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Accounting: Profitability Analysis

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Accounting: Profitability Analysis

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Appendix B
Profitability Analysis
Solutions to Questions
B-1Absolute 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-2Relative 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-3Every 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-4The 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-5The 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 required by the segment. Consequently, to measure relative profitability, one would need the incremental profit from the segment and the amount of the constrained resource required by the segment. B-6A volume trade-off decision involves trading off units of one product for another. In such decisions fixed costs are usually irrelevant and the products can be ranked by dividing their unit...