitability Analysis Appendix 008

Problem B-5 'continued( Other situations might arise in which total revenue is the organi!ation>s constraint, but ordinarily the constraint would not be revenue. +nstead, the constraint would be something like a particular production process or a critical input. )onse*uently, it is almost always the case that relative profitability should not be measured using segment revenues in the denominator.

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Problem B-6 '61 minutes( 2. $his problem can be solved by first computing the profitability index of each customer and then ranking the customers based on that profitability index4 Regina, s Time Require d (B) : 9 3 : 3 8 6 8 : 7 Regina, s Time Require d : 3 9 8 3 : 6 7 8 :

In$rement al Profit "ustomer (A) Afonso. . . . 52;: )arloni.... 50:; )ullins..... 521: Grese....... 5291 .erst....... 5229 Jelovich. . . 5208 Klarr........ 52;0 -elby...... 5288 Rideau.... 52:1 $owner.... 50:6

Profitabili ty Inde (A) ! (B) 53; 539 53: 538 53; 532 530 536 531 530 "umulati#e Amount of Regina,s Time Required : 7 2: 2; 00 09 33 82 8: :1

"ustomer Afonso. . . . .erst....... )arloni.... -elby...... )ullins..... Grese....... Klarr........ $owner.... Jelovich. . . Rideau....

Profitabili ty Inde 53; 53; 539 536 53: 538 530 530 532 531

.iven that Regina should not be asked to work more than 09 hours, the four customers below the line in the above table should be told that their reservations have to be cancelled.
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Problem B-6 'continued( 0. $he total profit on wedding cakes for the weekend after canceling the four reservations would be4 Afonso..... .erst....... )arloni..... -elby...... )ullins..... Grese....... $otal........ 52;: 229 0:; 288 21: 291 5;;1

"otes4 =oth Regina>s time and the cakes would have to be #ery carefully scheduled to make sure that all cakes are completed on time. #e have assumed that the 09 hours of Regina>s time that are available for cake decorating do not include hours that have been set aside as a buffer to provide protection from inevitable disruptions in the schedule. +f the cumulative amount of Regina>s time re*uired for the cakes did not exactly consume the total amount of time available, some ad&ustment might be re*uired in which reservations are cancelled to ensure that the most profitable plan is selected. 3. $o avoid disappointing customers, reservations should probably not be accepted for any particular week after 09 hours of Regina>s time have been committed for that week>s cakes. $o ensure that only the most profitable cake reservations are accepted, a reservation for any cake with a profitability index of less than 538 should probably not be accepted. $his was the cutoff point for the cakes in the first week in June. $his cutoff may need to be ad&usted upward or downward over time%the cakes that were reserved for the first week in June may not be representative of the cakes that would be reserved for other weeks. +f too many reservations are turned down and Regina>s time is not fully utili!ed, then the cutoff should be ad&usted downward. +f too few reservations are turned down and Regina>s time is once again overbooked or profitable cake orders are turned away, then the cutoff should be ad&usted
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upward.

, $he -c.raw-/ill )ompanies, +nc., 0121. All rights reserved. Solutions -anual, <rofitability Analysis Appendix 007

Problem B-6 'continued( 8. -s. $herau should consider changing the way prices are set so that they include a charge for Regina>s time. On average, the prices may be the same, but they should be based not only on the si!e of the cakes, but also on the amount of cake decorating that the customer desires. $he charge for Regina>s time should be her hourly rate of pay 'including any fringe benefits( plus the opportunity cost of at least 538 per hour. =ecause Regina will not be working more than 09 hours per week, if another cake reservation is accepted, some other cake reservation will have to be cancelled. -s. $herau would have to give up at least 538 profit per hour to accept another cake reservation. :. -aking Regina happy involves not asking her to work more than 09 hours per week decorating cakes. -aking customers happy involves not canceling their reservations, not raising prices, and providing top *uality wedding cakes. -s. $herau can accomplish both of these ob&ectives and increase her profits by clever management of the constraint%Regina>s time. $he possibilities include4 -s. $herau should make sure that none of Regina>s time is wasted on unnecessary tasks. Gor example, Regina should not be asked to cream butter by hand for frostings if a machine could do the &ob as well with less labor time. -s. $herau should make sure that none of Regina>s time is wasted on tasks that can be done by other persons. Gor example, an assistant can be assigned to prepare frosting and to clean up, relieving Regina of those tasks. As long as the cost of the assistant>s time is less than 538 per hour, the result will be higher profits and more pleased customers. -s. $herau should consider assigning an apprentice to Regina. $he apprentice could relieve Regina of some of her workload while learning the skills to eventually expand the company>s cake decorating capacity. -s. $herau might consider subcontracting some of the less demanding cake decorating to another baker. $his would be profitable as long as the charge is less than 538 per hour.
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Problem B-7 '31 minutes( 2. $he constraint is customer representatives> time and the incremental profit is revenues less cost of drugs sold and customer service costs. &eaf$rest P*arma$y 5090,6:1 022,891 21,681 5 :1,:81 2;1 hours 5066 per hour Pro#iden$e 'ospital P*arma$y 50,;87,901 0,038,871 98,811 5 63;,781 2,081 hours 5:26 per hour -adison "lini$ P*arma$y 52,8:8,77 1 2,22;,881 80,111 5 0;3,88 1 :61 hours 5:08 per hour .en%ins P*arma$y 52::,071 22:,;01 8,871 5 38,771 71 hours 5836 per hour

$otal revenues....................... )ost of drugs sold................. )ustomer service costs......... +ncremental profit 'a(............ )ustomer representative time 'b(................................. <rofitability index 'a( A 'b(....

$he -adison )linic <harmacy is the most profitable of the customers, followed by the <rovidence /ospital <harmacy, the Jenkins <harmacy, and lastly the Ceafcrest <harmacy. 0. $he company could certainly afford to pay its customer representatives more in order to retain them. $he company makes at least 5066 in incremental profit per hour of customer representative time after taking into account their current wages and commissions. Another way of putting this is that losing 'and failing to replace( a customer representative who works 81 hours per week for :1 weeks a year costs the company between 5:30,111 '5066 per hour ? 0,111 hours per year( and 52,187,111 '5:08 per hour ? 0,111 hours per year( per year in lost profits.
, $he -c.raw-/ill )ompanies, +nc., 0121. All rights reserved. Solutions -anual, <rofitability Analysis Appendix 031

Case B-8 '8: minutes( Bectra>s management is not contemplating adding or dropping productsL it simply wants to redirect salespersons> efforts toward the more profitable products. $herefore, this is a volume trade-off decision and the appropriate way to measure profitability is with the profitability index4 @nit contribution margin <rofitability index for F a volume trade-off decision Amount of the constrained resource used by one unit $he unit contribution margin is the selling price of a product less sales commissions and the cost of sales, which is a variable cost in this company. $he operating expenses are all fixed. Selling price - Sales commission - )ost of sales <rofitability index for F a volume trade-off decision Amount of the constrained resource used by one unit $he case states that management wants Mto redirect the effort of salespersons towards the more profitable products.N $herefore, the constraint must be the effort of salespersons. @nfortunately, there is no direct measure of the amount of salespersons> effort re*uired to sell a unit of each product. /owever, all other things e*ual, if one product has twice the sales commission per unit as another, then we can expect salespersons to exert twice as much effort selling the first product. ffort is likely to be proportional to commissions. $herefore, given the limited amount of available information, the best measure of relative profitability for purposes of redirecting salespersons> efforts would be4 Selling price - Sales commission - )ost of sales <rofitability index for F a volume trade-off decision Sales commission

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Case B-8 'continued( "ote that this profitability index takes into account the salespersons> natural inclinations to focus their efforts on the products with the highest sales commissions. Of course, it would be an even better idea to change the salespersons> compensation scheme, but this alternative was ruled out in the case.

, $he -c.raw-/ill )ompanies, +nc., 0121. All rights reserved. Solutions -anual, <rofitability Analysis Appendix 030