When you are running a business that manufactures products, it’s critical to be on top of your financials. From your materials' cost and production expenses to overhead and labor, keeping tabs on every detail of the investment involved in manufacturing is essential to determine future spending, hiring and pricing. One aspect of your expenses that you will need to pay close attention to is your unit product cost. Not only is this information important in determining how much you will charge for your product, but it is also critical to understanding your company’s overall health and in developing a strategic plan going forward.
What Is Unit Product Cost?
Unit product cost is the total cost of a given production run (called a cost pool), divided by the number of units produced. The production cost is comprised of labor, overhead, materials and any other associated expenses. For instance, say you produce T-shirts. Your company is going to be printing 5,000 purple T-shirts for a local bank. The shirts themselves cost you $2,000, and the vinyl lettering costs another $500. All of your shirts are shrink-wrapped, which adds $200 to your overall costs. Cardboard boxes for shipping will add $50. Just for materials alone, you’re already at $2,750.
You need to have your full team of five on staff to produce the shirts on time, and it will take them two days. Also, you will have one manager and one quality-control technician present to oversee the work. Your labor costs for the project will be $2,000.
The cost to have your machines up and running on any given day is $100. This includes maintenance and repairs and other incidentals, divided over a year. Also, things like insurance, electricity and building rent need to be accounted for. In your company’s case, these all add up to $200 a day. Your total overhead expenses for the project are $300 per day, or $600 total for the time it will take to produce the T-shirts.
The total cost to produce the T-shirts for your local bank will be $5,350. You are producing 5,000 shirts, so to determine the unit product cost, you will need to divide the total cost ($5,350) by the total number of units produced (5,000). Based on this, the unit product cost for this job is $1.07.
This information can help you determine what to charge for the shirts. Many companies offer volume discounts for this type of large order, but it is also common to mark products up to ensure profit margins. Charging $4 or $5 per shirt would help to achieve decent margins on this order.
Why Is Unit Product Cost Important?
Unit product cost is important because it helps you determine how to price your products. Also, it is essential for strategic planning and estimating future profits, staffing needs and expansion plans. Depending on the purpose of determining the unit product cost, you may include or exclude certain labor or overhead expenses.
How to Calculate Unit Product Cost
Being able to calculate unit product cost correctly requires that you have access to certain information up front. Part of what makes this tricky is you will need to research some of the associated expenses before pricing a product. For instance, in the T-shirt production example used earlier, when the local bank called you to inquire about pricing, you would need to know how much you would charge to produce 5,000 T-shirts with vinyl lettering. If you have been in business for a long time, you might have access to this information from past jobs and be able to estimate with accuracy the cost of such a job. Don’t forget to consider inflation, though, on projects that were completed more than one-or-two years in the past.
For new businesses, it might be difficult or nearly impossible to estimate what you would need to charge for a particular job if you haven’t completed one like it in the past. This is where careful, strategic planning comes into play. When you first start your company, your business plan should include specifics as to where you intend to source your materials. If you know you will be selling T-shirts, find the supplier you would like to use. Get a written proposal from that company for the cost of the products you will need, and use that information in determining how much you will need to charge.
If all you will be producing are T-shirts, you can determine a general cost per shirt in the same way you calculated the unit product cost for the local bank’s order in the above example. You will still need to know your factory’s overhead costs, the cost of your materials and the price you will pay for labor. These three components are always necessary for determining your cost pool.
Let’s use another example to explain how to calculate a cost pool. Say you are a new business and will be making all-natural granola. For each flavor of granola you produce, you will need to calculate a separate cost pool, since the time to make it and the ingredients' cost may vary.
Your first flavor is peanut butter granola. You will be sourcing local oats and honey, as well as all-natural, local peanut butter. You know this will drive costs up, but your company is committed to a local, fresh product. You will produce your granola in 100-pound batches. The company can make one batch per day.
To make 100 pounds of peanut butter granola, you’ll need 80 pounds of locally grown oats at the cost of $500. You’ll be using 20 pounds of honey for each batch of granola at the cost of $200. The peanut butter itself is a bit pricier per pound, and you’ll use 10 pounds at the cost of $10 per pound, or $100 total.
Therefore, to make one batch of peanut butter granola, you will need to spend $800 on ingredients. One batch makes 100 pounds of granola, which is enough for 200 packages, even when production-line errors are considered. As such, you will also need 100 zipper bags printed with your company’s information and nutrition facts. These cost $0.25 each, or $50 for the batch. Cardboard shipping boxes will run you $20 for the whole batch.
Materials alone, therefore, will cost $870 per batch. You also need to consider your overhead. You use a large industrial oven and one assembly-line-style machine to produce your granola. The cost to have your machines up and running on any given day is $50. This includes maintenance and repairs and other incidentals, once again divided over a year. Insurance, electricity, your permit to produce food and the mortgage on your production facility also need to be accounted for. In your company’s case, these all add up to $300 a day. Therefore, your total overhead costs are $350 a day. Since it only takes you one day to produce one batch of peanut butter granola, this figure is fairly easy to calculate.
Labor costs are the final consideration before you can determine with certainty your cost pool. It takes two employees and one manager one day to produce a 100-pound batch of peanut butter granola. Therefore, your labor costs to produce the granola are $500. Don’t forget when calculating this cost to include less-obvious expenses like employee personal time and health insurance, as well as the employer tax responsibility. These costs should be split over the course of a calendar year and added to the expense of having each employee on staff for a day.
Based on all this information, the cost pool for your peanut butter granola is $1,720. This means that in one day, you will spend $1,720 to produce 100 pounds of granola. To determine the unit product cost, you will need to divide the cost ($1,720) by the total number of units you will produce (200). Therefore, the cost per one-pound bag of granola is $8.60.
Given the higher cost of your granola, you will either need to find alternative ways to source your materials, lower labor costs, reduce overhead expenses or raise the price on your granola. However, the market may not support a price that would yield appropriate margins for your granola. It is for reasons like this that determining a unit product cost before beginning work is so critical. With this information in hand, you can step back and decide what changes, if any, need to be made before you proceed with full-blown production.
The Variations of Unit Product Cost
Though unit product cost can be straightforward, there are a variety of ways in which it can vary. These include abnormal costs, overhead inclusions and the purpose of the information. Depending on your company’s treatment of these factors, your unit product cost may vary,
As with all things in life, it is possible to incur abnormal costs when manufacturing a product. If due to a change in supplier, a bad harvest or other reason out of your company’s control, you find yourself incurring abnormally high production expenses at certain points, you will need to determine whether you will include them when you calculate your unit product cost. If the reason for the abnormal cost was temporary and is not expected to be a recurring problem, if you choose to include this information in your calculations, it can yield skewed results, which in turn, may lead to problems with your budgeting or pricing levels.
When calculating your overhead, you should only include things directly related to manufacturing. For instance, in the examples above, the cost to run the granola oven and the insurance needed to operate the plant were included. However, the cost to market your granola or to hire an administrative assistant were not included. As they are not correlated directly with your production by unit, it is best to exclude any administrative costs of this nature.
The reason you need the unit product cost is also important when determining what information to include in its calculation. If, for instance, you are calculating it so that you can find the lowest possible price at which you can sell your product, you should leave out certain overhead or labor costs. This is particularly the case if you might be able to cut these costs in some way down the line. If, however, your purpose in determining unit product cost is to determine a long-term pricing strategy that will take into consideration all involved expenses, you need to include everything outlined above so that all costs are absorbed. By doing so, you will then be able to develop a cost that allows for maximum profitability over the long term. Whichever approach your company chooses to take, however, be sure that you note it alongside your calculations so that it is clear to future bookkeepers or accounts.