True Product Costing

The Phantom Profit Problem

Many manufacturers and distributors have a product that everyone in the company believes is the star. It sells at a good price, the gross margin on the report looks healthy and sales are encouraged to push it. Then someone traces where factory time, quality checks, special packaging and delivery effort actually go, and finds that the star is losing money on every unit, while a dull, high-volume item is quietly carrying the business.

This is phantom profit: profit that exists in the costing report but not in the bank. It comes from cost systems that spread overhead across products using one simple measure, usually labour hours or units produced, when the real drivers of overhead are things like setups, inspections, small batches and special handling.

True product costing means assigning to each product the costs it actually causes, as closely as is practical. This guide explains the layers of product cost, why traditional allocation distorts it, how activity-based costing works with a fully worked example, what the accounting standards require for inventory valuation, and how an ERP makes the whole thing maintainable.

The Three Layers of Product Cost

Layer 1: direct costs

Materials that go into the product and labour that works directly on it. These are the easiest to measure because a bill of materials and a routing tell you exactly how much each unit needs. Most companies get this layer roughly right.

Layer 2: production overhead

Everything that happens inside the factory but cannot be traced directly to one unit: machine depreciation, maintenance, energy, supervision, quality control, internal transport, storage of raw materials and work in progress, production planning. In many modern plants this layer is as large as direct labour or larger, and it is where most distortion happens.

Layer 3: costs to sell and serve

Sales commissions, marketing, delivery, customer service, returns and warranty, credit terms and the finance cost of carrying receivables. These are not part of inventory cost, but they are very much part of whether a product or a customer is profitable. A product that needs frequent small deliveries and generous credit can lose money even if its factory cost is low.

Why Traditional Allocation Misleads

Traditional costing collects production overhead into one pool and spreads it using a single rate, such as overhead per direct labour hour. That worked reasonably well when labour was the dominant cost and products were similar. It breaks down when products differ in complexity, because complex, low-volume products consume a share of overhead far larger than their share of labour hours.

Think about what drives a setup. Changing a line from one product to another takes the same time whether the next run is 100 units or 10,000. A product made in many small batches therefore causes many setups, and each setup costs money in technician time, scrap during start-up and lost capacity. If overhead is spread by labour hours, the high-volume product pays for most of the setups caused by the low-volume one.

The idea of tracing overhead to the activities that cause it was set out by Robin Cooper and Robert Kaplan in their 1988 Harvard Business Review article "Measure Costs Right: Make the Right Decisions", and became known as activity-based costing (ABC).

A Fully Worked Example

The following is a hypothetical factory with two products and SAR 520,000 of production overhead per month.

• Product A: standard item, 10,000 units a month, 1,000 direct labour hours, direct cost SAR 28 per unit, selling price SAR 95.
• Product B: customised item, 500 units a month, 200 direct labour hours, direct cost SAR 120 per unit, selling price SAR 500.

Traditional allocation by labour hours

Total labour hours are 1,200, so the rate is SAR 433.33 per hour. Product A absorbs SAR 433,333 and Product B absorbs SAR 86,667. Per unit, that is SAR 43.33 for A and SAR 173.33 for B.

Activity-based allocation

Now the same SAR 520,000 is split into the activities that actually generate it, each with its own driver:

Product A's overhead is 45,000 + 48,000 + 128,000 + 40,000 = SAR 261,000, or SAR 26.10 per unit. Product B's is 135,000 + 72,000 + 32,000 + 20,000 = SAR 259,000, or SAR 518 per unit.

The two pictures side by side

Total monthly profit is the same SAR 340,000 under both methods, because the same overhead is being shared. What changes is the story. Under traditional costing, Product B looks like the most profitable item in the range and management would push it. Under activity-based costing, every unit of B loses SAR 138, and Product A is subsidising it.

What management can do with this

• Reprice B: customised products often carry a setup or minimum order charge that recovers the cost of small batches.
• Change how B is made: fewer, larger batches, or a dedicated setup procedure that halves setup time, would cut its overhead sharply.
• Grow A deliberately: A is more profitable than anyone thought, so it deserves sales attention and capacity.
• Drop or outsource B: only after checking which overhead would actually disappear. Depreciation on a shared machine does not go away when one product stops.

That last point is important. ABC tells you which products consume resources. It does not by itself tell you what you will save by stopping one, because some costs are fixed in the short term. Use the ABC result to start the conversation, then model the decision on incremental cost.

What the Accounting Standards Require

Management costing and inventory valuation are not the same thing. Under IAS 2, which applies under IFRS as endorsed in Saudi Arabia, the cost of inventory includes purchase cost, conversion costs and other costs to bring inventory to its present location and condition. Production overheads are included; selling costs, general administration not related to production, and abnormal waste are not.

Two specific rules affect how you allocate:

• Normal capacity: fixed production overheads are allocated based on the normal capacity of the facilities. The amount per unit is not increased because output is low or a plant is idle. Unallocated overhead goes to expense in the period. Without this rule, a slow month would make every unit look more expensive and push cost into inventory.
• Lower of cost and net realisable value: if a product's selling price less costs to complete and sell falls below its cost, inventory must be written down. In the example, if Product B's true cost really were above its net selling price, that test matters.

Standard costing is acceptable for inventory if the standards approximate actual cost and are reviewed regularly. Many companies use ABC rates to set better standards, then value inventory on those standards, while keeping customer and channel costs in a separate management analysis.

Beyond the Factory: Cost to Serve

Two customers can buy the same product at the same price and generate very different profit. Consider a hypothetical comparison for a distributor selling SAR 1 million a year to each of two customers at the same gross margin of 20%:

The sales report shows two equal customers. The cost to serve shows one strong account and one that barely pays for itself. The fix might be minimum order values, delivery charges or tighter credit, not losing the customer.

Keeping Costs Honest With Variance Analysis

Even a good standard cost goes stale. Variance analysis compares what a product should have cost with what it did cost, and splits the gap into causes someone can act on. Take a hypothetical month for Product A, with a standard of 1.2 kg of material at SAR 10 per kg:

The total material variance is SAR 11,040 adverse. The price variance is (10.40 − 10.00) × 12,600 = SAR 5,040, which belongs to purchasing: a supplier price rise or a rushed order. The usage variance is (12,600 − 12,000) × 10.00 = SAR 6,000, which belongs to production: scrap, a machine setting or a wrong bill of materials. Without the split, the two departments would each blame the other. With it, both know exactly what to investigate.

The same logic applies to labour (rate and efficiency) and to overhead (spending and volume). The volume variance is especially telling: it shows the cost of running below normal capacity, which IAS 2 says should be expensed rather than buried in inventory.

Using True Cost in Pricing

Better costing does not mean pricing by cost plus a fixed markup. Market prices still set the ceiling. What true cost gives you is the floor and the room in between. For a quotation on a custom order, add the actual setup and inspection cost for the batch size requested, not an average spread over all units. If a customer wants 200 units instead of 2,000, the quote should show what that small batch really costs, either as a higher unit price or a separate setup charge. Sales teams who see this in the ERP at quotation time stop winning orders that lose money.

How to Implement Better Costing Without Drowning in Data

1. Start with direct costs: accurate bills of materials and routings, with realistic scrap. If this layer is wrong, nothing else helps.
2. Set up cost centres that match how the factory works: lines, machine groups, quality, warehouse, maintenance. Our article on cost center types explains the options.
3. Pick a small number of activities: four to eight activities with clear drivers capture most of the insight. Hundreds of activities create work without much extra accuracy.
4. Record the drivers in normal transactions: setups and inspections logged on work orders, machine hours from the production record, moves from warehouse transactions.
5. Recalculate rates periodically: quarterly or annually, using normal capacity for fixed costs.
6. Compare and act: review product and customer profitability every month and decide on price, process or mix.

Common Costing Mistakes

• Using gross margin as profit: price minus material and labour ignores the costs that differ most between products.
• Overhead rates set years ago: energy, wages and depreciation have moved; the rates should too.
• Loading idle capacity into product cost: it makes products look more expensive in slow months and violates the normal capacity rule.
• Including recoverable VAT in cost: input VAT you can deduct is not a product cost.
• Ignoring scrap and rework: they belong in standard cost when normal, and in a separate expense when abnormal.

How an ERP Supports True Product Costing

Costing done in spreadsheets tends to be accurate once and then drift. An ERP keeps it current because the data comes from daily transactions: material issues from inventory, labour from timesheets, machine and setup data from work orders, overhead from the general ledger by cost centre. Tranquil is a cloud ERP whose financial accounting connects with inventory, purchasing, sales and manufacturing capabilities such as multi-level bills of materials, production scheduling and quality checks, and its projects module covers labour and parts costing. For more on production cost structures, see our cost of production guide.

Frequently Asked Questions

Is activity-based costing only for large manufacturers?

No. A small factory with a mix of standard and custom products often benefits most, because the distortion is largest there. Keep the number of activities small.

Can I value inventory using activity-based costing?

Yes, for production overheads, as long as you follow IAS 2: include only production costs, allocate fixed overhead on normal capacity and exclude selling and general administration.

Should I stop selling a product that shows a loss under ABC?

Not automatically. First check which costs would really disappear, and whether repricing or a process change fixes the problem.

How often should costing rates be updated?

At least annually, and whenever energy prices, wages or production volumes change materially.

Does Tranquil support product costing?

Tranquil links bills of materials, inventory, production and financial accounting so costs flow from daily transactions. Contact the Tranquil team to review your costing approach.