DO YOU REALLY KNOW WHERE YOU MAKE YOUR MONEY?

A lesson from the big end of town:
"Segment analysis" is one of the most powerful tools for driving business improvement.

Listen to Podcast
Click here for Nathan Sherry's interview with Phil Dobbie of CBS Interactive's BNet.com.

What is segment reporting?
Publicly reporting companies are compelled to report their results by classifying them into different segments. The business's assets and income are broken down by area of activity and geographical area. An individual "segment" can be a company, division, geographical region, or a sales segment.

A careful analysis often reveals management mistakes that would otherwise be buried in the totals - so we see profitable divisions subsidising under-performing divisions, bad takeovers, strategic errors, poor expense management, and poor investment decisions.

The principles underlying the Segment Reporting calculations are extremely valuable for all businesses.

A high-profile example: Woolworths exposed!

Take Woolworths as an example. Woolworths has been one of the most successful public companies in recent times. In 2008, Woolworths made a profit of $2,528 million, which was 5.38% of sales, and represented a healthy 31.4% return on assets employed. In other words, for every $100 invested by the Woolworths management, the combined businesses earned $31.40 - an excellent result.

Could they have done better? A quick look at some of their business segments, certainly raises a few questions. Have a look at the table below, where some simple ratios have been compiled.

Here's a few suggestions:

• Australian supermarkets (including fuel) are the standout segment - for every $100 invested, the business earned a return of $78.60. The question is, why is management pursuing other business segments, where the returns are nowhere near as good?

• NZ supermarkets are profitable, but the returns are poor - only 7.8% on invested funds, which are 4 times the Big W assets for a similar profit. An equivalent investment in Australian supermarkets would potentially earn a staggering $1.5 billion in additional profit! So what went wrong - did they pay too much for the NZ investments? Or were they poorly managed?

• Consumer Electronics appears to be a creditable result, although well short of the yield from Australian Supermarkets - 20.9% return on invested funds. However the overall contribution to profits is puny at just $68.1 million, so why are they diverting management attention to these businesses? What would be the result if the businesses were sold, and the funds and management time devoted to more profitable ventures?

• The investment in the Hotels segment is massive - about as much as in the entire Australian supermarkets segment. But the profit earned is a puny 8.3%, potentially foregoing a $2 billion profit had those funds been invested in Australian supermarkets. They could have earned the same modest profit by leaving the money on bank deposit, so there should be a darn good reason for not doing so! What's the strategy going forward, and how does it fit with the earnings requirements and risk profile of the Woolworths group?

Of course there are deeper questions, more segments to consider, and perhaps synergies in the businesses which are not apparent from the numbers.

However what this example shows, is that by looking at just a few simple statistics, some very useful observations can be made. Given the range of yields available, a "what if?" analysis of alternative strategies going forward would be fascinating.

So your business is not Woolworths - what's the point??

Go back and have a look at the last set of annual financial statements for your business. What do the statements tell you about the business? Probably not much! You'll get an idea of overall profitability, but within those numbers are buried some golden nuggets of information which may never see the light of day - unless you dig them out.

Every business is different, and of course, the segment analysis for your business would be different to Woolworths. You might be more concerned with a product analysis than a geographical analysis, or perhaps you have sales channels to compare, and no doubt you would want to take a close look at expenses. But the principle is the same, and flexibility is the key - you can select any meaningful segment to analyse, any time.

More than just a sales analysis
Many businesses analyse their sales, and that's useful. But that is only one part of the equation - what are the TOTAL costs of getting those sales? After taking into account all costs, marketing and promotion, administration, finance and overhead, what is the REAL profit on each product or service? And what investment in assets was required to achieve that? How does that compare with other investment opportunities (perhaps with lower risk)?

It's simply a fact that within the profit and loss account of all businesses, there will be some products or services which are making a bigger contribution to the business's results than others - wouldn't you like to know which ones? And once you know that, wouldn't you like to know accurately the effect of a change in your product mix or methods of delivery? That's where a targeted segment report will be most useful.

By seeing the TRUE profitability or your products and services you can avoid the mistake of sticking with strategies which might SEEM worthwhile (e.g. high sales or high margin) but which actually consume more of your business's resources than can be justified - resulting in low returns or even losses which are buried in your business's financial statements.

It's your decision - and emotion is OK (if you say it is)
Small and medium businesses can be more flexible, even emotional, about their strategic decision-making than a public company such as Woolworths. Sticking with low profit activities might even be a rational decision for an owner-manager, especially if there are other benefits, such as travel, or lifestyle. The real concern, however, is NOT KNOWING true profitability on a segmented basis, and therefore unwittingly accepting poor rates of return, in addition to the long hours, shouldering the stress of management responsibility, and with your house on the line.

Getting started
To establish a Segment Reporting framework it is firstly necessary to identify the "segments" - the divisions, areas, product or service groupings which are important.

Then the accounting systems will need to be arranged to capture the information broken down by segment. This can usually be achieved with some simple changes to the chart of accounts, but it may also be necessary to change or implement some basic procedures so that cost and revenue information can be identified from source documents, or if necessary, separately captured.

Manufacturing businesses with an Activity Costing framework in place will already have much of the basic data used for a segment analysis.

Segment profit calculations for management purposes are not just an annual event. Calculations can and should be done at regular intervals, and on an ad hoc basis whenever strategic decisions are being considered, when there are significant operational changes or cost shifts, or whenever there is a reason to query a segment profit contribution.

This flexibility is important, as the selection of segments to report on is a matter of judgement. For example,at different times a geographic segment may become more significant than a product-line segment.

The relevance of a segment, and whether it is worthy of investigation must be determined from a "drill-down" of regular management accounts, to determine the underlying reasons for profit and loss performance.

In doing this, "materiality" must be borne in mind - to avoid "paralysis by analysis". In other words, factors which have a significant impact on profit and loss performance should be the priority, and managers should be flexible enough to recognise the need for, and respond to, priority changes.