Why the Segmented Income Statement is a Powerful Management Tool
Mark A. Thomson
A company-wide income statement may be sufficient for lenders or other outsiders to evaluate your company’s financial performance. But from management’s perspective, a “segmented” income statement can provide valuable insight into key performance drivers and possible improvement strategies.
How does it differ from a traditional income statement?
A conventional income statement starts with revenue and then subtracts costs to arrive at a net profit or loss. A segmented income statement provides additional detail, breaking down revenues and expenses by business unit, such as product line, location, department, salesperson or territory. This breakdown helps management identify underperforming segments and develop strategies for boosting profits.
Creating a segmented income statement can be challenging, because you must assign costs to various segments. In addition to direct costs attributable to a segment, such as materials and direct labor, you will need to allocate a portion of the company’s indirect costs, such as rent, insurance, utilities and executive salaries, to each segment.
Another helpful segmented income statement is a contribution margin statement by product line, department or other meaningful breakdown. This helps management understand the contribution each segment provides while still allocating the company’s indirect costs below the computed margin. The statement allocates direct costs against each segment, while the company’s fixed costs are allocated below the contribution margin.
Indirect costs are allocated based on the extent that a segment benefits from or drives those costs. For example, you might allocate indirect costs based on segments’ relative sales dollars, units sold, direct labor hours or floor space occupied. Different methods may produce substantially different results, so carefully select a method that fairly reflects each segment’s net income.
Are your segments contributing to overall profits?
By uncovering business units that are underperforming, segmented income statements can help remedy the situation. Depending on the reasons for a segment’s poor performance, potential strategies might include:
- Increasing prices;
- Reducing costs;
- Addressing quality or design issues; or
- Shutting down a segment.
Just because a segment is operating at a loss does not necessarily mean that closing it will benefit the company. In some cases, terminating an underperforming segment can cause the company’s overall net income to go down. How is that possible? Because a seemingly unprofitable segment may still contribute to the company’s net income. This is where the contribution margin statement is very useful.
Most indirect expenses allocated to a segment, as well as some direct expenses, are fixed. That is, your company will continue to incur them even if you eliminate the segment. So, even if a segment is operating at a loss, you are likely better off retaining it (at least in the short term) if it contributes to company-wide net income.
To determine whether a segment is making a contribution, calculate its contribution margin, which is simply revenue less variable costs. Variable costs are those that increase or decrease with the level of production output and, therefore, will drop to zero if a segment is shut down.
If a segment has a positive contribution margin, it is contributing revenue to the company’s fixed costs and profit and is probably worth keeping. It is a good idea to report contribution margin on your segmented income statement.
Seek professional help
A segmented income statement, if properly designed, can help enhance profitability. However, determining an appropriate method for allocating costs among segments requires significant professional judgment. Consult your CPA for assistance.
For more information, contact Mark Thomson at firstname.lastname@example.org or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing & Distribution Group.