A companywide income statement may be sufficient for lenders or other outsiders to evaluate your manufacturing 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.
Segmented vs. 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 unit, 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 identifying 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.
Boosting underperforming segments
By uncovering business units that are underperforming, 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 that 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 is that possible?
Most indirect expenses allocated to a segment, as well as some direct expenses, are fixed. This means that eliminating the segment won’t eliminate those costs, it will just eliminate certain direct costs — and the segment’s revenue. So, even if a segment is operating at a loss, it could still be contributing to companywide net income.
To determine whether a segment is making a contribution, calculate its contribution margin, which is simply revenue less 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, it’s contributing revenue to the company’s fixed costs and profit and is probably worth keeping. So, it’s a good idea to report contribution margin on your segmented income statement.
Get professional help
A segmented income statement, if properly designed, can help enhance your manufacturing company’s profitability. However, determining an appropriate method for allocating costs among segments requires significant professional judgment. Contact us for assistance.