Most manufacturers publish company-wide income statements. But have you explored delving further into your data using a segmented income statement? If properly developed, a segmented version of this report could help you increase your profits.
Dissect Your Operations
A traditional income statement starts with revenue and then subtracts expenses to arrive at a net profit or loss. It is usually adequate when lenders or other third parties are assessing your company’s financial viability. However, your management team may require more detailed data.
A segmented income statement goes into greater depth, breaking down revenue and expenses by business unit, such as product line, location, department, salesperson, or territory. This analysis allows management to identify underperforming segments and take profit-boosting measures.
For example, if your company produces a variety of products, you may divide them into categories based on their similarities. Your segmented income statement would clearly indicate which product lines are most and least profitable. This information could then be used to make growth or divestment decisions.
Assign Costs
Creating a segmented income statement can be complicated since you must assign and distribute expenditures to different categories. Direct costs are those that are specific to a business segment, such as labor and materials utilized to make items within that segment. A direct cost is one that would be eliminated if the section were eliminated.
In addition to allocating these direct expenditures to the correct segments, you must also assign a portion of the company’s indirect costs—such as rent, insurance, utilities, and executive salaries—to each segment. Indirect costs, frequently referred to as overhead expenses, are allocated based on how much a segment benefits from or contributes to such costs.
For example, you could allocate indirect costs based on segment income, unit sales, direct labor hours, or floor space occupied. Different approaches can provide very different results, so choose one that accurately reflects each segment’s use of resources.
Assess the Findings
Segmented income statements can help identify underperforming business divisions and address profit drains. Depending on the reasons behind a segment’s poor performance, strategies may include:
- Increasing pricing
- Decreasing costs
- Correcting quality or design flaws
- Removing a segment
Take note: Just because a segment is losing money doesn’t indicate that removing it will benefit the company. In rare circumstances, eliminating an underperforming section might reduce the company’s overall net profitability. This can happen due to “contribution margins”.
Evaluate Contribution Margins
The majority of indirect expenses, and some direct expenses, allocated to a segment are fixed. In other words, even if you eliminate the segment, your company will continue to incur those costs. So, if a sector is losing money but contributing to overall net income, you may be better off keeping the segment (at least in the short term).
You can calculate a segment’s contribution margin by subtracting variable costs from its revenue. Variable costs are those that rise or fall in proportion to the level of production output, and hence fall to zero if a segment is shut down.
If a segment has a positive contribution margin, it is producing revenue to cover the company’s fixed costs and grow profit, and it is likely worth preserving. If not, it may be time to pull the plug.
Valuable Insight
A segmented income statement helps identify significant performance drivers and potential improvement options. It can help producers make better judgments by employing more transparent and understandable segments.
Contact us if you need help establishing how to split your revenue and allocate costs across various segments.
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