Revenues and costs associated with each segment in a business organization must be identified. The issue of appropriate segment costing has generated considerable debate in recent years. It is clear that most corporate accounting systems today are inadequate for detailed segment costing. Accounting systems that were originally developed for the purpose of valuing inventory and financial statement preparation do not provide accurate for measuring operational performance of channels, products, territories, or other critical operating divisions.
Traditional accounting systems tend to collect cost data and aggregate them into so called ‘natural’ categories. Natural expenses include such categories as salaries and wages, rent, utilities, supplies and taxes, which describe the nature of the cost item or the object of the expenditure. It is common for many such natural cost categories to be broken down by business function or responsibility center. For example, management can distinguish between salaries paid to salespeople and wages paid to warehouse employees. One marketing expert suggests seven such functional categories that reflect marketing functions: (1) direct selling costs, (2) indirect selling costs (3) advertising, (4) sales promotion, (5) transportation (6) storage and shipping, and (7) order processing. Cost companies perform this level of natural or functional cost identification relatively well. The major problem experienced and the subject of considerable controversy concerns the next step: identifying the costs associated with serving specific channels, territories, and/or products. Two approaches that have each received considerable attention are the contribution margin approach and the net profit approach.
Contribution Margin: A pure contribution margin approach requires that all costs be identified as fixed or variable according to the behavior of the cost. Fixed costs are those costs that do not change in the short run (management salaries, for example). Variable costs are those that change in a predictable manner in relation to some level of activity during a time period (sales commissions, for example). Normally the level of activity is sales volume. An extended contribution margin approach requires further identification of costs as direct or indirect A direct cost is one that is directly incurred by the segment under consideration. Indirect costs (frequently called joint costs) are those incurred due to the existence of more than one segment. Stated another way, direct costs are those that would no longer exist if a specific segment were eliminated. Indirect costs would continue to exist even if that segment were eliminated.
Income statements in the contribution margin method of analysis can be prepared that identify profitability for each segment by determinants of fixed, variable, direct, and indirect costs. Variable cost of goods sold is directly related to the product mix sold in each channel segment; it includes only direct labor, materials and suppliers. All factory overhead costs are treated as indirect fixed costs in the contribution margin approach. Variable direct costs include such items as sales commissions, discounts, and any other expenses that may vary directly with volume within a channel The percentage of variable direct cost-to-sales may vary in each channel. Fixed direct costs include any other costs that can be traced directly to a channel segment. Such costs might include sales salaries and expenses. If separate sales forces are utilized advertising media costs include all expenses that cannot easily be traced to any specific segment.
Net profit Approach: The net profit approach to financial assessment of segments requires that all operating costs be charged or allocated to one operating segment. Proponents of this approach argue that all of a company’s activities exist to support the production and delivery of goods and services to customers. Furthermore most of the costs that exist in a firm are, in fact, joint or shared costs. In order for the true profitability of a channel territory, or product to be determined, each segment must be charged with its fair share of these costs.