Segment Margin is the assessment of the profitability of any segment under the same company, the segment can separate by product line, geography location, or subsidiary.
In a big corporation, it is hard to manage and control the whole operation. So management usually decides to separate it into small independent parts which are called a segment. Each segment represents one part of the business which has its own KPI to access the performance.
The management needs to know their reporting by segment which analyzes the profit and loss to evaluate each segment. Some segments may need to close down as they produce less profit. By closing down some operations, the company will be able to focus on the main business that generates good profit. In order to make a decision, we need to have a report on the segment margin.
Each segment requires to have separate cost and revenue. Some of them just support business activities that sell goods or services to the main business. They allocate costs to the segment level, so management can compare their own efficiency with the external competitors. If it is not profitable, the company can outsource that specific segment from an external party.
Type of Segments
To separate one big entity into multiple segments, management needs to consider so many factors and it differs from one corporation to another. Here is the segment that the company may consider separating.
- Geography: Most big corporations create a separate entity in the country or region to operate their business. Each region may operate slightly differently from the headquarter due to the market.
- Product Line: Some companies evaluate the product line as they have the separate costs of goods sold and revenue. The production manager will be in charge of each product design to minimize cost and maximize profit.
- Service: The company separates services due to the specialist, resources, and regulations. It is more on the output that company provides to the customers. The company wants to ensure that customers receive the best quality service from experts in each field. In audit firms, they separate audit services, tax, and consultants separately.
Segment Margin Formula
We can calculate segment margin by deducting all the expenses from the segment revenue, please refer to the following formula:
|Segment Margin = Segment Revenue – Segment Expenses
ABC is a group company that operates across the US, EU, and Asia. It produces multiple products within these countries.
We can access the segment margin by dividing the revenue and expense by category as following:
- Product Line
The segment report allows the management to review each segment’s performance. The company has invested the capital into each segment, so they want to maximize the return from all investments.
Each company has limited funds even from debt or equity. The company tries to maximize the return by investing in the high-return segment. To do so, management needs to access each segment individually. If necessary, they have to move funds to high-return segments to increase the profit. The low return segment should be closed or outsourced to an external party.
What are the Advantages of Segment Margin Analysis?
|Advantages of Segment Margin Analysis
|Identify the strength and weakness
|The company needs to know its strength and weaknesses. When the segment is profitable, we have to analyze if there are remaining market shares that we will be able to obtain when we increase the operation. If so, we should inject more resources to maximize our profit in that segment. If the segment is not doing well, we have to analyze the cause of it. The right strategy must be put in place.
|High-performance management needs to receive a high reward as well. Usually, there is a leader in all the segments, we need to reward them based on their performance, it is also a factor that will force them to work hard and achieve higher goals next year.
|The top management needs this information in order to consider expanding or shutting down the operation of each segment.
What are the Disadvantages of Segment Margin?
|Disadvantages of Segments Margin
|Not all the costs can be fairly allocated across the segments. There are always costs that cannot identify such as branding, goodwill, management fee, core system, and so on.
|Even if we can identify all the costs, the allocation of them is not easy. It is almost impossible to allocate all these costs fairly across all segments.
|Some products need to supply within the same company. It will lead to the problem of the transfer price. If the seller wants to increase the fee it will impact the buyer.
|Conflict between segment
|Each segment will try to maximize its profit which may hurt the overall company performance.
Segment Margin Vs Contribution Margin
Contribution margin is the product’s sales less its variable cost. It is present in both amounts and percentages. We use the contribution margin to calculate the breakeven point as it presents the amount left to cover the fixed cost. So when the contribution is equal to fixed cost means the business is breakeven. Moreover, it is also a tool to evaluate company profitability when it shows the relationship between the sale and profit.
We use the contribution margin to evaluate each product type or while the segment margin to evaluate each segment’s profit and loss.
The Segment Margin is a tool to evaluate each segment and benchmark all of them together to find the best performance and the one that needs to improve.
Segment Contribution Margin
Segment contribution margin is the segment’s sales less its variable cost. The costs are included in avoidable costs only as they are correlated with the sale. These costs are expected to fluctuate linearly with the sales change.
The segment contribution margin can be positive or negative depending on the cost and sales generated from each segment. If it is positive means that the segment has remaining amount to cover the fixed cost within the period. If it is negative, means that the segment is making a loss. The loss is equal to fixed cost plus the negative contribution.
For a segment with a negative contribution, the management should consider shutting it down or revising the strategy as they are making a huge loss. The sale generates cannot even cover its variable cost.