10 Product Costing Tips After The White House, Disney, NBC...

Your vision is to provide an accurate cost to develop a new product.

Let’s say you have a shoe factory and you get requests for side projects. This is not an issue as you have the capacity but you want to figure out the true cost of the product, or product cost, so that when it’s time to determine if it makes sense, and set a price for your stores and for wholesale, you have a solid figure. While there are a lot of systems out there that you could use to help with this process, this article assumes you are a smaller business without a full ERP. Either way, you need to learn the basics before using a system. This article goes through what goes into a product cost, the formulas with examples, and tips from working in a manufacturing environment.

What is product cost?

Product cost includes all the costs that you have to pay in order to produce a product.

What goes into product cost?

Direct labor: This would be what you pay employees who are making or producing the goods.

Direct materials: These would be anything used to actually make the shoes. Example:

1. Leather
2. Rubber
3. Laces
4. Filler for the sole
5. Liner material
6. Bonded leather
7. Paint
8. Cotton
9. Hardware
10. Packaging

Indirect material costs: These would be materials that you have to have to complete the good, however, it’s not a direct ingredient essentially. Other types of costs that fall under these would be the things that are so low value it’s difficult to estimate it per item produced. Examples:

1. Thread
2. Glue
3. Disposable tools
4. Protective devices
5. Cleaning chemicals

Factory or manufacturing overhead: These are the costs that don’t necessarily fall under direct or indirect labor or materials. Things like equipment depreciation and rent aren’t materials and they aren’t labor so they fall under this one.

Indirect labor costs: These would be payroll, benefits, and insurance for employees who are required to complete production, but aren’t actually making the product. So this would include the quality team and managers for example.

What should you keep out of a product cost?

It may seem like everything above included all costs, however, there are a few to leave out. Generally, you would not include your marketing and sales for example because those are not directly related to the actual production. If the cost is incurred outside of your factory, it would be excluded most likely.

Formulas for calculating product cost

Note that often, you may have monthly or annual figures for labor and such. You want to take your answer for the product cost and divide it by the number of units produced if you went with annual costs for example to ensure you are looking at the product cost for just a single item produced.

Let’s say you have $200,000 in direct labor, $200,000 in indirect labor, $50,000 in direct material, $75,000 in indirect material and overhead is $50,000 for the year.

Step 1

Factory overhead = Indirect labor + Indirect material + Other factory overhead

Factory overhead = $200,000 + $75,000 + $50,000

Factory overhead = $325,000

Step 2

Product cost = Direct labor + Direct materials + Factory overhead

Product cost = $200,000 + $50,000 + $325,000

Product cost = $575,000

Now divide by 10,000 units produced and you get $57.50 each

Where would you find the cost of the product other than your spreadsheet?

You will find product cost in your financial statements. It’s on the income statement after it’s sold and on the balance sheet before it’s sold. The Generally Accepted Accounting Principles (GAAP) and Internal Financial Reporting Standards (IFRS) require it.

Tips when costing products

Having worked in manufacturing, and with companies like Disney for Mickey’s 90th birthday, NBC for Matt Lauer’s 20th, Hilton Hotels for luggage tags, American Airlines for travel cases, and The White House for President Obama’s Christmas staff gifts, among many others, I’ve acquired some tips to share when it comes to costing in general, but especially one-off projects like these.

1. Watch your scrap rates.

If you’re working with products where there is a quality level required to use it in production, scrap rate is really important to get right. Working with leather, for example, there were times when the scrap rate was 25% all the way up to 80%+ at times because of supplier quality issues, which drove cost up to unreasonable.

If you use similar materials frequently, it can be really useful to come up with a scoring system for the materials to estimate your scrap rates. For example, you know that leather A comes from factory C, and when it’s a particular type, you expect 25% scrap for a small item and 40% for a large item.

2. Build-in labor padding.

You will need to add a % to the cost on top of the direct labor to ensure you don’t get stuck short, especially when it’s a new project. In time, that cost usually comes down as employees establish a process and equipment is set properly. If cost is an issue for the customer requesting, you can offer that possibility.

3. Use project briefs.

You need details, and you need them all upfront. Using a project brief will allow you to get the requested due dates, and all other details to get the scope of what is being asked. You are going to need to build a bill of materials or BOM for your own costing and ordering. If you’re getting the project from an external source, you are going to need a BOM and technical specs.

Look out for special stamps, custom colors, or other processes that are out of the norm that will require additional equipment or vendor sourcing. This is another reason to get a brief upfront.

4. Get heavily involved in understanding manufacturing.

You need to be onsite and just as knowledgeable in manufacturing as the engineers and people on the line. You need to know the process inside and out. After a while, you will become familiar with processes and this is less of an issue.

5. Iterate.

Depending on your environment, you should have an initial sample of some sort to assist in figuring out labor and material costs. Once it gets manufactured, and you think you are done, you are not. You need to go back and compare estimated to actuals so that you can be always improving.

6. Understand the budget upfront.

If you don’t have a clear figure upfront, you may put a lot of time into costing something that will end up as a no-go. It’s a good idea when you can to get a ballpark of where the project needs to come in at or at least a max cost so you know which levers you may have to pull. Maybe you can get away with cheaper packaging for example, or lesser quality fillers if cost is a sticking point. Another option is if the requester is looking for an item but not sold on a specific one, you may be able to come up with some samples that fit the budget from other projects.

7. Push your sourcing and purchasing teams.

If you can use hardware from previous projects, or scrap leather, that really cuts down on cost for you but also the requestor if cost is an issue. However, if you can’t, try to think bigger picture and push your sourcing team or vendors to look into volume discounts or purchase commitments that allow for some discounts. Ask them questions about what volume you need to be at for various pricing tiers. Things you use on all projects like fillers for example are something you know you will use so you may as well take advantage of discounts.

8. Communicate everything.

You don’t want to be annoying, but communication is key during the costing process. Often, time is of the essence, and you may be up against a competitor so establishing your process and communicating effectively is key to being successful. Establishing a launch checklist can help greatly.

9. Make sure the vendor relationships are strong.

If you have a solid relationship with your primary vendors, you may get notice well ahead of price increases or material shortages coming which can be all the difference between a cost that makes sense and one that will be rejected. Not to mention, you may end up getting materials over another when times get tough if you keep a strong relationship.

10. Make sure your own profit margin is fair.

Along with padding labor to avoid risk, you need to make sure your margin makes sense that you build in to your cost. It really depends on the industry, but in consumer goods, I found 20% to 40% being typical.

In summary, you should feel comfortable in what goes into product cost, how to calculate it, and tips to know before starting a project like this.

Written by Nicole Hullihen, January 20th, 2022