Selecting an Appropriate Basis of Segmentation

In this article we will discuss about selecting an appropriate basis of segmentation.

The appropriateness of a basis of segmentation should be decided in terms of its relevance to external users for decision-making purposes. Generally speaking, that segment is material for users which show significantly different rates of profitability, diverse degrees of risk or varying opportunities for growth. The segment selected should provide the best measures of differing prospects for profits, growth and risk.

Among the many bases of segmentation, industry segmentation is widely recognised as the most appropriate basis of segmentation. According to the International Accounting Standards Committee, “industry segments and geographical segments are usual bases for presenting information on operations by segments. An enterprise would provide information on both bases if both are applicable to its operations”.

Mautz suggests that industry segmentation is fundamental:

“The kind of information useful to an investor appears to be, first and most basic, some indication of the industries in which the diversified company is active and the relative importance of each. Second, he needs to know the relative successfulness of the company’s operations in each of these industries. An investor commits his resources to a company primarily on the basis of his expectations of what the future holds for that company in the way of profits, risk and growth potential. Without knowledge of the industries in which a company participates, the extent of the activities in each one relative to others, and the success or lack of success of the company’s management in meeting competition, he can do little more than make a blind guess at the company’s future.”

The Canadian Institute of Chartered Accountants also states that the “basis of segmentation should generally be the industries in which the enterprise operates”. However, another basis may be chosen “if management decides that segmentation on a basis other than industries is more appropriate for the enterprise”. Segmentation according to “any particular industry classification guide is discouraged in favour of broad industry groupings which management of the enterprise recognises as being clearly distinguishable one from the other”.

Backer and Mcferland have found that no single basis of segment can be suggested for all companies:

“Review of evidence from this study leads to the conclusion that no single segment classification pattern can be applied to all companies. Wide differences in company operations made it necessary to select, in each case, the segments, which will be useful to investors in understanding a company’s business and in forecasting the outlook for earning in future periods… the useful segments are product groups in some cases, markets in other cases. There are also companies where at least some breakdowns into both product and market segments are needed.”

Organisational division as a basis of segmentation is not usually favoured. However, it may be useful to external users if ‘divisions’ clearly reflect diversity in profitability, growth, and risk.

Segmentation according to ‘basic activities’ has been proposed by Rappaport and Lerner who summarise their guidelines for “basic activities” thus:

“Basic activities are activities that generate both revenue and expense streams; they can be structured by product, market or both. The choice of classifying activities by product or market should take into account the classification systems (product and/or market) used by other information sources available to the investor. If two or more products or markets have a common demand elasticity, they may be treated as a single activity. If two or more activities make use of an identical production function, and as such have similar cost trends, they may be considered as a single basic activity. Basic activities should be of sufficient materiality to warrant separate disclosure.”

Those who favour that a single basis should be suggested for reporting segment information generally cite uniformity of reporting among enterprises as the reason for their position. Also, a specified basis of segmentation would eliminate the possibility that segments would be selected so as to present the enterprise in the most favourable manner.

Other persons contend that uniformity among enterprises is not an important factor in the selection of a basis of segmentation, because they believe that investors and creditors should use segment data to evaluate the enterprise as a whole and not to compare a segment of one enterprise with a similar segment of another enterprise.

Those who oppose specifying a basis (or bases) of segmentation point to the inflexibility of such an approach that it may force some enterprises to report segment information which may be uninformative to investors and creditors.

Companies differ so much in structure, operating procedure, and industry that it seems unlikely that any given system can be devised which will apply with equal force to all companies. This is true whether the particular company became diversified through internal growth or as a result of business acquisition.

It is the responsibility of management to exercise its judgment in determining how the enterprise activities are to be grouped for reporting as segments. In making such decisions, management normally takes account of many factors.

Such factors may include similarities and differences in the enterprise’s products and activities; in the profitability, risk and growth of those products and activities; and in the operating and marketing areas and the relative importance of those areas within the enterprise as a whole.

The existence of special regulatory requirements and specific industry characteristics such as in the banking and insurance industries may constitute additional factors to be considered in determining segments to be reported.