Calculating and evaluating profitability

Calculating and evaluating profitability

To calculate the profitability of a product, customer, or business unit, it is essential 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. This requires adjusting the income statement to include only costs that are directly traceable and avoidable if the segment were discontinued.

For instance, allocated common costs, such as the chief executive’s salary or company-wide administrative expenses, should not be included in the profitability measure. These costs are outside the control of segment management and would persist even if the segment no longer existed. Excluding such costs ensures that profitability analysis focuses on controllable costs, which are directly influenced by the decisions of the segment’s management.

Controllable margin

Segment profitability is best measured using the controllable margin, which isolates revenues and costs that are directly traceable to the segment. In practice, this means including only those costs that would be avoided if the segment were discontinued, such as variable costs and fixed costs tied exclusively to the segment. Common or allocated costs, like executive salaries or corporate overhead, are excluded, since they persist regardless of the segment’s existence and are not within the control of segment management.

$$\text{Controlable Margin}=\text{Revenues}-\text{Controllable Costs}$$

The controllable margin is calculated as revenues minus controllable costs, and it provides a clearer picture of a segment’s true financial contribution. In CMA exam problems, income statements may present allocated common costs as part of segment results. When this occurs, candidates should adjust the statement to remove non-controllable costs and focus on the controllable margin. This ensures that decisions about pricing, resource allocation, or discontinuation are based on costs that genuinely reflect the segment’s operational impact.

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 or business unit or division.

Example: 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 the division contributes this amount to covering its direct costs and allocated corporate costs.

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:

1. Division 1’s profitability would remain unchanged in terms of controllable margin.
2. Corporate costs would remain at $80,000, fully allocated to Division 1.
3. 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 explore strategies to improve its profitability while retaining its positive contribution to shared costs:

1. Optimize costs: Analyze variable and direct fixed costs to identify areas for cost reduction, such as renegotiating supplier contracts or improving operational efficiency.
2. Increase revenues: Enhance marketing efforts or adjust pricing strategies to boost sales volume in Division 2. This could involve targeting new customer segments or offering bundled products.
3. Reassess allocated corporate costs: Review the basis for allocating corporate costs to ensure fairness. If Division 2 is disproportionately burdened, adjusting the allocation method could improve its reported profitability.
4. Focus on high-margin products: Shift resources within Division 2 to prioritize high-margin offerings, reducing the emphasis on lower-margin products.