In Supply Chain and especially in Purchasing, much is said about the material cost, product price and total value of the purchase requisition. But, do you know how to use each of these terms correctly? Heads up! They are not synonymous! In case you don't know the difference, we will help clarify!
Cost: It is the amount (monetary) necessary to "bring life" to your product or service. The cost can be classified as direct or indirect cost and we will clarify these differences as well.
Let's say you own a small company that manufactures and sells chocolate chip cookies. To be able to sell the cookies you need to make them first and to make them, you need flour, milk, cream, butter, chocolate chips, molds, cardboard boxes to store the cookies, bows to decorate the packages and labels to identify them. Each of these components has its unit cost which must be calculated. You should consider how much you pay when buying a bottle of milk and calculate approximately how much of this ingredient is used per cookie. A practical tip is to cook the dough, roll it up and check how many cookies resulted from this operation. If a gallon of milk is used to make 50 cookies and it cost $2.00, we can say that the cost of milk per cookie is $ 0.04. You must make this calculation for each of the components of the cookie (as already mentioned: flour, milk, cream, butter, chocolate chips, molds, cardboard boxes to store, bows to decorate and labels to identify). For this example. you reach a total of $1.00. after adding up all the unit costs per unit. This is the direct cost to manufacture the cookie. Put simply, the direct cost is the cost of the raw materials needed to make something.
However, you should still consider the gas that was used to cook the cookie, the electricity used to light up the kitchen at night, the phone you used to research the prices of raw materials you needed to buy and the employee who helps you make the cookies. All of this should also be considered part of your cost and just as the unit raw material cost per cookie was calculated, you should calculate the unit cost of each of these components. The basic rule is to divide the amount of the electric bill or the employee's salary by the total number of cookies manufactured. After considering all the values involved in the manufacture of cookies (except the raw material), you will arrive at its indirect cost. Let's say your indirect cost is $ 0.46 per cookie. Analogous to direct cost, indirect cost is the cost to maintain the business, in this case, the cookies manufacturing operation.
Well, we already have the direct cost and the indirect cost for the manufacture of cookies and now we need to define what will be the price at which the cookies will be sold. Let's look at:
Price: To set the cookies price, you will first need to add your indirect cost to the direct cost and add your profit margin — after all, you need to pay your own salary, in addition to maintaining a reserve to invest in the company if you choose to increase and optimize your production. If cost is the basis, the price is for how much you are willing to sell your product for, so that this amount covers your costs (direct and indirect) and your profit margin. More important than how much you are willing to sell your product, is to find out how much your customers are willing to pay for your product.
It is important to consider that costs (direct and indirect) and profit margin should not be the only components of your price. Let's say you have defined that your profit margin will be $0.20 (normally the profit margin is expressed in % based on the total direct and indirect costs, so in this case, your profit margin would be 40%) and therefore the price of your cookie will be $ 0.75 per unit. There are still other variables that need to be analyzed, such as your competition. For example, in your neighborhood there is a small cookies manufacturing company at every corner and the average price of cookies sold is $0.50, you may need to review the your profit margin or invest in advertising so that your customers know why your cookies cost more. Similarly, if the cookies sold in restaurants and bakeries close to you have an average cost of $ 2.00, a cookie sold for $0.75 will certainly convey an image that your cookies are of an inferior quality. You then need to review (and increase) your profit margin.
In general, costs are internal factors (material cost plus operating cost, profit and reserve to reinvest) and price is the sum of all factors internal to external factors (competition).
Having defined cost and price, we will now understand the concept of value.
Value: This is a subjective measure, which when considered in conjunction with direct, indirect costs, profit margin, investment reserve and competition, will help you to price your product more assertively.
For example, do your friends always ask you to bake the cookies for parties and even strangers say that your cookies are "the best they've ever eaten in their lives"? Good for you! You know that your cookies are good and maybe their quality gives you the opportunity to increase your profit margin a little. Another example, if you offer options of light, diet and lactose-free cookies, you will certainly attract consumers with dietary restrictions, who will be willing to pay a little extra for your cookies. Or the fact that you always have ready (and fresh) cookies in stock will make you remembered by that consumer who urgently needs to buy a gift for someone.
In other words, value is defined by how the customer sees your product and what are the differences between your product and competitors' products. Why is your product better than the one at the corner restaurant?
Lack of understanding these concepts leads to errors in pricing, which in turn causes small entrepreneurs to often set aside the dream of having their own business when realizing that they are not succeeding. Incorrect pricing of products or services leads to an unsustainable business.