A basic rule for any successful business is to charge more for its products than they cost to make. Production costs can vary widely, though, and it isn’t practical to set a unique price for each item.
This is where determining the average cost for making and selling each unit becomes important, helping you set a selling price that’s profitable overall.
Here are some essential things to understand about cost per unit and how managing this cost can boost your business’s efficiency and profitability.
What is cost per unit?
Cost per unit is the average expense a business incurs for each product (or service) it produces and sells. It’s determined by calculating total production costs and dividing that figure by the number of goods produced.
Businesses use cost per unit to gauge their manufacturing efficiency or delivery of services. Crucially, cost per unit helps establish your business’s financial breakeven point, where price equals cost. Pricing above breakeven means your product is profitable; pricing below means you’re selling at a loss.
Cost per unit is regarded as a key performance indicator (KPI) for all businesses, along with profit margin, sales growth, and market share, among other crucial metrics. Analyzing per-unit costs helps businesses improve their competitiveness by looking for ways to control spending. Ecommerce businesses, for example, scrutinize costs of inventory and order fulfillment, which often are a big part of their unit costs.
Cost per unit vs. price per unit
Cost per unit is how much a company spends to make its product. Price per unit is how much it receives for selling the product. Cost per unit is influenced by volume—the number of product units made—and the mix of direct and indirect costs that make up total production costs. Price per unit reflects both the cost per unit and the target profit margin, or how much a business expects to charge customers above production cost. A business determines price per unit by weighing demand for its product against market competition and any outside factors such as government regulations.
In general, it’s better to have a lower cost per unit for your business, provided it doesn’t lead to reduced product quality and reliability.
How to calculate cost per unit
Calculating cost per unit starts with adding up total production costs for a given period, such as a quarter or a year, and dividing by the number of products made or services delivered in that period. Total production costs consist of two parts, fixed and variable costs, that are then used to find your cost per unit:
Find your fixed costs
These expenses don’t change, regardless of how much your business produces. Rent for your factory or warehouse, salaries for permanent staff, equipment expenses, property taxes, and business insurance are examples of fixed costs.
For ecommerce businesses, fixed costs can also include recurring expenses for website hosting and maintenance, marketing and social media advertising, and payments to third-party providers of services such as order fulfillment and customer billing. Fixed costs will only increase when a business expands and needs more capacity—a bigger factory, more equipment, or more staff, for example.
Find your variable costs
These are costs that change according to how much you produce. Typical variable costs are material costs and direct labor costs, which are direct costs of production. For example, if your widget-making business cranked out 1,000 units in one quarter, and in the next quarter increased to 1,500 widgets, your variable costs would increase proportionately to make the additional 500 widgets. Variable costs for ecommerce companies include things like packaging and shipping charges, inventory holding costs, sales commissions, and merchant fees for customer credit card transactions.
Use the cost-per-unit formula
Cost per unit is calculated using this formula
Total variable costs + Total fixed costs / Number of units produced = Cost per unit
As an example, let’s use a hypothetical company that sells car-interior accessories online and through physical retailers. Its total fixed costs in a quarter are $400,000, and variable costs are $350,000. It produces 10,000 accessories in the quarter. Its cost per unit is:
($400,000 + $350,000) / 10,000 = $75
How to reduce cost per unit
- Increase production
- Lower fixed costs
- Reduce variable costs
- Automate and streamline
- Improve logistics
- Outsource
Businesses have several possible ways to reduce per-unit costs. Some may be more pertinent to traditional manufacturing businesses, while others apply more to service and ecommerce companies:
Increase production
When more goods are produced, variable costs increase, but not fixed costs. The increased production spreads the fixed costs across a larger number of units, thus lowering the cost per unit. For example, consider the hypothetical company above that makes and sells car-interior accessories. If the company doubled quarterly production to 20,000 accessories from 10,000, its variable costs would double, to $700,000, but fixed costs remain at $400,000. Its cost per unit would drop to:
($400,000 + $700,000) / 20,000 = $55
Lower fixed costs
If your business can’t increase production, then consider ways to cut fixed costs, often referred to as indirect or overhead costs. Keep only as much production or warehouse space as you need, as well as equipment for production, order processing, and shipping. Negotiate for lower rent through longer-term leases. By allowing more work-from-home arrangements for office staff, you may reduce costs by renting less office space. Review all subscriptions, including for software, and cancel any you don’t use.
Reduce variable costs
Materials can account for a large part of production costs, so negotiate with suppliers on price and seek discounts for bulk purchases or longer-term contracts (provided you aren’t purchasing too much and facing the risk of excess or expired inventory). Reduce labor costs by rationalizing production workflows and training workers to increase output.
Automate and streamline
Keeping equipment up to date and using modern production systems can boost efficiency and product quality, reducing scrap and waste. Consider ways to lower energy consumption with technology that automatically regulates electricity and fuel use.
For ecommerce businesses, automating order fulfillment and shipping processes can hold down costs while reducing error rates. Think about standardizing components to speed up production; if you’re a service business, simplified service content makes it easier for customers to understand what you provide. When you review your product lineup, consider scaling back or dropping products with higher per-unit costs and lower profit margins.
Improve logistics
A business’s logistics include inventory management, storage, and warehousing, all known as holding costs. Businesses sometimes pay for storage they don’t need, adding to holding costs. Logistics are particularly important for ecommerce businesses, which tend to hold more inventory than brick-and-mortar retail stores, meaning storage and warehousing are a big part of their per-unit costs.
Outsource
Consider using third-party providers with particular expertise in accounting, customer billing, and account management. This is often more cost-effective than doing it yourself. Particularly for ecommerce and other businesses with large inventories, managing storage and warehouse costs can be done by a third-party logistics (3PL) service, which handles all inventory tracking, storage, and warehousing.
Cost per unit FAQ
How do you calculate cost per unit?
Calculating cost per unit starts with adding all the business’s variable and fixed costs for a given period, such as a quarter or year, then dividing by the total number of products made or services delivered in the period.
What are the differences between total cost per unit and quantity sold methods?
Total cost per unit is the average cost to produce, store, and sell a single item. Quantity sold methods are used to calculate the total cost of goods sold and to manage the quantity of goods sold through techniques such as demand forecasting.
How can an increase in sales volume reduce cost per unit?
Higher sales volume increases variable costs, but not fixed costs. This means total production costs don’t rise in proportion to the increase in output, thus leading to lower per-unit cost as production volume increases. Another way to think about this is that total fixed costs are spread over a larger base of products.
