A segmented income statement differs from the traditional income statement.
The typical income statement is created to showcase a company’s performance for investors and stockholders.
In contrast, a segmented income statement serves an internal purpose, helping the company’s management team gain a deeper understanding of its operations.
Segmented income statements provide a more detailed and comprehensive breakdown compared to traditional ones.
They divide the company’s overall financial performance into segments based on regions, product lines, and other factors.
Normal income statements are generally published for the benefit of investors and stockholders. Segmented income statements, on the other hand, are intended for internal use by the management team to assess the company.
Before we delve further, it’s essential to understand some basic terms:
Fixed Cost: Fixed costs are expenses that remain constant for a company, regardless of its activities. They are unchanging.
Direct Cost: Direct costs are directly linked to specific segments. Costs evaluated for a particular segment are considered direct costs. For example, in a mobile manufacturing company with divisions for cell phones and tablets, the raw material cost is a direct cost.
If you eliminate a segment, its associated direct costs are also eliminated. These costs can be traced directly to the segment.
Indirect Cost: Indirect costs, also known as non-traceable costs, are not directly related to segment expenses. For instance, building depreciation is an indirect cost.
Even if you eliminate a segment, you still need to pay rent. These costs cannot be directly traced to a specific segment.
Let’s take an example:
As mentioned earlier, consider a mobile manufacturing company with two divisions: cell phones and tablets. A segmented income statement is created based on various factors such as the number of units sold, sales revenue, and geographic location.
Here’s an example for this mobile company:
Sales for cell phones: $90,000
Sales for tablets: $70,000
Variable expenses are $20,000 for cell phones and $12,000 for tablets.
Variable costs fluctuate with production. They depend on the quantity and quality of products. For instance, if demand for cell phones increases in December, the company will likely need to purchase more raw materials. These costs can be either direct or indirect.
You might wonder why we need to create segment-wise income statements. It’s simple: they allow the company’s management team to gain a comprehensive understanding of each segment, including its revenue, profit, and loss.
Using segmented income statements, management can make informed decisions about segments that are operating at a loss. They can choose to increase product prices, reduce expenses, or even consider shutting down a segment.
It’s important to note that if a segment is shut down, not all expenses will be eliminated. Some expenses may persist, contributing to the company’s overall net income.
Furthermore, segmented income statements help determine whether a segment is making a positive contribution to the company.
To calculate this, subtract variable expenses from revenue to obtain the contribution margin.
If the contribution margin is positive, the segment is contributing positively, and management can consider its continued operation.
If the contribution margin is negative, improvements are needed, or the segment may need to be shut down.