As the number of products offered by a company increases and/or its geographical presence grows, it needs to create different departments/divisions to look after each unique product or business area.
For example, an airline may have segments like domestic operations, international operations, freight operations and an automobile manufacturer may have segments like motorbikes, cars, trucks, SUVs, and so on. Divisions may be carved out based only on geographical locations, such as Americas, Europe, Middle East, Australasia, etc.
Segments are either a cost center, a revenue center, a profit center or an investment center depending on the nature of their operations and the level of responsibility given to the segment management.
- A segment is a cost center when it has no revenue of its own and it just provides support to other revenue-making segments. An accounting center would qualify as a cost center. The performance of a cost center can be measured with reference to some budgeted or standard cost.
- A revenue center is one which generates revenue but has no separate costs of its own. A marketing department is a good revenue center example.
- A profit center is a segment which has both revenues and expenses. Performance of profits centers can be measured by comparing their segment/division contribution margins or controllable margins. But this analysis does not consider the amount invested in each division.
- An investment center is the highest level of responsibility. It allows investors and central management to determine return per dollar of each segment. Segments are best compared at the lowest investment center level.
While the central management provides the overall direction and strategy, the operational decision-making is delegated to the segment management. This enables a company to respond quickly to opportunities and threats and tailor its products to different markets thereby improving efficiency and profitability. However, it is important for the central management to actively monitor the segment performance in order to decide which segments are doing good, which segments need further funding, which segments ought to be shut down, etc.
Performance measurement tools
Segment performance is measured using management accounting tools such as:
- Residual income,
- Return on investment,
- Accounting rate of return, etc.
These tools are also useful in comparing performance of different managers and in many businesses their remuneration is linked to the ROI or residual income they earn.