Most manufacturing leaders believe they understand which products make money. They pull up gross margin reports, see comfortable percentages next to their product lines, and assume they have a handle on profitability.
The problem is that gross margin is an accounting construct, not an economic truth. It's directionally useful, but structurally incomplete. Gross margin tells you what happened after you subtract direct costs from revenue. It doesn't tell you which products actually deserve your capacity, your capital, and your management attention.
Understanding true product profitability in manufacturing requires moving through three layers of analysis:
Most manufacturers stop at layer one. The opportunity (and the risk) lives in the second and third layers.
Gross margin assumes your cost of goods manufactured scales neatly with production volume. This might work in some industries, but in a complex manufacturing organization, this assumption breaks down quickly.
Consider labor costs. Most manufacturers don't add or remove workers with each unit produced. Labor is step-fixed: you have a crew that can produce within a certain range before you need to add headcount. A product requiring frequent changeovers consumes more of that fixed labor capacity than one running in long batches, but gross margin treats them the same if their direct labor per unit is similar.
Setup time creates similar distortions. A product requiring 90 minutes of setup for a 2-hour production run looks very different economically than one requiring 20 minutes of setup for an 8-hour run, even if their per-unit costs appear comparable.
Then there's the overhead that doesn't fit neatly into any allocation formula: engineering support for products with tight tolerances, quality interventions for items with high reject rates, expedited scheduling for customers with unpredictable orders. These costs are real, but they get averaged across the entire product portfolio, making resource-intensive products look better and straightforward products look worse than they actually are.
Two products can show identical gross margins while having completely different impacts on your operation. Consider a hypothetical manufacturer with two SKUs, both showing a 35% gross margin. Product A runs in predictable weekly batches with minimal scrap. Product B runs in small quantities on customer request, requires three changeovers per week, and generates rework that ties up the quality team.
On paper, they seem equally profitable. Here's what the math actually looks like when you factor in capacity consumption:
Let’s say that Product A generates $50 contribution per unit and requires 0.5 hours of constraint time (the bottleneck machine). That's a $100 contribution per constraint hour.
Product B generates $75 contribution per unit (higher than Product A), but requires 1.5 hours of constraint time due to changeovers, quality holds, and scheduling disruption. That's a $50 contribution per constraint hour.
Product A, despite its lower unit contribution, generates twice the economic value per hour of your scarcest resource. If your constraint runs 2,000 hours annually, prioritizing Product B over Product A costs you $100,000 in lost contribution: value that never appears on any report but is very real to your bottom line.
This is why the right question isn't "What margin does this product generate?" but rather "What does this product generate relative to the capacity it consumes?"
Traditional overhead allocation spreads costs using simple bases like direct labor hours or machine hours, assuming it costs the same to support any unit of production regardless of complexity. This assumption distorts profitability in ways that show up in the decisions that matter most.
Consider a manufacturer evaluating whether to bid aggressively on a large contract for a complex, custom product line. Standard costing shows acceptable margins, so they pursue the business. What they don't see is that this product line will consume three times the engineering support and twice the quality intervention hours of their standard products.
Eighteen months later, they're struggling to understand why overall margins have declined even as revenue grew. The answer: they priced the contract based on averaged overhead rates that didn't reflect the true cost of supporting that business. They subsidized a margin-destroying product line with profits from simpler, higher-performing products.
This pattern plays out repeatedly in capital allocation, product discontinuation analysis, and customer profitability assessments. When overhead is allocated on convenience rather than causality, the numbers actively mislead.
The corrective action here isn't necessarily a full activity-based costing implementation; that can be more effort than it's worth. It's understanding, directionally, which products and customers consume disproportionate resources so that high-stakes decisions reflect operational reality.
Most manufacturers track operational metrics including scrap rates, equipment uptime, and labor efficiency. The problem is these metrics sit in a different silo than financial reporting. Operations reviews scrap rates while finance reviews margins, and the two conversations rarely connect.
When scrap rates increase, the quality team sees a problem to fix. What they often don't see is the dollar impact: material cost, labor absorbed in rework, capacity consumed that could have produced saleable goods. The metric is tracked, but it’s not expressed in financial terms that leaders can act on.
By the time margin compression appears on the income statement, the root causes are weeks old. Manufacturers who understand true product profitability close this gap by translating operational performance into financial impact in near-real-time, while there's still time to affect outcomes.
Calculating true product profitability isn't a one-time analysis. Markets shift, product mixes evolve, cost structures change. Manufacturers who get this right build profitability analysis into their manufacturing accounting processes, reviewing financial and operational metrics together and tracking leading indicators rather than just trailing results.
Moving from gross margin reporting to true product profitability requires connecting data that typically lives in separate systems: ERP transactions, production schedules, quality records, and time tracking. Most manufacturers have the raw information, but what they often lack is the analytical framework to translate it into decision-useful insight.
At G-Squared Partners, our fractional manufacturing CFOs specialize in building that connective tissue. We help manufacturing leaders identify their true constraints, quantify capacity consumption across products and customers, and surface the overhead drivers that traditional costing obscures.
Contact G-Squared Partners to discuss how a product profitability analysis could change the way you allocate capacity and price your products.