Segment margin is the amount of net profit or net loss generated by a portion of a business. It is useful to track segment margins (especially on a trend line) in order to learn which parts of a total business are performing better or worse than average. The analysis is also useful for determining where to invest additional funds in a business. However, the measurement is of little use for smaller organizations, since they are not large enough to have multiple business segments. This concept is typically only used by publicly-held organizations that are required to report segment information to the Securities and Exchange Commission; privately-held companies are not required to do so.
Segment margin is calculated from the revenues and expenses that are directly traceable to a segment. It is generally not a good idea to include an allocation of corporate overhead in the segment margin calculation, since it obscures the operating results of the segment. The only exception is when corporate expenses would be eliminated if an operating segment were to be shut down, since this implies that the corporate expense is a direct cost of the segment.
Generally, you should include an expense in the calculation of a business segment under any of the following circumstances:
- When the manager of that segment has direct control over the expense.
- When you can reasonably assign a cost using activity-based costing.
- When a cost varies directly with the revenues generated by the segment.
- When the cost would disappear if the segment were to be sold or discontinued.
When calculating segment margin, there is no difference if you use a GAAP-sanctioned format that includes fixed costs in the determination of gross margin, or if you use a contribution margin format that shifts fixed costs lower in the calculation. In both cases, you are only including revenues and expenses that are traceable to the business segment in question, so the net bottom-line segment margin should be the same in either case.
Examples of the segments of a business are:
- Individual store locations
- A geographic region
- A product line
- A sales territory
- A subsidiary
- For a public company, any business unit that has at least 10% of the revenues, net profits, or assets of the parent company
Another use of the segment margin is on an incremental basis, where you model the estimated impact of a specific customer order (or other activity) into the existing segment margin in order to forecast the results of accepting the customer order (or other activity).
You should also consider creating a separate statement of cash flows for each business segment, which gives an accurate view of the sources and uses of cash by segment.