True Product Costing

Why you sell at phantom profit and lose money and how ABC Costing reveals the truth

A question that decides any manufacturer’s survival: Do you really know what each product costs you to produce? The shocking answer per IMA’s 2026 study: 67% of mid-sized industrial companies use inaccurate cost systems, showing phantom profits on products that actually lose money, and phantom losses on products that are most profitable. The consequence: wrong pricing decisions, continued production of resource-draining items, and discontinuation of products that should have been scaled.

The problem starts with a simple but devastating idea: “Overhead is allocated uniformly across all products.” This worked in the 1960s when direct labor was 60% of cost. Today, direct labor is 10-15% at most, while technology, quality, storage, and delivery costs dominate. Allocating these uniformly is a catastrophic distortion of true profitability. This article reveals the truth, details the ABC (Activity-Based Costing) system, with a real calculation model and a Saudi case study.

67%

use inaccurate costing

23%

typical deviation from true cost

40%

of products sold at unknown loss

SAR 2.4M

typical annual loss

Components of True Product Cost

True cost has three layers, most companies measure only the first accurately:

Layer 1: Direct Costs (DC)

Easiest to measure: raw materials going directly into the product, and direct labor wages working on it. Example: producing 100 liters of juice requires 80 kg of fruit (SAR 1,200) and 4 hours direct labor (SAR 320). Total direct cost: SAR 1,520 = SAR 15.20/liter. Most companies stop here and call this “the cost.”

Layer 2: Manufacturing Overhead (MOH)

Everything happening inside the factory but not entering the product directly:

Factory rent and electricity: SAR 180,000/month.
Equipment maintenance: SAR 45,000/month.
Machine depreciation: SAR 90,000/month.
Supervisor and quality salaries: SAR 120,000/month.
Operating consumables (oils, cleaning): SAR 25,000.
Raw material and finished goods storage: SAR 60,000.

Total: SAR 520,000/month. The critical question: How do we allocate this across different products? This is where the biggest distortion happens.

Layer 3: Non-Manufacturing Costs

Many companies entirely ignore this layer in product costing, despite it representing 25-40% of total:

Sales and marketing: commissions, advertising, sales team salaries.
Delivery and logistics: transportation, distribution warehousing, freight insurance.
Customer service and after-sales: warranties, returns, complaints.
General administration: leadership salaries, IT, HR.
Financing: loan interest, bank fees, cash discounts.

⚠️ Common Mistake: Misleading “Gross Margin”

Many managers decide based on “gross margin,” which only computes price minus direct cost. A product priced SAR 100 with SAR 60 direct cost looks profitable at 40%. But adding SAR 25 manufacturing overhead and SAR 20 non-manufacturing costs flips it into a SAR 5 loss per unit. Right decisions need full contribution margin.

Why Traditional Costing Methods Fail

Traditional costing relies on a single cost driver to allocate all overhead — usually direct labor hours or production volume. Watch how it fails:

Imagine a factory producing two products:

Product A: Simple, high-volume (10,000 units/month), consumes 1,000 direct labor hours, no complex setup.
Product B: Complex and customized, low-volume (500 units/month), consumes 200 direct labor hours, but needs 15 machine setups and 30 quality checks.

Traditional method allocates overhead (SAR 520,000) by labor-hour ratio: Product A takes SAR 433,000, Product B takes only SAR 87,000. Result: Product B looks ultra-cheap and ultra-profitable, so the company expands it. Hidden truth: Product B consumes most of supervisor time, quality inspection, machine setup, and extra storage. Its true cost is much higher, and the company loses on every unit.

ABC Costing: The Solution That Reveals Truth

Activity-Based Costing fundamentally changes the equation: instead of one driver, each activity in the factory becomes its own cost center, allocated by its own logical driver. Five steps:

Step 1 — Identify activities: Inventory every resource-consuming activity (machine setup, quality inspection, internal transport, storage, purchase orders, customer order processing, etc.).
Step 2 — Assign costs to each activity: Determine monthly cost per activity (e.g., one machine setup = SAR 2,800).
Step 3 — Define a cost driver per activity: Setups by setup count, quality by check count, transport by movement count, etc.
Step 4 — Compute rate per activity: Total activity cost ÷ total driver units = unit cost.
Step 5 — Allocate activity costs to products: Each product takes its cost based on actual consumption per activity.

Real Calculation Model: Methods Compared

Item	Product A (Trad.)	Product A (ABC)	Product B (Trad.)	Product B (ABC)
Direct cost/unit	SAR 28	SAR 28	SAR 120	SAR 120
Overhead/unit	SAR 43	SAR 22	SAR 17	SAR 198
Total cost	SAR 71	SAR 50	SAR 137	SAR 318
Selling price	SAR 95	SAR 95	SAR 280	SAR 280
Profit / (Loss)	+SAR 24	+SAR 45	+SAR 143	-SAR 38

The difference is shocking. Traditional method shows Product B as the “company star” at SAR 143/unit, so the company concentrates marketing and production effort on it. Hidden reality: every unit of B loses SAR 38. Product A, looking “ordinary,” is actually highest-profit (SAR 45/unit at 10,000 units = SAR 450,000/month profit).

ERP’s Role in Implementing ABC Costing

Manual ABC via Excel is theoretically possible but practically impossible above 50 SKUs. Modern ERP delivers:

Hierarchical cost centers: Unlimited definition across multiple levels (department → machine → process → product).
Auto activity tracking: System automatically logs every activity (setup, check, transport) and links to production order.
Smart cost allocation: Editable allocation rules without coding, enabling scenario testing.
SKU-level contribution margin analysis: Real-time reports showing profitability per product, customer, channel, region.
Variance alerts: System alerts instantly when actual cost deviates from standard by a defined %.

Case Study: Food Manufacturer

Background: Mid-sized Saudi dairy and juice manufacturer, 47 SKUs, SAR 95M annual revenue, declared net profit 4.2%.

Problem: Management was puzzled — sales growing 18% annually, but profitability eroding. Traditional analysis didn’t reveal why.

Diagnosis after ABC Costing:

• 19 SKUs (40%) sold at actual loss, despite appearing profitable in legacy system.
• Total losses on these SKUs: SAR 2.4M annually.
• Cause: “specialty” products (custom packaging, rare flavors) consumed 4-7× the setup and quality time, but priced as ordinary products.
• Conversely, 12 SKUs were far more profitable than legacy system showed.

Actions taken:

• Discontinued 8 unsalvageable loss-makers.
• Raised prices on 11 loss-makers by 15-35% (lost 20% of customers, but profit rose).
• Set minimum order quantity for custom orders to cover setup costs.
• Reallocated marketing budget toward truly highest-profit SKUs.

Results after 12 months:

✓ Net profit rose from 4.2% to 11.7%.
✓ Net earnings improved by SAR 7.1M despite 4% sales drop.
✓ Reduced operational complexity and freed 22% of factory capacity.
✓ More confident pricing and product portfolio decisions.

Conclusion

True product cost isn’t an accounting figure — it’s a strategic compass. Every pricing, expansion, discontinuation, or market-entry decision depends on its accuracy. Companies using traditional costing in an era of escalating product complexity decide on broken information. The question every GM should lose sleep over: Do I really know which products earn me money and which drain me? Answering “yes” requires ABC Costing — nothing less.