Every business needs to have a good understanding of its product costs. If it doesn’t it could end up quoting or pricing incorrectly. You could have a situation where losses on one product are wiping out profits on another product.
So how do you improve your understanding of product costs?
The first thing to understand is that there are two components to product costs. The first component we call direct costs. These are costs where its easy to see a direct link between the elements making up the product and the product itself.
The second element we call indirect costs. These usually relate to the general costs of running the business but it’s hard to quantify the link between the cost and the finished product.
Let’s take a simple example. Sean has a sandwich making business supplying local retailers with sandwiches.
Sean’s direct costs include bread, butter, fillings, packaging and the labour of the staff who make the sandwiches.
Sean’s indirect costs include marketing costs, premises costs, rent of this production unit, labour cost of staff who do provide admin support, office costs, delivery costs, accounting and legal costs, financing costs etc.
While it’s easy to see how many slices of bread go into a sandwich, it’s harder to quantify how much of the marketing costs should be charged to a single sandwich.
So the first thing Sean has to do is to do put together a recipe, sometimes called a bill of materials, for each product. This will set out how much of each raw material is used to make one unit of a product.
When doing this, remember that you may well have to buy more raw material than will end in the product. We are likely to have some waste in the process – we may have raw materials getting damaged or going out of date. We may have to take product samples for testing or possibly to be given as samples.
When we are looking to develop a unit cost, we are better to think in terms of a batch – lets say that we want to make 100 sandwiches. How much bread, spread, fillings and packaging will we use to make those 100 sandwiches. Then we cost those materials and divide by 100 to get the costs of a single finished sandwich. This has the benefit of averaging out any overs or unders on an individual sandwich.
There are a few things to remember when doing these calculations. Not every employee will use the exact amount of raw materials. While we should standardise as much as possible, we need to allow for this variation also and working with batches does that.
Additionally, we may not sell every item that we make, so we need to allow for the fact that we will have some overproduction. What we have to do is identify all the costs of making our batch and then allocating those costs as best we can to the units that are sold.
Next we need to think about indirect costs or overhead.
The first step here is to estimate your indirect costs for a specific period – could be a year or could be a quarter.
We need to make our best estimate of each of the marketing costs, premises costs, rent of this production unit, labour cost of staff who do provide admin support and deliver, office costs, delivery costs, accounting and legal costs, financing costs etc. This exercises is effectively preparing a budget for the period under review.
That will give us our total overhead costs.
Then we need to link the overhead costs to the costs of each individual item. There are a number of different ways of doing this.
One way is to express our total overhead costs as a percentage of our direct costs and then add that percentage onto the direct cost of each product. So in Sean’s example, if the direct costs for the year are 50K and the indirect costs are also 50K, then Sean will determine his direct costs for each product and double that to get a total product cost
He will do that for each product.
You can get a lot more sophisticated about that process but for now let’s just work with that as a simple way of doing it.
There are a few things to watch out for.
The initial estimate of how many products to be made and sold in a year is important. Direct costs vary with production quantities but indirect costs tend to be flat or else not vary to the same extent.
Let’s say you planned on having production quantities that used 100K of direct costs and you also had 80K of indirect costs then you would be expecting to have total costs in the year of 180K.
If you are making 100K units then each unit would cost 1.8 each.
However, if you only did 80K units, you would expect your direct costs to be 80K but your indirect costs would still be 80K as they don’t vary in line with production quantities. So your total costs to produce 80K units would be 160K giving you a unit cost of 2 each.
So the initial assumption on production volumes is quite important.
Another angle on this comes into play if you are starting up and you only have sales of say 50% of your full capacity. You may have competitors who are long established and are producing to their full capacity.
Let’s say you can produce 100K units per annum but you only have sales for 50K. Your direct costs are 50K and your indirect costs are 80K so total costs are 130K. If you divide your 130K costs by 50k units you get a cost of 2.60 each.
However, your competitor has a similar sized operation which can produce 100K unit and he is producing selling all of those 100K units.
Lets assume for simplicity that his direct costs are likely to be similar to yours, so 100K and his indirect costs are also similar to yours, say 80K. Now his total costs are 180K and when we divide by his production, 100K, we get a unit cost of 1.8 each.
What is happening here is that you are asking your customers to pay for your unused capacity. If you do that they are likely to just buy from the cheaper producer rather than from you.
You need to think about setting your prices as if you were using your full capacity – in that way you will have a better chance of selling. This area needs a bit of thought from you to be sure you understand the consequences of your decision.
When pricing there are three broad approaches. One is to use a cost plus approach. A second is to match the current market rates. The final approach is to price the product based on the value of the product to the customer.
For any of these approaches you need a good understanding of what is happening in the market place and you need a good understanding of your own product costs.
If you have any questions about this article, feel free to contact me on 086 2323525 or by email at firstname.lastname@example.org.