Concepts used in segmental analysis

To understand segmental analysis, you need to know about the concepts of variable cost, fixed cost, direct cost, indirect cost, net income of a segment, and contribution to indirect expenses. Next, we describe each concept.

Costs may be either directly or indirectly related to a particular cost object. A cost object is a segment, product, or other item for which costs may be accumulated. In other words, a cost is not direct or indirect in and of itself. It is only direct or indirect in relation to a given cost object.

A direct cost (expense) is specifically traceable to a given cost object. An indirect cost (expense) is not traceable to a given cost object but has been allocated to it. Accountants can designate a particular cost (expense) as direct or indirect by reference to a given cost object. Thus, a cost that is direct to one cost object may be indirect to another. For instance, the salary of a segment manager may be a direct cost of a given manufacturing segment but an indirect cost of one of the products manufactured by that segment. In this example, the segment and the product are two distinct cost objects.

Because a direct cost is traceable to a cost object, the cost is likely to be eliminated if the cost object is eliminated. For instance, if the plastics segment of a business closes down, the salary of the manager of that segment probably is eliminated. Sometimes a direct cost would remain even if the cost object were eliminated, but this is the exception rather than the rule.

An indirect cost is not traceable to a particular cost object; therefore, it only becomes an expense of the cost object through an allocation process. For example, consider the depreciation expense on the company headquarters building that is allocated to each segment of the company. The depreciation expense is a direct cost for the company headquarters, but it is an indirect cost to each segment. If a segment of the company is eliminated, the indirect cost for depreciation assigned to that segment does not disappear; the cost is simply allocated among the remaining segments. In a given situation, it may be possible to identify an indirect cost that would be eliminated if the cost object were eliminated, but this would be the exception to the general rule.

Because the direct costs of a segment are clearly identified with that segment, these costs are often controllable by the segment manager. In contrast, indirect costs become segment costs only through allocation; therefore, most indirect costs are noncontrollable by the segment manager. Be careful, however, not to equate direct costs with controllable costs. For example, the salary of a segment manager may be direct to that segment and yet is noncontrollable by that manager because managers cannot specify their own salaries.

When preparing internal reports on the performance of segments of a company, management often finds it is important to classify expenses as fixed or variable and as direct or indirect to the segment. These classifications may be more useful to management than the traditional classifications of cost of goods sold, operating expenses, and nonoperating expenses that are used for external reporting in the company’s financial statements. As a result, many companies prepare an income statement for internal use with the format shown below.

Indirect Expenses not allocated to Segments

This format is called the contribution margin format for an income statement because it shows the contribution margin. Contribution margin is defined as sales revenue less variable expenses. Notice that all variable expenses are direct expenses of the segment. The second subtotal in the contribution margin format income statement is the segment’s contribution to indirect expenses. Contribution to indirect expenses is defined as sales revenue less all direct expenses of the segment (both variable direct expenses and fixed direct expenses). The final total in the income statement is segmental net income, defined as segmental revenues less all expenses (direct expenses and allocated indirect expenses).

Earlier we stated that the performance of a profit center is evaluated on the basis of the segment’s profits. It is tempting to use segmental net income to make this evaluation since total net income is used to evaluate the performance of the entire company. The problem with using segmental net income to evaluate performance is that segmental net income includes certain indirect expenses that have been allocated to the segment but are not directly related to it or its operations. Because segmental contribution to indirect expenses includes only revenues and expenses directly related to the segment, this amount is often more appropriate for evaluation purposes.

To stress the importance of a segment’s contribution to indirect expenses, many companies prefer the contribution margin income statement format. Notice how the indirect fixed costs are not allocated to individual segments. Indirect fixed expenses appear only in the total column for the computation of net income for the entire company. The computation for each segment stops with the segment’s contribution to indirect expenses; this is the appropriate figure to use for evaluating the earnings performance of a segment. Only for the company as a whole is net income (revenues minus all expenses) computed; this is, of course, the appropriate figure to use for evaluating the company as a whole.

Arbitrary allocations of indirect fixed expenses As stated earlier, indirect fixed expenses, such as depreciation on the corporate administration building or on the computer facility maintained at company headquarters, can only be allocated to segments on some arbitrary basis. The two basic guidelines for allocating indirect fixed expenses are by the benefit received and by the responsibility for the incurrence of the expense.

Accountants can make an allocation on the basis of benefit received for certain indirect expenses. For instance, assume the entire company used a corporate computer for a total of 10,000 hours. If it used 4,000 hours, Segment K could be charged (allocated) with 40 per cent of the computer’s depreciation for the period because it received 40 per cent of the total benefits for the period.

For certain other indirect expenses, accountants base allocation on responsibility for incurrence. For instance, assume that Segment M contracts with a magazine to run an advertisement benefiting Segment M and various other segments of the company. Some companies would allocate the entire cost of the advertisement to Segment M because it was responsible for incurring the advertising expense.

To further illustrate the allocation of indirect expenses based on a measure of benefit or responsibility for incurrence, assume that Daily Company operates two segments, X and Y. It allocates the following indirect expenses to its two segments using the designated allocation bases:

The following additional data are provided:

The following expense allocation schedule shows the allocation of indirect expenses:

When it uses neither benefit nor responsibility to allocate indirect fixed expenses, a company must find some other reasonable, but arbitrary, basis. Often, for lack of a better approach, a firm may allocate indirect expenses based on net sales. For instance, if Segment X’s net sales were 60% of total company sales, then 60% of the indirect expenses would be allocated to Segment X. Allocating expenses based on sales is not recommended because it reduces the incentive of a segment manager to increase sales because this would result in more indirect expenses being allocated to that segment.