Profitability Index Method: Definition & Calculations

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  • 0:04 Is It Worth It?
  • 0:56 The Profitability Index
  • 1:35 Interpreting Results
  • 2:20 Examples of…
  • 3:47 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Ever wish there was an easy way to quickly calculate if a business endeavor was worth your time and resources? The profitability index method gives you just such a way to quickly check the nature of a project.

Is It Worth It?

As the owner of a small business, you're constantly faced with the prospect of having to make the best possible decisions for your organization. Some of these are pretty easy to make. After all, if a customer is knocked out by one of your employees for no reason, it's probably a good idea to fire that employee. Likewise, if a customer tries to steal your most expensive goods, then it's probably a good idea to file criminal charges against that individual. However, not every business decision is as clear-cut as those are. Sometimes, people who really want to see a decision come to fruition, may try to sugarcoat it in an attempt to make sure you make the call that they want to hear. Luckily, you have a secret weapon. By using the profitability index, business managers can quickly see if a decision will provide a profit, and thus be worth their time, or will fail to break even and thus should be avoided.

The Profitability Index

At the core, the profitability index is just a fraction. The profitability index is equal to the present value of future cash flows divided by the cost of the investment. Present value of future cash flows simply means the money that you expect to make from the investment. Of course, initial investment refers to the money that you have to put down to make that money.

Sometimes, you'll see another formula in which the net present value of the cash is instead used. All this refers to is that the cost of the investment is subtracted from the future cash flows. From there, it's divided by the initial investment. This is then added to one, to allow the following interpretations to still make sense.

Interpreting Results

Three possible outcomes are possible with the profitability index. The first of these is that the number you get is less than one. If this is the case, then you should avoid the investment! This is because the investment will cost more money than it will make back. In other words, it is a waste of money. The second outcome is that the number is equal to one. In this case, you'll absolutely break even - you won't lose money, but you won't make money either. However, the most desirable outcome is to have a number larger than one. This means that the new investment will actually make money, since the cash flow increases relative to the cost of the investment. In this case, you absolutely should put money towards this new investment. To not do so would be to just let money flow down the drain!

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