Unit Economics

The $7 price you see for a jar of organic, local applesauce at your local specialty foods store represents much more than what the manufacturer is receiving. Let’s break down the major cost factors involved in creating a packaged food product.

Ingredients

Unsurprisingly, your raw ingredients are a primary cost factor. Typically, the more you buy the cheaper your per-unit ingredient costs. This is a strong argument for producing at scale.

Packaging

Another cost you face for every unit is your packaging. This is not only the container, but also any labels/wrapping and external packaging (if you sell individually wrapped bars, include the cost of the box that contains them). Like ingredients, you will see per-unit costs go down as total order quantity rises.

Production

Production costs include the cost for the facility (kitchen or co-packer), labor, and incidentals. When factoring in labor, make sure to count the cost of your own time. Even if you aren’t paying yourself a wage or salary right now, you should include a theoretical cost (say, $20/hr) so that your production costs aren’t artificially low. When you eventually pay someone else to make your product, you need to be able to afford their wage without raising prices.

The three costs above - ingredients, packaging, and production - wrap up to the cost of goods sold, or COGS. This is how much it costs you to produce your product. This does not include general overhead, marketing, or any of the costs associated with getting your product to the consumer.

Warehousing & Transport

Once you have your product, you need somewhere to put it. If it’s shelf-stable, you can keep it at home, but you might find it more convenient to warehouse your product. If you worked with a co-packer, they may be willing to store your product on-site (for a fee) until you can get it shipped to a distributor.

You will need to ship your products either to consumers directly or to a fulfillment center, distributor or retailer. Shipping costs vary based on distance and size of your shipment. As with ingredients, you typically can get better shipping rates by shipping larger quantities. If using a distributor, you will likely be shipping Less Than Truckload, or LTL, which is any number of pallets less than a full truck’s worth (the alternative is FTL, or full truck load). If you are shipping directly to consumers, look into discounts at USPS, UPS, and FedEx for business accounts; if your online sales platform is Shopify, you can see shipping costs and print labels directly from the Shopify platform.

Wholesale Price

This is the price at which you sell your product to distributors. This is your COGS + margin. How much margin should you target? Well, more is certainly better, but this also depends on consumer willingness to pay. A good target is 50%. Thus, if it costs you $2 to produce and ship your applesauce, you would sell to distributors for $4. We’ll get back to this later.

Distributor Margin

If you use a distributor to access retailers, they will add an extra 20-30% margin on your product. To continue with the applesauce example, if your distributor adds a 20% margin, they sell your product to retailers for $4.80 per unit. Note that if you seek out retail accounts outside of your distributor, this is the price you should offer! This keeps things consistent across your accounts, and gives you a little bump in revenue from avoiding the distributor markup.

Retailer Margin

Finally, retailers will add their own margins to your product when selling to end consumers. Retail margins are typically between 30-50%, with big grocery stores on the low end and specialty stores on the high end. If a retailer expects a 40% margin on your applesauce, they would sell it for $6.72 (or they’d round up to $6.99 and take the extra $0.27 cents for themselves). 

Thus, the applesauce you can produce and ship for $2 per jar sells for $6.99 per jar on most store shelves! Since you know this, you can recommend the $6.99 MSRP, or manufacturer’s suggested retail price, to encourage new retail accounts to conform to your pricing. 

The $2 you earn on each unit from your wholesale pricing is not pure profit (you wish!). Your business faces additional costs beyond the COGS. One such cost might be hiring a broker, which is someone who promotes your product and helps get you into stores. Brokers typically set a 5% fee for accounts that they win you. You may also find a merchandiser helps you keep sales flowing by visiting retailers to make sure your products are displayed correctly and the next order is placed. Another possible cost is trade marketing. If you work with larger grocery stores, they will expect you to commit a certain amount of money to marketing and promotions at their stores; a good rule of thumb is to set 20% aside for this. This leaves you with 25% margin instead of the original 50%. Part of this will offset lost revenue from products that expire, which you will no longer be able to sell. You’ll also use this 25% for administrative costs, licensing and fees, rent (if needed), and any other business expenses that don’t factor directly into producing your packaged food product. What’s leftover after all of this is your profit.

What if my unit economics don’t work?

If you run through this pricing exercise and realize that in order to be profitable your product is going to cost so much consumers won’t buy it, you have a few options. First, double check that it is really too expensive for consumers. Run surveys, consider a Van Westendorp pricing analysis, and gauge consumer interest in applesauce for $7/jar. If it still seems prohibitively expensive, don’t worry. One of the most effective ways to reduce costs is to reduce the cost of your ingredients and packaging. You can buy ingredients in bulk to get better prices, or shift between suppliers to find a lower price point. You can transition from Organic to Sustainably Grown ingredients, or source from larger suppliers that offer better rates. You could also try reframing the value proposition to consumers, and testing your new messaging to see if consumers would be willing to pay more if they perceive healthier, more ethically produced products. 

Another option is to increase your rate of production. Maybe you have been operating at a loss in order to build initial traction. At the right time, you can scale up to larger quantities with a co-packer, reducing the per unit production costs of your product. 

Finally, while you need cash to continue operating your business, profitability does not need to come immediately. Many food manufacturers break even, or even lose money, on their first production run. If you are planning to scale your business and sell it, remember that large food manufacturers have their own ways to drive down costs and realize profitability, even if you might not be able to.

What if I plan to sell online?

Great question. If you plan to sell through retail and online, you should set your online price equal to your average retail price (or MSRP). This keeps pricing consistent across channels and avoids confrontation with your retail account representative if they feel you’re undercutting them elsewhere. You can also use the higher margin to offset shipping, labor, and ecommerce costs associated with online sales.

If you plan to sell through online retailers, such as Amazon.com or Thrive Market, in addition to your own website, you should be aware of their pricing schemes. Thrive Market asks manufacturers for a sweetheart deal of 25-30% below standard wholesale pricing. They are effectively asking for the distributor margin. Amazon charges several fees, which are best described here; in general, Amazon charges an 8% “referral fee” for food products $15 or less, and a 15% fee for more expensive products. They also charge you for fulfillment costs, redistribution costs across their warehouses, storage costs (which skyrocket during the busy Oct-Dec season), and various other fees. If you choose to fulfill orders placed on Amazon yourself, you can avoid many of these costs, but keep in mind that Amazon sets shipping rates.

A note on markup vs. margin

Markup is the increase in a price, while margin is the percentage that goes to the interested party. If you wholesale a product for $4 and the retailer sells it to consumers for $7 (assume no distributor), then the retailer has marked up your product by $3. Their margin on your product is 43%; that is, for every unit sold, the retailer earns 43% of the revenue. The food space uses margin more often than markup, but if you have one you can calculate the other.