Monday, 27 January 2014

Product Costing for Small Businesses

Congratulations on finally deciding to start your own small business. If you’re going to be doing some small-scale manufacturing as part of your business venture, then this article is a must-read for you.

Today we’re looking at product costing for small businesses – how to arrive at a selling price for your home-made or small-scale goods.

It takes a lot of courage and vision to start up your own business – and one thing I know every entrepreneur loves more than actually kick-starting a business idea is actually making it profitable. 

[Related Article: 4 Best Kept Secrets of Product Marketing]

You want your goods to sell and you want your business to be self-sustaining. It’s achievable, but there are a few ground rules – product costing is one of them because getting it right the first time can mean the difference between success and failure.

How Do You Cost a Product?

As described in the figure above, your selling price is simply the sum of your product cost per unit (how much it cost you to create a single unit of your product) and a convenient markup (a small percentage added for profit).

The key to arriving at an ideal selling price that will guarantee maximum profit at the market is twofold:

  1. Correctly figuring out your Product Cost Per Unit (PCPU) – this is critical.

2. Selecting the Proper Scaled Markup (PSM), and not just any arbitrary markup (very important!)

Let’s take a look at these two important factors in turn.

Step 1: Correctly Evaluating Your PCPU

As illustrated in the figure above, your PCPU (product cost per unit) is the sum of three other costs:

·         Material Cost Per Unit (cost of materials for a single unit of your product)

·         Labor Cost Per Unit (cost of labor – wages paid per single item produced)

·         Machine Cost Per Unit (total cost of machines, power, etc., used to produce a single unit of your product)

Nice. We now know how to arrive at our PCPU. But like all things in life, it’s a bit more complicated than just adding these three components up. 

The reason we can’t just add them up is that two of the three components (labor cost per unit and machine cost per unit) are functions of time (depend on time) and must be evaluated separately.

Moving along, we combine these two time-dependent costs into a single cost called the plant cost. It can be calculated with the following simple formula:

Once we have this plant cost per unit, we simply add it to the material cost per unit to obtain our PCPU. Now for an example, so you can see it all in practice.

Example: PCPU of Freshly Packed Fruit Product

For this example, let’s imagine we’re opening a small business that supplies freshly-packed fruits to local stores and schools.

Our aim is to calculate the PCPU for this business. Our first move is to draw up a profile of the business as follows:

Staff (n) = 2

Wages = $10 per hour

Fruits packed = 1 Apple (60 cents) + 1 Banana (80 cents) + 1 Cucumber (75 cents) = $2.15

Cost of Packing Bag = $ 0.2 per unit

Rental Cost for Packing Machine = $5 per hour

Time to pack 1 bag = 2 minutes = 2/60 hours = 0.033 hours

Operational Costs per hour = $0 (negligible infrastructure costs)

What is the PCPU?

PCPU = Material Cost per Unit + Plant Cost per Unit

PCPU = (Cost of Fruits + Cost of Bag) + Packing Time x (Wage x Staff + Rent Per Hour + Operational Cost Per Hour)

PCPU = ($2.15 + $0.2) + 0.033 x ($10 x 2 + $5 + $0)

PCPU = $2.35 + 0.033 x $25 = $2.35 + $0.825 = $3.175

PCPU ≈ $3.18

The product cost per unit for this product is $3.18. That’s how you do it! 

I guess that was a bit of a workout – but it was totally worth it. 

I’m sure by now you’re thinking “Wow, I didn’t go through ALL THAT to cost my product!” Well, as you can see, doing it right takes a few more steps than would normally come to mind.

Tip: Please make a note of these steps in your journal, so you can do your own calculations and come up with the actual PCPU for your product.

We’re not done! We still have to figure out the Proper Scaled Markup for our product before we can arrive at the selling price for the product.

Step 2: Select the Approved Markup (PSM)

A lot of people actually just guess what markup to use for their product. This can be very dangerous, and can actually harm sales of your product.

This is because the market works like a magnet and attracts demand on the basis of price. The lower the price, the higher the demand (for a reasonable level of quality).

If you select the wrong markup, your product will be overpriced and attract very little demand (poor sales). If you under-price your product, you will be operating a loss on principle. You have to get it right the first time – and you need a little formula called the PSM (Proper Scaled Markup):

The Quality Factor is a percentage that expresses how people perceive the quality of your entry-level product relative to more established competitors. 

For example, if you are producing home-made soap, and you intend to sell in the same market with factory-manufactured brands, a quality factor of 40% - 50% is reasonable. 

For our freshly-packed fruit example, a quality factor of 80% - 95% is reasonable, since we are dealing with a natural product that requires no refinement or processing and very little packaging.

Let us assume Q = 90% = 0.9 for this example.

Let’s also assume that the price of the directly-competing product in the market is $5 (P0 = $5.00). Recall that our PCPU = $3.18.

From the equation for PSM, our approved markup is (0.9 x $5) - $3.18 = $1.32

This means you should add no more than $1.32 to your PCPU to arrive at an optimized selling price for your product.

Finally, we can find the optimal selling price for our product as:

Selling Price = PCPU + PSM = $3.18 + $1.32 = $4.50

So, while it cost you $3.18 to make your product, and the competition sells at $5.00, you should sell at $4.50 to generate the highest sales for your product!

I hope you’ve learned a lot today. If you have questions, please post a comment below! Thanks for reading – always come back for more great business and technology content!