Ever wonder how electronic contract manufacturers come up with their prices? Simple: they estimate their costs, then add profit. This method is called “cost plus”; cost plus profit.
Most businesses price their products or services based on the value they bring to customers. We pay hundreds of dollars for software products with no idea or even concern as to what they cost the software company to produce. We buy them based on the value they bring to us.
But some things we don’t buy based on value, we buy based on cost. These tend to be things we might otherwise do ourselves. Because we can do it ourselves, we are likely to have some idea what it costs. Therefore we want to compare the cost of doing it ourselves to the price of having someone else do it. The value is in not having to do it ourselves, which can only be understood by comparing the cost of doing it ourselves with the higher price of having someone else do it.
If you happen to be handy enough to remodel a bathroom, you can calculate the cost of materials and estimate the amount of time it would take you. If you solicited bids from contractors to do the job, you would naturally expect to pay a price for the materials, a price for the time at some hourly rate, and some profit for the contractor. Often referred to as a “time and materials” quote, this is a form of “cost plus” pricing. In cost plus, cost is the actual cost and plus is the profit.
Electronic contract manufacturers (CMs) build products designed by their OEM customers, who know the approximate cost to manufacture their product. The OEM must choose between manufacturing themselves or outsourcing. Because the OEM knows the approximate cost of manufacturing and could choose to build it themselves (at least theoretically), CMs use cost plus to determine price.
For the CM, the basic components of cost are materials, direct labor, and overhead. Typically, the direct labor and overhead costs are combined into the “burdened labor rate.” The average burdened labor rate for North America is about $40. If a widget has $500 of materials and takes 1 hour of labor, the cost is $540 ($500 plus 1 hour at $40 per hour). A profit margin will then be added to the $540.
A common misunderstanding is how to calculate the profit: margin or markup? Margin is the percent of the selling price that is profit and is calculated as cost divided by (1 – Margin %). For example, if cost is $33 and margin is 25 percent, the calculation is 33 divided by .75 (1 - .25), which equals $44. Markup is an adder applied to cost and is calculated as cost times (1 plus Markup %). If cost is $33 and markup is 25 percent, the calculation is 33 times 1.25 (1 plus .25), which equals $41.25.
Returning to our example above, a product with a $540 cost and 25 percent margin (typical for low-mid volume) the cost plus price would be $720.00 (540 divided by .75).