Even when business results are good enough I believe that many companies do not grasp which items or services produce the profits. Some companies grasp it intuitively but it is not based upon concrete figures, so it is difficult to judge how they should approach the business for the next stage. The most important thing is to understand the profit by segment.
There are several classifications of segments; for example, companies can classify the segments service by service, product by product, area by area, etc. It depends on what areas management wants to focus on and how they make decisions. The following are possible ways of comprehending the profit by segment.
Decide segments
Deciding segments is the first step for profit control. It is entirely up to the type of business though focusing attention on target customers is important as the first step.
For example, in the case of a watch business, classifying the segments by men and women is one idea. If your focus is profit by item classifying by high-class goods, middle-class goods and others is also another solution. Also, if the company has branches it goes without saying that a breaking down of the profit by branch should be implemented.
Classification of expenses
Once the segments are decided, the classification of costs related to each segment is important. Primarily costs should be classified into variable costs and fixed costs though this classification is also useful to do a break-even analysis. If several departments exist, a calculation of department costs should be made first before the variable and fixed costs classification. Examples of variable costs include cost of goods, material costs, outsourcing costs, etc, and examples of fixed costs include rent, insurance, depreciation (using the straight-line method) and salaries. Some costs are mixed/ semi-variable/ semi-fixed costs. An example of a semi-variable cost is utilities, where there is usually a fixed charge in addition to charges for consumption.
Accounting system
The accounting system is another important factor in understanding the segments profit, and once the classification of the costs is decided it should be reflected on the accounting system.
- Classify each department into the accounting system (if there are several branches, segmenting each department is more useful than an area segment), and prepare journal entries based upon the segment.
- Set flags on each segment sale and variable cost. In the case of the watch business above, setting flags such as A, B and C for high-class goods, middle-class goods and others is common.
- The above flags should be reflected in the inventory ledger.
Gross margin of each segment
Setting up the categories and accounting systems above makes it easier for companies to grasp gross margin (gross margin is defined as sales revenue minus variable costs) here by each segment, and the fixed costs should also be covered by the gross margin. Not only the amount of the gross margin but also the gross margin rate and units margin are important for further analysis.
The following is an illustration of the analysis.
<In the case of a watch business>
Segment A: High-class goods 50% JPY 20 million
Segment B: Middle-class goods △25% △JPY 5 million
Segment C: Others 5% JPY 25 million
In this case, the highest gross margin rate is Segment A though the largest profit is Segment C despite of the lowest gross margin rate. On the contrary Segment B recorded a minus gross margin in spite of a relatively high gross margin rate. The management might implement the following actions.
- Focus on Segment A more due to the highest gross margin rate.
- Reform Segment B business due to the minus gross margin in spite of the good gross margin rate.
- If there are some absolute or aged goods in each segment, the management might sell them at a discounted price to secure money.
Break-even analysis
The above gross margin is called “Contribution Margin” upon the break-even analysis.
As long as companies cover all fixed costs by the contribution margin, they can recognize where profits are made. The following is an example using break-even analysis.
<Annual result>
Unit : Million of Yen
|
Segment |
Quantity sold |
Sales |
Variable cost |
Contribution |
Fixed cost |
Profit |
| A |
200 |
60 |
30 |
30 |
10 |
20 |
| B |
400 |
40 |
30 |
10 |
15 |
△5 |
| C |
100,000 |
700 |
665 |
35 |
10 |
25 |
It is important to calculate the “Breakeven point” upon the break-even analysis though a correct understanding of the “Unit contribution margin” is needed in order to calculate it.
Unit : Yen
|
Segment |
Unit sale |
Unit Variable cost |
Unit contribution margin |
| A |
300,000 |
150,000 |
150,000 |
| B |
100,000 |
75,000 |
25,000 |
| C |
7,000 |
6,650 |
350 |
Breakeven point is defined as:
Breakeven Point = Fixed Costs/ (Unit Selling Price – Variable Costs)
If the quantity sold of each breakeven point is defined as A, B, C, all we have to do is to calculate with the following formula.
Segment A : 10,000,000 /150,000×A = 0 A = 66.7
Segment B : 15,000,000 / 75,000 ×B =0 B =200
Segment C : 10,000,000 / 350 ×C = 0 C =28,571.4
Once the breakeven point is calculated companies should consider several plans of action. The following are examples of tactics related to the above.
- Transferring a worker from Segment B to Segment A. If Segment A has more potential for opportunity, transferring a worker is one of the solutions.
- Decrease the fixed costs of Segment B. If there is not a big difference regarding the work volume of each segment, the fixed cost of Segment B should be decreased.
- Increase the sales volume of Segment C
If Segment C isn’t made up of face-to-face transactions but rather paper transactions, the work volume might not increase a lot by increasing the transaction volume, so increasing the number of transactions is one tactic.
Of course, there are a lot of solutions to be considered in the above cases though I believe that a little ingenuity gives way to further information and solutions.
By Certified Public Accountant & Tax Accountant, Koji Takahashi,
Tokyo & Yokohama
