Accounting

Accounting

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 Every business that seeks to maximize profits has a constraint. No business ever has had or ever will have infinite profits. Whatever prevents a business from attaining more profits is its constraint. The 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 organization faces at least one constraint. The same is true for almost all nonprofit organizations, which generally seek more of something—be it more health care, more land preserved from development, more art, or some other objective.

B-4 The 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. Consequently, to measure absolute profitability, one would need the incremental revenues and costs of the segment.

B-5 The 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