Segment Reporting and Profitability Analysis-Segmented Income Statements:

Learning Objectives:

1. What is segment reporting managerial accounting ?
2. How are segmented income statements prepared?

A different kind of income statement is required for evaluating the performance of a profit or investment center. This income statement should emphasize on the segment rather than the performance of the company as a whole. A contribution margin  format income statement is used to evaluate the performance of different segments. In a contribution margin format income statement cost of goods sold consists only of the variable manufacturing costs. This point has been discussed in detail on our cost volume profit CVP relationship page. To prepare an income statement for a particular segment variable costs are deducted from the sales revenue to yield contribution margin. Fixed costs are broken down further into traceable and common fixed costs. Traceable fixed are assigned to the segments but non-traceable or common fixed costs are not assigned to segments. For detailed study about traceable and common fixed costs see traceable and common fixed cost page.

Segment Margin:

The segment margin is obtained by deducting the traceable fixed costs of a segment from contribution margin. It represents the margin that is available after a segment has covered all of its own costs. The segment margin is the best gauge of the long-run profitability of a segment, since it includes only those costs that are caused by the segment. If a segment cannot cover is own costs, then that segment probably should not be retained (unless it has an important side effects on other segments).

From a decision making point of view, the segment margin is most useful in major decisions that effect capacity such as dropping a segment. By contrast, the contribution margin is most useful in decisions relating to short-run changes in volume, such as pricing special orders that involve utilization of existing capacity.

Example: 1

As an example, a portion of  the segmented report is shown below. In this report segments have been defined as divisions. Report also have a column of total company performance for the period. We can see that divisional segment margin is $60,000 for business product division and $40,000 for the consumer product division. This report is very useful for company’s divisional managers They may want to know how much each of their divisions is contributing to the company’s profit.

Segments defined as divisions:

Example: 2

Segmented income statements can be prepared for activities at many levels in a company. To provide more information to the company’s divisional managers the divisions can be further segmented according to their major product lines. In the consumer product division the product lines are clip art and computer games. This concept is further explained by the following example.

Segments defined as product lines of the consumer product division:

*Total traceable cost ($80,000) of consumer product division include 10,000 of divisional manager’s salary. This cost now is a common fixed cost for clip art and computer games. Because non of these products is solely responsible for this salary of manager. Click here for detailed study of traceable and common fixed costs.

Going even further , we can segment each of the product lines according to how they are sold–in retail computer stores or by catalog sales.

Example: 3

Segments defined as sales channels for one product line, computer games, of the consumer products division

Substantial benefits are received from a series of statements of such as those above. By carefully examining trends and results in each segment, a manager is able to gain considerable insight into the company’s operations viewed from many different angles. And advanced computer-based information systems are making it easier and easier to construct such statements and to keep them continuously current.

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

1. Decentralization in organizations
2. Traceable and common fixed costs
3. Segment reporting and profitability analysis-segmented income statements
4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
5. Segmented Financial Information on External Reports
6. Return on Investment (ROI) for Measuring Managerial Performance
7. Controlling and Improving Rate of Return on Investment
8. Return on Investment (ROI) and Balanced Scorecard
9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
10. Residual Income-Another Method to Measure Managerial Performance
11. Limitations, Criticism or Disadvantage of Residual Income Method
12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
13. Set transfer prices at cost using variable or full (absorption) cost
14. Set transfer prices at the market price
15. Divisional Autonomy and Sub optimization
16. International Aspects of Transfer Pricing