Why target costs are essential.

There is a certain romance involved in designing and creating something new. However the anticipation of success and potential rewards can be addictive and often clouds rational thinking during the product development process. This results in products that may look and feel great, but aren’t as profitable as the business needs them to be.

From our experience the starting point to work out costs should start with the eventual selling price and the biggest question you need to ask yourself is ‘What is a consumer willing to pay for my product?’

It’s a difficult question to answer and there are a number of different factors that can influence this. Is your product unique? Does it have some revolutionary technology? By purchasing your product will the consumer save money in other areas? What are the competition selling their product for? Does your brand have a solid reputation? These are just some of the questions that need to be considered at the start of your project so that you can inform your development team and build a business case for the investment.

Let’s take a typical example of a consumer electronic device that has features that are disruptive to its market sector. The product offers genuine consumer benefit and your initial market research, in conjunction with your brand’s reputation has indicated that a consumer would pay £80 for the product. Knowing this figure is critical as it allows you to then work backwards and generate your business case.

In this example let’s assume that you will sell your product through standard retail channels. High street store chains will typically look for a margin of 40-50% and the rate will vary from one retailer to another. If 50%, they will want to purchase your product at a wholesale price of £40 (80/0.5)

In order to generate a profit for your business, pay your overheads for marketing, staffing, offices etc we also recommend that you aim for a margin of 50% when selling wholesale. In product development, and business in general there are always unexpected costs that are incurred, if your gross margin is much less than 50% you may run into financial difficulties later down the line. A caveat to this is obviously volume of sales and if your volume is expected to be high then you can generally make a smaller gross margin but still run a successful business. Fluctuations in exchange rates can also make a huge difference from one day to the next so aiming for a higher margin will help to absorb issues like this.

So using the example of 50% gross margin at wholesale, this would leave you with a target unit cost of £20 (40/0.5) this figure then becomes the maximum unit cost that your development team are allowed to use when creating the product, along with your anticipated sales volumes and has a big influence on the materials and components that can be used, the manufacturing processes that should be utilised and the overall complexity of the product itself, right down to the type of cardboard that should be specified for the packaging. Obvious the £20 figure is the maximum and all efforts should be made to reduce the unit cost further so that your margin is increased.

Now let’s say that you have calculated that to pay for your development, tooling and first batch of stock is going to cost £75k. To recoup this investment and bearing in mind that at your wholesale price you generate £40, you would need to sell a minimum of 1875 units. This doesn’t take into account the costs of running your business, marketing etc and so that actual figure would be higher, but this gives you some indication of whether or not the product business case is viable. Further calculations would be needed to ensure you have the cash flow to make it work.

Selling the product direct to the consumer and maintaining your £20 manufacturing cost would obviously generate a much higher margin although it might be harder to initially generate the sales volumes that retail can offer.

For the purpose of making the article easier to follow we have used whole numbers however the context of calculating margins and unit costs remains the same.

North Product Design are an innovative UK based product design company with strong experience across a variety of industry sectors including consumer electronics, medical products, sports equipment, safety equipment and mechanical engineering.

We help businesses to grow through design.

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