## 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