Cost Per Unit: Definition, Importance, and Tips to Reduce It

You are a grocery retailer and spend around $10 to procure and sell a grocery product. You can set its selling price high enough to earn a decent profit.

But what if your competitor manages to sell it by spending only $8? In that case, they can entice customers with a lower price, leaving you behind in the race for sales. 

This is where the concept of cost per unit  (CPU) comes into play. This financial metric is integral to understanding what it costs you to manufacture, deliver, or sell a unit of your product and price it accordingly. 

This blog post defines the cost per unit, explains its components, elaborates on why it is important, and elucidates the strategies to reduce it.

This blog post defines the cost per unit, explains its components, elaborates on why it is important, and elucidates the strategies to reduce it.

What is the Cost Per Unit?

Cost per unit is the total sum of money a business spends to produce and deliver a single unit of a product or service. It comprises two components:

1. Total fixed costs

Total fixed costs are the expenses that remain constant irrespective of the number of units produced in a given period. They do not vary with the level of production or sales. It implies that you have to bear them even when your production or sales is zero.

Being static, they enable you to forecast financial obligations over time and plan your budget accordingly. Thus, these costs are crucial to shaping your company’s budgeting process. 

Examples of fixed costs are factory rent, utilities, direct labor costs/salaries, insurance premiums, property taxes, and lease payments for machinery or equipment.

2. Total variable costs

Total variable costs are the expenses that are proportional to the number of units produced or sold. It implies that they increase as the production or sales go up and decrease with lower values.

Tracking and managing these costs allow businesses to determine cost-saving opportunities and improve overall operational efficiency. They also provide insights into the cost structure and financial implications of different business scenarios, enabling informed decisions.

Examples of variable costs are raw material costs, production budget, packaging & shipping expenses, and variable overhead spends.

So, the individual components of the cost per unit are understood. Let’s understand the formula to calculate your CPU using them.

Cost Per Unit Formula

Cost Per Unit or CPU is equal to the sum of fixed and variable costs divided by the total number of units manufactured in a given period.

Significance of Cost Per Unit

Cost per unit (or CPU) is a crucial financial metric that provides valuable insights integral to assessing the financial health of your business.

It offers the 5 following benefits:

1. Cost control and efficiency

Cost per unit helps understand the costs associated with the procurement, inventory management, production, and shipping of one unit. A low value indicates that your production and logistics are efficient, while a high figure indicates otherwise. You can use CPU to find areas of improvement, implement cost-cutting strategies, and elevate overall operational efficiency.

2. Break-even analysis

CPU plays a pivotal role in break-even analysis. It helps you set a minimum price for your products or services that you must charge to cover production costs while preventing losses. It also helps you identify the point beyond which your business can start making profits.

3. Pricing strategies

Setting prices that cover your product costs and provide a profit margin is essential. A thorough understanding of CPU helps set the most suitable selling price for your products or services. It implies that you can ensure your prices are competitive and help you stay profitable. 

4. Cost benchmarking

CPU contributes to cost benchmarking. In other words, it enables you to compare your product costs with industry peers, competitors, or best-in-class performers. It helps identify the areas where you can improve your cost efficiency, productivity, and overall competitiveness. It also facilitates aligning your cost reduction or efficiency enhancement targets with reality.

5. Informed decision-making

CPU provides in-depth insights into the costs associated with increasing or decreasing production levels to decide the future course of action. It also helps optimize labor, materials, and machinery, paving the way for better resource management.

Moving forward, the next section draws a comparison between the cost per unit and price per unit.

Cost Per Unit vs. Price Per Unit

Cost per unit refers to the amount you spend to produce, deliver, or sell a single unit. On the contrary, the price per unit is how much you charge to your customer for each item sold. 

Case 1: Price per unit > cost per unit

This means that you are earning a profit on each unit.

Case 2: Price per unit = cost per unit

It means that you have attained a break-even point, which means you are making neither a profit nor a loss.

Case 3: Cost per unit > price per unit

This means that you are making a loss on each unit.

Aspect	Cost Per Unit	Price Per Unit
Definition	Average expenses incurred to produce one unit of a product or service.	The amount a customer pays for each unit of a product or service.
Components / Determining factors	Fixed and variable costs	Market conditions, competition, and perceived value.
Focus	Evaluating operational efficiency and controlling expenses.	Staying competitive and maximizing profits.
Purpose	Suitable pricing strategies to ensure profitability while covering costs.	Revenue generation and market positioning
Impact	A higher CPU can reduce profit margins, mandating cost-cutting steps and price adjustments.	An appropriate price per unit can boost sales, while setting it lower than industry standards can cause losses.
Usage	Internal decision-making	For external stakeholders, including customers and investors, as it directly affects sales and profitability.

Now that cost per unit vs price per unit is clear, let’s explore the aspects that affect the CPU.

9 Factors That Influence the Cost Per Unit

While the factors that determine cost per unit may vary, here are a few common ones that you can consider:

1. Product type

A product’s manufacturing cost can vary based on its type. For instance, the cost of producing a smart TV will be higher than that of a shirt.

2. Complexity level

As a product’s complexity increases, the cost of manufacturing also rises proportionately. This is because it may require more labor, expertise, and high-quality materials for production. For instance, the cost per unit of a basic smartphone can be lower than that of a high-end smartphone with multiple cameras, OLED display, and advanced security features.

3. Scale of production

As the scale of your production increases, the cost per unit decreases. The reason is that fixed costs get distributed over more units, lowering your CPU.

4. Location of production

Your location of production also influences your cost per unit. This is because labor charges, material spending, and tax regulations affecting the final cost of production may differ from country to country.

5. Material costs

The type, availability, quality, and demand for materials also form a determining factor in the cost per unit.

6. Labor costs

Labor costs that differ based on location, skill level, and demand also affect your final cost per unit.

7. Technology and automation

Technology and automation can improve efficiency and minimize errors, reducing total production expenses and hence, the cost per unit.

8. Research and development (R&D)

For a product involving extensive R&D, factoring in those costs is also vital. It is typically applicable to industries like pharmaceuticals, biotechnology, or consumer electronics that demand continuous innovation and technology.

9. Market conditions

Cut-throat competition may force you to look for measures to keep your CPU lower to offer competitive prices.

Now that the factors that determine the cost per unit are clear let’s explore how you can reduce it.

6 Strategies to Reduce Cost Per Unit

A lower CPU opens the door for you to maximize profits. Below are a few proven tips that you can follow to cut down your cost per unit.

1. Effective supplier negotiations

Raw materials are indispensable for your production processes. Therefore, entering into negotiations with your suppliers to source them at a lower cost and favorable payment terms is imperative. You can seek flexible options like volume discounts, extended payment terms, and trade credit arrangements. 

Further, building strategic and long-lasting relationships is important to foster supplier collaboration on cost-saving initiatives. You can also analyze your supplier’s cost breakdown to understand the components and find areas where you can reduce costs.

2. Process optimization

Mapping out your end-to-end product or service delivery process is essential. Following that, you can conduct a thorough analysis of bottlenecks, redundancies, and areas where you find resources underutilized. You can also consider implementing lean principles to achieve inventory optimization and minimize waste due to excess inventory, poor workflows, or long wait times. 

Utilizing advanced technologies to automate and streamline processes can also help. For example, deploying robots and IoT devices can detect inefficiencies, cut down on errors or rework, and expedite production speeds.

So, you should encourage employees to provide suggestions for quality improvement, reducing the costs of returns management.

3. Efficient logistics management

Logistics form a significant component of a unit cost reduction strategy. Therefore, focusing on achieving seamless supply chain management can reduce logistics costs. To start with, you can work on optimizing first-mile delivery operations and related expenses. Seeking suppliers located in proximity to reduce the shipping costs involved in moving goods to your distribution center or warehouse can also help.

Besides, you can consider partnering with third-party logistics service providers to store and deliver products to your customers. In case you decide to go for self-delivery, implementing route optimization software can help you plan and find the most efficient delivery routes. 

Route planning and optimization software like Upper considers factors, including distance, traffic, drivers’ availability, vehicle type, and preferred delivery time windows, to create optimal routes. It, thus, helps reduce the fuel and overhead operational costs associated with transportation, slashing your CPU.

4. Smart inventory management

Smart inventory management practices are indispensable for slashing the cost per unit. One of the measures is implementing the Just-in-Time (JIT) strategy. It means receiving or producing goods only when demanded to minimize inventory holding costs. 

Another tactic is demand forecasting. It can help anticipate customer expectations and needs to adjust inventory levels based on that, preventing overstocking or stockouts. Integrating systems that track and auto-trigger alerts when inventory levels reach predefined thresholds can also help control overproduction and reduce storage costs.

5. Economies of scale

Economies of scale are the cost savings that you can get as you increase your level of production. Put simply, it means that the average cost per unit goes down as units increase in number. So, you can consider scaling up your production volumes.

As production increases, your facility rent, machinery depreciation, and labor costs get spread over a large number of units produced, lowering the fixed cost per unit. Bulk production also enables the use of specialized equipment and machinery designed for high-volume business operations, reducing total production costs further.

6. Overhead cost optimization

Overhead costs have a significant effect on the CPU. Therefore, seeking measures to lower them is paramount. To begin with, you can outsource non-core tasks to specialized service providers instead of handling everything in-house. It can help cut down labor costs, space requirements, warehousing expenses, and the need for special equipment.

Tapping into renewable energy resources like solar or tidal power wherever feasible can also help reduce electricity consumption costs. You can also switch to energy-efficient appliances and optimized lighting to optimize utility costs. Cross-training your workers to handle varied tasks can also reduce the dependence on a niche-skilled workforce, cutting labor costs.

Moving ahead, we’ll learn about the mistakes while figuring the cost per unit.

5 Common Errors in Cost Per Unit Calculation

People sometimes fail to assess the cost per unit accurately as they fail to understand or incorrectly evaluate its components. 

Below are a few common cost-per-unit calculation errors you can avoid:

1. Incomplete cost consideration

It often occurs when you forget to include certain costs associated with the production, resulting in an incomplete understanding of the expenses per unit. To avoid this, you should thoroughly identify and consider all the fixed and variable cost elements based on your industry while calculating CPU.

2. Inconsistent periods

It usually occurs when you use data from different periods. For example, if you mistakenly mix your monthly costs with annual production figures while calculating CPU; it can lead to discrepancies. Hence, ensure that the period for which you consider the total cost of production aligns with that of manufacturing to maintain consistency and accuracy in CPU analysis.

3. Overlooking inventory changes

Failing to take into account inventory changes, especially if you have a significant inventory turnover, can cause inaccuracies in CPU analysis. So, you should always account for variations in the initial and final inventory levels over a given period to calculate accurate costs incurred in production and sales.

4. Not accounting for seasonal fluctuations

Overlooking seasonal fluctuations that can affect production levels or costs can also result in inaccurate CPU figures. Therefore, adjusting your CPU calculations for seasonality and fluctuations in production costs that may differ throughout the year is recommended.

5. Ignoring external factors

Neglecting external factors like economic changes and industry dynamics can result in cost-per-unit figures that don’t reflect the current business landscape. So, keeping yourself up-to-date with external factors in your industry and adjusting your calculations accordingly is pivotal to ensuring CPU accuracy.

In the next section, we’ll discuss the three different CPU calculation methodologies.

3 Approaches to Calculating Cost Per Unit

Following are the three ways to determine the CPU.

1. Direct calculation

Direct calculation works for businesses that have a straightforward cost structure, and distinguishing fixed and variable costs is easy. For example, a small confectionary owner can easily distinguish between fixed costs like rent and salaries and variable costs such as flour, sugar, and labor. It can then divide the total costs by the number of confectionary items produced. 

Step 1: Determine and add all the fixed costs associated with production.

Step 2: Identify and sum up all the variable costs directly related to the production volume. 

Step 3: Add the total fixed and variable costs to find the total cost of production.

Step 4: Divide the total cost of production by the total number of units produced to calculate the cost per unit.

2. Activity-based costing (ABC)

Businesses with complex cost structures and multiple factors influencing costs use this approach of activity-based costing (ABC). It links the costs directly to the activities or operations that drive them and helps evaluate resource consumption. For instance, a hospital or healthcare facility can allocate costs to activities related to patient care, diagnostic services, surgeries, and administrative costs. It helps gauge the true costs of medical services. 

Step 1: Define the production activities, including setup, machine usage, or inspection, that consume resources. 

Step 2:  Segregate costs related to each activity, encompassing both direct and indirect costs to create cost pools. 

Step 3: Allocate costs in each pool to the products or units as per the level of activity consumption to get a realistic representation of unit-based costs.

Step 4: Divide the total costs you allocated by the total units to find the cost per unit.

3. Standard costing

Standard costing is commonly used in industries with standardized production processes and relatively stable cost structures. It helps businesses assess their performance against predetermined benchmarks and identify improvement scope. 

For example, chemical manufacturing industries require precise formulations and processes. They may benefit from standard costing as it may provide a basis for estimating costs for raw materials, labor, and overhead in chemical product manufacturing. 

Step 1: Establish predetermined standards to estimate the costs to produce a unit. These can include direct materials, labor, and overhead. You can base these forecasts on historical data, industry benchmarks, and expected performance. 

Step 2: Track and record the actual production costs, including actual volumes and prices of inputs.

Step 3: Compare the actual costs against your preset standard forecasts to find variances. If the actual expenses are lower, it is favorable. On the other hand, higher-than-estimated expenses are unfavorable for your business. 

Step 4: Divide the total actual costs by how many units you produce to determine the cost per unit.

So, you can analyze the cost per unit with one of the above-mentioned methods based on your type of business. 

Let’s consider a real-life scenario to comprehend how to calculate CPU in the following section.

Understanding Cost Per Unit Calculation with a Real-World Example

Let’s say an automobile manufacturing company produces 15000 cars. Following are the details of cost components:

• Fixed Costs: Factory rent, permanent staff salaries, and machinery depreciation 
• Variable Costs: Raw materials (steel, plastic, rubber, or fiber), assembly labor costs, and electricity charges

If the total fixed cost is $10 million and the variable cost is $8 million; the total will be $18 million ($10 million + $8 million).

So, CPU = Total production cost / Total number of cars produced

   = $18 million/15000 

   = $ 1200 per unit

This cost per unit indicates that any car sold above $1200 will be a profitable deal. Any car sold at this CPU will be a break-even (no-profit-no-loss) deal. Any car sold below this value will be a loss-making deal.

Cost Per Unit Analysis is Your Way Forward to Competitiveness

Warren Buffett says, “Price is what you pay. Value is what you get.” This quote holds true in the context of cost-per-unit analysis and reiterates the importance of a fine balance between production costs and market value. 

Understanding the different components of CPU, including fixed and variable costs, sale of production, or external factors, paves the way for strategic decision-making. It helps ensure your price per unit aligns with CPU to secure profitability. 

CPU is not just a financial metric; it’s your guide to attaining efficiency, creating informed pricing strategies, and achieving sustainable growth. Optimizing your Cost Per Unit is key to protecting your profit margins and positioning your business strategically in the marketplace.