The Hidden Costs of Hardware
Consumer hardware is a tricky beast. Designing, building, testing, and iterating is challenging enough, and when it comes to the question of “how much does it cost?”, entrepreneurs all-too-often estimate product costs based on the sum of the component costs (what I refer to as the “Material BOM”) and massively under-estimate.
My goal with this post is to shed more light on the true costs that need to be accounted for, and how. I’ve built & shipped high volume consumer electronics for over a decade — at both big companies (Apple, Square) and startups (Pearl) — and I want to share what I’ve learned so that early-stage engineers and entrepreneurs can create accurate product cost estimates.
It’s fairly straightforward to pull part prices from Digikey, Mouser, McMaster-Carr and sum them up. But the reality is that a significant chunk of the total product cost isn’t accounted for in the Materials BOM. It’s made up of things like freight fees, fulfillment fees, warranty costs, manufacturing labor, import fees, tariffs… this list goes on and on.
Historically, there hasn’t been a lot of documentation around these “hidden” costs of hardware. This is knowledge that’s retained by operations experts with dozens of products under their belt.
Below, I explain all of the cost terms & categories. When building a cost model, you should have something filled in for each of these line items. The exact formula used to calculate each line item can vary based on your product, country of manufacture, country you’re selling into, etc. As such, I’ve listed out the variables that contribute to each line item, without giving specific formulas. So it’s still up to you to do your homework to confirm that the numbers you fill in are reasonable estimates.
In addition to this post, I’ve also added these terms and descriptions to the The Hardware Document Toolkit: Bill of Materials (http://bom.hwdocs.com). This toolkit is an open source repository of knowledge for developing BOMs. Credit goes to Jesse Rosalia & Ryan Vinyard for pulling the toolkit together, and showing how these operational costs roll-up alongside materials components to give a complete picture of unit economics.
Quick disclaimer: this applies to consumer products intended to ship in volume. This does not apply to low-volume or B2B (enterprise) hardware. Although these terms are industry standard, there is some variation in what people use colloquially (for example, COGS vs. Ex-Factory).
Have you seen costs accounted for in a dramatically different way? Or do you have questions about specific line items, and whether a quote you’ve received seems reasonable? Hit me up at chrissy@root.vc — I’d love to hear from you! And if you want to learn more about the hardware document toolkit, you can contact Jesse & Ryan by visiting the link.
Example document with explanations below:
Manufacturing Value Add (MVA)
- This is the per-unit cost that you pay to your factory to assemble, test, and ship your product. It includes everything that does NOT count as direct materials costs.
- It is advisable to get multiple quotes from different factories to compare and negotiate your MVA.
- MVA can end up adding 20% (or more!) to your materials BOM cost. “More” can be significantly more if you are manufacturing in low volumes, or manufacturing in expensive regions (eg. the US).
- Always ask for a breakdown. Many factories will not provide any detail, and instead just give you a total MVA dollar value or percentage. Push hard to get a more detailed breakdown, so you can make sure that certain portions aren’t inflated or assumptions incorrect — plus it helps with quote comparisons and negotiations (now and in the future).
MVA typically includes the following components:
Yield Loss
X% of your materials BOM cost. Where X is the number of units you expect to scrap (throw away) out of every 100 produced. This is also referred to as the scrap rate. Note that scrap only happens after all attempts at rework and repair have failed. If your failure modes are well understood and your product is easy to repair, yield loss is near 0%. This should be pre-negotiated with your factory, and written into their master services agreement. Negotiate to have this percentage applied to the minimum reasonable material BOM cost (for example, make sure that packaging and accessories are NOT included in the calculation).
Labor & Overhead
How much human “touch time” is required to assemble your product. This is calculated as an hourly labor rate x the total amount of time required to assemble one product. Hourly labor rate varies dramatically from region to region. Make sure your factory tells you the actual labor rate that you’re being charged.
SG&A: Selling, General, and Administrative Expenses
This covers everything required to keep the lights on in the factory. It rolls up all costs that are NOT directly related to the production of your product. This can include facilities, utilities, office staff, sales, travel, management, etc. It’s typical to see this calculated as a percentage of your material BOM cost.
CM Profit
This is the profit that the factory pockets for each unit they manufacture. It’s typical to see this calculated as a percentage of your material BOM cost.
VAT: Value Added Tax
Imposed by certain countries on any products assembled or produced. It’s typical to see this calculated as a percentage of your material BOM cost. It varies from country to country (products made in the US do not have this, but China does). Make sure this doesn’t get double-counted (e.g. included in both material BOM & MVA)
Cost of Goods Sold (COGS)
- This is typically defined as the Materials BOM cost + MVA.
- This can also be referred to as “Direct COGS” or “Ex-Factory”.
Operational Cost of Goods Sold (OCOGS)
- This is typically defined as COGS + any operational costs required to deliver a product to end customers.
OCOGS typically includes the following components:
Duty, Taxes,Tariffs
Fees paid to import your product into the US (if produced internationally). This is typically calculated as a percentage of your COGS.
Freight In
Cost to ship your product from the factory to a centralized fulfillment center. This cost is a function of product size, weight, distance shipped, and mode of shipping (air vs sea). Air shipping is significantly faster compared to sea (from China, 2–4 days vs. 5–8 weeks), but also can be 5–10x more expensive. If mixing shipping modes, calculate this as a blended average between the different modes.
Fulfillment
Cost you pay to a fulfillment center or third party logistics center (3PL). This covers them receiving your product, holding inventory, and shipping to end customers.
Freight Out
Cost you pay to ship your product from the fulfillment center to the end customer. This cost is a function of product size, weight, distance shipped, and shipping time. Two day shipping has become common, with the seller absorbing this cost (thanks, Amazon!), however it is much more expensive than standard shipping. You can also leverage your third party logistics (3PL) partner by using their negotiated freight rates, which will be much better than what you can get on your own. Note: This cost is significantly lower when shipping in bulk to retailers instead of directly to customer homes. The pros and cons of selling through retail stores warrants an entire post itself. However, here it is worth noting that any savings in freight out is offset by paying the retailer something called a channel margin (typically 15–50% of your selling price).
Credit Card Fee
Cost you pay to a credit card processor to process the transaction. This is typically 2.5–2.75% of your product’s selling price. Credit card fees are zero when selling through retailers (they absorb it in the channel margin they receive).
Warranty
The amount you expect to spend on warranty returns for defective products, amortized over all units produced. This is a function of how long you offer a warranty (1 year vs 5 years), the unit cost, and the expected rate of defects (often higher in the beginning, but dropping over time).
One final note
There can be some variation in what people include in the OCOGS roll-up. The variations are typically slight (some folks will include cloud hosting fees, or costs of direct customer support). And sometimes these items are intentionally excluded (bucketed into a company’s OpEx budget instead) to make product margins look better. The most important thing is that you must be consistent. As long as you decide up front and never change which things are included in OCOGS, you won’t get in trouble with your investors, accountants, and auditors.
