Calculating and evaluating profitability
To calculate the profitability of a product, customer, or business unit, you need to identify all relevant revenues and costs associated with that segment. The analysis often involves performing a what-if scenario to evaluate the impact of removing the segment, which requires adjusting the income statement to include only costs that are directly traceable and avoidable if the segment were discontinued. Allocated common costs - such as the chief executive’s salary or company-wide administrative expenses - should be excluded, since they’re outside the control of segment management and would persist even if the segment no longer existed.
Controllable margin
Segment profitability is best measured using the controllable margin, which isolates the revenues and costs a segment manager can actually influence.
Controllable fixed costs are the fixed costs the segment manager decides whether to incur, such as the segment’s own supervisory salaries or local advertising. Some fixed costs are traceable to a segment but fall outside the manager’s control - for example, depreciation on equipment corporate chose to purchase, or a facility lease negotiated by headquarters. Subtracting these traceable-but-uncontrollable fixed costs from the controllable margin produces the segment margin, the usual starting point for a keep-or-drop decision. Traceable is not the same as avoidable, though: before deciding, also remove any traceable cost that would continue after the segment is dropped, such as depreciation on equipment with no other use or resale value, or a lease that can’t be cancelled. Allocated common costs, like executive salaries or corporate overhead, belong in neither calculation, since they persist regardless of the segment’s existence and aren’t within the control of segment management.
In CMA exam problems, income statements may present allocated common costs as part of segment results. When this occurs, adjust the statement to remove non-controllable, common costs and focus on controllable margin (or segment margin, if traceable but uncontrollable fixed costs are broken out separately), so that decisions about pricing, resource allocation, or discontinuation reflect the segment’s true operational impact.
Product and customer profitability
The same controllable-margin approach applies to evaluating products and customers, not just divisions. Customer profitability analysis includes the costs of serving a particular customer: order processing, shipping and delivery, sales calls, returns, and any special pricing or discounts negotiated with that customer. Rank products or customers by controllable margin, not by reported operating income, for the same reason you’d use with divisions - allocated common costs distort the comparison. The main measurement issue is cost assignment: costs shared across multiple products or customers must be traced through meaningful cost drivers (for example, number of orders or delivery miles) rather than spread evenly or by revenue, or the resulting ranking will be distorted. Activity-based costing, covered later in this course, provides tools for tracing these shared costs more precisely.
Example of profitability evaluation
Although we are evaluating divisions in the example, the example below is applicable whether the segment being assessed is a product, customer, business unit, or division. Assume that all of each division’s direct fixed costs are controllable by the division manager and avoidable if the division were dropped, so controllable margin and segment margin are the same figure here.
Example: Evaluating whether to eliminate Division 2
Consider the following results of operations for two divisions of a company:
Division 1
(in USD)Division 2
(in USD)Total
(in USD)Revenues 500,000 300,000 800,000 Variable costs (300,000) (200,000) (500,000) Contribution margin 200,000 100,000 300,000 Direct fixed costs (120,000) (70,000) (190,000) Controllable margin 80,000 30,000 110,000 Allocated corporate costs (30,000) (50,000) (80,000) Operating income (loss) 50,000 (20,000) 30,000 The company is evaluating whether to eliminate Division 2, which is currently reporting an operating loss of $20,000. Management is concerned that the division’s negative operating income is dragging down overall profitability and wants to determine if this is a sound decision.
Assessing Division 2’s contribution
While Division 2 shows a net operating loss, further analysis reveals that it has a positive controllable margin of $30,000, meaning that after covering all of its own variable and direct fixed costs, the division contributes $30,000 toward common corporate costs and company profit.
If Division 2 is eliminated, the $50,000 of allocated corporate costs currently assigned to Division 2 will not disappear but will instead be absorbed by Division 1 or remain as corporate overhead. This means the overall profitability of the company will decline by $30,000, which is the amount Division 2 is currently contributing to shared expenses.
Eliminating Division 2 would create the following outcomes:
- Division 1’s profitability would remain unchanged in terms of controllable margin.
- Corporate costs would remain at $80,000, fully allocated to Division 1.
- Total operating income for the company would decline by $30,000, the controllable margin of Division 2.
Recommended actions to improve profitability
Instead of eliminating Division 2, the company should look for ways to improve its profitability while retaining its positive contribution to shared costs - such as reducing variable or controllable fixed costs, growing revenue, or shifting emphasis toward higher-margin products within the division - keeping in mind that simply reallocating corporate costs to another division only shifts where those costs appear and doesn’t change total company operating income.