Allocation moves profit between segments without moving a dollar of cash. Before a segment is closed on its allocated loss, the closure test has to be run on contribution and avoidable cost.
On a base that reflects what drives the cost, stated and never changed mid-year, and never as the basis for a closure decision. The base decides who looks unprofitable: an illustrative $18.0M corporate pool allocated on revenue gives the Equipment segment a $2.00M loss; on gross profit it earns $1.07M. Group profit is $5.5M either way, and closing Equipment would cut it to $1.20M.
Worked in full in Financial Planning and Analysis by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A company reports three segments. Each carries its own gross profit and its own direct operating costs; what remains, contribution, is what the segment earns before any shared cost. Above them sits an $18.0M corporate pool: finance, legal, IT, the executive team, the head office. All figures are illustrative, in millions.
| Segment | Revenue | Gross profit | Direct opex | Contribution | Headcount |
|---|---|---|---|---|---|
| Equipment | 60.0 | 15.0 | 8.0 | 7.0 | 120 |
| Software | 25.0 | 20.0 | 9.0 | 11.0 | 150 |
| Services | 35.0 | 10.5 | 5.0 | 5.5 | 130 |
| Group | 120.0 | 45.5 | 22.0 | 23.5 | 400 |
Less the $18.0M pool, group profit is $5.5M. Every segment has positive contribution.
Allocation to a segment = pool × segment base / total base
Segment profit = contribution − allocation
On revenue, Equipment: 18.0 × 60.0 / 120.0 = 9.00, so profit = 7.0 − 9.00 = −2.00
Excel: =Contrib-Pool*Base/SUM(BaseRange)
Run the same formula on three bases.
| Segment | Revenue base: share | Profit | Gross profit base: share | Profit | Headcount base: share | Profit |
|---|---|---|---|---|---|---|
| Equipment | 50.0% | −2.00 | 33.0% | 1.07 | 30.0% | 1.60 |
| Software | 20.8% | 7.25 | 44.0% | 3.09 | 37.5% | 4.25 |
| Services | 29.2% | 0.25 | 23.1% | 1.35 | 32.5% | −0.35 |
| Group | 5.50 | 5.50 | 5.50 |
Three bases, three different loss-makers. On revenue, Equipment loses $2.00M because it has half the revenue and a 25 per cent gross margin. On gross profit it earns $1.07M, a swing of $3.07M, and Software gives up $4.16M of reported profit to pay for it. On headcount, Equipment earns $1.60M and Services becomes the loss-maker. Across the three bases Equipment's result moves by $3.60M. No cash moved, no customer changed, and the group still earned $5.5M.
None of the three is wrong. Revenue is the easiest base to defend and the worst for a low-margin, high-volume segment. Gross profit charges overhead in proportion to the ability to pay it, which flatters the weak and penalises the strong. Headcount fits costs that follow people, such as HR and IT, and fits a head office poorly. The choice matters less than two rules: say which base, and do not change it to make a segment look better.
The reason allocation matters is that someone will eventually propose closing the segment that shows the loss. The question then is not the allocated profit but what disappears. Equipment brings $7.0M of contribution. If it goes, the corporate pool does not shrink by $9.00M: most of finance, legal and the executive team stay. Suppose 30 per cent of Equipment's allocation is genuinely avoidable.
| Avoidable share | Overhead saved | Contribution lost | Change in group profit | Group profit after |
|---|---|---|---|---|
| 0% | 0.00 | 7.0 | −7.00 | −1.50 |
| 30% | 2.70 | 7.0 | −4.30 | 1.20 |
| 60% | 5.40 | 7.0 | −1.60 | 3.90 |
| 100% | 9.00 | 7.0 | 2.00 | 7.50 |
At 30 per cent avoidable, closing the loss-maker cuts group profit from $5.5M to $1.20M. Closure only pays if more than 77.8 per cent of the allocation would disappear with the segment, which is 38.9 per cent of the whole head office. That is a restructuring, not a closure, and it should be costed as one.
The unavoidable $15.30M of the pool does not vanish; it is reallocated. On revenue, Services now carries enough of it to report a $3.43M loss, down from a $0.25M profit, and Software falls to $4.62M. The next review finds a new loss-maker. That cascade is the practical danger of allocated segment results.
The mistake is to read the bottom line of an allocated segment page as the segment's economics. It answers a different question: how much of the shared cost would this segment have to carry to pay its share. The decision questions, whether to grow, price, invest in or close a segment, are answered by contribution and by avoidable cost. Present both on the same page: contribution first, allocation below it, and the base in the footnote. The same discipline, measuring the decision on what it actually changes, is what exposes a commission plan that rewards a losing discount.
The contribution build, the allocation on revenue and on gross profit side by side, and the closure test with the avoidable share as an input are live in the free workbooks for the book's company.
The one that best reflects what drives the cost, stated and held constant. Revenue is simple but loads low-margin, high-volume segments; gross profit loads high-margin ones; headcount follows people-driven costs. In this case the Equipment segment's profit moves by $3.60M between the three bases while group profit stays at $5.5M.
Not on that number. Run the closure test: contribution lost against the overhead that genuinely disappears. Equipment shows a $2.00M loss after a revenue allocation but contributes $7.0M. If 30 per cent of its $9.00M allocation is avoidable, closing it saves $2.70M and group profit falls by $4.30M.
They absorb the unavoidable overhead. After Equipment closes, $15.30M of the pool remains and, reallocated on revenue, turns Services from a $0.25M profit into a $3.43M loss. The next review then finds a new loss-maker, which is how allocation-driven closures cascade.
This article is one calculation from Financial Planning and Analysis. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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