Financial statements play an important role in any manufacturing business. Your management team, lenders and other external stakeholders rely on these reports to assess your overall financial health and historical performance. But for internal purposes, you might want to drill down into the numbers to learn which products contribute most to your bottom line. One useful tool for understanding your business’s profitability is the segmented income statement. Here’s how to use it to enhance decision-making related to product lines, staffing, investments and other critical areas.

What does a segmented income statement reveal?

A traditional income statement generally shows your manufacturing business’s overall revenue (operating and nonoperating) and expenses. It may also show certain gains and losses from, for example, selling equipment.

However, for strategic planning purposes, you may benefit from more granular information. A segmented income statement breaks down your revenue and expenses by segment. For a manufacturer, the most obvious segments are product lines or customers. But you could also segment based on geographic location, salesperson, divisions or another category relevant to management’s decisions.

Assigning revenue and direct costs (such as labor, materials and supplies) to the appropriate segment may be relatively simple. But allocating indirect costs — those costs that can’t be readily traced to a specific segment — presents a greater challenge.

Several approaches are commonly used to allocate indirect (or overhead) costs such as rent, utilities, insurance, and compensation for administrative staff and upper management. Some manufacturers, for example, allocate these costs based on the segment’s revenue, units sold, labor or machine hours. The essential point is that the method should allocate costs in a way that reasonably reflects resource usage; if it doesn’t, the segmented income statement will distort a segment’s reported profitability.

Note: Potential lenders and investors may request segment-level profitability information. Having a segmented income statement on hand (or at least maintaining the necessary detail in your accounting system) makes it easier to respond. Constructing a segmented report later from a traditional income statement can be difficult.

What are the benefits?

Segmented income statements make it easier to spot the segments that are strong and weak performers. This information, in turn, can guide vital decisions about resource allocations, investments and long-term strategic plans. For example, a segment with both high revenue and high costs may be a good candidate for cost-reduction measures.

You might also discover that, say, 20% of your product lines account for 70% to 90% of your profits. This information could prompt you to raise prices on some low-margin products or eliminate them altogether.

However, don’t hastily eliminate a product line solely because it appears unprofitable on your segmented income statement, especially based on a single period of underperformance. Instead, determine which revenue and costs would actually disappear, how the decision would affect related products or customer relationships, and whether the resulting production capacity could be put to more profitable use.

Underperformance can be caused by a variety of factors, including:

Seasonal or temporary shifts in demand,
Unexpected increases in materials, labor or other production costs,
Excessive scrap, rework, downtime or setup activity,
Natural disasters and other supply chain disruptions,
Entry of a new competitor in the market, or
Volatile market conditions.

A segment could also underperform as a new product finds its footing. In other words, context matters.

Remember, too, that a single segmented income statement — like a single traditional income statement — captures only that accounting period. You’ll gain more actionable insights by examining historical trends and future projections.

Next steps

If the advantages of segmented income statements sound appealing, contact us. We can work with you to identify useful segments, establish defensible cost drivers and incorporate segment analysis into your regular financial reporting. We can also help you use the results to evaluate pricing, budgets, product mix, capacity and other strategic decisions.