Understanding what drives product costs is essential for manufacturing companies aiming to improve profitability and make informed operational decisions. Two critical factors—product profitability segmentation and the limitations of standard costing practices—play a central role in shaping effective cost management strategies.
Segmenting Product Profitability
In manufacturing, product-level profitability directly influences overall business success. Research shows that approximately 40% of products are unprofitable, while 20–30% generate all reported earnings, often compensating for the underperforming products. The remainder are only marginally profitable. Despite this imbalance, many manufacturers lack visibility into which products belong to each profitability segment.
To enhance financial performance, it is critical to obtain precise and reliable cost data for each product. It is necessary to assess whether products perceived as unprofitable are genuinely so—and if they are, to determine the extent of the issue and appropriate corrective actions. Flawed product segmentation can lead to investments in the wrong products, undermining both profitability initiatives and revenue growth strategies.
Rising Cost Pressures and the Pitfalls of Standard Costing
Most manufacturers rely on standard or normal costing to estimate the cost of production and distribution. This model breaks costs into three categories:
- Direct materials
- Direct labor
- Factory overhead
Factory overhead is typically allocated based on machine hours, labor hours, or similar direct cost metrics. This approach can work when:
- Product volumes and batch sizes are consistent
- Technologies and labor requirements do not vary significantly
- Overhead remains relatively small compared to direct costs
However, evolving technologies and increased automation have significantly increased overhead costs. At the same time, product portfolios have become more diverse, with varying batch sizes, volumes, and production complexities. As a result, standard costing methods do not reveal the true cost of individual products.
While standard costing and variance analysis may suffice for accounting and financial reporting, they fall short in supporting strategic and operational decisions.
The Case for True Cost Understanding
To make informed decisions, businesses must adopt a costing methodology grounded in actual operational requirements. This includes:
- Analyzing the unique costs of producing each product within a given fiscal unit such as batch sizes and technologies can impact all products that share resources
- Recognizing that the same product may incur different costs at different locations—even with identical technologies—due to portfolio composition and operational context
Operational restructuring should never be undertaken without a comprehensive understanding of the specific production requirements of each product within the larger context reflected in its cost calculation. Failing to do so results in strategic missteps and excessive risk.
Conclusion
Manufacturers seeking sustainable profitability must go beyond traditional costing models and gain a deeper understanding of product-level costs. By segmenting product profitability accurately and adopting Vayoom’s cost analysis approach, organizations can make smarter investments, optimize operations, and drive long-term value.