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Segment Margin & Decision-Making in Accounting

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  • 0:04 Segment Margin &…
  • 0:32 Variable & Fixed Costs
  • 1:51 Contribution Margin
  • 2:40 Segment Margin
  • 4:50 Importance
  • 5:23 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Businesses must determine if it is profitable to keep operating different segments. In this lesson, you'll learn how analyzing the segment margin assists businesses in making this decision.

Segment Margin and Decision Making

Mr. Green operates Lawns R Us in his hometown. He currently offers lawn mowing, aeration and landscaping services to his clients. Despite his marketing efforts, he has not been successful in getting customers to take advantage of his aeration services and is wondering if he should close that part of his business. Let's examine the factors that Mr. Green needs to consider before making this decision.

Variable and Fixed Costs

All businesses incur costs in order to generate sales, and these costs can be separated into variable and fixed costs. Variable costs are those costs that vary with the amount of activity. For example, the more lawns that Lawns R Us mows, the more direct labor costs it will incur, as more people will need to be hired to complete the work. Fixed costs are those costs that do not fluctuate with the amount of activity. The rent that Mr. Green must pay for his office building would be an example of a fixed cost, as rent will cost the same whether Lawns R Us mows one lawn or one hundred lawns monthly.

Fixed costs can be subdivided into those costs that are avoidable and those that are unavoidable. Unavoidable fixed costs are those costs incurred regardless of how many business segments are operating. Mr. Green's rent expense is also an example of an unavoidable fixed cost. Whether he operates one segment or three segments, he will still need to pay the same rent (assuming he can't downsize his office space). An avoidable fixed cost is one that would not be incurred if a particular segment were not operating. For example, if Mr. Green decided to stop offering aerating services, the salary paid to administrative staff working in this department would be saved.

Contribution Margin

In order to calculate his business, Mr. Green would want to calculate the contribution margin for each of the three segments. Contribution margin represents the amount of money a business has left over (after deducting variable costs) to cover its fixed costs and contribute to profit.

The formula for calculating contribution margin is:

sales - variable costs

Let's examine the contribution margin for each of Mr. Green's three segments.

Contribution Margin by Segment
Segment Margin - Contribution Margin

We can see that the contribution margin for each segment is positive, which means it is contributing to covering fixed costs and profits. If we only examined contribution margin, we would conclude that there were no issues. However, if Mr. Green wanted to examine how profitable each segment was, he would need to look at the segment margin.

Segment Margin

The segment margin takes into consideration all costs that can be traced directly to a particular line or segment of business. It includes variable costs as well as avoidable fixed costs that can be traced to an individual segment. Unavoidable fixed costs are not included in the calculation of the segment margin, as they are usually allocated to each segment based on a pre-determined percentage.

The formula for calculating segment margin is:

sales - variable costs - avoidable fixed costs per segment

Let's review the segment margin for each of Mr. Green's three segments: lawn mowing, landscaping and aerating.

Segmented Income Statement
Segment Margin - Revised II

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