421. The segment margin is the best gauge of the long-run profitability of a segment because it includes only those costs that are caused by the segment.422. From a decision-making point of view, the segment margin is most useful in major decisions that affect capacity such as dropping a segment.423. By contrast, as we noted earlier, the contribution margin is most useful in decisions involving short-run changes in sales volume, such as pricing special orders that involve temporary use of existing capacity.424. The distinction between traceable and common fixed costs is crucial in segment reporting because traceable fixed costs are charged to segments and common fixed costs are not.425. On the other hand, the president of the company undoubtedly would continue to be paid even if one of many divisions was dropped.426. Any allocation of common costs to segments reduces the value of the segment margin as a measure of long-run segment profitability and segment performance.427. The decision to retain or discontinue a business segment should be based on the sales and expenses that would disappear if the segment were dropped.428. Because common fixed expenses will persist even if a business segment is dropped, they should not be allocated to business segments when making decisions.429. All of these functions, from research and development, through product design, manufacturing, marketing, distribution, and customer service, are required to bring a product or service to the customer and generate sales.430. As a result, such companies omit from their profitability analysis part or all of the “upstream” costs in the value chain, which consist of research and development and product design, and the “downstream” costs, which consist of marketing, distribution, and customer service.431. These upstream and downstream costs, which are usually included in selling and administrative expenses on absorption costing income statements, can represent half or more of the total costs of an organization.432. If either the upstream ordownstream costs are omitted in profitability analysis, then the product is undercosted and management may unwittingly develop and maintain products that in the long run result in losses.433. To the extent that selling and administrative expenses are not driven by sales volume, these expenses will be improperly allocated—with a disproportionately high percentage of the selling and administrative expenses assigned to the segments with the largest sales.434. In short, there is no cause-and-effect relation between the cost of the corporate headquarters building and the existence of any one product.435. As a consequence, any allocation of the cost of the corporate headquarters building to the products must be arbitrary.436. While it is undeniably true that a company must cover its common costs to earn a profit, arbitrarily allocating common costs to segments does not ensure that this will happen.437. In fact, adding a share of common costs to the real costs of a segment may make an otherwise profitable segment appear to be unprofitable.438. Therefore, variable costing advocates argue that fixed manufacturing costs are not part of the costs of producing a particular unit of product, and thus, the matching principle dictates that fixed manufacturing costs should be recognized as an expense in the current period.439. Segmented contribution format income statements contain vital information that companies are often very reluctant to release to the public (and hence competitors).440. By contrast, absorption costing treats fixed manufacturing overhead as a product cost, along with direct materials, direct labor, and variable overhead.
