[Last Updated June 30th 2009]
From “Article 3: Correct Product Selection”, you now know the cost of each product you would buy/produce for sale/resale. (If you do not, you have to go back to Article 3 and determine the cost of your product.)
For the purpose of calculation, we will refer to “unit” as one piece of the product in the form it is sold as:
For example:
Unit = 1 piece or 1 box of 10 pieces. (e.g. 1 cell phone or 1 pen or 1 box of 10 ballpoint pens etc.)
Unit by weight (e.g. coffee powder, dry chemicals etc.) = 10 oz, (or grams), 1 lb (or kg) etc.
Unit by liquid (e.g. perfume, wet chemicals, soda etc.)= 1 L, 1 quart, 10 gallons etc.
Unit by service (e.g. plumbers, contractors, programers) = 1 hr, 1 month, 1 job or assignment.
Unit by software = 1 license, 1 title, 1 download
Therefore, “unit cost” is the price of one piece of the product that you buy for resale. Or, the cost of one product that you produce for sale.
From “Article 4: Selling Price”, you should have now worked out your product’s selling price. (If not, please read Article 4 to determine your product’s unit selling price)
From your “unit selling price” and “unit cost”, you can calculate your gross profit and gross margin.
E.g.: One pen’s selling price is $20.00 and your unit cost is $10.00
1. Selling price for a pen is $20.00
2. Less unit cost for the pen ($20-$10) is $10.00
Therefore, your gross profit is $10.00 and your gross margin is 50%. However, you do have other costs and expenses (e.g. rent, salaries, utilities etc.)
If the other costs amount to $12 per unit, you will have a loss of $2.00 per unit.
If the other costs is $3 per unit, you will be making a profit of $7 per unit.
These other costs and expenses will greatly affect your business. Question is, how would you know what they amount to?
The answer is, you need to do Product Costing.
Product costing will give you an indication whether you are able to make money. If you know that you are not going to make money, don’t start, why court disaster?
However, if you find that you can make money through product costing, you can move forward with confidence.
Rule 4: Product Costing
a. For all new products, you must do Product Costing.
b. Do Product Costing on all existing products regularly. Costs will change without you knowing (e.g. increase in expenses, new staff, moving to a more expensive location etc). This increases your overall costs and therefore you must have a corresponding increase in sales to cover the extra expenses.
What should the minimum increase in sales be? How do you find out? The answer is Product Costing, without which, you may make wrong decisions.
Product Costing is a very important aspect of a successful profitable company.
1. You will be able to work out your ex-factory/ex-store/ex-home based office cost of each product at a certain volume of sales. This cost includes all your cost and expenses excluding sales and marketing and delivery.
2. You will be able to work out the break even point. (I.e. the volume of sales you need to achieve each month as not to incur a loss.
3. You will be able to calculate the projected profit or loss at any volume of sale.
4. It gives you the right information to allow you to make the right decisions. Without which, you will be blindly working month after month. Only realizing you are incurring losses when your money runs out. It will be too late by then.
Product Costing, in it’s simple form, has only 3 items.
1. Unit cost (the price you pay your supplier or the cost of the product you produce)
2. Fixed cost (indirect cost)
3. Variable cost (direct cost)
Explanation:
1. Unit cost: (Please refer to the earlier paragraph where it was explained)
2. Fixed cost: Costs that remains fixed over time. It remains fairly constant month after month (until you remove/add costs like moving to a more expensive premises or hiring a permanent employee etc).
Examples of Fixed Costs are:
Warehouse rental
Part of the cost of your home (if home based)
Equipment (e.g. Computers, based on purchase price divided by 36 or 48 months or the replacement period)
Your Salary
Salaries of permanent employees
Fixed monthly charges for merchant account and banking gateway
Broadband Internet Connection
etc.
If you are currently operating a physical or online store, look around you and you will identify more items of Fixed Cost. If you are yet to start, you have to guess the items and their costs. It is not that difficult.
Add a miscellaneous items section as you will definitely miss out on some items and costs.
Add up all the above and you will get your Fixed Cost.
3. Variable costs: Costs that vary month to month depending on the volume of sales. It is a direct cost. Variable costs stays fairly constant to the unit.
Packaging is an example of variable cost. If you pack 1000 units this month and 2000 units the next, your packaging cost next month is 2 times higher then this month. Note that packaging cost per unit remains the same. For example, if packaging cost is $0.50 per unit, it will remain at $0.50 this month to the next for one unit. But total packaging cost for this month is $500.00 while next month’s packaging cost is $1000.00 .
Examples of variable costs:
Part time labor
Banking Gateway transaction charges
Merchant account discount rates
Paypal processing charges
Charge backs
Lost mail etc.
Look around and you will find more variable costs to add to your list.
You will always miss some costs, so add a miscellaneous item to this list and estimate the value.
If you haven’t started your business, you have to estimate the items and their costs.
You can now add all the above to get your total variable costs per unit.
For demo purposes, we will use $1.00 as the variable cost per unit.
Now you can move to the next stage: Calculating the break even point. (The sales volume where you neither make or lose money)
Below is an example of how the Break Even point is calculated:
a. Let us use the pen example:
The selling price of the pen is $20.00
Your unit cost for the pen is $10.00
Your fixed cost is $5000 per month
Your variable cost per unit is $1.00
Therefore, your Break Even point is as follows:
Your selling price of the pen is $20.00
(minus) your unit cost $10
Your gross margin is $10
(minus) your variable cost of $1 per unit
Your margin is $9
Your monthly fixed cost is $5000
Therefore, your break even point sales volume is $5000/$9 = 556 units
You have to sell at least 556 pens a month to break even. At the break even point, you can earn enough to cover all your expenses for the month.
Of course you are aiming much higher than to just break even. Note that you still have 2 more costs.
1. Sales and Marketing (you don’t have to incur costs here if you do not want to, or you may if you want to increase your sales)
2. Shipping/Delivery. (to be paid by the customer)
The above calculations is for one product (a pen). However, you are (or will be) selling more than just one product.
How do you handle the Product Costing for multiple products?
If all the products’ unit costs are close to one another, one method is dividing the total fixed cost by the total number of units of all the products. (i.e. All the products share the same fixed cost evenly).
If the unit costs of each product are substantially different. (e.g. The unit cost of one pen model is $10 and another pen model is $20) You might want the $20 pen to absorb 66% of the fixed cost and the $10 pen to absorb 33%. Do the same for the other products.
For variable cost, the calculation is easier. Let’s take the pen example.
Variable cost for one pen is as follows:
packaging material cost……………………..$0.20
direct labor ……………………………………….$0.20
all others …………………………………………. $0.14
bank discount rate 2.3% at $20(sales)…$0.46
total direct cost for 1 pen ………………………..$1.00
c. Try to understand “Product Costing” as it is going to assist you greatly in good decision making most of the time. With the correct information, you will be more confident, do less guess work and make less mistakes. Mistakes cost money. Mistakes create stress.
Good luck with your Venture!
From, Sell Online and Profit.com
[Last Updated June 30th 2009]