Building a Smarter Business – The Cost of Goods

Posted by Tom LarsenNov 20, 2013 Operations, Organization, Planning, Product Development 0 Comment

The foundation of the widget based business, whether the widgets are medical devices, consumer products or packaged foods, is the Cost of Goods (COG). Every decision that is made in the business is built on the fundamental knowledge of “what does it costs completely, to make one selling item”.

Unique to the widget business is the fact that in order to take revenue from Customers, something tangible must be delivered. Service businesses or software/app based businesses have different models both require different investments of time or capital to create revenue.

I’ve always been surprised at how often the COG is not taken seriously enough by startups and early stage businesses. Now, with the advent of crowd-sourcing, numerous entrepreneurs are finding themselves having funded the cost of a production run, but not appreciated the full COG let alone the other costs it will take to actually build a business.

This article is exclusively on the COG, and it is relatively easy to describe, but, complicated to solve. The COG encompasses all the costs directly associated with acquiring the widget and being able to deliver it to a buyer. The operative word is all. Here is why:

Amanda is a baker and is planning to make organic/gluten free cookies and wants to sell them in local stores. She’s created a nice package and will sell them in boxes. Her sales unit is the box of cookies. Amanda will be making the cookies from her family recipe at a local commercial kitchen because she loves to bake.

Amanda knows how much the recipe ingredients cost that go into each box of cookies – $1.35 – and calls that her COG.

Here is what Amanda has NOT included in her COG:

Amanda buys all the ingredients from local wholesale providers. They are delivered via UPS for which she pays to have them shipped to her. Not included. Sometimes she buys volume from a local supplier. The cost of her time is not included.

Amanda puts her personal labor into the production of the cookies, which she has not quantified in hours per batch or dollars per box. She is working for free. Not included.

Catchy has waste in her process with broken cookies at some unknown percentage of each production. Not included.

Amanda personally does the packaging, forms the boxes, fills and seals the bags and puts the finished boxes into cartons. Not included.

Amanda rents the time needed at the commercial kitchen on an hourly basis. Not included.

Amanda is saying in her COG of $1.35, that all other costs to produce her cookies are in fact, free. Going through this exercise with Amanda, we found her actual COG to be almost $3.50, almost triple her original thought! Her complaint that she had no money in her business to grow it, started to make a lot of sense based on the COG awareness problem. Her desire to scale up and add retail distribution instead of selling retail at farmer’s markets was starting to look slim. Retailers will need to make a margin on the product, as will the eventual distributors who will sell to the retailers, which would leave Amanda in a hopeless cycle of working for free and never really understanding how this business can grow without more of her free labor.

Every conversation I have with people starts in the COG area. Is it the COG comprehensive? Is it optimized (best pricing). Does the business owner know what steps can be taken to improve it (volumes necessary)? If you know these answers, you’re way ahead of the curve. Simply looking at the ingredient costs, or the materials costs is not enough. Take the time (an hour or two, tops) to really think through how much it costs, for all the steps associated with making your widget and getting it to you, including freight, people’s time, waste, etc., and get your COG. Do it with every product you create, every time. The entire business stands literally on top of that awareness. You can’t begin to envision how much you can spend on any of the other parts of your business until you know what it costs to make the products you are selling.

Next: Figuring out your business model.

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