What is Segment Margin?
Segment Margin simply means the profitability of an individual product line of large business selling multiple products/ service or to ascertain profit or loss or for a particular geographic location operating in multiple geographical region and is used for comparing profitability of different components of the company and relevant decision making.
Large multinational companies operating over a varied region or sell a variety of products/ services would be interested to know how their different business segments are performing. You can evaluate the performance in a better way if the company breaks down its operations in segments and determine segment margins. It is important to evaluate it to understand which part of the business performs above or below average. Also, it helps business to decide where there exist need to invest additional funds. This concept is irrelevant for small business organizations since they don’t have multiple operating segments. According to generally accepted accounting principlesGenerally Accepted Accounting PrinciplesGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors., a public company must report profit and loss according to its segment separately if the total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity or revenue are 10 percent or more of total companies’ profit or assets.
Segment Margin Formula
Segment Margin = Contribution Margin of Segment – Traceable Fixed Cost
Segment Margin = Segment Sales – Segment Variable Cost – Traceable Fixed Cost
- Segment contribution marginsContribution MarginsThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution. = Segment Revenue – Segment Variable Cost
- Traceable fixed cost are those fixed costs directly attributable to a particular segment, and there will be no such cost if the segment shut down.
Most of the business have departments based on the markets they serve, and all departments have various products. Each department’s product has some variable costs attached. Moreover, some of the fixed costs might incur due to the product. The rest of the fixed cost can be of different products and some fixed costs might be common for all. And if the segment is a business unit, the margin of the segment will depend on the margin of contribution for all products, and the fixed cost will be traced to the department.
Ceat Tyre Inc. manufactures automotive tyres. It has two departments, retail and wholesale. Below are the cost and revenue of each department.
The wholesale department has two products Light Motor Tyre (LMT) and Heavy Motor Tyre(HMT). Details are as under –
The company wants to know whether products of the wholesale department are profitable or not –
Segment margin calculation can be done as follows –
- Margin (Wholesale) = $500 – $250 – $60 = $190
- Margin (Retail) = $75 – $30 -$10 = $35
Margin calculation can be done as follows –
- Margin (LMT) = $100 – $100 – $25 = ($25)
- Margin (HMT) = $400 – $100 -$25 = $275
LMT of wholesale depart has a negative segment margin. This means that the wholesale department can improve the profits by closing the LMT department.
(Please note overall mentioned above is not overall company profit as common fixed cost are not deducted in any of the above calculation).
Segment Margin and Fixed Cost
Segment cost includes three types of fixed cost – avoidable fixed costs, unavoidable fixed costs, and common fixed costs. Avoidable fixed costs are very important in the decision-making process regarding continue a product line or to discontinue it. This cost gets terminated if the product or segment line is discontinued. On the other hand, unavoidable fixed expenses and common expenses are not relevant in decision making for a product lineProduct LineProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing.. Unavoidable fixed expenses are essential to carry on a segment or product line and cannot be eliminated. This cost will still get incurredCost Will Still Get IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. if the product line or segment is closed. Discontinuation of a segment will force the unavoidable expenses to be allocated to another product or segment line. Common expenses are the expenses forming part of the company on the whole and are allocated to various segments of the product line and cannot be eliminated as a part of a single segment margin analysis.
- Companies use segment margin to check, document, judge, analyze the performance of different business areas.
- By this, one can determine the profit earning capacity of the business segments and decide to carry on the segment or not.
- Business gets to know the worst sectors of its units.
- It increases transparency in reporting.
- Segment reportingSegment ReportingSegment Reporting is the disclosure of financial details of key units or segments by public companies and is based on certain regulatory requirements. can be used to undertake drastic changes if the business operating in the overseas market is more demanding than business operations in the domestic market.
- Focus on Short-Term Goals – Segment margin focuses on short term numbers. Breaking down these numbers given the data point will help create pressure to reduce the losses and increase short term earnings. If a business started a new division, in the beginning, this division would incur a loss in the beginning due to a non-efficient workforce and improper infrastructure. Still, eventually, over a period of time, it may generate profits.
- Data Manipulation – Identification and fixation of any particular sector as a different segment is not regulated by any ruling law but is left open for management to decide and mark different operating units as separate segments. This generates an open area for management to decide and manipulate the operating segment’s information, which may lead to misguiding investors and other stakeholders.
Segment margin can be described as determining and reporting financialsReporting FinancialsFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. of the separate individual operating area of any large-scale multinational company individually. The identification of segments can be at the product service level or a geographical level. Segment reporting helps management to determine which segment needs greater attention and which should be scrapped. The basic objective of this concept is to determine the profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. and financial position of the different operating segments.
This has been a guide to what is Segment Margin and its definition. Here we discuss the formula for calculation of segment margin along with advantages, disadvantages, and differences. You may learn more about financing from the following articles –