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

Recent years have seen an increasing emphasis on developing more precise accounting measures of marketand customer-level profitability. These efforts are aimed at helping prune unprofitable constituencies and targeting resources to more profitable segments. This paper demonstrates that even if perfected, such refined segment profitability measures may unwittingly neglect a latent cross-subsidization effect linked with firm participation in multiple markets. In particular, when a firm relies on a privately informed supplier for inputs used across markets, the wholesale price it pays depends on the average profitability of its markets. Thus, if a firm were not to serve its less profitable markets, it may face a steeper wholesale price. Taking such interaction between upstream pricing and the firm's downstream reach into account, the paper shows that: (i) segment profit calculations can understate or overstate the value added by the segment depending on the segment's relative contribution margin, and (ii) the firm sometimes benefits from devoting resources to less profitable segments and perhaps even from serving unprofitable markets and/or customers.