A segment contribution margin is a segment’s sales revenue minus its direct costs (direct variable costs and direct fixed costs traceable to the segment). Such costs are assumed to be avoidable costs. An avoidable cost could be eliminated if management were to drop the segment.
If a segment has a positive segment margin—that is, the segment’s revenue is greater than its direct costs—it is able to cover its own direct costs and contribute a portion of its revenue to cover common costs and add to operating income. In that case, management should keep the segment.
If a segment has a negative segment margin, that is, the segment’s revenue is less than its direct costs management should eliminate the segment. However, certain common costs will be incurred regardless of the decision. Those are unavoidable costs, and the remaining segments must have sufficient contribution margin to cover their own direct costs and the common costs.
An analysis of segment profitability includes the preparation of a segmented Income statement using variable costing to Identify variable and fixed costs. The fixed costs that are traceable to the segments are called direct fixed costs. The remaining fixed costs are common costs and are not assigned to segments.