Amount of net profit or net loss generated by a segment of a business
Segmentis a pivotal concept in financial analysis that offers a comprehensive view of a company's operational efficiency and profitability by focusing on individual business segments.
In essence, it acts as a financial microscope, zooming in on specific divisions, product lines, or geographical sectors to uncover their true financial contributions.
It is derived from a straightforward calculation: subtracting direct costs from the revenue generated by a particular segment. These direct costs encompass an array of expenses, ranging from the cost of raw materials and production expenses to direct labor costs.
This subtraction results in a figure representing the segment's gross profit, allowing for a granular evaluation of its. By breaking down the financial results into distinct segments, companies can precisely pinpoint which aspects of their operations are thriving and which might be underperforming.
The significance of segment margin extends far beyond numerical analysis. It empowers decision-makers with the ability to allocate resources strategically and proactively. This approach enables companies to channel investments into high-potential segments, propelling growth and innovation.
Conversely, suppose a segment exhibits a low or negative margin. In that case, it serves as a red flag, indicating the need for closer scrutiny and potential restructuring to optimize operational efficiency and bolster financial results.
In practical terms, segment margin provides a roadmap for management to make informed decisions. For instance, a company operating in various geographical regions can utilize segment margin to assess which areas yield the highest returns.
This can lead to tailored marketing strategies and localized offerings, tapping into the unique preferences of each region's customer base.
Moreover, the segmentation approach can be especially advantageous for diversified corporations with multiple product lines. By analyzing their margins independently, companies can identify the most profitable ones and those that might require adjustments in pricing, manufacturing processes, or marketing efforts.
- Segment margin is a financial analysis concept that provides insights into a company's operational efficiency and profitability by focusing on specific business segments. It zooms in on divisions, products, or geographical sectors to reveal their true financial contributions.
- Segment margin is calculated by subtracting direct costs from segment revenue, revealing gross profit. It offers a detailed view of financial health, helping companies pinpoint thriving and underperforming areas.
- Segment margin empowers decision-makers to allocate resources strategically, fostering growth and innovation. High-margin segments receive investments, while low-margin segments signal the need for scrutiny and potential restructuring.
- By analyzing segment margins, companies can tailor strategies to different geographical regions or product lines. This approach enables localized offerings and marketing strategies.
- Segment margin aids in product and customer profitability analysis. It identifies profitable products, customers, and geographical regions, enabling informed decisions on investments, pricing, and resource allocation.
Segment Margin is the amount of net profit or net loss generated by a segment of a business.
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.
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.
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.
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.
As discussed earlier, the segment margin can be a particular business unit, a separate product line, and customers.
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.
1. Product profitability analysis
It 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
- Loss-making and considered for discontinuance
- Require further cost/price evaluations
- Need support through marketing and promotional campaigns
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.
|Less: Variable costs||($315,000)|
|Other variable costs:|
|Product line margin||$105,000|
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.
|Less: Variable costs (VC)||($110,000)||($125,000)||($80,000)||$315,000|
|Product line margin||$198,000||($41,000)||($52,000)||$105,000|
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.
2. 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.
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.
|(Other relevant costs)||($1200)||($2500)||($4500)||($4500)||$12,700|
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.
|Area Office Margin||$195,000||$175,000||$50,000||$705,000||$1,125,000|
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.
Let us take a glance at the main advantages and disadvantages surrounding the concept:
Some of the advantages are:
- 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 whether 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.
- 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 divisions 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.
The disadvantages are:
- 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.
- 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.