If a company has multiple product or service lines, it's useful to know which business activities generate the most profit. To better understand its profitability, a business can segment its operations into divisions and calculate a profit margin for each one.
1. Determine the Divisions
Identify the different divisions in the company. Divisions can be segmented by product line, sales territory, geographic region or individual store locations. For example, a clothing manufacturing company may divide its company by children's clothing and women's clothing.
2. Identify Revenues
Identify all the revenues that can be specifically attributed to each division. For example, the company may have booked net sales of $400,000 for children's clothing and $500,000 for women's clothing during the accounting period.
3. Find Direct Costs
Determine the division's direct costs. According to AccountingTools.com, you can include a cost as a direct cost if any of the following applies:
- The manager or executive that oversees the segment had control over the expense.
- The cost varies directly with variances in revenues generated by the segment.
- If the division were to close, the expense would disappear.
For a children's clothing division, potential direct costs would include:
- Direct materials and cost of labor incurred to produce the clothing.
- Factory rent, utilities, property taxes, machine depreciation, factory supervisors and support staff salaries (assuming the factory is used exclusively for children's clothing).
- Any administrative or executive staff that spend 100 percent of their time on children's clothing.
- Marketing, shipping and sales commissions that were exclusively for children's clothing.
4. Identify and Allocate Shared Costs
Some costs can't be directly attributed to a single division, yet each division still benefits from the expense. Using a cost allocation model, allocate shared expenses and overhead costs to each division. Examples would be CEO and administrative salaries, corporate office rent and business insurance. Costs can be assigned based on a number of factors, like the relative proportion of revenue each division brings in or the amount of time that executives dedicate to each division. For example, if the total compensation for the CEO is $400,000 annually and he estimates he spends about 10 percent of his time working on children's clothing, allocate $40,000 in costs to the children's clothing margin.
5. Calculate Division Margin
To calculate the division's profit margin, divide its net income by its revenues. To find net income, subtract the division's direct costs and its portion of shared costs from direct revenues. For example, if the children's clothing line has revenues of $400,000, direct costs of $200,000 and its portion of shared costs is $100,000, then its net income is $100,000 and its profit margin is 25 percent ($100,000 divided by $400,000). This means that approximately 25 percent of the revenues that the division generates flow through to the company as income.