The company might decide to pursue this project instead of the new factory project because it is expected to generate more value per unit of investment. The profitability index helps rank projects because it lets investors quantify the value created per each investment unit. A profitability index of 1.0 is the lowest acceptable measure on the index. Mathematically, a value lower than one means the project’s present value (PV) is less than the initial investment. For example, if your revenue is $200,000 and your total expenses are $185,000, your net profit margin is 7.5%. Businesses with above-average net profit margins tend to be in good financial shape.

It is also known as the benefit-cost ratio or the profit investment ratio. The PI helps investors and managers to evaluate the attractiveness and efficiency of a project and to rank different projects based on their profitability. In this section, we will discuss the formula and assumptions of the PI and how to use it in practice.

What Is the Profitability Index (PI) Rule?

If we compare both of these formulas, they both will give the same result. However, both PIs are less than 1.0, so the company may forgo either project.

The PI can be used to rank and select projects based on their profitability and efficiency. A project with a PI greater than 1 indicates that it is profitable and has a positive NPV. A project with a PI less than 1 indicates that it is unprofitable and has a negative NPV. A project with a PI equal to 1 indicates that it is breakeven and has a zero NPV. The higher the PI, the more profitable and efficient the project is. Therefore, the PI can help managers to choose the best projects among a set of mutually exclusive or independent alternatives.

Accounting Ratios

The net present value analysis favors project 1 because its NPV number is bigger than project 2. But the profitability index indicates otherwise and says that project 2 with its higher PI value is a better opportunity than project 1. The profitability index, in fact, is another way of representing the net present value model. The only difference between two is that the NPV shows an absolute value whereas the PI measures the relative value in ratio format. As per the formula of the profitability index, it can be seen that the project will create an additional value of $1.003 for every $1 invested in the project.

1. Higher PI values indicate more attractive investments, helping prioritize resource allocation.
2. While the net present value gives us the absolute value that a project adds, it is wrong to compare the net present values of different investments directly.
3. The profitability index rule is a decision-making exercise that helps evaluate whether to proceed with a project.
4. Corporate charge cards with built-in spend controls are another way to manage expenses effectively.
5. The PI of the project is 1.44, which means that the project will generate a positive NPV of $43,881 and a return of 44% on the initial investment.
6. One of the limitations is that the PI does not take into account the size of the project or the initial investment.

How To Calculate Profitability Index

This eliminates unnecessary costs and ensures employee spending stays within budget. You can also customize the sheets to suit your needs – organizing your data by business units, applying conditional formatting to highlight low margins, or including graphs to visualize trends. These tools help you spot patterns quickly and take steps to improve profitability.

The NPV of Project A is positive, confirming that it is profitable and efficient. Since the NPV is negative, the project is not profitable and should be rejected. For example, if a project costs $1,000 and will return $1,200, it’s a « go. » Get new tipps on retirement savings, investment decisions and antifraud tipps. Since the PI is greater than 1, the project is considered profitable and worth pursuing.

Although not a perfect approach, profitability index goes a long way toward handling of capital rationing, if used with caution. N Enterprise has decided to invest in a project for which the initial investment would be $100 million. As they are considering whether it’s a good deal to invest in, they have found out that the present value of the future cash flow of this project is 130 million. The best thing about this index is that it allows businesses to compare between different projects whenever they require choosing one out of the other. The projects having more chances of generating profits is the project that the firms are likely to choose. At the beginning of the project, the initial investment required for the project is $10,000, and the discounting rate is 10%.

Ratio Calculators

The IRR is not a reliable indicator of profitability for project D, as formula for profitability index it does not reflect the timing of the cash flows. Therefore, the PI is a better measure of profitability than the IRR, as it accounts for the time value of money. The Profitability Index (PI) or profit investment ratio (PIR) is a widely used measure for evaluating viability and profitability of an investment project.

While the net present value gives us the absolute value that a project adds, it is wrong to compare the net present values of different investments directly. Let’s say there are two projects, A and B, each with initial investment outlay of $10 million and net present values of $2 million and $2.2 million respectively. It is wrong to conclude that Project B is better just because it has higher net present value. We need to calculate the net present value added by each project per $1 of initial investment i.e. their profitability index.

1. The IRR is not a reliable indicator of profitability for project D, as it does not reflect the timing of the cash flows.
2. Calculating the initial investment of a project is a crucial step in assessing its profitability.
3. Firms follow the profitability index rule to obtain ratios that depict returns with respect to each investment dollars.
4. However, even if the PI is widely used for doing cost-benefit analyses, it is not free of demerits.

For production-related costs like COGS, tools like automated vendor tracking and negotiation software help you identify inefficiencies and reduce duplication. Real-time expense tracking, such as the solutions Ramp offers, provides instant insights into spending patterns. Corporate charge cards with built-in spend controls are another way to manage expenses effectively. Instead of relying on manual expense reports, these cards let you set spending limits by category.