Segment Margin
Segment margin is a measure used by businesses to determine the profitability of a particular segment within their operations. In larger companies, operations are often divided into segments based on products, services, regions, or other criteria. By calculating the segment margin, companies can determine which parts of their operations are most and least profitable, and make informed decisions about resource allocation, strategy, and potential areas for improvement or expansion.
Segment margin is calculated as:
Segment Margin = Segment Revenue − Directly Attributable Segment Costs
The key to understanding segment margin is recognizing that it only considers costs that are directly attributable to that segment. This means that general overhead costs (like corporate salaries, building rent, or utilities that benefit the entire company) are typically excluded from this calculation. Instead, the segment margin focuses on the variable and fixed costs that are directly tied to producing that segment’s products or services.
Example of Segment Margin
Let’s delve into a fictional example of a company named “TastyTreats Inc.” that operates in two segments: ice creams and pastries.
Scenario: TastyTreats Inc. – Profitability Analysis
TastyTreats Inc. wants to understand which of its business segments – ice creams or pastries – is more profitable. The company decides to calculate the segment margin for both segments.
Ice Cream Segment:
- Segment Revenue: TastyTreats Inc. sold $1,000,000 worth of ice creams in the last fiscal year.
- Directly Attributable Segment Costs:
- Raw Materials (cream, sugar, flavors): $400,000
- Direct Labor (workers involved in ice cream production): $100,000
- Marketing and Promotions for ice creams: $50,000
- Total Direct Costs for Ice Cream Segment: $550,000
Ice Cream Segment Margin = $1,000,000 (revenue) – $550,000 (costs) = $450,000
Pastries Segment:
- Segment Revenue: TastyTreats Inc. sold $700,000 worth of pastries in the same period.
- Directly Attributable Segment Costs:
- Raw Materials (flour, butter, sugar, fruits): $250,000
- Direct Labor (bakers and helpers): $100,000
- Marketing and Promotions for pastries: $30,000
- Total Direct Costs for Pastries Segment: $380,000
Pastries Segment Margin = $700,000 (revenue) – $380,000 (costs) = $320,000
Analysis:
From the calculations:
- The ice cream segment has a higher segment margin ($450,000) compared to the pastries segment ($320,000).
- However, in terms of profitability ratio:
- Ice Cream Segment Margin Ratio = $450,000 / $1,000,000 = 45%
- Pastries Segment Margin Ratio = $320,000 / $700,000 = 45.7%
Though the ice cream segment provides a higher absolute margin, when we consider the margin as a percentage of segment revenue, pastries are slightly more profitable.
Outcome:
Using this analysis, TastyTreats Inc. might decide to allocate resources differently, reconsider pricing, evaluate cost structures, or invest more in the slightly more profitable pastry segment to maximize its potential. This example highlights how segment margin analysis can guide strategic decisions in a multi-segment business.
