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Segmented income statements can help enhance manufacturers’ 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 may 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. It’s typically 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.

Assigning costs

Creating a segmented income statement can be challenging because you must assign and allocate costs to various segments. Direct costs are those that relate specifically to the business segment, such as labor and materials used to manufacture products in a particular segment. If a cost would be eliminated if the segment was eliminated, it’s a direct cost.

In addition to assigning these direct costs to their correct segments, you’ll need to allocate to each segment a portion of the company’s indirect costs, such as rent, insurance, utilities and executive compensation. 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? Because of “contribution margins.”

Evaluating contribution margins

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, if a segment is operating at a loss but it contributes to companywide net income, you may be better off retaining it (at least in the short term).

To determine whether a segment is contributing, 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.

Valuable insight

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, contact us.

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