Segmented Income Statements Can Help Enhance Profitability
Most manufacturers issue companywide income statements. But have you considered digging a little deeper into your numbers with a segmented income statement? If properly designed, a segmented version of this report can be used to improve your bottom line.
Dissecting Your Operations
A conventional income statement starts with revenue and then subtracts costs to arrive at a net profit or loss. These typically are sufficient for lenders or other third parties to evaluate your company's financial performance. But your management team might want more granular data.
A segmented income statement provides additional detail, breaking down revenue and expenses by business unit, such as product line, location, department, salesperson or territory. This breakdown helps management identify underperforming segments and develop strategies for boosting profits.
For example, if your business manufactures multiple products, you could create segments made up of similar products. Your segmented income statement would clearly show which product lines are the most and least profitable. This insight could be used to guide expansion or divestiture decisions.
Creating a segmented income statement can be challenging, because you must assign and allocate costs to various segments. Direct costs are those costs — such as direct labor and materials — that relate directly to the business segment. If a cost would be eliminated if the segment were eliminated, it's a direct cost.
In addition to these direct costs, you'll need to allocate to each segment a portion of the company's indirect costs, such as rent, insurance, utilities and executive salaries. Also known as overhead expenses, 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 revenue, 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 consumption of resources.
Assessing the Results
By uncovering business units that are underperforming, segmented income statements can help remedy profit drains. Depending on the reasons for a segment's poor performance, potential strategies might include:
- Increasing prices,
- Reducing costs,
- Addressing quality or design issues, or
- Eliminating a segment.
Beware: Just because a segment is operating at a loss doesn't necessarily mean that eliminating 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? A seemingly unprofitable segment absorbs some of the company's indirect costs and may still contribute to the company's net income and, in fact, help drive revenue from other, more profitable segments.
Evaluating Contribution Margins
Before eliminating an underperforming business segment, it's important to understand the concept of "contribution margins." Here's how it works. 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 is making a contribution, calculate its contribution margin (revenue minus variable costs). Variable costs are those that 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, then it's contributing revenue to absorb the company's fixed costs and increase profit and is probably worth keeping. If not, it might be time to pull the plug.
A segmented income statement can highlight key performance drivers and possible improvement strategies. It can help manufacturers make better decisions using more transparent and understandable segments. For help determining how to segment your revenue and allocate costs among those segments, consult your CPA.