Cost

Part II of a Four Part Pricing Series (Part I, Part III, Part IV)

We’re going to go into some detail here about cost, perhaps more than the average salesperson needs to know to sell a product. For a quick and dirty understanding of cost, simply lump everything that follows into the one overarching category of “Cost”, and know that your cost is essentially your break-even price — if your wholesale price was the same as your cost, you wouldn’t make a cent of profit, nor would you lose a cent.

Business owners, however, must segregate the different categories of cost, for three important reasons:

1. To keep your accounting ledger squeaky clean for the IRS.
2. To strengthen your application for loans and your appeal to potential investors.¹ For example, COGS is used in calculating Gross Margin, which is an important measure of a business’ profitability.²
3. To better pinpoint your highest cost areas so that you can focus on reducing them when trying to improve your profit or lower your wholesale price.

This latter point is relevant to salespeople who are tasked not just with driving up revenue, but also profitability. We’ll go into more detail about this in a future post about cost control.

In accounting for manufactured goods, cost boils down to two general categories: Cost of Goods Sold (COGS) and Overhead Expenses. In the previous post, our woodworker’s COGS and Overhead Expenses were said to be as follows:

Let’s take a closer look at how these figures were determined.

Cost of Goods Sold (COGS), aka Direct Costs

Cost of Goods Sold refers to the direct costs that go into manufacturing and packaging your product. Direct costs are expenses that a company can easily connect to a specific product. In the example of cutting boards, that would include the raw materials (wood, glue, etc), the shipping fees for getting those materials delivered to the woodworking shop, any costs associated with packaging and labeling the boards, and any labor involved in making, packaging, and labeling the boards. For most wholesale producers, labor and materials make up the majority of COGS.³

Sidenote: only labor that is directly involved in making the boards is included in COGS. If you’re in business alone and you’re wearing all the hats, then you must decide on a fair manufacturing wage for yourself and book your pay for the time you spend manufacturing under COGS. Your wage should not come out of your profits. This is important because eventually you may have employees, so you will want to have a realistic cost for labor built into your price.

Calculating Your COGS
Since these are direct costs, they should be relatively easy to trace. Simply measure your average labor, materials, and packaging costs per unit for a given product, and total them to arrive at your COGS. For our woodworker, COGS is $13 per cutting board. We’ll say the wood costs $3 delivered, labor costs $9 (a half hour at $18 per hour) to shape and finish the board, and packaging is a spiffy hang tag that costs $1, including the labor to affix it to the board and the cost of having the tag delivered to the woodworking shop.

Overhead Expenses, aka Indirect Costs

In most successful wholesale businesses, individual products are part of a larger overall business strategy. Let’s say our woodworker doesn’t make just one style of cutting board, but rather a variety of cutting boards and chopping blocks. And let’s say that wholesale only represents 60% of her revenue, while the other 40% comes from popup markets (where she sells direct-to-consumer), woodworking classes that she teaches in her shop at night, and rental income from third party woodworkers who rent out her shop on weekends.

The more layers you add to a business, the more difficult it becomes to trace certain expenses to one specific product. Overhead expenses are simply operational expenses that can’t be tied directly to a given product, but that are necessary for the business to exist, and therefore contribute indirectly to the cost of producing that product. These fall into two accounting categories:

• Fixed overhead expenses. These include overhead costs that don’t change from month to month, regardless of a business’s revenues. In the case of our woodworker, this would include expenses such as rent for her shop, booth fees, depreciation on machines and tools, depreciation on the company vehicle, mileage, loan repayments, salaries for salespeople and office workers, employee benefits, payroll, legal and accounting costs, liability insurance, utilities, phone and internet, website upkeep, trade organization membership dues, etc. Even if she stopped producing for a month, these expenses would still have to be paid.
• Variable overhead expenses. These expenses vary based on production and sales activity. If you’re making and selling more products, these expenses will rise. Examples include distributor and broker expenses, any shipping or delivery costs if you offer free or discounted shipping, office supplies (the more business you do, the more toner, pens, and sticky notes you use), postage, marketing and advertising fees, credit card fees, commission for salespeople, and disposable shop equipment like earplugs and sandpaper.

Calculating Your Overhead Expenses
Each unit that you produce over the course of a year should bear a proportionate percentage of the your total overhead for that year. If our woodworker is wholesaling a variety of different products, plus doing popup markets, plus teaching, plus renting out her shop, then any one style of cutting board should bear a percentage of the total overhead that is equal to its percentage of the total revenue that it generates for the entire business. Said another way, if sales of one style of cutting board make up 5% of the business’ total revenue in a given year, and 1000 of those boards are sold that year, then 5% of the total annual overhead expenses for the business should be shared by those 1000 cutting boards.

All that said, it would be quite a pain to come up with such a specific number for each product you make, so most wholesale businesses come up with a flat overhead percentage that is applied to all products:

Overhead Percentage =

Total Annual Overhead Expenses / Total Annual Revenues

For pricing purposes, you apply this percentage to your Gross Profit (which we will get to in the next post). For now, understand that this overhead percentage will vary from business to business and industry to industry, depending both on a business’ expenses and its plans and goals for the future. For our woodworker, we’ll assume an overhead percentage of 30% of Gross Profits, which is fairly common as far as small wholesale producers go.⁴

One final thought about cost before we turn to profit: there are definitely more ways than one to categorize expenses, and pretty much every source you turn to will suggest a different method. The most important thing when it comes to pricing is that you account for every little last cost when setting your wholesale price. Leave no stone unturned! And for the sake of the IRS, make sure you’re categorizing these costs consistently within your internal bookkeeping system. And don’t forget to account for taxes!

Up Next: Part III of IV

¹ http://www.businessnewsdaily.com/5498-direct-costs-indirect-costs.html
² https://www.entrepreneur.com/encyclopedia/pricing-a-product
³ http://www.businessnewsdaily.com/5498-direct-costs-indirect-costs.html
⁴ http://gredio.com/blog/how-to-price-your-food-product-and-still-make-money/