Segmented Income Statements

Companies often consider whether to introduce a new product or service, refine an existing one, or eliminate an underperforming product or service. In many cases, managers work with accountants to generate a segmented income statement. A segmented income statement is a managerial accounting document that breaks down sales, cost allocation, and income information so a manager can see how each of these measurements relates to specific segments of the company.

A segment is a part of a company—either a product or a service—that the company sells in addition to other products and services. Businesses divide segments into many forms, such as products, services, and even internal departments.

A segmented approach differs from the approach companies take when they generate a traditional income statement. An income statement is one of the four major financial statements that companies produce for investors, the government, and the general public to examine. It measures revenues minus expenses to arrive at the net income or net loss during a specific time period. The income statement does not differentiate between segments and only reports on the company's activity as a whole.

It is necessary for companies to generate income statements so that outsiders can evaluate their level of success and decide whether to invest. Also, because income statements report only on company activity as a whole, they make it more difficult for competitors to find out which products, services, and product lines are most profitable for that business. For internal use, though, segmented income statements help a business focus on where it can make the most profit. A segmented income statement helps managers determine how profitable a segment is and how much profit—if any—it is contributing to the company's bottom line. The goal of the segmented income statement is to separate the analyzed segments to better understand how each segment contributes to the company's overall profitability. For example, a company might learn from this analysis that it is putting too many resources, such as marketing and sales, toward an unprofitable product. This provides an opportunity for the company to adjust its costs and better use its resources.

Because the segmented income statement relies heavily on the company's classification of costs, it is vital for accountants and managers to make sure that costs are correctly categorized. Otherwise the segmented income statement will give an inaccurate picture of products' profitability.

Once the accountant has completed a segmented income statement, he or she can use it to provide the company with a segment margin. A segment margin is a company's net loss or net profit in relation to the specific segment analyzed within the segmented income statement. While contribution margin can be used to measure a single product, segment contribution margin (or simply segment margin) reflects the contribution margin derived from a business segment. It is also important to note that contribution margin and segment margin can both be measured in dollars and percentages. Here, segment margin is analyzed as a percentage which enables managers to compare one segment to another.
Companies use the segment margin to determine whether to eliminate or modify a segment. For example, Vinny's Vacuums knows based on sales that its new cordless vacuum is not performing as well as its corded vacuum. This is an opportunity for Vinny's Vacuums to create a segmented income statement to get a bigger picture of its vacuums' performances.

In the period the new cordless vacuum was on the market, it had net sales of $50,000 and its costs were $38,000. The segment margin is 24%. Vinny's standard corded vacuum had net sales of $45,000 and its costs were $25,000. The segment margin is 44%. This demonstrates that the corded vacuum offers a much larger segment margin (44%) than the cordless vacuum (24%). Based on these results, Vinny's should invest more in its corded vacuum product, because this will generate larger profits. This example also shows that even though revenue was higher for the cordless vacuum, it does not mean that the cordless vacuum is the company's most profitable product.

Segmented income statements are useful in a variety of settings but are especially common in manufacturing. They are documents that break down sales, cost allocation, and income information by product or service so that a manager can see how each of these measurements relates to specific segments of the company. Segmented income statements can help a company decide whether to keep a particular segment: a product, department, or even a sales or manufacturing center.

Companies use segmented income statements to improve their business. It is first helpful for companies to look at the segment's contribution margin. 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. The higher the contribution margin is, the more profitable a company will probably be. If the analyzed segment has a positive contribution margin, then that segment's sales are covering its variable costs and at least some of its fixed costs. In that case, the company will likely proceed to the next step: determining whether any fixed costs can be eliminated.

Fixed costs can be categorized as either direct fixed costs or common fixed costs. A direct fixed cost, also called a traceable fixed cost, is an unchanging expense that is linked to a specific segment and that does not vary with activity level. For instance, if a company is renting a factory, then that rent is a direct fixed cost. The rent payment stays the same whether the business is running production lines 8 hours a day or 24 hours a day, and whether it is employing 20 production-line workers or 200.

Depreciation can be an example of a direct fixed cost. Depreciation means the gradual loss of an asset's value because of normal wear and tear over time. For instance, let's say a company buys six machines for assembly-line operators to use. Each year, the value of those machines will depreciate as they become older and more worn out and as new machines or new technologies potentially take their place. Once a company decides to buy equipment, the depreciation of that equipment is a direct fixed cost unless the company decides to replace it or eliminate it. Depreciation is an expense that flows through to the income statement and reduces net income. The asset itself is found on the balance sheet in the long term asset section.

In some cases, a company decides to eliminate a segment but the direct fixed costs associated with that unit cannot be eliminated or reduced. Then a company's overall loss will increase because the segment will no longer be contributing to the company's total contribution margin.

An indirect fixed cost, also referred to as a common fixed cost, is an unchanging expense that is not directly linked to a specific segment and that does not vary with activity level. This means that if a specific segment is eliminated, the common fixed cost will continue—it will just be spread across fewer segments. For example, if a company decides to eliminate a segment, it must decide whether it can use the resources allocated to the now-eliminated segment to other existing segments or new segments. These resources may make the company more profitable when committed elsewhere.