How to Calculate True Product Profitability Accurately

Authored by: Brett Leibfried — Partner, CPA | Date Published: February 25, 2026

Time and time again, business owners think they know which of their products are driving profits. What they don’t know is the shock they’ll feel when they discover they were completely wrong.

How do you switch out of this mindset? It starts with understanding that true product profitability may include your selling price, but it also involves capturing every dollar from making, storing, and delivering your product.

The Components of True Product Profitability

The problem often lies in how overhead costs are allocated. When you spread factory overhead, administrative expenses, and other indirect costs evenly across all products using a simple percentage markup, you’re making assumptions that rarely reflect reality.

Calculating accurate product profitability requires a comprehensive understanding of both direct and indirect costs:

Direct Costs: Your raw materials, component parts, direct labor hours, and any costs that are usually simple to track and can be directly traced to a specific product.
Indirect Costs: Factory overhead like utilities, equipment depreciation, maintenance, production supervision, and quality control.
Carrying Costs: These costs vary based on how long the products sit in storage and the space they occupy. Logistics costs should be traced to specific products, and you also must account for administrative costs, sales commissions, and even customer service time when calculating true profitability.
Hidden Cost Drivers: Special handling requirements like scrap rates, rework, warranty claims, and rush orders consume technical resources that need to be captured in your costing model.

You might be pouring resources into products that are actually losing money, while overlooking your real profit drivers. It’s time to get a new costing method.

What is Activity-Based Costing?

Today, a manufacturer’s reality is realizing that the straightforward method of allocating overhead might be creating an incorrect structure for their business.

That’s why we suggest Activity-Based costing.

Start seeing the most accurate picture of product profitability when you assign costs based on the activities that actually drive them. Spreading overhead evenly leaves out the key step of allocating cost pools based on consumption.

Let’s look at an example:

Setup costs represent a significant expense in your operation. Using ABC would assign more cost to low-volume products that require frequent changeovers. Similarly, quality control costs would be allocated to products that require extensive quality inspections rather than to simpler products.

What does this do?

Identifying the 20% of cost drivers that account for 80% of the variation in your costs will help you build your pricing model and adjust it accordingly. That high-volume product with tight margins might be your most profitable once you realize it requires minimal setup time and rarely needs rework.

Here are the benefits of the ABC method:

Better decision-making across your business
Price new products with confidence
Know exactly what margin will hit profitability targets
Negotiations with customers become more strategic
Identify which products deserve process improvement investments

Modern manufacturing is far from perfect, but developing a method that understands how outlays are allocated will move you closer to perfect operations.

There are more reasons traditional costing might be failing manufacturers; to understand the full picture, read more.

What Costing Method is Best for My Business?

Tracking labor hours, service costs, volume variances, and process changes is wearing you down, and you aren’t seeing the benefit. What worked for the previous owner might not work for your business anymore.

Let’s compare some key dimensions and see how Activity-based and Standard costing differ.

The highlights of Activity-Based Costing:

Overhead Allocation: ABC assigns costs based on consumption.
Cost Accuracy: ABC traces costs to products.
Cost Visibility: See which activities drive costs and which products consume which resources.
Decision-Making Value: Powerful pricing, product mix, process improvement, and customer profitability tool.
Process Improvement Focus: Find improvement opportunities by linking costs to activities.

The choice between these methods isn’t always clear. Many manufacturers use standard costing for financial reporting and compliance while implementing ABC for decision-making and profitability analysis.

It all comes down to knowing your business. If you’re making decisions about pricing or customer relationships without accurate data, you’re navigating blind. We want to see manufacturers thrive by understanding their true costs.

Should You Switch Costing Methods?

Before making the choice to switch to a more sophisticated costing system, ask yourself these critical questions:

Q: Are you making pricing decisions based on gut feel rather than data?

If you find yourself negotiating prices without clear visibility into your true costs, or if different people in your organization have conflicting views about which products are most profitable, you likely need better cost accounting. When the market conditions shift or a competitor undercuts you, you’ll need a system stronger than intuition.

Q: Have your material or labor costs changed significantly in the past year?

Using standard costs established before recent inflation, supply chain disruptions, or wage increases, your profitability data does not show your true numbers. The gap between standard and actual costs can make the difference between profit and loss, especially in volatile cost situations.

Q: Do your products have different production processes, cycle times, or complexity levels?

The more diverse your production environment, the more important accurate allocation becomes. A job shop with custom orders requires a different costing approach than a repetitive manufacturer, but many companies still use the same simple overhead rate.

Q: Are you planning capital investments or capacity expansions?

Before you invest in new equipment or facilities, you need to know which products will use that space and whether they’ll generate returns. Making expansion decisions based on inaccurate profitability can create an unprofitable business model for years to come.

Build Profitability in 2026

This year, stop wondering where to focus your resources and instead, where you should expand next. For a profitability assessment, contact MBE CPAs’ team of manufacturing advisors. With our industry consulting experience, we’ll show you insights you might be missing.

Let’s work together to build the financial clarity your manufacturing business needs to make confident, profitable decisions.