Do you know your company’s bottom line but don’t necessarily understand which parts of your business are responsible for your struggle or success? If so, you’re certainly not alone. While large corporations usually have a sophisticated understanding of segment profitability, most small businesses and many mid-market companies have not yet matured their financial function to identify these attributes and leverage the benefit of this knowledge.
Segment profitability analysis involves an assessment of profitability broken down into groups – products, services, customers, divisions, locations, and more. A segment profitability analysis is important to see if certain customers add to your profits or cost your company money. Or to know if a particular store is more profitable than another. Or to understand if a new service line just isn’t pulling its weight.
Segment profitability analysis elevates a business owner’s understanding of his/her business by analyzing contribution (or lack thereof) of component parts of the business, and they can provide an invaluable perspective into the strengths and weaknesses of your company.
Prepare To Measure Segment Profitability – in 3 Steps
Although the role of an interim CFO is temporary, you should still make the most out of their expertise and skillset. Interim CFOs go beyond merely filling the gap left after a permanent CFO has left. They can provide your company with valuable insights, help drive goals, and play an integral role in strategic financial planning.
Interim CFOs generally perform the same duties as permanent CFOs. They can analyze your company’s financial well-being and assist with changes that arise during their tenure. When you think of the role they play in your company, remember they are there to help you in whatever way is needed. In the same way you would utilize a permanent CFO, utilize these individuals. Whether you need aid in navigating and structuring a specific project or a fresh perspective on a financial matter, they are equipped to handle it. Additionally, due to the short time they spend with your company, they’re motivated to accomplish objectives within a shorter timeframe and leave your company better than they found it. Below are a few ways to get the most out of your Interim CFO.
Step 1: Categorize Segment Groups
First your team needs to define your segment groups. For example, if your business is an apparel store that sells clothing for men, women, and kids, then you can group those customers by gender and age. If the store is part of a franchise, you could group them by location or specific stores. If you have an industrial facility that supports both commercial and retail customers, you might want to evaluate these segments separately.
Step 2: Identify Your Segment Revenues and Costs
Next, your business needs to understand the revenue and expenses that can be directly attributed to each segment. How much sales/revenue is related to each segment? What direct costs are we incurring to support each sale? – i.e., materials, direct labor, sales commissions, shipping costs, return/warranty costs, or other expenses that are incurred directly as a function of an associated sale.
Step 3: Consider Indirect Costs that Relate to Each Segment
In addition to the direct costs associated with the products and services, you also may benefit from identifying segment data for certain indirect costs as well. While it’s not always possible to attribute every cost to a particular segment, you might consider some of the following questions:
- How much is the handling/processing cost per order for this segment?
- How much does marketing/advertising spend is required to acquire and retain a customer in this segment?
- Is one group “higher maintenance” than another in terms of demands customer service, accounting, or other administrative functions?
How To Calculate Segment Profitability Analysis
The formula for calculating segment profitability is very straightforward once you have evaluated the related data:
Segment Revenue – Segment Costs = Segment Profitability
Segment Profitability / Segment Revenues = Segment Profitability Margin (%)
Let’s take a look at an example. The clothing store could have two segments: women’s and men’s clothing. On average, women’s clothing brings in $100 per transaction, while men’s clothing brings in $80.
You may think that women’s clothing in this store is more valuable than men’s clothing based on the revenue. However, what if women’s clothing is more likely to cost more than men’s clothing?
As more customers shop for women’s clothing, there are more likely fulfillment requests, such as refunds and customer service on these products.
Let’s say it costs $70 per transaction for women’s clothing, from the labor, fulfillment, shipping, and/or returns. For men’s clothing, the cost per transaction will be $10.
So, if we were to calculate the segment profit, it would look like this:
- Women’s clothing segment: $100 revenue per transaction – $70 costs = $30 profit with a 30% profit margin.
- Men’s clothing segment: $80 revenue per transaction – $40 costs = $40 profit with a 50% profit margin.
We will see therefore that, despite lower sales levels per unit, the men’s clothing segment is more profitable than the women’s clothing segment. Companies might adjust any number of strategies to focus on the more profitable segment.
Other Considerations With Segment Profitability
Does this mean, though, that you should focus more on selling men’s clothing? The answer could be both yes and no – there are more factors that we need to consider.
It could make sense to focus on the men’s clothing segment as that makes more profit for your business. More quality products and marketing for this segment can increase the volume of transactions and perhaps the revenue per transaction as well.
However, as the women’s clothing segment generates more revenue on a per unit basis and could have more customers, your company could also focus on lowering the associated costs. And if, for example, higher costs are derived from refunds and customer service, the company could consider why this group is making more refunds than the other and whether its return policy needs to be adjusted.
Could it be the quality of the products? Could the products not be accurately compared to what’s advertised? How can we make customer service more efficient and improve customer experience?
If the store’s brand sells for both groups, it doesn’t mean that they should abandon the less profitable group. Adjust your strategies for both groups to maximize your overall business profits.
Ultimately, there are ways you can improve your business’s segment profitability. You can do this by increasing revenue and/or decreasing costs for each segment – with strategies derived from high-quality data-driven analysis.
How Can We Help?
Sabre Financial Group offers CFO and Controller services for small to middle-market businesses in many industries on a fractional or interim basis.
We can collaborate with your team at every stage of the segment profitability analysis. From evaluating revenue and costs to categorizing segments and calculating profit, we’re here to support you.
Please contact our team to schedule a consultation so we can discuss how to drive growth and boost profitability throughout all segments of your business.