A segment refers to any part or activity within an organization for which a manager wants to obtain cost, revenue, or profit information. This can include individual stores, sales territories, and service centers. Constructing segmented income statements involves two vital components: utilizing a contribution format to distinguish fixed costs from variable costs and calculating a contribution margin. To determine a segment margin, it is necessary to isolate traceable fixed costs from common fixed costs.
The cost can be attributed to the office, but not to any specific doctor. It is important to identify traceable and common fixed costs in order to report segments accurately. Traceable fixed costs are allocated to the segments, while common fixed costs are not. However, it is often difficult to determine whether a cost should be classified as traceable or common. Generally, only costs that would cease to exist if the segment itself disappeared should be considered traceable.
The traceable cost may turn into a common cost. A fixed cost that can be attributed to one segment can also be considered a common cost for another segment. Let’s take the example of an airline that wants to analyze the income statement for a specific flight from Loss Angeles to Paris. They want to break it down into segment margins for first class, business class, and economy class. In order to operate at Charles DeGaulle airport in Paris, the airline needs to pay a fixed landing fee. Although this landing fee is directly linked to the flight and can be considered a traceable fixed cost, it is also a common fixed cost for all three segments – first class, business class, and economy class. This means that even if the first class section is empty, the entire landing fee still needs to be paid.
Although the landing fee is not specifically attributed to the first class segment, it is still a necessary expense for all passengers in the first, business, and economy classes. Therefore, the landing fee can be considered a shared cost for these three passenger classes and is traceable to the overall flight.
The segment margin is the difference between the contribution margin and the traceable fixed costs of a segment. It indicates the profitability of a segment once all its costs have been covered. The segment margin is considered the most accurate measure of a segment’s long-term profitability as it only includes costs directly attributable to the segment.
If a segment cannot cover its own costs, it is likely not worth keeping (unless it has significant impacts on other segments). From a decision-making perspective, the segment margin is particularly helpful in major capacity-related decisions, such as discontinuing a segment. On the other hand, the contribution margin is most useful in decisions concerning short-term changes in volume, like setting prices for special orders that utilize existing capacity. Identify the acceptable range for a negotiated transfer price, if any.
A transfer price is the price charged for goods or services provided within a company. It is essential for determining costs and revenues in cost, profit, and investment centers. The division selling the goods or services would generally favor a higher transfer price, whereas the buying division would prefer a lower transfer price.
Transfer prices, do they hold significance? When considering the company as a whole, transfer prices do not impact the overall income, except for potential tax consequences if divisions are situated in diverse regions. What is considered as revenue for one division is regarded as a cost for the other and is nullified during the consolidation procedure. Economically speaking, it is akin to moving money from one pocket to another.
The impact of transfer pricing on segment managers’ decision-making is what truly matters. In companies that embrace decentralization, segment managers are granted considerable autonomy in their dealings with one another. Depending on the transfer price, division managers will determine whether to sell a service on the external market or internally to another division, as well as whether to procure a component from an external supplier or internally from another division.
The concept of negotiated transfer prices suggests that if managers have a good understanding of their respective businesses and are willing to cooperate, it can be an effective approach. Ideally, if a transfer is advantageous for the entire company, overall profits should increase. In such cases (excluding external factors), a transfer price can be determined that benefits each division by increasing their individual profits. To better comprehend this principle, an analogy using a pie is helpful.
Cooperating in a transfer can increase the profits of the entire company, which can be seen as the pie. A larger pie enables division managers to divide it in a way that results in bigger pieces for everyone. Transfer prices play a role in this division process. Although negotiated transfer prices can be effective, they may not succeed if managers are uncooperative and driven by high competitiveness.
The lowest acceptable transfer price for the selling division is determined by the manager’s willingness to go below their “cost.” While the selling division prefers a higher transfer price, the manager will not agree to a price that is lower than their own cost. However, if the manager is rational and fixed costs remain unchanged, they should recognize that any transfer price that covers variable cost and opportunity cost will increase segment profits. The opportunity cost refers to the contribution margin lost on units that cannot be produced and sold due to the transfer. If there is idle capacity, no sales are lost, resulting in a total contribution margin loss of zero.
When determining transfer prices, two options are commonly used: cost-based and market-based. For cost-based transfer prices, it is suggested to use standard cost rather than actual cost. On the other hand, market-based transfer prices involve using the market price for the good or service being transferred. This approach is straightforward to manage and ensures a theoretically accurate transfer price when there is no unused capacity. However, if the selling division has idle capacity, the transfer price may be too high, leading the buying division to potentially purchase from an external supplier or reduce their volume.
