The previous chapter provided insight into the preparation of performance reports by area of responsibility. The notion of holding unit managers accountable only for activities and costs under their control was introduced, along with a promise that the topic would be further developed within the present chapter. It is now time to give added consideration to the measurement and reporting of such segmented business data. A segment can be defined in many ways, but one prevailing view is that it is a discrete business unit for which separate financial information is prepared and evaluated by an operating decision maker within the organization. This decision maker usually has authority to allocate resources and judge performance of the unit, and typically relies upon the segment's financial reports in making those calls. Thus, it is quite important that segmented data be prepared in ways that facilitate thoughtful and correct decisions.
Internal Reporting of Segment Data
Within the scope of the introductory definition, a segment might be a region, territory, division, product category, department, or other classification. A "segment" as judged by upper management might be made up of "sub segments" that are, in turn, judged by middle managers. The segmentation of an entity is a highly subjective process. The goal is divide/allocate overall performance outcomes to the various moving pieces that make up the entire entity. In other words, segment data should indicate what each part of the entity is contributing to the overall basket of business outcomes.
The Problem of Segment Income Measurement
Great care must be taken to develop a very logical structure for evaluating the income of individual segments. Recall the distinction between direct costs and indirect costs. Direct costs are easily traced to and associated with a particular business segment; indirect costs are not. It is fairly easy to understand how direct costs should be pinned on a particular segment in measuring its results. Indirect costs are a more vexing problem. They may be necessary costs for the overall organization to function, but how are they to be allocated to segments? Virtually any allocation scheme is potentially arbitrary. Furthermore, such costs may be well beyond the control of the segment to which they are potentially assigned. For instance, a soft drink company may engage in an expensive national advertising campaign that benefits ten different bottling plants; how much (if any) advertising cost should be assigned to each plant? It is an interesting question - especially if you are a plant manager whose compensation is tied to the profitability of your operation.
Another problem of segment profit measurement is that a direct cost can become indirect as it is pushed down within an organization. This problem can be understood from the perspective of an example that might be quite familiar to you. Suppose you share an apartment with a roommate. The apartment may have a separate electric meter, and you and your roommate probably get a single bill representing your shared usage. The electricity cost is a direct cost clearly matched to your apartment. But, how is the cost to be shared between you and your roommate? Probably, you and your roommate have an agreement to split the cost equally. This split will occur even though you and your roommate do not use exactly the same quantity of electricity. At the individual person level, the electricity cost is an indirect allocated cost, even though it is a direct cost of your apartment. In similar fashion, many business costs can be traced to a segment at one level, but are simply allocated to the sub segments. Because these allocations impact the perceived profitability of individual business units, great care must be exercised in the allocation and interpretation process.
It is not uncommon for a business to develop a model for allocating indirect costs to business units. The allocation scheme is often the subject of debate and consternation. Depending on the scheme in play, there will likely be winners and losers. But, more likely than not, each business unit will feel that their profit measurement is unduly burdened by more than a fair share of indirect cost absorption.