Simply defined, segment margin is a measure of the profitability of a particular segment within a business. The segmentation may be based on product lines or geographic regions. Segment margin is a means of comparing the financial performance across different areas of operations, to decide which component of the business needs to be invested in more, and which needs improvement before receiving further investment. Thus, we can say that segment margin helps a business allocate resources efficiently.
Segment margin is particularly useful for large companies that sell multiple products. Besides helping in identifying segments that generate below-average revenues, it also calls for the management to reconsider some of their decisions. Furthermore, public limited companies are required to share their financial performance via regulatory filings and company reports periodically. This information needs to be presented in a segment-by-segment format.
If you are wondering why such a format is mandatory, be informed that in addition to the fact that it presents data in a more detailed, clear, and concise manner, it is also a requirement under the Generally Accepted Accounting Principles that segments earning revenue more than or equal to 10% of the company’s assets must present the financial information separately.
How to Calculate Segment Margin?
The easiest way to calculate segment margin is to subtract the costs incurred by a particular segment from the revenue it generated.
Hence, the formula would be:
Segment Margin = Segment Revenue – Segment Costs
When calculating this value, special care must be taken to ensure that the costs we use are specific to the particular segment and do not include expenses incurred by the company or other departments. Even fixed costs that are shared by multiple segments should not be included in this calculation.
The following example might help you further understand what is segment margin and how it should be calculated.
Let’s assume a company has a product line called ‘A’.
‘A’, generated a dollar amount of 40,000 in revenue whereas the cost of goods sold is $30,000. Under such a situation the segment margin would be 40,000-30,000= $10,000. The segment margin percentage would be (10,000/40,000) × 100 = 25%.
Now consider that another product line ‘B’ also exists that is owned by the same company and has a segment margin of 40%.
When comparing both the percentages, 40% is higher which means that product line ‘B’ is yielding greater profits and hence is more beneficial for the company. Therefore, if the company needs to choose between ‘A’ and ‘B’ in terms of investing limited resources, ‘B’ is likely to be selected.
Advantages and Disadvantages of the Segment Margin
It’s time to check out the advantages and disadvantages of the segment margin:
- Segment margin helps businesses decide which product lines should be discontinued and which should be worked upon by providing a realistic account of their profitability
- It helps the organizations identify their low-performing components and allows them a chance to make timely rectification or improvement
- The segmented market serves as a useful tool for internal benchmarking which motivates low-performing segments to work harder
- It serves as an eye-opener for the management
- Segment margin focuses on the short-term profitability of the segment. It does not take into account the fact that the performance may improve and the fact that new ventures and even product lines take time to make their mark
- There are no rules or laws regarding what constitutes a segment. Hence, organizations may misuse this loophole by classifying operating units as a segment and misguiding all stakeholders
- If the segmentation is done based on geographic regions, segment margin values might not be comparable due to different economic factors
- The value of the segment margin might be easily manipulated by altering the figure that constitutes sales volume.
Segment margin provides a realistic snapshot of various divisions within a business in terms of profitability. It is a useful tool for benchmarking, both within the organization and the industry. Within the organization, it can also serve as a parameter for the performance of a segment. The only drawback to this otherwise useful measure of a segment`s financial health is that managers may falsify certain values to depict the higher profitability of a segment.