PROFITABILITY, ALTERNATIVE
INVESTMENTS AND REPLACEMENTS
Chapter#10
WHAT IS PROFITABILITY
• The word profitability is used as the general term for the measure of the amount of
profit that can be obtained from a given situation. Profitability, therefore, is the
common denominator for all business activities.
• Before capital is invested in a project or enterprise, it is necessary to know how
much profit can be obtained and whether or not it might be more advantageous to
invest the capital in another form of enterprise.
• Thus, the determination and analysis of profits obtainable from the investment of
capital and the choice of the best investment among various alternatives are major
goals of an economic analysis.
• There are many reasons why capital investments are made. Sometimes, the
purpose is merely to supply a service which cannot possibly yield a monetary
profit, such as the provision of recreation facilities for free use of employees.
• The profitability for this type of venture cannot be expressed on a positive
numerical basis. The design engineer, however, usually deals with investments
which are expected to yield a tangible profit.
• Because profits and costs are considered which will occur in the future, the
possibilities of inflation or deflation affecting future profits and costs must be
recognized.
Profitability Standards
• In the process of making an investment decision, the profits anticipated from the
investment of funds should be considered in terms of a minimum profitability
standard.
• This profitability standard, which can normally be expressed on a direct numerical
basis, must be weighed against the overall judgment evaluation for the project in
making the final decision as to whether or not the project should be undertaken.
• The judgment evaluation must be based on the recognition that a quantified
profitability standard can serve only as a guide. Thus, it must be recognized that
the profit evaluation is based on a prediction of future results so that assumptions
are necessarily included.
• Many intangible factors, such as future changes in demand or prices, possibility of
operational failure, or premature obsolescence, cannot be quantized.
• It is in areas of this type that judgment becomes critical in making a final
investment decision.
• A primary factor in the judgment decision is the consideration of possible
alternatives. For example, the alternatives to continuing the operation of an
existing plant may be to replace it with a more efficient plant, to discontinue the
operation entirely, or to make modifications in the existing plant. In reaching the
final decision, the alternatives should be considered two at a time on a mutually
exclusive basis.
BASES FOR EVALUATING PROJECT PROFITABILITY
• Total profit alone cannot be used as the deciding profitability factor in
determining if an investment should be made. The profit goal of a company is to
maximize income above the cost of the capital which must be invested to generate
the income.
• If the goal were merely to maximize profits, any investment would be accepted
which would give a profit, no matter how low the return or how great the cost.
• For example, suppose that two equally sound investments can be made. One of
these requires $100,000 of capital and will yield a profit of $lO,OOO/year, and the
second requires $1 million of capital and will yield $25,0OO/year. The second
investment gives a greater yearly profit than the first, but the annual rate of return
on the second investment is only
($25,000/$1,000,000) x (100) = 2.5 percent
• The basic aim of a profitability analysis is to give a measure of the attractiveness
of the project for comparison to other possible courses of action. It is, therefore,
very important to consider the exact purpose of a profitability analysis before the
standard reference or base case is chosen.
• If the purpose is merely to present the total profitability of a given project, a
simple statement of total profit per year or annual rate of return may be
satisfactory.
• On the other hand, if the purpose is to permit comparison of several different
projects in which capital might be invested, the method of analysis should be such
that all cases are on the same basis so that direct comparison can be made among
the appropriate alternatives.
Mathematical Methods for Profitability Evaluation
• Rate of return on investment
• Discounted cash flow based on full-life performance
• Net present worth
• Capitalized costs
• Payout period
Each of these methods has its advantages and disadvantages, and much has been
written on the virtue of the various methods.
Rate of Return of Investment
• In engineering economic studies, rate of return on investment is ordinarily
expressed on an annual percentage basis. The yearly profit divided by the total
initial investment necessary represents the fractional return, and this fraction times
100 is the standard percent return on investment.
• Profit is defined as the difference between income and expense. Therefore, profit
is a function of the quantity of goods or services produced and the selling price.
• The amount of profit is also affected by the economic efficiency of the operation,
and increased profits can be obtained by use of effective methods which reduce
operating expenses.
• To determine the profit, estimates must be made of direct production costs, fixed
charges including depreciation, plant overhead costs, and general expenses.
• Profits may be expressed on a before-tax or after-tax basis, but the conditions
should be indicated. Both working capital and fixed capital should be considered
in determining the total investment.
Rates incorporating minimum profits as an
expense
• Another method which is sometimes used for reporting rate of return is based on
the assumption that it must be possible to obtain a certain minimum profit or
return from an investment before the necessary capital outlay will be desirable.
• This minimum profit is included as a fictitious expense along with the other
standard expenses. When return on investment is determined in this manner, the
result shows the risk earning rate, and represents the return over and above that
necessary to make the capital expenditure advisable.
• If the return is zero or larger, the investment will be attractive. This method is
sometimes designated as return bused on capital recovery with minimum profit.
• Example 10.1 and other Methods are from BOOK.
(Page 301 from book and page 315 from pdf)
