I'm Karl Ulrich, I'm a professor at the Wharton School. And this session is on target costing and channel economics. In order to achieve financial sustainability as a new business, the entrepreneur has to be able to satisfy this basic expression. Quantity times price minus cost must be greater than the fixed costs. Put simply, quantity Q, the number of units you sell per unit time, times the difference between the price you get for the product and the cost you pay for the product. That quantity has to cover your fixed cost of being in business, the cost you incur per unit time. What we're going to do in this module is to give a better sense of how you actually calculate these numbers and how you come up with a system, with a business model that's financially sustainable. Now, the basic logic behind this is, we're going to set price based on the market, based on the other products that are in the market, and what your competitors are doing. We're then going to work backwards from price. In order to set a cost target, and then we're going to check the cost of goods, that is our own cost structure against that cost target in order to be sure that our business is financially sustainable. Let me work through an example for you. I want to talk about the Belle-V bottle opener and Belle-V is a kitchen accessories company, of which, I'm one of the co-founders. And so this is one of our products. And these are luxury goods, so the Belle-V bottle opener sells for $50 in the retail store. And I want to now work through the logic around that price and around the target cost that we knew we had to be able to hit in the factory in order to be able to make this business work. Now in order to walk through that logic, I want to walk through the supply chain, or the sequence of supply actions, that get this bottle opener from the factory to you. Let's start with the factory. This is a photograph of a factory in Taiwan. Actually, it's a factory for another of my products, but very similar to the factory where the bottle-opener is made, and that factory produces that bottle opener to our specifications. Once the factory is produce the batch of openers, those openers are shipped to the United States, and they're shipped via container ships. So this image shows a container ship being loaded with shipping containers. The shipping containers are those metal boxes that you've seen on the back of rail cars, or on the highway on the backs of trucks. They measure 40 feet long by 8 feet tall by 8 feet wide. They actually do use imperial units, feet, to measure that. But in rough terms, that would be about 13 meters long, about 3 meters tall and about 3 meters wide. So those shipping containers are then loaded onto ships as shown here. And then they're transported, in our case, from China to a port in the Untied States, in our case to Long Beach California, which is shown here. So this is the container yard where those goods get unloaded. From there, they go to our distribution warehouse, also located in California, and then finally, they're shipped to the retailer. So here is shown a kitchen goods retailer that would carry the Belle-V bottle opener. And so, as we think about target costing, we really have to work back from the price this product would sell for in the store, all the way back to what the cost must be at the factory in order for that system to work. Let me walk you through the arithmetic on how to do that. I mentioned that the retail price is $50, and we've treated elsewhere the setting of retail prices, but in some, they're based on the market forces. In effect, what is the customer willing to pay and what are the competitive offerings in the marketplace? So in our case, the bottle opener sells for $50 because it's intended as a premium gift item sold in museum stores and design boutiques, where there are lots of $50 items. And so $50 does not seem a ridiculously high price for our beautifully designed object, like that bottle opener, that could serve as a gift. So that logic about where the $50 comes from, I'm not going to treat in this session. I'm just going to take that as a given, that the $50 is the retail price. Now if you think about it, that's the price the consumer will pay for the product. But the consumer isn't giving us, the brand owner, that $50. Instead, they're paying the retail store that $50. And in order for the retail store to be in business the retailer has to buy it from us for quite a bit less than $50. In our case, the retailer margin, that is the difference between the price the consumer pays and the price the retailer pays us, is 50%. And so the retailer buys the product from us for $25. Now we have to work back from the price we get, which is $25, to what our target cost would be. Now to do that we need to think about what our target gross margin is. We, as the manufacturer, or probably more accurately we, as the brand owner, what is our target gross margin. Let's just for the sake of argument say that our target gross margin is 40% that is on average. We want to be able to make about 40% of our revenue in terms of gross margin. What that suggest is that we need to pay no more than 60% of $25, or $15. $15 would be the maximum cost of goods for us to have the product in our hands, ready to deliver to the retailer. For us to be able to sustain a supply chain, that gives us 40% gross margin and gives our retailer 50% gross margin. So working back from $50, $50 is the retail price the consumer pays, $25 is the wholesale price the retailer pays us. And in order for us to be able to sustain a 40% gross margin, we must pay no more than $15 to have that product in our warehouse in California. I want to now dive in on two additional points. One is, where that gross margin comes from and how you actually calculate the gross margin. And the other is to talk about what's in cost of goods. That is, what has to be included in that $15 in order for this all to work. So let's first start with gross margin. Gross Margin is defined as the price minus the cost, divided by the price. And this is always taken from the perspective of the entity that's selling the product. So, if we take, as an example, the museum store that is selling our product to the consumer. Their price, minus their cost, divided by their price, will give the gross margin. And so for instance, using the numbers in this example, $50 is the price they offer to the customer, $28 is the cost they paid to us. So 50 minus 28 is $22. That divided by the retail price, or divided by 50, gives us 44%. So that would be an example of a retail margin calculation of 44%. Now it just gave in the example that the retailer buys it from us for $25. That would give a gross margin of 50%. 50- 25 divided by 50 would be 50%. And so depending on what those different parameters are, the price and the cost you get different gross margins. Now I want to just identify a difference in terminology that's sometimes used in retailing. Some retailers and some manufacturers will use the term mark up. Which is related but different from margin. More specifically, mark up is defined as the price divided by the cost minus one. And so, let me give a numerical example that I think will help make that a little more clear If price is $50, and if my cost is $28 then my mark up is 79%. Let me just walk through that arithmetic. 50 divided by 28 is 1.79. That means I'm selling the product for 1.79 times what I buy it for, 50 is 1.79 times 28. If I subtract 1 from that then what I get is a mark up of 79%. And the way to think about that, is the retailer takes the price that he or she buys the product for, and marks it up by a value of 79% of his or her cost. Now, that obviously is closely related to gross margin, but they give very different numerical values. And so I want you to keep them straight and to make sure you're talking about gross margin and not mark up, or mark up and not gross margin, when you're having a conversation about these numbers. Mark up is related to gross margin by the following expression. Gross margin divided by 1 minus gross margin is equal to mark up. So that's how they're related parametrically. Mostly we're going to use gross margin, but I want you to understand markup as an alternative way that some people describe the relationships between price and cost. The second issue or qualification that I want to talk about is what determines this margins for retailers and what are some typical values. Because when you go to calculate your target cost, you need to anticipate what your retailer is going to expect for gross margin. Well what determines margin for a retailer? First of all volume. The higher the volume of the product, the lower the margin the retailer requires in order to be able to stay in business. So just consider the difference between a grocery store that moves hundreds of thousands of dollars in volume every week, compare that to a jewelry store. That a small jewelry store that might only sell one or two items a day in that entire store. The higher the volume typically the lower the margin that's required for the retailer. Secondly is the price point. Consider the difference between selling a new automobile and selling a piece of chewing gum. The automobile has a much higher price and typically at those very high price points, all else equal, the manufacturer's or the retailer's margin will be much smaller than for lower priced products. Third is differentiation, is your product so unique that you're the only source of supply of that product? A less Initiated product that is one for which there's a lot of competitive offerings is going to end up having lower margin the competition is going to drive the margin out of the prices. Next would be what are the retailers costs that are required to support distribution of your product? And this relates to things like is it a seasonal good or is it a good that sells steadily throughout the year. How long is the life cycle for the product? Is it a very short-lived life cycle, perhaps with a season lasting only days or weeks? Or is it something that could be sold over years? Third, how many customers return the product and require a lot of service when they return the product? And lastly, what kind of sales effort is required to sell the product? Is it a product that basically sells itself? That people can find for themselves on the shelf, or is it a product that requires a dedicated sales effort and a lot of expensive sales people. Those things will all drive the margin requirements for the retailer. Now to put this all together, just consider the difference between construction materials And luxury cosmetics. Construction materials, relatively low differentiation, with relatively stable demand and relatively high price points in relatively high volumes. Those are going to be sold at quite low margins, maybe only 10, 15% retailer margin. Whereas luxury cosmetics, which are the opposite on all those dimensions. Those might have very high gross margins. Retailers might expect 60, 70% gross margin in that category. To give you a sense of the typical ranges, the retailing of most consumer goods requires margins of between 35 and 50 or 55%. But the extremes are say building materials at maybe 20% and fashion apparel maybe 60, 70%. So in order to understand your target cost, you first need to understand your retailers margin requirements. Those are going to be based on the kind of retail channel you use or whatever margin requirements are required for whatever channel you use. You're going to to use those margin requirements to then calculate what the wholesale price would have to be to your channel partner in order In order to support the target retail price that you've set for your product. Let's now turn to the question of what your target gross margin should be. And here I'm referring to you as the manufacturer or more typically the brand owner, because often you'll contract with the third party to actually produce your product. What determines your margin requirement? It's very similar to the logic for the retailer. The higher the volume, typically the lower margin that's required. The higher the price point, typically, the lower margin that's required. The more differentiated your product is typically the higher margin you can command. And similar to the retailers cost, the higher your cost of SG&A or sales, general, and administrative and R&D, or research and development, the higher those costs are, the higher your margins are going to have to be in order to support your business. So to give you an example, in software development SG&A or the selling general and administrative and R&D costs are very, very high. And so software has to have very high margins in order to be able to support that business. Whereas if you sell cleaning supplies, industrial cleaning supplies, your SG&A and R&D will be quite low and you could get away with a sustainable business model that has lower gross margin. So again, to give some representative values. Manufacturers of typical consumer goods would expect to operate with gross margins between about 30 and 50%. But at the high end, you'd have products like software, as I just mentioned, which might have gross margin Of 90 or more percent in part because the actual production cost of software are quite low or luxury cosmetics where the manufacturer, the brand owner, might have gross margin of 75 or more percent. And at the other extreme would be automobiles which, typically the manufacturer would have gross margins of maybe 15 or 20%, relatively low gross margins, relative to products like software or luxury cosmetics. Now the way you can estimate your margin requirements would be to go to the annual reports, the public financial filings of companies that are publicly traded and therefore, that are required to disclose their financials. And so, find a company that offers a product or service similar to your product or service. Find a public company that is in the same category, look at their annual report, look at their average gross margin from their financial statements and that gives you a pretty good idea of what your target gross margin will need to be as you go through the target costing analysis. The target cost logic of working back from the retail price using the retailers gross margin and then using your gross margin target gives you a target cost of goods. That target is the maximum you would be willing to pay to get the product into your warehouse ready to deliver to your customer. However, that's just the Maximum. It would be great if you could keep your costs well below that maximum. Because that would result in even higher gross margin for you. Or it could allow you to lower your prices, and perhaps increase volume. So you should think of that target cost as the maximum, as the ceiling on the costs of procuring the goods. Let me just give you a sense of what goes into the cost of goods calculation, so that you can then figure out what your real target cost at the factory would have to be. So if we take this example of the bottle opener, let's imagine that I pay the factory $12 for that bottle opener. Now remember that I produce that product in China and I want to sell it in the United States and so I have to import that product across that border between China and the United States. The United States collects duties on products produced in other parts of the world. The duties vary, in some cases they're zero, in some cases they're very high. In the case of kitchen utensils the duties are 3.4%. That duty applies to the value of the goods when they leave the factories. So you could think of that as the factory price. Whatever I paid the factory. The U.S. government will collect duties of 3.4% of that when those products enter the United States. I also have to pay for the freight to get that product from China to my factory, to my warehouse in the United States. And let's just for the sake of argument use the value of $0.90 or .9 US dollars for freight, per unit. That gives me a so called Landed Cost, which is the factory cost plus the freight plus the duties of $13.31. Typically added on top of that is a factor for scrap and shrinkage. Scrap refers to when you just have to throw away some product because it's defective or somebody returned it or It has some problem or some defect with it. And shrinkage is sort of a fancy name for theft. It means that your products mysteriously disappear from your warehouse, but it has a technical term called shrinkage. So scrap and shrinkage together we might consider to be about 1%. And of course, this would vary depending on your industry and your products. But if we use it at 1% and we apply that to the landed cost, then that's an additional 13 cents that we need to account for in the cost calculations. And so that would then give me cost of goods of $13.44. That would be my total cost of goods. Now, of course, your values will differ, based on what product or service you're producing them, producing, where you produce it and what the relative parameters are for your particular type of product. So these are just illustrative values but in our case we happily work out the numbers such that 13.44 that's $13.44 cents is well below our cost target of $15 which means that we can have a financially sustainable business. We can make the business model work. We satisfy the margin requirements of both our retail partner and of ourselves.