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Profitability Analysis

 Profitability analysis basically measures the performance of the firm against

acceptable standards – it can be as per the requirement of the management to
SCMPE assist them in identification of critical success factors and to take appropriate
decisions

Case Studies Strategic Profitability Analysis:

Operating income is analysed through three main areas/components
Topic – Chapter 10  Growth component: Change in profit due to change in quantity sold
 Price recovery component: Change in profit due to changes in prices of
outputs as well as inputs
 Productivity component: Change in profits due to change in product mix
and/or yield of inputs

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Profitability Analysis through ABC Direct Product Profitability

 ABC system helps in tracing overheads to products/services with its
emphasis on activities and their cost drivers
 Cost is accurately measured and hence ABC is helpful in providing more
useful information to management
Direct Product Profitability:
 DPP is one of the methods to analyze the profitability for each product or
segment of products – DPP is primarily used in retail sector
 DPP can help in knowing the relative profitability of individual products so
that management can concentrate on profitable products and weed-out loss-
making products
 Benefits of DPP: Better cost analysis + Better pricing decisions + Better
management of stores and warehouse space + rationalization of
product range
Direct Product Profitability Statement:
 Profit = Selling price – Purchase cost – Indirect costs
 Indirect costs: Overhead cost (cost not directly linked to a particular
product) + Volume related cost (Cost related to space occupied by
products ~ storage and transportation) + Product batch cost (cost
incurred on stocking items in shelves) + Inventory financing cost
(interest cost on inventory)

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Customer Profitability Analysis
 It is similar to DPP. However in this case profitability is computed for
different customers/segments/groups – Service organizations such as
bank or hotel need to cost customers
 Benefits: Helps in identification of which customers are eroding
profitability and which are contributing to it + Basis for constructive
dialogue between buyer and seller to improve margins
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ABM
 Cost Driver Analysis: Cost driver is basically the factor that cause activities to
be performed – Cost driver analysis can help in improving the cost-
effectiveness of activities and cost management through ABM – For example:
Lack of training to employees could be the reason for slow processing of
customer invoices
 Activity Analysis: Activity analysis helps in identification of value-added and
non-value added activities
 Performance Analysis: Organization should focus on significant activities for
performance analysis – We should measure the performance of activities
(comparison of actual versus expected) – this can help in knowing how well
the improvement efforts are working and is an integral part of continuous
improvement
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Activity-based cost management
[ABM]
 ABM basically utilizes cost information gathered through ABC – It
focuses on managing activities – it determines what drives the activities
and how these activities can be improved to increase profitability
 Objective is to manage costly activities with the goal of reducing costs
and improving quality
 ABM involves cost driver analysis, activity analysis and performance
analysis
Value-added and non-value added
activities
 Value-added activities are those which are unavoidable in order to
complete the process – customers are willing to pay for these services
 Non-value added activities are those which are not valued by internal
or external customer – this is a waste and should be avoided –
customers are not willing to pay for these
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Manufacturing cycle efficiency
 Process time = Time taken to convert input into output
 Inspection time = time spent on confirming if the product is of high quality
 Waiting time = Time that raw material/WIP waiting for the next operation
 Storage time = Amount of time inventory is in stock
 Delivery cycle time = Gap between receipt of order and delivery of goods
 Manufacturing cycle time = Production time required per unit
 MCE = (Processing time)/(Processing time + Inspection time + waiting time +
Movement time + Storage time)
 Velocity = Number of units produced in a given time
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Business Applications of ABM
 Activity based budgeting: Framework for identifying amount of resources
needed for budgeted activity level – Actual results can be compared with
budget to identify activities with major discrepancies and then use this for
continuous improvement
 BPR: Business process consists of set of linked activities – ABM can help in
BPR by measuring performance + determining cost of output + identify
opportunity to improve process efficiency and effectiveness
 Benchmarking: Comparing ABC derived activity cost of one segment with
other segments
 Performance measurement: Focus on measuring the efficiency and
effectiveness of activities relating to cost, time, quality and innovation
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Business Applications of ABM
 Goal of ABM = Satisfy customer needs with few resources
 Customer needs = Lower costs + Higher quality + Faster response time
+ Greater innovation
 Uses of ABM in business applications = Cost reduction + Activity
based budgeting + Business process re-engineering + Benchmarking +
Performance measurement
 Cost reduction: ABM helps in identifying and quantifying process
waste and help in continuous improvement through continuous cost
reduction
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Steps for implementing ABM
 Identify important issues and what information is needed to address those
issues
 Top management support for identifying critical needs
 Incorporate ABC method in financial reporting process
 Actual users of ABM should be part of implementation team
 Existing information system should support input requirements
 Integrate ABC into main costing system – if this is not feasible then we should
develop a separate system
 Implement ABM
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Benefits of ABM
 Excellent basis and focus on cost reduction
 Helps in implementation of Activity based budgeting
 Clear understanding of underlying causes of business processing costs
 Excellent basis for effectiveness of management decision making
 Identify key process waste elements, permit management prioritisation and
leverage of key resources
ABC versus ABM:
 ABC basically focus on finding accurate cost of product – ABM is a broader
concept and it focuses on using ABC data for better management of activities
leading to continuous improvement
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Activity Flexible Budgeting
 Prediction of required activity levels as output changes – making it
flexible with change in output
 This will help in doing variance analysis and also enhances ability to
manage activities
 It is different from traditional flexible budgets. Under traditional
flexible budgets, the cost varies with a single cost driver (output) –
however here we have different activities and each will have a separate
cost driver
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Activity Based Budgeting
 Planning and controlling the expected activities to derive a cost-
effective budget that meets required goals
 Key elements: Type of work/activity to be performed + Quantity of
work/activity to be performed + Cost of work/activity to be performed
 ABB works well with Activity based costing system – ABB improves
the accuracy of forecasts
 It can also help in cost reduction through elimination of wasteful
activities
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ABC – Decision making tool
 Complement to TQM: Provides data that can help in tracking the financial impact of
improvements implemented as part of TQM
 Significant advantage for wholesale distributors: Helps in decision
addition/deletion of product line
 Facility and resource expansion: ABC can help in knowing the need for expansion
based on activity demand – It will help in tracking whether the specified cost benefits
are achieved as expected post expansion
 Decision support for human resources: Ability to generate information about
employee/revenue ratios, productivity data through automation – this can help in
deciding on hr expansion/outsourcing
 Cost plus markup method: Fix accurate pricing if company follows cost plus mark-up
method
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LMN [Question No.16]
Issues in performance management system:
 Arbitrary allocation of head office costs + No control on head office
expenses or its efficiency
 Transfer price imposed by head office
 Limited control over investment – investment beyond 1,00,000 need
approval
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PQ [Question No.20]
Allocation and absorption of costs:
 Traditional system: Overheads absorbed by OAR – OAR based on
single based – normally labour hours or machine hours
 ABC – Cost allocated to various activities – Compute cost driver rate
for every activity and then absorb overheads to products
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Advantages of ABC
 Understanding the cause of various expenses
 We can identify expenses incurred by divisional actions and hence it
would be easy to allocate them to branches
 Profitability improvement by finding the cause of cost and then looking
at reducing the costs
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Benefits of ABC
 Identification of activities causing costs
 Implementation of Direct product profitability
 Implementation of customer profitability analysis
 Better decision based on profitability analysis of products/customers
 Cost reduction and profitability improvement
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XYZ Ornamental Company [Question
ANCA Limited [Question No.26]
No.24]
Activity based cost management (ABM):  Volume contribution vs profit contribution
 ABM refers to cost management application of ABC  Discount analysis
 Focus on efficient and effective management of activities – improve value
received by customers – improve strategic and operational decisions  Overhead cost contribution
 Operational ABM – Increase efficiency, lower cost, improve revenues –  Contribution per unit analysis
improve value added activities and remove non-value added activities  Profit per unit analysis
 Strategic ABM – Determine which products are to be manufactured –
activities are to be used
 ABM can be used to improve operations and obtain useful activity
information

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ST [Question No.31] Golden East Limited [Question No.33]
Profitability improvement:
Benefits of Customer Profitability Analysis:  Order processing costs
 Passing on additional support cost due to customer behaviour in the  Customer visit costs
price being charged  Ordinary deliveries
 Speed deliveries
 Advising customers to change behaviour especially in relation to
List of service organizations where CPA can be used:
urgent deliveries
 Financial institutions, hospitality services, professional services, Hospitals and
 Making changes in operations to reduce cost of activities Logistics & freight companies
Benefits of CPA:
 Identification of true profitability
 Constructive dialogue between buyer and seller to improve margins

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Jawahar Stationery Mart [Question
No.34]
 Operative CRM – Focuses on recording of individual transactions by
operational teams – improve staff efficiency to deal with customers
 Analytical CRM – Analyses the data created on operational side of the
CRM for evaluation and prediction of customer behaviour
 Collaborative CRM – information about customer must seamlessly flow
throughout the supply chain – collaborative effort by all departments to
improve the quality of service provided
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6-Twelve [Question No.36]
Advantages of Activity Based Budgeting:
 Better estimation of support activities and support costs
 Better identification of resource needs
 Clearer linking of costs with staff responsibilities
 Identification of budgetary slack
Kaizen Costing:
 Benefits: Pressure on managers to innovate and reduce costs
 Limitations: Focus on minor incremental improvements – however
improvement can also occur due to fluctuation in processes/ supplier
networks/customer interaction – hence company should focus on both small
and these type of improvements