Segment profitability analysis helps managers decide whether to keep or cut business units. It involves examining relevant revenues and costs, calculating contribution and segment margins, and considering the impact of cost allocation methods on performance evaluation.
When evaluating segments, managers must focus on controllable costs and revenues. They should also consider incremental analysis, joint costs, and qualitative factors. These tools help make informed decisions about segment discontinuation or retention.
Segment Profitability and Discontinuation
Revenues and costs for discontinuation
- Relevant revenues
- Revenues lost if segment discontinued (sales revenue from segment)
- Relevant costs
- Costs avoided if segment discontinued
- Variable costs directly associated with segment
- Fixed costs generally not relevant unless avoidable by discontinuing segment (rent, salaries)
- Irrelevant costs
- Costs continuing regardless of segment discontinuation decision
- Allocated fixed costs (corporate overhead)
- Sunk costs (equipment purchase, research and development)
- Opportunity cost of resources used by the segment
Product line margin calculations
- Contribution margin
- Segment revenue minus segment variable costs
- Amount each segment contributes to covering fixed costs and generating profit
- Segment margin
- Segment revenue minus segment variable costs and directly attributable fixed costs
- More accurate measure of segment profitability by considering segment-specific fixed costs (advertising, dedicated equipment)
- Segment profitability evaluation
- Compare segment margin to allocated fixed costs
- Positive segment margin indicates profitable segment contributing to overall company profitability
- Breakeven analysis can be used to determine the sales volume needed to cover all costs
Impact of cost allocation methods
- Cost allocation methods
- Direct method: Allocates only directly attributable costs to segments
- Step-down method: Allocates service department costs to other departments based on sequence of allocation
- Reciprocal method: Allocates service department costs to other departments considering mutual services provided
- Impact on segment performance
- Different cost allocation methods lead to different segment profitability measures
- Over-allocation of costs makes segment appear less profitable than actual
- Under-allocation of costs makes segment appear more profitable than actual
- Limitations of cost allocation
- Allocated costs often irrelevant for decision-making
- Managers should focus on controllable costs and revenues when evaluating segment performance (direct labor, materials)
Additional considerations for segment evaluation
- Incremental analysis: Comparing the difference in costs and revenues between alternatives
- Joint costs: Costs incurred to produce multiple products simultaneously, requiring appropriate allocation methods
- Qualitative factors: Non-financial considerations that may impact the decision to keep or discontinue a segment (brand image, employee morale, customer relationships)