Financial statements play an important role in any manufacturing
business. Your management team, lenders and other external stakeholders rely on
these reports to assess your overall financial health and historical
performance. But for internal purposes, you might want to drill down into the
numbers to learn which products contribute most to your bottom line. One useful
tool for understanding your business's profitability is the segmented income
statement. Here's how to use it to enhance decision-making related to product
lines, staffing, investments and other critical areas.
What does a segmented income statement
reveal?
A traditional income statement generally shows your
manufacturing business's overall revenue (operating and nonoperating) and
expenses. It may also show certain gains and losses from, for example, selling
equipment.
However, for strategic planning purposes, you may benefit from
more granular information. A segmented income statement breaks down your
revenue and expenses by segment. For a manufacturer, the most obvious segments
are product lines or customers. But you could also segment based on geographic
location, salesperson, divisions or another category relevant to management's
decisions.
Assigning revenue and direct costs (such as labor, materials and
supplies) to the appropriate segment may be relatively simple. But allocating
indirect costs — those costs that can't be readily traced to a specific segment
— presents a greater challenge.
Several approaches are commonly used to allocate indirect (or
overhead) costs such as rent, utilities, insurance, and compensation for
administrative staff and upper management. Some manufacturers, for example,
allocate these costs based on the segment's revenue, units sold, labor or
machine hours. The essential point is that the method should allocate costs in
a way that reasonably reflects resource usage; if it doesn't, the segmented
income statement will distort a segment's reported profitability.
Note: Potential
lenders and investors may request segment-level profitability information.
Having a segmented income statement on hand (or at least maintaining the
necessary detail in your accounting system) makes it easier to respond.
Constructing a segmented report later from a traditional income statement can
be difficult.
What are the benefits?
Segmented income statements make it easier to spot the segments
that are strong and weak performers. This information, in turn, can guide vital
decisions about resource allocations, investments and long-term strategic
plans. For example, a segment with both high revenue and high costs may be a
good candidate for cost-reduction measures.
You might also discover that, say, 20% of your product lines
account for 70% to 90% of your profits. This information could prompt you to
raise prices on some low-margin products or eliminate them altogether.
However, don't hastily eliminate a product line solely because
it appears unprofitable on your segmented income statement, especially based on
a single period of underperformance. Instead, determine which revenue and costs
would actually disappear, how the decision would affect related products or
customer relationships, and whether the resulting production capacity could be
put to more profitable use.
Underperformance can be caused by a variety of factors,
including:
- Seasonal or temporary shifts in demand,
- Unexpected increases in materials, labor or other
production costs,
- Excessive scrap, rework, downtime or setup activity,
- Natural disasters and other supply chain disruptions,
- Entry of a new competitor in the market, or
- Volatile market conditions.
A segment could also underperform as a new product finds its
footing. In other words, context matters.
Remember, too, that a single segmented income statement — like a
single traditional income statement — captures only that accounting period.
You'll gain more actionable insights by examining historical trends and future
projections.
Next steps
If the advantages of segmented income statements sound
appealing, contact us. We can work with you to identify useful segments,
establish defensible cost drivers and incorporate segment analysis into your
regular financial reporting. We can also help you use the results to evaluate
pricing, budgets, product mix, capacity and other strategic decisions.
