RUN · Business Foundations / Module 4 of 5Free
M04
Unit Economics
A product can show a healthy margin and still lose money once time, rework and handling are counted.
Gross margin is the figure most businesses use to judge whether a product is worth selling. It is a useful figure, but it counts only some of the costs a product causes. Time on the workshop floor, rework, special handling and after-sales support all fall outside it. This module follows those costs back to the products that create them.
You will
- Calculate contribution per unit, order or customer
- Allocate time, rework and handling costs to the products that cause them
- Recognise when high gross margin hides low real profitability
- Decide whether to grow, reprice, simplify or discontinue a product
By the end you will have
- True contribution per unit for each main product, service or order type
- Activity costs assigned to the lines that cause them
- Contribution per hour of your constraint, with lines ranked
- The price your weakest line would need, and what could be charged separately
Time to apply: an afternoon with the people who do the work, plus two hours of analysis
The case · Furniture manufacturer, 60 people
The custom line everyone is proud of
Mvule Furniture makes dining chairs, beds and made-to-order pieces for hotels and offices from a workshop outside Dar es Salaam. Revenue last year was USD 1.32 million. The custom line, introduced five years ago, now brings in 41% of revenue, and it is the work the team is proudest of: hotel lobbies, boardroom tables, reception desks.
The management accounts show every line earning a gross margin of about 52–53%. So when a hotel group asks for 400 custom bedroom sets for a new property, the sales director wants to expand the design office and hire four more craftsmen to handle it. 'Custom pays the same margin as standard,' he says, 'and the orders are bigger.'
The workshop manager disagrees. Custom jobs take a designer days of drawings, the machines are reset for every job, rework is constant, and his best craftsmen spend days on site fitting and fixing. None of that shows in the gross margin. Profit last year was thin despite strong sales, and nobody can say why.
- Revenue
- USD 1.32 million
- Custom share of revenue
- 41% (USD 540,000)
- Gross margin, every line
- 52–53%
- Workshop overheads
- USD 330,000 a year, spread by revenue
- Skilled craftsman hours
- About 36,000 a year, fully used
- Proposal
- Expand design office, hire four craftsmen
Should Mvule grow the custom line, reprice it to reflect its real cost, or restrict it?
Before you read on: form your own view
- 1.If every line earns the same gross margin, which line would you grow, and why?
- 2.Which costs do you think the gross margin leaves out for custom work?
- 3.What would you want to measure before hiring four more craftsmen?
Write your answer down. We return to this case after the worked example.
Step 01 / 13
The business problem
Most businesses know the gross margin of each product. Few know what each unit really costs to sell, make, deliver and support. Staff time, rework, delivery and returns are usually treated as overheads and spread evenly across everything the business sells, or not allocated at all. Spreading costs evenly conceals a pattern that is almost universal: some products consume far more of the business's scarce resources than others. When those costs are hidden in overheads, the demanding products look better than they are, the simple products look worse, and the simple products quietly subsidise the demanding ones.
Mvule's accounts are not wrong; they are incomplete in a systematic way. Materials and direct labour are charged to each product. Design time, machine set-ups, rework, installation and delivery are charged to 'workshop overheads' and spread across all products in proportion to revenue. Because custom work causes most of those costs, spreading them evenly makes custom look better than it is and standard products look worse.
The problem compounds with growth. If the business expands the line whose true contribution is lowest, it fills scarce capacity with the least profitable work and adds fixed cost to do it. Revenue rises and profit does not.
Why it matters
Growth multiplies unit economics. If each unit makes money after all its costs, growth compounds the gain. If each unit loses money once its full costs are counted, selling more makes the problem larger, and the business can grow itself into difficulty while its reports show healthy margins. Knowing true contribution tells the owner what to grow, what to reprice, what to redesign and what to stop. Without it, those decisions are made on a figure that is systematically optimistic about the most complicated work.
What it costs when it is left alone
- The most complicated work looks as profitable as the simplest, so it is priced too low and grown too fast.
- Simple products subsidise demanding ones, and may be priced too high to compete.
- Scarce capacity (skilled hours, machine time) is consumed by work that earns little per hour.
- Small and custom orders are accepted that lose money once set-up and handling are counted.
- Investment decisions (hires, machines, design staff) are justified on a margin figure that is optimistic about the hardest work.
Step 02 / 13
The decision
For each product, service or order type: grow it, reprice it, simplify it or stop it, based on what one more unit really adds to profit?
The products that look worst on true contribution are often the ones the business is proudest of, the ones that win awards or impress customers. Repricing them risks losing prestige work; restricting them feels like shrinking. And the analysis requires estimating costs that no system records, which invites the objection that the numbers are 'only estimates'. They are, and they are far closer to the truth than the zero implied by ignoring them.
Grow
True contribution per unit and per hour of constraint is high. Sell more.
Reprice
Customers value it, but the price does not cover its real cost. Raise price or charge separately for design, set-up or installation.
Simplify
Redesign the product or process to remove cost: standard components, fewer variants, minimum order sizes.
Restrict or stop
True contribution is low or negative and cannot be fixed. Limit it to the cases that make money, or discontinue.
Step 03 / 13
The concept
Unit economics asks a simple question: what does one more unit (a product, a job, an order) add to profit after every cost it causes? Gross margin answers only part of that question, because it counts materials and direct labour but leaves out the activities each unit triggers: design, quoting, set-up, inspection, rework, delivery, installation and support.
Those activities have real costs, and they are not consumed evenly. A standard chair made in a batch of 200 needs one set-up shared across 200 chairs; a custom desk needs its own drawings, its own set-up and usually a site visit. The fair way to allocate an activity's cost is by how much of the activity each product uses, not by how much revenue it brings in. This is the idea behind activity-based costing, and it can be done roughly, in a spreadsheet, in an afternoon.
When capacity is full, a second measure matters: contribution per unit of the constraint. If skilled craftsman hours are the bottleneck, the question is not which product earns the most per unit but which earns the most per hour of the resource the business cannot easily add.
- Gross margin per unit
- Price minus materials and direct labour.
- Activity cost
- The annual cost of an activity such as design, set-up, rework, installation or delivery.
- Activity driver
- The measure of how much of an activity each product uses: drawings, set-ups, rework hours, site days, deliveries.
- True contribution per unit
- Gross margin per unit minus the activity costs the unit causes.
- Contribution per constraint hour
- True contribution per unit ÷ hours of the scarce resource each unit uses.
- Cross-subsidy
- When even spreading of costs makes one product carry costs another product caused.
Step 04 / 13
The framework
Three steps: identify the activities that gross margin leaves out, assign their cost to the products that cause them, and compare products on true contribution per unit and per hour of the constraint.
The KSL true contribution calculation
01
Price
After discounts
02
− Materials and direct labour
= Gross margin
03
− Activity costs caused
Design, set-up, rework, install, delivery
04
= True contribution per unit
05
÷ Constraint hours per unit
= Contribution per hour
| Activity | Typical driver | Ask the people who do it |
|---|---|---|
| Design, drawings, specifications | Number of drawings or design hours per job | 'What share of your week goes to each product type?' |
| Quoting and order processing | Number of quotes or orders | 'How long does a quote take for each type?' |
| Machine set-up and changeovers | Number of set-ups | 'How many set-ups per month, for what?' |
| Inspection, rework and scrap | Rework hours or scrap value | 'Where does rework come from?' |
| Installation, site visits, snagging | Site days | 'Who goes to site, for which jobs, how long?' |
| Delivery and handling | Deliveries or weight-distance | 'Which orders need special transport?' |
| After-sales support and warranty | Call-outs or claims | 'Which products come back?' |
Activity cost per unit
(Activity cost × product's share of the driver) ÷ units of the product
True contribution per unit
Price − materials − direct labour − Σ activity cost per unit
Do not allocate costs that would stay the same if the product disappeared, such as rent or the owner's salary. Those are covered by total contribution. The aim is not a perfect cost for each product but a fair comparison between products.
Reprice
Valued but under-priced. Raise price, or charge separately for design, set-up and installation.
Grow
Valued and profitable per hour. Put capacity and sales effort here.
Simplify or stop
Low value, low contribution. Standardise it, set minimums, or discontinue.
Maintain
Profitable but not a differentiator. Keep efficient; do not over-invest.
← Low true contribution per constraint hour
High true contribution per constraint hour →
The rule that matters most
When capacity is full, never grow a product because its margin percentage is high. Grow the product that earns the most per hour of the resource you cannot easily add.
Step 05 / 13
Diagnostic questions
These questions show whether your margins tell the whole story. Ask them of the people who do the work, not only of the accounts.
The questions this module must answer for your business
- 01What does one more unit really add to profit?
- 02Which products consume disproportionate time or rework?
- 03Which orders are too small to be profitable?
- 04What would change if we stopped selling our least profitable line?
What happens today
- How are your prices set for standard and non-standard work? Who decides?
- Which costs sit in 'overheads' that are really caused by particular products or orders?
- How are overheads allocated in your management accounts: by revenue, by labour hours, or not at all?
Where cost is caused
- Which products or jobs take the most design, quoting or planning time relative to their price?
- Where does rework come from? Which products return under warranty?
- Which orders are so small that set-up, delivery and invoicing cost more than the margin?
- Which jobs need your most skilled people, and for how long?
Capacity and decisions
- What is your constraint, and which products use most of it?
- What would change if you stopped selling your least profitable line? What capacity would it release?
- When you last invested to grow a product line, which margin figure justified it?
Step 06 / 13
Worked example
The workshop manager and the finance lead spent an afternoon with the designer, the machine supervisor and the installation team. All amounts in USD.
Mvule Furniture: finding the real cost of custom work
1.Start with the gross margin everyone uses
Line Units a year Price Materials Direct labour Gross margin/unit GM % Standard dining chair 6,000 60 22 6 (1.5 h) 32 53% Standard bed 1,500 280 110 24 (6 h) 146 52% Custom piece (average) 600 900 300 120 (30 h) 480 53% 2.List the activities and estimate who uses them
Activity Annual cost Chairs Beds Custom Design office (2 designers) 96,000 5% 10% 85% Machine set-ups 60,000 20% 20% 60% Rework and scrap 54,000 11.5% 18.5% 70% Installation and snagging 72,000 0% 10% 90% Delivery 48,000 17% 33% 50% Total activity cost 330,000 31,000 54,800 244,200 Shares estimated from designers' time sheets, the set-up log and installation team diaries. 3.Calculate true contribution per unit
Line Gross margin/unit Activity cost/unit True contribution/unit True margin Total contribution Standard dining chair 32.0 5.2 26.8 44.7% 161,000 Standard bed 146.0 36.5 109.5 39.1% 164,200 Custom piece 480.0 407.0 73.0 8.1% 43,800 Custom work brings 41% of revenue and 12% of contribution. Its true margin is 8%, not 53%.
4.Compare contribution per craftsman hour
Line Craftsman hours/unit True contribution per hour Share of craftsman hours Standard dining chair 1.5 17.9 25% Standard bed 6 18.2 25% Custom piece 30 2.4 50% Craftsman hours are Mvule's constraint. Custom work uses half of them and earns USD 2.40 an hour; standard work earns about USD 18. The hotel order for 400 custom sets would consume another 12,000 hours at that rate.
5.Work out the price custom would need
To earn USD 15 per craftsman hour, a 30-hour custom piece needs a true contribution of USD 450. Adding materials (300), direct labour (120) and activity costs (407) gives a price of about USD 1,280, 42% above the current average.
Option Effect Grow custom at current prices (hotel order) More hours at USD 2.40; four hires and a bigger design office; profit barely moves Reprice custom: design fee, installation charged separately, base price up, average about USD 1,280 If volume falls 40% to 360 pieces: contribution about USD 163,000 (from 43,800); 7,200 craftsman hours released Restrict custom to orders of 20+ identical pieces Set-ups and design shared across pieces; activity cost per piece falls sharply
The lesson
Every line had the same gross margin, and they were not remotely equal. The custom line consumed the activities that gross margin left out and half of the scarcest resource, and earned almost nothing for it. Growing it would have made Mvule busier and no richer.
Back to the case: The custom line everyone is proud of
Mvule did not hire four craftsmen. It introduced a design fee (credited against orders over USD 20,000), charged installation by the site day, raised custom base prices by 25% and set a minimum of 20 identical pieces for hotel work.
The hotel group accepted the new terms for 250 sets rather than 400. Custom volume fell by a third over the year, its true margin rose to about 27%, and the released hours went into an extra 1,000 standard beds for a distributor who had been waiting. Total contribution rose by about half, from roughly USD 369,000 to USD 550,000, on revenue about 14% higher.
If your initial view was to grow custom because the margin looked the same, notice what changed it: activity costs assigned to the products that caused them, and contribution per hour of the constraint.
Compare this with the view you wrote down at the start. What changed, and why?
Step 07 / 13
Apply it to your business
Now do the same for your business. Allow an afternoon with the people who do the work, plus two hours of analysis.
Gather this first
- Units sold, average price, materials and direct labour per unit for your main products or job types
- The annual cost of activities sitting in overheads: design, quoting, set-up, rework, installation, delivery, support
- An estimate, from the people who do each activity, of how their time or cost splits across products
- The hours of your constraint (skilled labour, machine time) each product uses
- 1
Choose up to three lines to compare
Pick products, services or order types whose complexity differs, for example standard versus custom, large versus small orders.
- 2
List the activities
In part B, list the activities gross margin leaves out, with their annual cost.
- 3
Estimate shares
For each activity, estimate what share each line uses. Ask the people who perform it. Round numbers are fine.
- 4
Transfer activity totals
The total activity cost for each line appears at the foot of part B. Enter it in the 'Activity cost (annual)' column of part A.
- 5
Enter unit data
In part A, enter units, price, materials and constraint hours per unit, and your labour rate.
- 6
Compare true contribution
Read true contribution per unit, true margin and contribution per constraint hour for each line.
- 7
Decide per line
Grow, reprice, simplify or restrict each line, and work out the price a weak line would need.
Step 08 / 13
Worksheet
Use annual figures. Complete part B first if your activity costs are not already split by product. Your entries are saved in this browser.
Unit contribution calculator
ATrue contribution by line
| Product or order type | Units a year | Price per unit | Materials per unit | Labour hours per unitYour constraint | Activity cost (annual)From part B | Gross margin per unit | Activity cost per unit | True contribution per unit | True margin | Contribution per hour | Total contribution | Total hours | Share of hours | Rank | Remove |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Total | – |
- Total true contribution
- –
- Total activity cost assigned
- –
- Best contribution per hour
- –
- Worst contribution per hour
- –
BActivity costs by line
Enter each activity's annual cost and the share used by each line (line 1, 2 and 3 in the same order as part A). Shares for each activity should add to 100%.
| Activity | Annual cost | Share line 1 (%) | Share line 2 (%) | Share line 3 (%) | Line 1 cost | Line 2 cost | Line 3 cost | Shares add to | Remove |
|---|---|---|---|---|---|---|---|---|---|
| Total | – |
- Line 1 activity cost
- –
- Line 2 activity cost
- –
- Line 3 activity cost
- –
CRepricing the weakest line
Step 09 / 13
Interpret your results
A completed worksheet is evidence, not a conclusion. Read it before you decide.
- 1.Which line's true margin is furthest below its gross margin? What activity explains most of the gap?
- 2.Which line earns most per hour of your constraint, and how much of the constraint does it get?
- 3.Is any line contributing little or nothing once its activities are counted?
- 4.What price would your weakest line need, and would customers pay it?
- 5.Which of your estimates, if wrong by half, would change a decision? Can you check it this month?
- 6.What would happen to capacity and profit if you restricted the weakest line?
| If you find… | It usually means… |
|---|---|
| Similar gross margins, very different true margins | Overheads are spread evenly and hide a cross-subsidy. Price on true cost. |
| Custom or complex work has the lowest contribution per constraint hour | Charge for design, set-up and installation, or set minimum order sizes. |
| Small orders have negative true contribution | Introduce a minimum order value or a small-order fee. |
| Rework is concentrated in one line | Fix the cause before repricing (see M07 and M17); the cost may disappear. |
| Simple products have strong true margins but low sales effort | They are subsidising the rest. Grow them, or reduce their price to win volume. |
| You could not estimate an activity's split | Ask the people who do it to log their time for two weeks, then repeat the analysis. |
Step 10 / 13
Make the decision
Make a decision for each line you analysed. Record the most significant one.
Grow
Choose this whenHigh true contribution per constraint hour and spare demand.
What followsShift capacity and sales effort to this line.
Reprice
Choose this whenCustomers value the line but the price does not cover its activity cost.
What followsRaise the price or unbundle design, set-up and installation charges.
Simplify
Choose this whenCost comes from variety, small batches or rework that could be designed out.
What followsStandardise components, reduce variants, fix rework causes.
Set minimums
Choose this whenSmall or one-off orders carry most of the activity cost.
What followsIntroduce minimum order sizes or a small-order fee.
Restrict or stop
Choose this whenTrue contribution is negative or tiny and cannot be fixed.
What followsLimit to profitable cases or discontinue with notice to customers.
Your decision record
Step 11 / 13
Action plan
Price changes need notice to customers; process changes need time to work. Edit to suit your decision.
Implementation cycle: 30 / 60 / 90 days
| Action | Owner | Deadline | Expected result | Resources needed | Measure of success | Review date | Remove |
|---|---|---|---|---|---|---|---|
| Days 1–30: Measure | |||||||
| Days 31–60: Change prices and terms | |||||||
| Days 61–90: Redeploy capacity | |||||||
Step 12 / 13
Management routine
True contribution drifts as products, customers and processes change. These habits keep it current.
Every quote for non-standard work
Estimate true contribution and contribution per constraint hour
- Does this job earn our target per hour?
- What activities will it trigger?
Monthly
Track rework, set-ups and site days by line
- Is activity cost per unit falling?
- Which line is driving rework?
Annually
Rebuild the calculation with updated activity costs
- Has any line changed quadrant?
- Which prices need to change?
Step 13 / 13
Final output
By the end of this module you should have
- True contribution per unit for each main product, service or order type
- Activity costs assigned to the lines that cause them
- Contribution per hour of your constraint, with lines ranked
- The price your weakest line would need, and what could be charged separately
- A recorded decision for each line: grow, reprice, simplify, set minimums or stop
- A 90-day plan and a quoting routine that keeps true cost visible
When the problem is bigger than this module
A rough activity-based calculation is enough for most decisions. Where a business has hundreds of products, complex shared processes or a costing system that needs redesigning, the work becomes more involved. In a Growth Partnership, KSL builds that costing with you and connects it to pricing (M50), customer profitability (M46) and quality control (M17).