Profit Comparison Method

Description of the method

As the name suggests, the profit comparison method (PCM) differs from the cost comparison method because it considers both the cost and revenues of investment projects. The target measure is the average profit, which is determined as the difference between revenues and costs. Apart from this difference, all of the other assumptions made in the CCM continue to apply for PCM.

Key Concept:

Absolute profitability is achieved if an investment project leads to a profit greater than zero.

Relative profitability is achieved if an investment project leads to a higher profit than the alternative investment project(s).

Example 2-2

The PCM is illustrated in the following example. A company has the choice between the following two investment projects A and B:

Data

Project A

Project B

Initial investment outlay (€)

180,000

200,000

Freight charges (€)

15,000

25,000

Set-up charges (€)

2,000

2,000

Economic life (years)

5

5

Liquidation value at the end of the economic life (€)

12,000

17,000

Other fixed costs (€ per year)

4,000

20,000

Production and sales volume

9,000

12,000

(units per year)

Sales price (€ per unit)

10

10

Variable costs (€ per unit)

2

1.90

Rate of interest (% per year)

6

6

Tab. 2-2: Data for the investment projects A and B (PCM)

Tab. 2-2: Data for the investment projects A and B (PCM)

To assess the absolute and relative profitability of the two investment projects, the projects' average revenues and costs must be determined. The annual revenues of projects A (RA) and B (RB) amount to:

ra = 9,000 units/year-€ 10/unit = €90,000 per year and

RB = 12,000 units/year •€ 10/unit = €120,000 per year.

The average cost can be determined in the same way as for the CCM approach described in Section 2.1. The amounts for each cost category, as well as the average total costs of projects A (CA) and B (CB), are shown in the following table:

Cost category (each in € per year)

Project A

Project B

Depreciation

37,000

42,000

Interest

6,270

7,320

Other fixed costs

4,000

20,000

Variable costs

18,000

22,800

Total costs

65,270

92,120

Tab. 2-3: Cost categories for the investment projects A and B (PCM)

The average profits for alternatives A (PA) and B (PB) amount to:

PA = ra - CA = €90,000/year - €65,270/year = €24,730 per year

PB = RB - CB = €120,000/year - €92,120/year = €27,880 per year

Both investment projects achieve absolute profitability, since they earn a positive profit. Project B achieves relative profitability because of its higher average profit.

Assessment of the method

The PCM acknowledges the fact that different investment opportunities (projects) lead to different revenues. Thus, the method has a wider range of use than the CCM. However, its application may be restricted by the fact that it is impossible to allocate revenues to some investment projects; in these cases the CCM has to be used. Apart from this difference, both methods have broadly the same strengths and weaknesses. Therefore the corresponding earlier assessment of the CCM applies equally to the PCM.

The next section introduces an analysis method that differs from the CCM and PCM in regard to the assumptions it makes about differences in capital tie-ups between competing investment projects.

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Responses

  • mathew
    What are the methods of comparing profitability in investment?
    2 months ago

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