Many small manufacturers believe they are profitable because their sales price exceeds the cost of raw materials. This is a dangerous assumption.
When a business ignores indirect costs, it often falls into a profitability paradox. Revenue grows, but cash reserves shrink because the business is effectively paying customers to take its products.
Calculating the true production cost is the only way to set prices that ensure long-term resilience and growth.
Identifying direct costs
Direct costs are expenses that can be traced specifically to a single unit of production. These are the easiest to track but often the most volatile due to inflation.
Direct materials include every raw ingredient or component. For a small furniture maker in Lagos, this includes the timber, nails, glue, and varnish used for one table.
Direct labour is the cost of the manpower required to create that specific item. If a technician is paid 50,000 Naira a month and spends 10 hours making one table, the direct labour cost for that table is a portion of their monthly wage.
Small business owners often make the mistake of excluding their own time from these calculations. If the founder is the primary producer, they must assign themselves a market-rate hourly wage to find the true cost.
Accounting for overheads
Overheads are the indirect costs required to keep the business running, regardless of how many units are produced. These are frequently overlooked in SME pricing.
Common overheads include factory rent, administrative salaries, and marketing expenses. In many African markets, energy costs are a significant overhead, particularly the cost of diesel or petrol for generators during power outages.
To apply these to a single product, manufacturers use an allocation rate. This is done by dividing the total monthly overhead by the number of units produced.
For example, if monthly overheads are 200,000 Naira and the business produces 1,000 units, each unit must carry 200 Naira of overhead cost to ensure the business breaks even.
Common calculation errors
Many founders fail to account for waste and spoilage. No production process is perfect. If 5% of raw materials are wasted during cutting or mixing, that 5% must be added to the unit cost.
Another frequent error is ignoring logistics. The cost of transporting raw materials to the factory and finished goods to the warehouse is a production cost, not just a selling expense.
Failure to update these figures regularly is also a risk. In high-inflation environments, a cost calculation from six months ago can lead to severe losses if input prices have risen.
Impact on cash flow and growth
Accurate costing prevents the erosion of working capital. When products are underpriced, the business lacks the cash to replace raw materials or maintain machinery.
Correct calculations also improve compliance and investment readiness. Investors and lenders require clear margins and evidence of commercial viability before providing capital.
SME owners should begin by auditing a single product line. List every material, calculate the exact labour time, and add a proportionate share of monthly overheads to find the true cost of that item.
