A segment is a fairly autonomous unit or division of a company defined according to function or product line. Traditionally, owners have organized their companies along functional lines. The segments or departments organized along functional lines perform a specified function such as marketing, finance, purchasing, production, or shipping. Recently, large companies have tended to organize segments according to product lines such as an electrical products division, shoe department, or food division.

For example, Thomas Alva Edison started the Edison Electric Light Company in 1878 to market his incandescent lamp and other later products. In 1892, Edison merged his company with two other electric companies and formed the General Electric Company.

Today, GE identifies the following segments: Power, Renewable Energy, Aviation, Healthcare, and Capital.

• The Power segment offers technologies, solutions, and services related to energy production, which includes gas and steam turbines, generators, and power generation services.
• The Renewable Energy segment provides wind turbine platforms, hardware and software, offshore wind turbines, solutions, products and services to the hydropower industry, blades for onshore and offshore wind turbines, and high voltage equipment.
• The Aviation segment provides jet engines and turboprops for commercial airframes, maintenance, component repair, and overhaul services, as well as replacement parts, additive machines and materials, and engineering services.
• The Healthcare segment provides healthcare technologies in medical imaging, digital solutions, patient monitoring, and diagnostics, drug discovery, biopharmaceutical manufacturing technologies, and performance enhancement solutions.
• The Capital segment leases and finances aircraft, aircraft engines, and helicopters, and also provides financial and underwriting solutions.

Here are five questions you can address as you contemplate segments:

1. Does the segment have a positive contribution margin?
2. What happens to fixed costs if we eliminate a segment?
3. How will dropping a product or segment affect other areas of the business?
4. What can the company do with freed-up capacity?
5. What are the qualitative (non-financial) considerations?

Let’s look at a hypothetical company called 3Yachts, Inc. Management and the owners of the company are concerned about the low amount of operating income. The company produces 3 different models of sailboats: the HighLine, which sells for $11,000; the MidLine, which sells for $6,500; and the LowLine, the base model, which sells for $4,000.

The current contribution margin income statement looks like this:

Management is thinking about dropping the base model, but they want more information. You have been asked to analyze operating income by product line (segment).

Here is the sales price by model:

Here is the information you have gathered on variable costs:

Which you have summarized:

And you have identified fixed costs as follows:

By modifying the CVP model slightly, you can show that the HighLine model is the culprit here. It sells for $11,000 but costs $12,050 to produce, not including fixed overhead.

Question 1: Does the segment have a positive contribution margin?

Often, in deciding whether to keep or drop a product line, segment, or territory or other business unit (we’ll use the term ‘segment’ from here on to represent all of these), management will start with the contribution margin.

You can review the contribution margin here:

You can view the transcript for “Contribution Margin Income Statement” here (opens in new window).

If a segment has a negative contribution margin, it’s not even covering its variable costs, and unless it is a product with some future potential (like an electric motorcycle) or that contributes to other sales (such as a line of printers that supports a profitable toner cartridge segment), it should probably be dropped.

Let’s look at what would happen to this company if we drop the HighLine model:

Let’s look at this using differential analysis:

It seems fairly obvious that we should drop the HighLine model and concentrate on the MidLine, since that has the highest contribution margin.

But we have only addressed the first of the five proposed questions. We’ll explore the remaining questions in the next section, but first, check your understanding of market segments.