Segmented Statements Boost Profitability

A segmented income statement gives more information, dividing revenue and costs by business unit, such as product line, location, department, salesperson or territory. This division helps management identify segments that are not performing well and develop strategies to improve profits.

For example, if your business makes different products, you could create segments based on similar products. Your segmented income statement would show clearly which product lines make the most and least profit. You could use this insight to decide whether to expand or sell off certain segments.

Allocating Costs

Creating a segmented income statement can be difficult because you have to assign and allocate costs to different segments. Direct costs are those that are specific to the business segment, such as labor and materials used to make products in a certain segment. If a cost would go away if the segment was gone, it's a direct cost.

Besides assigning these direct costs to the right segments, you'll also need to allocate a part of the company's indirect costs, such as rent, insurance, utilities and executive pay, to each segment. These are also called overhead expenses and they are allocated based on how much a segment benefits from or causes those costs.

For example, you might allocate indirect costs based on segments' relative revenue, units sold, direct labor hours or floor space used. Different methods may give very different results, so choose a method that fairly reflects how much each segment uses resources.

Analyzing the Results

By finding out which business units are not performing well, segmented income statements can help fix profit problems. Depending on the reasons for a segment's poor performance, possible strategies might include:

Raising prices

Cutting costs

Fixing quality or design issues, or

Getting rid of a segment

Be careful: Just because a segment is losing money doesn't mean that getting rid of it will help the company. Sometimes, removing an underperforming segment can make the company's overall net income go down. How can that happen? Because of "contribution margins."

Looking at Contribution Margins

Most indirect expenses allocated to a segment, and some direct expenses, are fixed. That means your company will still have to pay them even if you eliminate the segment. So, if a segment is losing money but it adds to the company's net income, you may be better off keeping it (at least for now).

To see if a segment is adding anything, calculate its contribution margin: revenue minus variable costs. Variable costs are those that change with the level of production output and, therefore, will stop if a segment is shut down.

If a segment has a positive contribution margin, then it's adding revenue to cover the company's fixed costs and increase profit and it's probably worth keeping. If not, it might be time to let it go.

Useful Information

A segmented income statement can show key performance factors and possible ways to improve. It can help manufacturers make better decisions using segments that are more clear and easy to understand. For help deciding how to divide your revenue and allocate costs among segments, contact us.