Ingredients of Product Cost:

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In a prior blog on Gadgets and Gizmos I touched on product cost and the typical focus of the consumer on manufacturing cost compared to sale cost. A consumer might think that a widget is made from a little bit of plastic and metal bolted together, probably 50 cents to make, why does it cost me $10? Well, the real reason behind the $10 is supply and demand, but what makes the product commercially successful is the amount of margin the manufacturer can achieve between the sale price and the sum of the development and manufacturing costs. If the product costs $11 total to get to market but the market will only bear $10, it fails. On the flip side, $9 in cost for $10 in price leaves a little profit margin for firm sustainability. Pretty elementary, but let’s look a little closer at the overall product cost:

For a conventional consumer product such as a golf club or iPad there are 2 main areas of cost to get the item to market. We will call these ‘Development’ and ‘Operational’ costs.

Development:

Development costs are mostly one-time expenses that occur over the span of a product design cycle, which could be 2 weeks or 2 years or longer. That sounds awkward, but these are a group of expenses that are incurred one time to bring a product to a manufacturable state. These costs can include:

  • Product Management time to evaluate concepts, market research, focus groups, specification creation and so on. This is mostly a man hour investment of resources.
  • Engineering time to develop the concept into a functional and manufacturable product that meets specification and customer expectation. This activity includes a man hour investment as well as capital expenditures for prototypes, testing, tools, and other activities in the design cycle.
  • Production tooling, this is typically under the Operations umbrella, however it is considered a one-time cost so it is included in development. Production tooling is the cost of hard or soft tools required to manufacture components within the product.

These costs can be significant to a company, and moreover these are all paid up-front before a single widget is sold. This is a risky proposition for an organization, which is why the Product Management stage is critical to ensure efforts and costs are recoverable. Development costs must be amortized into product price, which is where some mathematical magic has to happen to predict unit sales, overall product life and market price. Let’s look at a simple product such as a ball-point pen. It might take 1000 man-hours to fully develop a ball-point pen from concept to production, about $120-150k in cost. Prototypes and testing may run another $30-40k. Production tooling for that pen may include injection molded plastic, extrusions and metal stampings. This will be (hopefully) high volume, so quality tooling will run $90-120k. In the end, the first pen that gets sold cost over a quarter of a million bucks to make.

800px-Ballpoint-pen-parts

Operational Costs:

Operational costs are incremental expenses to manufacture and distribute products on a quantity basis. These costs include everything it takes to fabricate a product from scratch and get it into the consumer’s hands. I believe this is where most consumers draw their attention when they evaluate the value of a product, however operational costs include a lot of things that are not-so-obvious:

  • Material costs: This includes both raw materials and purchased off-the-shelf components needed to complete the product. This is typically call the BOM cost, or Bill of Material cost.
  • Transportation cost: This includes transportation of raw goods from mines or factories to processing points to fabrication plants to assembly facilities. After assembly a product enters a distribution network to transport the goods from the factory to the store shelves. This is a big expense, as the plastic within that ball-point pen may zig-zag the globe a number of times before reaching the consumer.
  • Manufacturing cost: This is the cost of fabricating the raw materials into components of the product. Production tooling paid for in advance is used in this process, as well as non-tooled fabrication such as cutting, bending, welding, painting, etc.
  • Assembly cost: This is the labor to assemble the goods from components into a finished good. Product testing the QA is included in this step.
  • Packaging costs: This may include boxing of goods, shrink-wrap, bubble packs or a variety of other packaging methods for the salable product. Packaging can also include the cost of combining consumer goods into shippable lots to retailers.
  • Distribution: This is distribution of finished goods through a network of nodes to get the product to store shelves for consumer purchase.

Again, Operational costs are per unit and economies of scale highly influence the final cost. Make a lot of something and material, shipping, manufacturing and distribution costs can be combined to drive down cost. Back to the example of the ballpoint pen, in high quantities the combined operational cost may be $.30 start to finish.

Pen #1 effectively costs the combined value of the Development and Operational costs, or roughly $310,000.30. If 1 million pens are made and the development cost is amortized over that quantity, the cost to make each pen is down to $.61, that’s getting more reasonable. 2 million pens? Cost just dropped to $.45, and so on. If the sale price is $.50, the firm is staring to see a profit. Of course this in an oversimplified example, in reality there are a number of variables that influence every aspect of the costs.

pen-2

Where is all this going? I’m trying to show that there is much more than goes into the cost of a product that the plastic and metal alone. If I haven’t put you to sleep yet, I will show where CPI fits in. CPI and lean practices are aimed at eliminating waste in operations, ultimately driving down the incremental cost to manufacture and distribute a product. This is very impactful to a firm’s bottom line by reducing the COGS, or cost of goods sold. This is a direct line to profit, or an option to strategically reduce price to gain market share while retaining margin.

What about the Development (fixed) costs, where does CPI fit there? The development costs are already sunk in order to get the product into Operations. I believe the value of CPI in the design cycle is not necessarily about reducing development costs, but shortening time to market to allow for more, or more highly developed products.

Did you find this interesting? Please leave a comment.

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