A companywide income statement may be sufficient for lenders or other outsiders to evaluate your company’s financial performance. But from management’s perspective, a “segmented” income statement can provide valuable insight into key performance drivers and possible improvement strategies.
How does it differ from a traditional income statement?
A conventional income statement starts with revenue and then subtracts costs to arrive at a net profit or loss. A segmented income statement provides additional detail, breaking down revenues and expenses by business units, such as product line, location, department, salesperson, or territory. This breakdown helps management identify underperforming segments and develop strategies for boosting profits.
Creating a segmented income statement can be challenging because you must assign costs to various segments. In addition to direct costs attributable to a segment, such as materials and direct labor, you’ll need to allocate a portion of the company’s indirect costs, such as rent, insurance, utilities, and executive salaries, to each segment.
Indirect costs are allocated based on the extent that a segment benefits from or drives those costs. For example, you might allocate indirect costs based on segments’ relative sales dollars, units sold, direct labor hours, or floor space occupied. Different methods may produce substantially different results, so carefully select a method that fairly reflects each segment’s net income.
Are your segments contributing to overall profits?
By uncovering underperforming business units, segmented income statements can help remedy the situation. Depending on the reasons for a segment’s poor performance, potential strategies might include:
- Increasing prices,
- Reducing costs,
- Addressing quality or design issues, or
- Shutting down a segment.
Just because a segment is operating at a loss doesn’t necessarily mean closing, it will benefit the company. In some cases, terminating an underperforming segment can cause the company’s overall net income to go down. How’s that possible? Because a seemingly unprofitable segment may still contribute to the company’s net income.
Most indirect expenses allocated to a segment, as well as some direct expenses, are fixed. That is, your company will continue to incur them even if you eliminate the segment. So, even if a segment is operating at a loss, you’re likely better off retaining it (at least in the short term) if it contributes to companywide net income.
To determine whether a segment contributes, calculate its contribution margin, which is simply revenue less variable costs. Variable costs increase or decrease with the level of production output and, therefore, will drop to zero if a segment is shut down.
If a segment has a positive contribution margin, it contributes revenue to the company’s fixed costs and profit and is probably worth keeping. So, it’s a good idea to report the contribution margin on your segmented income statement.
Get professional help
A segmented income statement, if properly designed, can help enhance profitability. However, determining an appropriate method for allocating costs among segments requires significant professional judgment. Consult your CPA for assistance.