Segmental Profitability Analysis and Evaluation

1 Management Accounting | 303 Segmental Profitability Analysis and Evaluation Unless a business is a not-for-profit business, all businesses have as a primary goal the earning of profit. In the long run, sustained and satisfactory profit requires good decision-making and performance Evaluation . The income statement, while serving many purposes, is a primarily a tool of performance Evaluation from a management point of view. When prepared on a Segmental basis, the use of the income statement for Evaluation purposes can be highly tend to be complex and varied in nature. It is highly unlikely that a business will have only one product. Single product businesses exist only in text book theory for illustrative purposes of certain business principles.

2 Many corporations have hundreds of products and also operate in different territories or regions. In today s business environment, the majority of enterprises are likely to be global in nature. Given the existence of many products and many different areas of operations, it is unlikely that over time all products or areas will be profitable. The need to evaluate profit performance systematically and regularly on a Segmental basis has been recognized and has been a common practice since the early 1900s. Even if a company had a single product, the need for Segmental performance would still exists. The product may be sold in different markets and in different areas of the country. A single product business can be segmented in many different ways. For example, assume that the Widget Company operates in four territories.

3 Does this mean that sales and, consequently, profit is equal in all territories? The obvious answer is, of course not. Many factors can contribute to why one territory is profitable and another is not. It logically follows that Evaluation of profit in each segment is highly desirable. Unprofitably segments, if they can not be made profitable, should be business can segment its operations in many different ways. Some of the more common ways of segmentation include the following:1. Product lines 5. States2. Departments 6. Plants3. Divisions 7. Sales people4. Territories 8. Operating hours 304 | CHAPTER FIFTEEN Segmental Profitability Analysis and EvaluationThere has over a considerable period of time developed two primary ways of performing Segmental Analysis : (1) the full cost approach and (2) the contribution approach.

4 The full cost approach attempts to measure the net income of each segment while the contribution approach attempts to measure the Segmental contribution of each Cost ApproachOn the surface, the full cost approach seems to be the logical method because of the fact that ultimately a business can not be successful without profit (net income). However, when the attempt to measure net income of a segment is made some problems come into existence that are not present when the objective is to simply measure the over-all net income of a business. From a Segmental perspective, there are two types of expenses, (1) direct and (2) indirect. Direct expenses are those expenses of a segment that are caused by the existence of the segment and can, therefore, be eliminated by the closing of the segment.

5 Indirect expenses or common expenses as they are sometimes called are those expenses that are not directly caused by any one particular segment. The key characteristic of indirect expenses from a Segmental viewpoint is that they must be allocated in order to measure the net income of a segment. Examples of indirect expenses include the following:1. Salaries of top management, for example the president s salary2. Home office operating expenses3. Insurance on home office and home office equipment4. Salaries of home office staffThe theory underlying the full cost approach is that all expenses regardless of where and why incurred must be charged to the segments that benefit directly and indirectly. In order to do this, these types of expenses must be allocated.

6 Because various methods of allocation are available and because different methods results in different allocation percentages, the allocated cost may be perceived to be somewhat arbitrary. Some of the methods used to allocate indirect expenses include the following:1. Sales dollars 3. Number of employees2. Units of dollars 4. Floor space occupiedWhatever method is used, it should appear to be logical and fair. An improper use of an allocation method can cause one segment to appear to be more profitable than another when in fact this is not the case. The basic principles of the full cost approach may be summarized as follows:1. The objective is to measure net income of each operating Over-all net income of the business is the sum of the Segmental net All indirect expenses (common) must be Allocation of indirect expenses involves selecting bases of The Segmental net income approach may be defined mathematically as follows:Management Accounting | 305 Segmental net income = Segmental sales - direct expenses - allocated indirect expenses, or in more symbolical termsSNI = S - DE - AIE (1)Direct expenses are those expenses that can be eliminated by the closing of a segment.

7 These types of expenses are also sometimes called escapable and indirect expenses called inescapable. Variable expenses because they are activity expenses are always considered escapable. For example, if in a clothing store the decision has been made to no longer sell children shoes, then the cost of goods sold for children shoes would no longer exist. Cost of costs sold, a variable expense, is a good example of an escapable Segmental expenses may either be direct or indirect depending on the circumstances. If a store is closed but the contract for rent is a five year lease and only one year has expired on the lease, then for the next four years the rent is inescapable. However, if the sales manager of the store is let go, then his or her salary, a fixed expense, is escapable.

8 The contractual nature of fixed expenses must be examined carefully to determine whether or not the expense is Contribution ApproachThe major problem of the full cost approach is that it is technically possible for a segment to show an operating loss yet at the same time be making a positive contribution to net income. In other words, if the seemingly unprofitable segment is closed, then the overall net income of the business will decrease. The paradox will be examined more closely later in this overcome this adverse feature of the full cost approach, many businesses prefer to use the contribution approach to measuring Segmental Profitability . The Segmental contribution approach as indicated by its name measures Segmental contribution. Segmental contribution may simply be defined as sales less direct expenses.

9 As a student, you should be careful to distinguish between Segmental contribution and contribution margin. Contribution margin, which was discussed and defined in chapter 7, is sales less variable expenses. Because some fixed expenses can be direct expenses, Segmental contribution and contribution margin are not the basic principles of computing Segmental contribution may be outlined as follows: 1. Only the contribution of each segment is computed. No attempt is made to compute the net income of the Indirect or common expenses of each segment are not Indirect or common expenses, however, are usually deducted from to-tal Segmental contribution in order to arrive at overall business net A segment is considered profitable if sales of the segment exceed the direct expenses of the segment.

10 306 | CHAPTER FIFTEEN Segmental Profitability Analysis and Evaluation5. The Segmental contribution approach may be presented mathemati-cally as follows: Segmental contribution = Segmental sales - direct expenses In more symbolical terms:SC = S - DE (2)DE = V(Q) + F D (3)S = P(Q) (4)Where: DE - direct expensesP - price of the product in the segmentV - variable cost rate for the segmentQ - units of sales in a specific segmentF D - direct fixed expenses of the segmentTherefore, equation (2) may be restated as follows:SC = P(Q) - V(Q) - F D (5)It is apparent from equation (3) that the principles of cost-volume-profit Analysis covered in chapter 7 apply to Segmental decision-making. Variable costs are always direct costs.