Step 6 to Build a Better Business – Figure Out the Cost of Production

In Step 5  of 30 Steps to Build a Better Business, you documented a step-by-step version of your production process. In this step, you’ll get an idea of how much that production process costs you.  Why is this important? One word.

Margins.

Many business owners make the mistake of focusing solely on revenue or cash earned from sales as a measure of how much they’re making. The erroneous assumption is, sell more product and make more money. But if your costs are out of line due to an inefficient production process, you end up with less profit than you should, and in the worst of cases you may even have negative profit. But you’ll never know until you take a close look.

I’ve seen several instances of a business owner going through hell and high water to serve a ‘big fish’ client. Adding more staff, getting materials from suppliers with much higher prices than they usually pay just to meet a time crunch or fill a huge order. But once they look at how much it cost them to fill that order, they often find that they did not earn as much profit off of that major client as they had expected to.

It’s understandable to have a situation like that happen once or twice, but if your plan is to continue growing your business, those tiny leaks can eventually turn into big waves of lost profit. It’s much easier to get a handle on them early.

Understanding Margin

Margin (a.k.a. profit or profit margin) is what actually makes it to the bottom line, that is, revenue minus how much it cost you to earn that revenue.  To get an adequate gauge of how much margin you make on each item or unit you sell, you need to know how much it costs to make that product. There are two main components to production cost – material and labor.

• Material cost is how much you pay for the actual ‘stuff’ that your product is made out of, including any shipping costs to get it to you.
• Labor cost is based on the amount of your or your employees’ time and effort that goes into the production process. If you’re a 100% service-based company, your production costs will be mostly labor, with very little or no material costs to consider.

Calculating Material Cost

In Step 4 of Building A Better Business, you set up a Product Management System as part of your business infrastructure. The material costs you use to produce a unit of product should be readily available in your Product Management System. If you haven’t already set one up, take some time to go back and complete Step 4 before proceeding.

Calculating Labor Cost

Go back to the production process outline you created in Step 5. For each step, you should already have the name / title of the person performing it, and a reasonable estimate for how long it takes that person to do the step. In the sample file provided, there was also space for you to put how much that person makes per unit of time (day, hour, minute) that your steps are measured in. Enter that information now. If you have multiple people w/different salaries doing the same process steps, take an average of their salaries.

Note: For a salaried employee,  the rule of thumb is to divide the annual salary by 2,080 to get the dollars paid per hour.

Multiply the pay rate and amount of time for each step, add them all together, and you have a general idea of the labor cost to produce your product / service.

Calculating Margin

Add the labor cost to the material cost for one unit, and subtract that total from the price you charge for one unit.

PRODUCT PRICE   -   (LABOR COST + MATERIAL COST)   =   PRODUCT MARGIN

The result is your profit, or margin, per unit. Is the number higher or lower than you expected? If you find that you’re making negative profit, first double-check your numbers to make sure everything is correct. If the math is good, then go back to the previous step and take a look at your process to see what unnecessary steps or people you can fesaibly take out or slim down (by changing the actual process, not just by fudging the numbers of course). If you’re still not happy with the resulting margin, you may need to adjust your pricing. We’ll talk more about this in detail in the next installment.