Whether it’s a one-off product or a SaaS subscription, understanding product cost is crucial for any business to succeed. Breaking down your costs into materials, labor, overhead, and other expenses reveals insights into where your money is going.
In this guide, we’ll show you how to calculate product cost and how doing so can help you make informed decisions about crowdfunding, refine your pricing strategy, and improve profitability.
Table of contents
- What is product cost?
- Period cost vs. product cost
- Why product cost is important for product managers
- How to calculate product cost
- Factors that affect product cost
- Strategies to reduce product cost
What is product cost?
Product cost refers to the total expenses incurred during the development, production, and maintenance of a software product or technology solution. It encompasses a wide range of costs, including research, design, development, testing, deployment, and ongoing support and maintenance.
Product cost plays a crucial role in determining the pricing strategy and overall profitability of a product or service.
Product cost vs. period cost
While product costs are directly tied to the creation and development of a software product or technology solution. Period costs are the expenses that a company incurs during a specific accounting period but aren’t directly related to the product’s development.
Product costs include direct materials, direct labor, and overhead expenses. These costs are capitalized as inventory and become part of the cost of goods sold when the product is sold.
Period costs, on the other hand, are typically associated with selling, general, and administrative (SG&A) expenses, such as marketing, rent, salaries for non-production staff, and other administrative costs. Period costs are expensed in the period they are incurred and appear on the income statement as operating expenses.
Understanding how to properly categorize these costs helps you optimize your spending, prioritize investments, and ultimately, drive the company’s growth and success.
Why product cost is important for product managers
Put simply, understanding the costs of developing a product, feature, or update helps you make more informed decisions throughout the product lifecycle.
But it’s not just about knowing the costs. It’s also about knowing the value a project will bring to the product. This not only helps you determine the next project to prioritize but also maximizes your profits.
When it comes to pricing, many stakeholders have a say in how much a customer should pay for a product. It should be a collaborative effort from executives, marketing, sales, product managers, and finance. Depending on the company, product managers may or may not determine the pricing strategy for the product. Either way, you should at least participate in the conversation.
How to calculate product cost
Calculating product costs can be a difficult task, especially when it comes to determining the development costs of SaaS. However, there are some basic formulas to help calculate the product cost.
But first, let’s go over the few variables that affect product costs. These include:
- Direct material — Raw materials that are easily measurable and used to directly manufacture products
- Direct labor — Wages, payroll taxes, benefits, and insurance of employees who directly work on the product
- Overhead — These are costs related to manufacturing a product but are not a result of direct labor or direct material. This section is made up of three variables:
- Indirect material — Materials used in the manufacturing process but aren’t classified as direct material. Examples include office supplies
- Indirect labor — Wages, payroll taxes, benefits, and insurance of employees who aren’t directly manufacturing the product, but are crucial for a smooth manufacturing process. One example is managerial roles
- Other overhead — Overhead costs that aren’t classified as material or labor but are part of the overall expenses. An example is the electricity bill
To calculate product costs, you’ll use the following equation:
Direct labor + direct material + overhead = Product costs
To break this down into a per-unit cost, then use this formula:
Product costs (the answer from the previous equation) divided by the number of units produced = Per-unit cost
Let’s apply this formula using a practical example. Suppose you’re developing a new mobile application. The following costs are associated with the development of the app:
- Direct material — $5,000 (licensing fees for software libraries)
- Direct labor — $50,000 (salary and benefits for developers)
- Overhead — $20,000
Using the formula, we can calculate the product cost as follows:
$5,000 (direct material) + $50,000 (direct labor) + $20,000 (overhead) = $75,000 (product costs)
Now, let’s say the company expects to develop and sell 500 units (subscriptions) of the mobile application. To determine the per-unit cost, we’ll use the following formula:
$75,000 (product costs) / 500 (number of units produced) = $150 (per-unit cost)
With this information, you can make informed decisions about pricing strategies, potential profitability, and areas to optimize costs during the development process.
Factors that affect product cost
Various factors can influence the overall cost of developing and maintaining a software product or technology solution. By understanding these factors, product managers can better manage their resources, anticipate potential challenges, and make informed decisions that ultimately impact the product’s success. The following are some key factors to consider when evaluating product cost:
Scope of product
You may be envisioning a SaaS product with several features and components. It can be costly to fully build out this level of complex software and maintain it. You’ll also need to consider quality assurance processes and maintenance.
An excellent developer usually also comes at a high costs. However, it may pay off in the long run if they deliver high-quality code. Some cost-saving measures, like hiring junior developers, may result in several issues later on in the development process.
Are you going to hire employees, an agency, or freelancers to build your product? Each option has varying costs.
For example, an in-house employee will expect benefits like paid time off, workspaces, and equipment. Meanwhile, a freelancer wouldn’t expect any of those benefits. In some cases, this is a more affordable option.
Equipment and software purchases
You may need to buy state-of-the-art equipment for your developers and other team members. You may also face development expenses such as external APIs. These are variables that can impact your product costs.
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It’s not enough to just build a great product. You also need to invest in marketing, sales, customer support, legal, and more to ensure your product reaches the hands of the customers you want to serve.
A bit harder to calculate, time is a crucial factor to consider nevertheless. The software development lifecycle is time-consuming, and you may face obstacles that could lengthen your timeline.
Time is money in this scenario, so you’ll want to consider how long you expect the development process to take and keep track of the actual timeline of events.
Strategies to reduce product cost
You may find yourself in a situation where you determine your production costs are more than you desire. Or, maybe your customers aren’t willing to pay that much for your product. In this case, you may want to consider strategies to reduce product costs.
But reducing product costs can come with an unexpected price that doesn’t involve money: if you’re not careful, it could end up lowering the quality of the product. It’s a delicate balancing act to minimize product costs without compromising on quality.
Here are some strategies to consider if you want to reduce your product cost without dropping your standards:
- Do your customer research correctly
- Create a minimal viable product (MVP)
- Analyze your current tech
- Understand the scope of the project
- Don’t skimp on quality assurance
Do your customer research correctly
Customer research may be the most important step in building and maintaining any product. Many product managers and stakeholders think they know what the customer wants. Sometimes they’re right, but when they’re wrong, the consequences could be disastrous.
Backing up your assumptions with data can bolster your confidence that you are building a product that actually meets the needs of your customers. Alternatively, customer research can show that you are on the wrong path and need to pivot. This is an essential step, and it shouldn’t be skipped over.
Create a minimal viable product (MVP)
A minimal viable product (MVP) is an app or product that is just functional enough to serve early adopters’ bare-minimum needs.
By aiming to create a useful product with minimal features, you can avoid spending too much time and money on features that may or may not resonate with your target market.
Analyze your current tech
Your tech stack can have an impact on your budget. For example, you may be using several SaaS applications that have overlapping features. You may also be maintaining your own servers, but using cloud servers could help lower costs.
Evaluating your expenses can help you determine whether you’re getting the most value out of them or need to consider alternatives.
Understand the scope of the project
Before you even begin developing a product, you need a clear plan for what you’re building. Without a project plan or product roadmap, it’s hard to make sure all stakeholders and teams are on the same page.
You’ll need to have the following to reduce labor and costs:
- Technical specifications
- Wireframes or a design vision
- Detailed development plan
- MVP plan
Don’t skimp on quality assurance
This may seem like an additional cost at first, but quality assurance (QA) is crucial to spotting errors and bugs. Without QA, your development costs could increase and your timeline can extend further than originally anticipated.
An investment in QA can go a long way toward protecting your budget and preventing your project from becoming overdue.
Knowing the true costs of development can help you determine what features to build, whether for an MVP or for your next major update.
With a solid financial plan in place, you can identify which components are driving up your product costs and adjust accordingly. This way, you can optimize your resources and maximize profits.
Featured image source: IconScout
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