Segment margin is a measure of profitability that applies to individual product lines. It is calculated as segment revenues minus variable costs minus avoidable fixed costs. It is also used to measure the profitability of a segment or product line when you make the decision of whether to continue or discontinue that segment or product line.
Use the following formula to calculate segment margin:
SM = Segment Revenues – Variable Costs – Avoidable Fixed Costs
Segment margin separates relevant costs from irrelevant costs when analyzing a product line. For instance, if management is deciding whether to continue or discontinue a product line, the appropriate calculation for measuring the relevant revenues and relevant expenses for the decision would be to use this type of margin.
The difference between segment margin and other measures of profitability, such as contribution margin, is that it divides fixed costs into three categories. Consider one of the categories of fixed costs relevant when making decisions about the segment in question; the other two categories of fixed costs are irrelevant.
The three categories include the following: avoidable fixed costs, unavoidable fixed costs, and common expenses. Avoidable fixed costs are relevant in the decision-making process of whether to continue or discontinue a product line. Whereas, unavoidable fixed costs and common expenses are irrelevant for decisions regarding a particular product line.
Avoidable fixed costs are those fixed costs that would not incur if you eliminated the segment or product line. Unavoidable fixed costs are fixed costs necessary for the continuation of the segment or product line. But those fixed costs would still incur if you discontinued that segment or product line. Eliminating the segment in question would merely cause the allocation of these unavoidable fixed costs to another segment. Refer to common expenses as expenses incurred by the company as a whole that are allocated to various segments or product lines.
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Barfield, Jesse T., Michael R. Kinney, Cecily A. Raiborn. “Cost Accounting Traditions and Innovations,” West Publishing Company, St. Paul, MN, 1994.