1.4 Cost and Trends in Cost
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before it becomes price, and the computer designer should understand how a de-
sign decision will affect the potential selling price. For example, changing cost
by $1000 may change price by $3000 to $4000. Without understanding the rela-
tionship of cost to price the computer designer may not understand the impact on
price of adding, deleting, or replacing components. The relationship between
price and volume can increase the impact of changes in cost, especially at the low
end of the market. Typically, fewer computers are sold as the price increases. Fur-
thermore, as volume decreases, costs rise, leading to further increases in price.
Thus, small changes in cost can have a larger than obvious impact. The relation-
ship between cost and price is a complex one with entire books written on the
subject. The purpose of this section is to give you a simple introduction to what
factors determine price and typical ranges for these factors.
The categories that make up price can be shown either as a tax on cost or as a
percentage of the price. We will look at the information both ways. These differ-
ences between price and cost also depend on where in the computer marketplace
a company is selling. To show these differences, Figures 1.7 and 1.8 on page 16
show how the difference between cost of materials and list price is decomposed,
with the price increasing from left to right as we add each type of overhead.
Direct costs
refer to the costs directly related to making a product. These in-
clude labor costs, purchasing components, scrap (the leftover from yield), and
warranty, which covers the costs of systems that fail at the customer’s site during
the warranty period. Direct cost typically adds 20% to 40% to component cost.
Service or maintenance costs are not included because the customer typically
pays those costs, although a warranty allowance may be included here or in gross
margin, discussed next.
The next addition is called the
gross margin
, the company’s overhead that can-
not be billed directly to one product. This can be thought of as indirect cost. It in-
cludes the company’s research and development (R&D), marketing, sales,
manufacturing equipment maintenance, building rental, cost of financing, pretax
profits, and taxes. When the component costs are added to the direct cost and
gross margin, we reach the
average selling price—ASP in the language of
MBAs—the money that comes directly to the company for each product sold.
The gross margin is typically 20% to 55% of the average selling price, depending
on the uniqueness of the product. Manufacturers of low-end PCs generally have
lower gross margins for several reasons. First, their R&D expenses are lower.
Second, their cost of sales is lower, since they use indirect distribution (by mail,
phone order, or retail store) rather than salespeople. Third, because their products
are less unique, competition is more intense, thus forcing lower prices and often
lower profits, which in turn lead to a lower gross margin.
List price and average selling price are not the same. One reason for this is that
companies offer volume discounts, lowering the average selling price. Also, if the
product is to be sold in retail stores, as personal computers are, stores want to
keep 40% to 50% of the list price for themselves. Thus, depending on the distri-
bution system, the average selling price is typically 50% to 75% of the list price.