Supply Chains and Segment Profitability: How Input Pricing Creates a Latent Cross-Segment Subsidy

Abstract

ABSTRACT: Recent years have seen an increased emphasis on developing more precise accounting measures of market- and customer-level profitability. By their very nature, such segment profitability measures may unwittingly neglect complementarities. Such complementarities have been widely recognized on the demand side due to brand recognition, predatory pricing, or interdependent products. We develop a model showing that important supply-side complementarities can also be prevalent. In particular, when a firm relies on a self-interested supplier for inputs used across multiple segments, the wholesale price it pays depends on the average profitability of its segments. Taking such interaction between upstream pricing and the firm’s downstream reach into account, the model shows that: (1) segment profit calculations can understate or overstate the value added by the segment depending on the segment’s relative contribution margin, and (2) the firm sometimes benefits from devoting resources to less profitable segments and perhaps even from serving seemingly unprofitable markets and/or customers.