How to estimate product cost: 3 key steps
Determining product cost may seem simple at first glance: you add an extra percentage to what it costs you to source or produce it so that you generate a profit. But how exactly do you determine the rate you need to add?
Let's start with the fact that if your company manufactures the products, the cost of raw materials fluctuates. Still, your prices are usually fixed (believe us: few customers will welcome a sudden increase or restructuring of your prices).
Then, you must consider your workers' salaries, facility rent, machinery maintenance, licenses and permits, distribution...
What about taxes? You're going to need accountants. Internal? Add salaries. Outsourced? Make sure you follow the rules for outsourcing in your country.
Now, how are you going to reach your potential customers? Social media ads, billboards, TV commercials? A mix of all three and many others? You better ask a marketing specialist.
And where is your profit?
Anyway... We know that determining this equation is tricky, and the resources at hand tend to be technical in nature, because, in fact, determining the pricing of a product is only simple in the first instance or once you have it figured out.
The reality is that it is a complex process that demands a lot of care, and it is expensive (literally) if not done correctly.
Therefore, we prepared this brief guide with some basic concepts, the most important variables, as well as the 3 key steps to calculate the cost of a product.
Product cost: what you need to know
Let's start from the beginning. To determine the product cost, we resort to pricing, which in economics and finance refers to the establishment of the value of a product or service.
In other words, pricing is what happens when, as part of its strategy and business model, a company determines how much the end consumer should pay for its product or service.
Usually, this is a process that takes place in the finance and product development area of a company, but the final decision usually comes from the general management.
Although each exercise has its particular features, the most commonly used approaches to a pricing strategy can be summarized in three.
As the name implies, this approach is guided by an analysis of your competitors' offerings. Based on this frame of reference, you can decide if you match the industry standard, if you can afford a lower offer or, alternatively, if the product quality justifies a higher price than the rest.
Unlike the previous one, this approach ignores —in theory, but not always in practice— the pricing that its competitors set for an identical or similar product. Rather, it chooses to assign a selling price based on its cost of production.
A model generally used under this premise is known as markup: an industry multiple applied to the final cost of manufacturing the product.
This approach mainly responds to the movement of demand, whether it is falling or rising.
If demand goes up, the price is likely to increase, especially if supply is limited. Conversely, if demand goes down, so do prices, with the aim of encouraging greater consumption of the product.
A good example of this model is the real estate market: prices fluctuate depending on how many consumers are looking for a property and how many units are available.
Now that we understand a little more about the approach of some pricing strategies, let's go a little deeper.
Cost and price: the variables that matter
It is common for these terms to be used synonymously on a daily basis, but in a more specialized field - such as pricing - the difference between cost and price is something worth elaborating on.
So, let's put some order into it:
Cost refers to the expense incurred in manufacturing a product or offering a service, such as raw materials or labor. Cost has a direct impact on the profitability of a business.
Price, on the other hand, is the amount a consumer is willing to pay for a product or service. The difference between price and cost is profit: if, for example, a customer pays $10 for a product whose cost is $6, the company generates $4 profit per unit.
Now that we are a little clearer about this distinction, let's see how to put it into practice.
Cost/Selling Price Formula
While there is no industry-wide standard that tells us how to calculate cost over selling price in each case, this formula is useful to obtain a starting point from which we can consider other variables.
The formula is as follows:
P = Sales price
C = Cost of production
R = Profitability
An important detail to consider is that the result of your operation must always be positive and less than 100.
Why? The closer the profitability approaches the value of 100, the higher the selling price to the consumer will be. On the other hand, if the profitability approaches zero, the price of the product tends to be equal to the cost.
Now, commonly, this formula makes a lot of sense when we talk about tangible goods because it takes into consideration the sum of raw materials, manufacturing, rent and wages, among others.
However, the issue of determining a price based solely on the result of this operation is insufficient when intangible assets are included: reputation, intellectual property or brand value, for example.
For this, there is one more factor that you must consider as fundamental and that is the value of the product to the customer. The luxury fashion industry is a clear example.
Product quality, brand reputation or shopping experience are intangibles that certain customers may be willing to pay for, but are unlikely to appeal as effectively to the general public.
Therefore, although there are models, approaches and formulas to determine the cost of a product, we do not yet have a general standard.
The process to determine the cost of your product has nuances that are worth taking into account. The following are some that we consider indispensable.
3 key steps to calculate product cost
The following steps that we recommend you to follow are useful to integrate in your pre-pricing analysis, because they will give you the relevant scope for a rounded exercise.
1. Add up your variable costs
First of all, you need to understand the costs involved in manufacturing just one of your products: from the assembly line to the customer's door, so to speak. Given this, there are two possible scenarios.
The first one is that if you source your product from a third party (for example, a wholesaler), you will have a very clear estimate of the exact unit cost of your business.
The second is that, if you are directly in charge of the manufacturing of your products, you will have to look in more detail at the chain: raw materials, labor, fixed costs, and so on.
To this, you must add your time and effort: what is the reasonable rate you can afford. Then divide it by the time it takes your company to produce one unit. Your salary should be a variable that is always present in this calculation.
2. Add your profit margin
Now that we have figured out what the amount of variable costs per product sold is, it is time to add a profit margin to the price.
Let's say you are looking for a 20% profit margin on variable costs. As we pointed out earlier, before deciding on that percentage, you need to consider two issues:
- Fixed costs, which are independent of variable costs, are not yet integrated into the equation (we will see this in a moment).
- Whether you want to compete on the basis of low prices, use a multiple, or value the intangibles of your product above average, make the decision based on acceptable criteria within your product category.
If you have already considered the above, the next step is to take your total variable costs and divide them by 1 minus your profit margin.
So, to get a margin of 20% (0.2), you have to divide your total variable costs by 0.8.
3. Check your fixed prices
Unlike variable costs, fixed costs are those that you must pay without exception: whether you sell 1 or 1000 products. They are a fundamental part of the administration of your business, and you should set as a goal that the sales of your products cover this expense.
Our advice is to perform a thorough and rigorous analysis of the elements your company has at its disposal to design the ideal pricing strategy for your objectives.
Now, it is important to consider that none of this is set in stone: iterating your pricing strategy is completely valid... However, you need business sensibility to understand when is the best time to do it.
Determining the cost of your product is not an exact science, but if you take into account the right factors, your company has a chance to succeed.