Segment Margin

Amount of net profit or net loss generated by a segment of a business

In an organization with centralized management, the managers have less freedom to make decisions. In a centralized organization, decision-making is a controlled activity that is well directed and coordinated from the top.

Segment Margin

On the contrary, an organization with decentralized management has decision-making capacities spread out at different levels of the organization.

The managers at different levels have the authority to make decisions profitable to the organization. These levels are called responsibility centers and strategic business units (SBUs).

The most common responsibility centers are cost centers, profit centers, revenue centers, and investment centers. Each of these centers has its functions and responsibilities, with its managers leading its activities.

These SBUs have their costs, expenses, revenues, profits, and investments. And they are divided based on the responsibility the managers undertake.

Since these business units are within the same organization but are away from direct surveillance, they have their reporting segments to measure their profitability and productivity.

The performance and profitability of these units are measured to ensure that they align with the organization's goals, objectives, and strategies. 

This segment's performance evaluation aids the owners in evaluating not only a business unit's performance but also the manager's ability to direct and redirect specific measures.

Margin

Managers of profit and revenue centers are most likely to use segment margin for the purpose of evaluation.

A manager's ability to control specific factors, monitor all the uncontrollable factors and understand revenue and cost drivers are evaluated. This is done to ensure that this contributes toward organizational goals, objectives, and strategic decisions. 

These SBUs are entities/operating units within the giant corporation and are assessed using

  • The Contribution Margin (CM),

This assessment helps the organization understand the individual segment's/unit's profit contribution tied to overall profitability, the company's strategy, and objectives.

Reporting segments are portions of the business that are divided to report. A segment can be a product line, geographical area, or any other meaningful division provided.

Segment Margin Formula

It is the amount of net profit or net loss generated by a segment of a business.

Calculator

It is useful to track this margin to learn which segments/SBUs of the organization are performing better or need attention to convert them into profitable ones.

The analysis is also helpful in determining where to invest extra funds in a business. But, the measurement is of little use for smaller organizations since they are not large enough to have many business segments.

Money

Segment margin calculation starts with the segment's contribution margin. A segment's contribution margin (or, simply, contribution margin) is the difference between the segment's sales revenues and the segment's variable costs. 

But here, since we are discussing the segment's contribution, we specifically mention the segment's contribution margin.

Segment's CM = Segment's sales revenues - segment's variable costs

Each of the elements used in the calculation should be directly traceable to the segment evaluated. This calculation does not include common costs/unavoidable costs in the calculation because they aren't directly traceable to one single SBU.

Once the segment's contribution is calculated, all traceable fixed costs are deducted from the segment's CM.

The traceable fixed costs refer to the fixed costs that are directly attributable to the segment being evaluated and are incurred in the segment during its operations. For Example, depreciation, insurance, and salaries are traceable to the segment.

Traceable fixed costs are also known as controllable fixed costs because of their nature and the degree to which managers can control these costs.

The reason behind omitting the common costs for the calculation of segment margin is that their presence dilutes the profitability and makes profitability assessment difficult. 

The common costs are shared costs that are to be divided or apportioned among the business units within the larger organization using an allocation base. 

Common costs are also known as Uncontrollable costs because of their nature and controllability by the managers of the segment.

Pie Graph

Traceable fixed costs (or controllable fixed costs) are the costs on which managers can exercise their control and decide, unlike common costs/uncontrollable costs, which are the non-negotiable corporate allocation of headquarters' expenses.

The segment margins differ for customers, product lines, and area offices.

Segment Margins = Segment CM - All traceable fixed costs for the segment.

It separates relevant costs from irrelevant costs when analyzing a product line.

Report

Consider this, if management is deciding whether to continue or drop a product line, the appropriate calculation for measuring the relevant revenues and expenses for the decision would be to use this type of margin.

The difference between segment margin and other profitability measures, such as contribution margin, is that it divides fixed costs into three categories. 

Consider one of the categories of fixed costs relevant(traceable fixed costs) when making decisions about the segment in question; the other two categories of fixed costs are irrelevant.

Type Of Segment Margins:

As discussed earlier, the segment margin can be a particular business unit, a separate product line, and customers. 

Papers

Segment margin profits may be similar to the financial statements' profits. But they differ since the financial statements are prepared according to GAAP requirements or standards set by any other board.

Product profitability analysis is used by business unit/product line managers to determine how each product's profitability contributes to the overall productivity and profitability of the organization.

Product profitability analysis helps to determine which product lines

  • are most profitable

  • require further cost/price evaluations

  • need support through marketing and promotional campaigns

  • are loss-making and considered for discontinuance

Analysis

Before adding or dropping a product line, qualitative and quantitative factors should be considered, and careful evaluation is a must.

For example, let us look at this table, which consolidates three different products, namely Ace, Base, and Case.

ParticularsAmount
Sales$550,000
Less: Variable costs($315,000)
Contribution Margin$235,000
Other variable costs: 
Marketing$112,000
R&D$18,000
Product line margin$105,000
Fixed costs$24,000
Operating Income$81,000

 

The company looks profitable and a good investment if we look from a bird's eye view. But that's not the whole picture. We will see a different perspective if product profitability analysis is executed. 

ParticularsAceBaseCaseTotal
Sales$350,000$120,000$80,000$550,000
Less: Variable costs (VC)($110,000)($125,000)($80,000)$315,000
Contribution Margin$240,000($5000)$0$235,000
Other VC:    
Marketing($36,000)($30,000)($46,000)($112,000)
R&D($6000)($6000)($6000)($18,000)
Product line margin$198,000($41,000)($52,000)$105,000
Fixed costs   ($24,000)
Operating Income   $81,000

 

After the analysis, we can conclude that only Ace is the profitable product of the organization and single-handedly contributes to the overall profitability. 

The base has a negative contribution meaning that the product isn't capable of covering its variable costs. The case has a zero CM that then goes negative with increasing marketing and R&D expenses.

The customer profitability analysis

The customer profitability analysis is a managerial accounting method that allows businesses to determine the overall profit a customer generates.

A profitable customer generates a revenue stream greater than the cost of their acquisition, selling, and serving. 

Because a particular customer may appear profitable from a bird's eye view, but if you take a detailed look, an accurate picture will appear.

The customer will tend to appear profitable in terms of sales and units purchased. But the actual costs associated with the customer to maintain/keep them will make the customer unprofitable.

Customer Analysis

Critical components of the customer profitability analysis are special discounts, shared expenses, and special administrative costs required to maintain customer service programs.

These customer service programs are used to determine the ways to improve profitability and drop un/profitable customers.

ParticularsPietroKhanPatelTakeshiTotal
Sales$10,000$40,000$65,000$25,000$140,000
(COGS)($7500)($25,000)($45,000)($18,000)$54500
(Other relevant costs)($1200)($2500)($4500)($4500)$12,700
Customer Margin$1300$12,500$15,500$2500$31,800
Allocated Fixed($1500)($6000)($9000)($5000)$21,500
Costs     
Operating Income($200)$6500$6500($2500)$10,300

 

Conducting customer profitability analysis helped the upper management determine that it's no longer in the best interest of the business unit to continue to provide services to Pietro and Takeshi since both customers have negative operating income.

The primary benefit is identifying customers who are eroding profits and those who are contributing to profits, along with identifying constructive dialogue between buyer and seller to improve margins.

Other considerations in the customer profitability analysis are 

  • Costs associated with the customers (Credit and payment terms),

  • Special discount arrangements.

Area office profitability analysis is for the geographical divisions of the organization to assess their contribution to profits. This is important to understand the profitable and unprofitable divisions.

ParticularsMiamiRiyadhHyderabadBeijingTotal
Sales$1,500,000$1,000,000$2,000,000$4,500,000$9,000,000
Less: VC($800,000)($450,000)($1,500,000)($3,000,000)($5,750,000)
Other VC($255,000)($175,000)($350,000)($545,000)($1,325,000)
CM$445,000$375,000$150,000$955,000($1,925,000)
Traceable FC($250,000)($200,000)($100,000)($250,000)($800,000)
Area Office Margin$195,000$175,000$50,000$705,000$1,125,000
Non-traceable FC    ($500,000)
Operating Income    $625,000

 

The profitable divisions are continued, if they aren't, they are discontinued (unless they add value), and the proceeds are used elsewhere where the investment is profitable.

Advantages and Disadvantages:

Advantages:

Companies use it to check, document, judge, and analyze different business areas' performance. Segments with positive margins are highly valued; the organization can decide to invest in them further. Or can utilize the earnings from such segments elsewhere.

With segment margin, one can determine the profit earning capacity of the business segments and decide to carry on the segment or not. Unprofitable parts are usually discontinued unless they serve many non-financial purposes. For example, they are absorbing some crucial non-traceable fixed costs.

Piggy Bank

Business gets to know the worst sectors of their units. Possible areas of weakness can be identified and strengthened. Reasons for failure can also be discovered with the right resources and teams deployed.

It increases transparency in reporting. Preparing profitability reports according to the products, customers, or division will aid the users in understanding the contribution of each element and department.

Segment reporting can help immensely when the business operating in the overseas market is more demanding than business operations in the domestic market. Hence, it increases opportunities for growth and expansion.

Disadvantages:

Segment margin focuses on short-term numbers. Looking at numbers, especially the negative ones will create panic among the managers. Breaking these numbers into pieces will help put pressure to reduce the losses and increase short-term earnings.

disadvantages

An organization may start a new business. During the initial stages, the organization will not generate profits due to a lack of brand recognition, limited product awareness, and product consumption. 

The segment margin will only show profitability and not liquidity or solvency position. This view can hamper the perspective that real operational efficiency and longevity lie in the ability of an organization to generate cash and manage short and long debt obligations.

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Researched and authored by Farooq Azam Khan, CMA | LinkedIn 

Reviewed and Edited by Aditya Salunke | LinkedIn

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