Variable Costing

Decision-Making with Segmented Income Statements

By breaking down income and expenses to cost components, managers can make wiser decisions about processes and departments.

Managers can often make wiser decisions about processes or departments if they work with an accountant to break down income and expenses into cost components. Consider a company that is deciding whether to keep one of its two current products. Here, a segmented income statement is useful. Segmented income statements are financial documents that break down sales, cost allocation, and income information by product or by department. By using a segmented income statement, a manager can see how each of these measurements relates to specific segments of the company instead of just considering overall expenses or overall profits.

Assume that managers from Jack’s Electronics Store consider their company’s segmented income statement. Management determines that its net loss for DVD players and televisions is −$10,000. DVD players have a net income of $40,000, while televisions have a net loss of −$50,000. At first, it appears that Jack's Electronics Store should stop producing and selling televisions in order to help its bottom line. However, segmented income statements cannot be analyzed so easily. Instead, Jack's Electronics Store should take a contribution-margin approach.

The company should look at the contribution margin for each product. A company's contribution margin is the amount remaining after a company's total variable costs are subtracted from its total sales for a given period.
Contribution Margin=Total SalesTotal Variable Costs\text{Contribution Margin}=\text{Total Sales}-\text{Total Variable Costs}
By calculating the contribution margin for each product or service, the accountant knows how much (or little) each individual product or service helps the company. The higher the total contribution margin is, the more profitable a company is likely to be.

Determining whether the product has a high, low, or negative contribution margin can be very helpful. This calculation shows whether the product or service is bringing in more than it costs to make. In this scenario, assume that televisions have a positive contribution margin, which means that this product is covering its variable costs and at least some of its fixed costs. Increasing sales of televisions would increase its contribution margin and decrease the company's total net loss.

After determining contribution margins, Jack's Electronics Store can look at its fixed direct costs and its common direct costs—in other words, ones that it spreads across all the goods and services it produces rather than examining them by segment or department. Eliminating a fixed direct cost will result in increased profits. However, eliminating a common direct cost will likely not lead to increased profits, as Jack's Electronics will still have to allocate those common direct costs to other segments.

As Jack's Electronics analyzes its segmented income statement, it may consider whether some of its resources may be better allocated to different segments. Another consideration is whether eliminating a segment will have a negative effect on the sales of remaining segments. This is particularly important for companies that sell complementary goods.

Complementary goods, or complements, are goods that are sold separately but need to be paired together to function. They complement (enhance or complete) one another; they create a demand for one another. If a company eliminates one of its complements, that action could have an unexpected negative effect on the remaining complement. Examples of complements are printers and ink cartridges. A consumer may buy ink cartridges from the business because they have already bought the printer. If the company eliminates the printer, then it will likely see a decline in its ink cartridge sales.

Complementary Goods and Segmented Income Statements

While analyzing each segment of a business can help managers make wise decisions, it is important to consider the effects each decision may have. Reducing or eliminating one product or service may affect demand for other goods or services.