📬 Marginal Impact: Contribution Margin vs. Absorption Costs

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Now, on to today’s Mailbag.

We’ve got some great topics. Here’s what’s on tap:

Now, let’s get into it.

NewAgeFinance from the US asked:

Why are so many physical products (e.g., manufacturing firms) stuck to outdated concepts, especially when it comes to finance and accounting? The concept of "absorption" is always tossed around, whereas contribution margin is often overlooked.

I believe absorption is entirely irrelevant (barring some crazy long inventory cycle), and looking at results under a contribution margin (e.g., fixed is fixed, variable profit is the key indicator) is the better approach.

NewAgeFinance… can we be friends?!

I broadly agree with you. For decision-making purposes, contribution margin wins every time. Understanding the marginal effect of an individual decision is what matters. Profit and cashflow attribution > mechanical cost absorption.

If you’re deciding:

You need to know the incremental revenue and the incremental cost. Fixed is fixed in the short term. Contribution margin for the win.

But let’s explore where absorption costing comes from, because it didn’t appear out of thin air.

First up: what is it?

Absorption costing takes layers of your fixed cost base and allocates them to products based on assumed drivers. In practice, that means creating standards.

For example:

Every time we run Product X, we attach $0.03 of factory property cost. And Product Y might carry $0.05 because it uses more floor space or machine time.

You then compare the total “absorbed” overhead (volume × standard rate) to actual overhead incurred and report over/under absorption.

And yes, this can lead to ugly accounting behavior.

I’ve seen finance teams celebrate “over-absorption” as if it were performance, when all they’ve done is load more overhead into inventory and make products look more expensive and less competitive. If I had a penny for every time I’ve seen that, I could personally absorb global overhead under-absorption. I’m getting annoyed just thinking about it.

But let’s dive into why absorption exists:

1) External reporting

Let’s start with the worst reason. Under most versions of GAAP, inventory must include a share of production overhead. So for statutory reporting, you don’t get a choice. Absorption is required. And most CFOs are too lazy to think beyond that, so it becomes the system they run their business on, too.

2) Capacity economics

In real factories, capacity is not infinitely flexible. Machines, floor space, maintenance teams; these are lumpy, stepped costs.

If you ignore absorption entirely, you can make a series of “positive contribution” decisions that collectively destroy return on capital because you underutilize a very expensive asset base.

A seasoned manufacturing CFO will always understand the trade-offs in capacity utilization and how to optimize the whole.

Contribution margin answers the short-term question. Absorption attempts to answer the long-term sustainability question.

3) Production vs sales timing

Many manufacturing businesses smooth production to keep unit costs down, while sales are volatile or seasonal.

By absorbing overhead into inventory, you defer some fixed cost recognition to the period of sale rather than the period of production. In a fireworks or Christmas decoration manufacturer, that dramatically changes the monthly P&L shape.

That smoothing is not inherently evil. It reflects the economic reality that the cost of running the factory supports future revenue.

Now, back to where I agree with you…

Absorption costing becomes dangerous when it is treated as a decision tool rather than a reporting framework.

It can:

And yes, it was built for an old world of:

Modern manufacturing is faster, more flexible, and often more SKU-complex. In that world, marginal analysis becomes more important, not less.

Where I land for the modern manufacturing CFO is here:

Run the business on contribution margin-based decisions, but make sure your hurdle rate for decisions is high enough to support the fixed cost base. I’ve seen plenty of poor decisions justified on the basis that they are ‘contribution margin’ positive. You must guard against that dangerous race to the bottom.

And how do you set your hurdles? Well… that’s where absorption costing thinking comes in, so you can make sure your total portfolio of volume is sufficient to generate your target levels of return.

Thanks for letting me nerd out.

TLDR: Use absorption costing for statutory reporting, contribution margin for decisions, and always sanity-check both against capital intensity and utilization.

WatchingTheTrainwreck from the US asked:

When operating as a de facto CFO with the title Vice President Finance, reporting to the CEO, I found treading the path in a private equity portco extremely challenging. I wasn't given the comp, title, or reporting line to the Board, and the CEO had instructed me to do things objectively bad for cash flow, that soaked up our liquidity.

Meanwhile, he was not clearing that with our Board to ensure it wouldn't put us in a compliance debacle (it did). During a Board meeting with the lender reps in the room, our Managing Partner said something that was objectively untrue about our liquidity (and the bankers knew it).

It was the first time I've ever blindsided a Board member, and it nearly tanked my employment there. The Board didn't have me reporting to them, the CEO was objectively my boss, and yet somehow I found myself on the hook for the fact that the CEO's direct instructions destroyed our liquidity and blindsided his Board.

How would you handle a situation like this, where you weren't the CFO, had no reporting line to the Board, but knew what was being done was bad for the business (without being immoral, illegal, or unethical, just far too risky and mathematically bad)?

Thanks for the question.

And yes… WatchingTheTrainwreck feels painfully on brand.

I’m going to be straight with you. What you described is structurally broken.

You were carrying CFO-level accountability in a leveraged PE portco… without CFO authority, title, comp, or direct Board access. That is not a ‘tough job.’ You are structurally exposed.

You can’t be accountable for liquidity, covenant risk, and lender optics while someone else controls the narrative upstairs. Especially in a debt-loaded business where cash is oxygen.

So here’s the uncomfortable truth: your position was untenable… probably from the very start.

You cannot be on the hook for blowing up liquidity without the tools to stop it.

Now, rewind.

If you’re stepping into a “de facto CFO” role in a PE-backed business, you need to make sure you fully understand the rules of engagement. That includes ‘what happens when this doesn’t go to plan.’ Because nothing ever goes to f*cking plan.

You need clarity on:

The dual reporting line for a CFO (CEO + Board) exists for a reason. It prevents exactly what you experienced.

If you don’t have it, but you’re carrying the risk, that’s a red flag. In hindsight, yes, you’d want to spot that earlier.

But as mid ‘00s punk band The Rakes said… sometimes you can’t smell the shit until you’re in it.

Now, you have two jobs once you’re already in it:

On fixing the business. You have to be uncomfortably clear with the CEO. Show the math. Show the covenant headroom. Show the liquidity bridge. Strip it of emotion. Make it mechanical. If they override you, they override you. But they do it in full view of the numbers.

On protecting yourself. Process is your friend. If you don’t report to the Board, then at a minimum, you circulate a clean, factual liquidity and covenant summary on a regular cadence.

If your boss says something “objectively untrue” in a meeting, and the bankers know it, you need to make sure your documented reporting tells a different, accurate story. So there is an irrefutable audit trail to show the bull shit started and finished with your CEO.

Not to play politics, but to ensure there is a record of reality.

But if you are at the stage where you are relying on email trails to CYA because you don’t trust the CEO’s representations… the relationship is already broken.

So how would I navigate it in the future?

If I don’t have:

…I don’t take the role. Or I change the structure fast. Or I leave.

Because the worst place to sit in corporate life is the middle of a power imbalance, where you carry all the accountability but none of the tools to serve that accountability.

Sorry, you went through this, you’ll be stronger for it.

TLDR: You must make sure your rules of engagement are clear up front. Who is the face of finance to the lenders and the board? Is it you? Or is it the CEO? Make sure it is clear what that means in practice.

Anonymous from New Zealand asked:

My role is pretty consistent. However, one of the biggest challenges we have as an importer is foreign exchange rates affecting our profitability. I'm not in America or Europe, so our weak currency is hurting us and has been for the past 12 months.

What resources or strategies can I employ in a weak currency market? Trying to time forward contracts has been difficult.

Thanks for the question. FX is one of those topics that looks tactical on the surface but is almost always strategic underneath.

I’ll assume you’re importing in USD and selling domestically in NZ$.

The first thing to say is this: you need to think of FX exposure as part of your business model. Not just an inconvenience for finance to manage. What it means is that the long run depends far more on your competitive dynamics than on how clever you are with forward contracts.

Start with the commercial reality.

The key question is this: is the currency move making you structurally less competitive than your peers?

If your competitors are exposed to the same FX (for example, everyone imports in USD), then FX volatility is painful but neutral. In that world, the winners are the ones with the discipline to protect gross margin through pricing, product mix, and timing.

If, however, you’re competing against local producers or businesses with natural hedges, then FX weakness is effectively a tax on your business model. And while clever hedging will delay that in the short term, it won’t in the long term. And therefore, you are facing a much bigger strategic problem that you won’t solve from the CFO seat alone.

On pricing and margin discipline. If you can pass FX through, even imperfectly, then your job is to get very tight on gross margin management. That means:

It’s fine if your cost base and selling prices move quarter to quarter. What matters is protecting the margin, not the headline price.

On hedging strategy. Trying to “time” FX with forwards is usually a losing game. Most CFOs who think they’re good at this have just been lucky.

The purpose of FX hedging is not to make money. It’s to reduce volatility and give you planning certainty.

Good practice generally looks like:

On balance sheet resilience. Weak currency environments tend to expose fragile balance sheets. You need enough liquidity to survive a bad year without being forced into terrible decisions.

That might mean:

Finally, you need to be honest about whether this is cyclical pain or a structural shift.

A weak currency for 12 months is annoying. A weak currency for five years can kill an import-dependent business with thin margins.

If FX weakness fundamentally breaks your economics, then the real work is finding ways to change the model. Different products, different supply chains, different channels, or different pricing logic. That’s hard work, but it’s the right work.

TLDR: Don’t think of FX as a ‘below the line’ problem. Think of it as a gross margin issue that’s fundamental to your business model. Understand where your competitive dynamics protect you vs where they expose you.

A few of the biggest stories that every CFO is paying close attention to. This is the section you might not want to see your name in.

Turns out fraudsters might be the first ones to have truly figured out AI ROI… Your periodic reminder (in all caps for additional effect): DON’T FORGET TO DO CALLBACKS WHEN VENDOR BANK DETAILS CHANGE!

Pretty funny to watch the tech industry lose its mind over CapEx heavy financials. Certainly not what they are used to. Meanwhile, we are witnessing the greatest capital allocation event in history right now with the AI infrastructure build out. I’m sure we’ll see some headlines of some ‘regrettable’ accounting practices before too long.

Remember - your first duty is to the accuracy of the financials your business reports, not to ‘be strategic.’ Headlines like this are a great way to blow up your whole career.

ICYMI, here are some of my favorite finance/business social media posts from this week.

Let me know what you thought of today’s Mailbag. Just hit reply… I read every message.

In Saturday’s Playbook, we dived deeper into the art of storytelling for CFOs, seeing what we could learn from the WWE and Breaking Bad. Read it here

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director, or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need.