Once you have identified the product or service you want to produce and sell and believe there will be sufficient market demand for it, you must determine if you can generate enough profit to justify bringing it to market. The best way is to create a financial model containing all known and likely expense components and sales margin parameters.
When attempting to determine the cost to produce a product or service, it is usually beneficial to consult with one or more persons who have significant experience in the same or similar industry. In many industries, labor is the most significant cost component. However, cost components may vary greatly by industry, and in some cases, the geographic location of raw materials and production facilities will be major factors as well. Obtaining the advice of a mentor or consultant with industry experience would likely prove to be very insightful and a good place to start.
Understanding Product/Service Cost
When most people think of the cost of a manufactured good, they think of the raw materials that go into making it. However, often raw materials are only a small fraction of the total cost incurred to bring most products to market. The product cost will likely include the following:
- Sourcing and delivery of raw material(s)
- Manufacturing and processing the raw materials
- Supplies utilized in the manufacturing process
- Product packaging and labeling
- Fright and storage incurred to get the product to a distributor or seller
- Labor to support all manufacturing, distribution, and storage operations
- Lease/purchase production facilities
- Lease/purchase manufacturing equipment
- General and Administrative
Marketing and Sales
In addition to the cost directly related to manufacturing and distributing a product, there will likely be a significant expense required to market and sell a product. While the marketing plan and sales strategy will likely vary by product or service and industry, the marketing and sales expenses can be a significant portion of costs, especially prior to establishing brand recognition when marketing and promotional efforts are typically larger.
Distribution Channels and Points Of Sale (POS)
No standard cost model will be effective for products in all industries because each industry has different cost components and structures. For example, the bottled beverage industry relies heavily on the use of distributors who work directly with both manufacturers and retailers. These distributors typically have relationships with a large number of retailers, enabling a manufacturer to sell their products in multiple retail locations while only contracting with one distributor. Of course, the distributor charges a significant fee to provide the convenience of access to a large number of retail locations. Whereas a professional services business cost model would look completely different, likely containing very few of the same expense components.
In addition, the popularity of buying and selling products via the internet has completely altered the standard product distribution model in recent years. With many products, consumers are now able to purchase directly from the manufacturer, known as Direct-To-Consumer (DTC), or through online distributors, such as Amazon. Products are being introduced and sold exclusively on these platforms more than ever before. Their use can dramatically affect and, in some cases, eliminates some of the otherwise typical marketing and distribution costs. Whether offering a product through traditional retail locations, DTC, or via third parties, it is vital to understand the complexities and costs involved in utilizing each.
Eliminate the Unknowns
When developing a cost model for the manufacture, distribution, marketing, and sale of a new product, the need to research and understand each step in the process is vital. Only after you have obtained a thorough understanding of the process and variables affecting the production and distribution will you be capable of creating an accurate financial model to forecast the cost of a product or service.