Management Accounting 101: Decision Making with Relevant Costs - Keep or Drop, a Product/ServiceDivision Segment Margin Avoidable Fixed Costs

What This Is

Segment Margin Analysis is a decision-making tool used to evaluate the profitability of a product, service, or division. It helps managers determine whether to keep or drop a product by comparing its contribution margin to its avoidable fixed costs. For example, Toyota uses segment margin analysis to decide which models to produce and which to discontinue.

Key Frameworks & Metrics

• Segment Margin = Sales - Variable Costs - Avoidable Fixed Costs – measures the profit generated by a product or division after considering variable costs and avoidable fixed costs.
• Avoidable Fixed Costs = Total Fixed Costs - Unavoidable Fixed Costs – identifies the fixed costs that can be eliminated if a product or division is discontinued.
• Contribution Margin = Sales - Variable Costs – calculates the amount of revenue available to cover fixed costs and generate profit.
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit – tells you how many units must be sold to cover all costs.
• Residual Income = Net Income - (Capital Invested × WACC) – measures the profit earned by a product or division after charging for the cost of capital.
• Economic Value Added (EVA) = NOPAT - (Capital Invested × WACC) – measures true economic profit after charging for the cost of capital.
• Return on Investment (ROI) = Net Income / Total Assets – calculates the return earned by a product or division relative to its total assets.
• Segment Margin Ratio = Segment Margin / Sales – measures the profitability of a product or division as a percentage of sales.

Step-by-Step Process

1. Identify the product or division: Clearly define the product or division being evaluated.
2. Calculate the segment margin: Use the formula Segment Margin = Sales - Variable Costs - Avoidable Fixed Costs to calculate the profit generated by the product or division.
3. Determine avoidable fixed costs: Identify the fixed costs that can be eliminated if the product or division is discontinued.
4. Compare segment margin to avoidable fixed costs: If the segment margin is greater than the avoidable fixed costs, the product or division is profitable and should be kept. If not, it may be dropped.
5. Consider qualitative factors: Evaluate the product or division's strategic importance, market trends, and competitive position.
6. Make a decision: Based on the analysis, decide whether to keep or drop the product or division.

Common Mistakes

• Mistake: Treating all costs as relevant when evaluating a product or division.
• Correction: Only consider avoidable fixed costs and variable costs when calculating segment margin.
• Mistake: Ignoring qualitative factors in make-or-buy decisions.
• Correction: Consider strategic, not just quantitative, factors when evaluating make-or-buy options.
• Mistake: Using ROI alone without considering residual income or EVA.
• Correction: Use a combination of metrics to evaluate a product or division's profitability and strategic importance.

Decision-Making Tips

• Always isolate avoidable costs: When evaluating a product or division, focus on the costs that can be eliminated if it is discontinued.
• Consider strategic factors: Evaluate the product or division's strategic importance, market trends, and competitive position.
• Use multiple metrics: Use a combination of metrics, such as segment margin, ROI, and EVA, to evaluate a product or division's profitability and strategic importance.

Quick Practice Scenario

A division is considering dropping a product that generates $100,000 in sales, $60,000 in variable costs, and $20,000 in avoidable fixed costs. What is the segment margin?

Answer: $20,000 Explanation: Segment margin = Sales - Variable Costs - Avoidable Fixed Costs = $100,000 - $60,000 - $20,000 = $20,000.

Last-Minute Cram Sheet

• Segment Margin = Sales - Variable Costs - Avoidable Fixed Costs
• Avoidable Fixed Costs = Total Fixed Costs - Unavoidable Fixed Costs
• Contribution Margin = Sales - Variable Costs
• Break-Even Point (units) = Fixed Costs / Contribution Margin per Unit
• Residual Income = Net Income - (Capital Invested × WACC)
• Economic Value Added (EVA) = NOPAT - (Capital Invested × WACC)
• Return on Investment (ROI) = Net Income / Total Assets
• Segment Margin Ratio = Segment Margin / Sales
• Fixed costs are only fixed in the short run within a relevant range