Business segments such as divisions and product lines should be evaluated based on revenues and costs that are directly related to them. Direct costs (or traceable costs) refer to costs that are directly associated with the existence of the business segment. Without the segment, the organization will not incur in such costs.
Direct costs may be controllable by the segment manager or controllable by other segments. In the computation of segment margin, these are deducted.
Common costs (non-traceable costs or indirect costs) are excluded in the computation of segment margin.
Segment margin is equal to revenues minus direct costs (controllable and non-controllable). In segment reporting, the computation is presented in several steps.
1. Sales - Variable costs = Contribution margin
2. Contribution margin - Direct fixed costs controllable by managers = Contribution controllable by segment managers (also known as short-run segment margin)
3. Contribution controllable by segment managers - Direct fixed costs controllable by others = Segment margin
For evaluation purposes in segment reporting, common costs are not allocated.
Here is a sample segmental report for a company with two segments. All figures are assumed.
|Segment 1||Segment 2||Total|
|Less: Variable Costs||42,000||25,000||67,000|
|Less: Direct fixed costs controllable by managers||30,000||20,000||50,000|
|Contribution controllable by segment managers||$18,000||$25,000||$43,000|
|Less: Direct fixed costs controllable by others||16,000||10,000||26,000|
|Segment Margin||$ 2,000||$15,000||$17,000|
|Less: Unallocated common fixed costs||8,000|
|Net Income||$ 9,000|
It would be unfair to include the common fixed costs in evaluating the segments since these costs are not traceable to the existence of any of the segments. If the common fixed costs of $8,000 were allocated, say at 50% to each segment, Segment 1 will report a loss. However, its segment margin shows a positive amount.
In segment reporting, only the direct costs are taken into account when calculating segment margin. Common costs are not included.
Also, when evaluating a segment manager's performance, the only fixed costs to include are fixed costs that the manager can control.