Earlier, I discussed how to come up with a revolutionary startup idea. In this post, however, I will discuss two types of production related startup costs that if calculated inaccurately, can lead to the destruction of your startup.
In the beginning, the majority of startup founders are extremely ambitious and motivated. but, with the passage of time, their energy dwindles, and they eventually give up on their dreams.
Why does this happen?
Failure in setting realistic goals is usually the culprit here. Another aspect is being over excited about the product launch. With so much excitement, several important things are either missed or miscalculated, putting the reputation of the product at stake.
In fact, CB insights, a machine intelligence data platform, reports that almost 29% of startups fail during the initial years because they are either short of money or lack a clear vision.
The good news is that this issue can easily be solved by evaluating the costs associated with the production and scaling of the product.
Startup founders should realize that coming up with practical estimates of the costs required for building an MVP is essential for success but they can’t solely depend on it. This is because the inventory turnover ratio also plays a major role in keeping the startup afloat.
Let’s learn how to estimate the cost of an MVP and inventory cost of startups.
1. Calculate Cost of Minimum Viable Product (MVP).
First, let’s learn how startups can produce a prototype after they have finalized an idea.
What is a Minimum Viable Product (MVP)?
Every startup team needs to build a basic product that they can take to the market. This first working product/prototype is called an MVP, and it is crucial for the life and future of all startup businesses, if messed up, it can be catastrophic, leading towards overall production cost failures.
Building an MVP entails costs. The challenge here is to realize that cost is not a single consolidated number. It actually comprises several sub-costs that could impact the overall development process of the MVP.
Recurring Costs vs One-time Costs
A ‘recurring cost,’ is the cost component that repeats regularly. A good example would be web-based tools for which you pay either monthly or yearly until you unsubscribe.
A ‘one-time cost’ is a cost component that is paid only once. Two good examples would be software lifetime licenses and the hardware platforms. It is, therefore, better to divide the startup’s cost further into a direct and indirect cost.
Direct Costs vs Indirect Costs
Costs that are associated with discrete areas of the project are known as direct costs. Examples include the cost of hardware components, fuel, and profits distributed among team members.
On the other hand, indirect costs are costs that couldn’t be associated with a specific expense head. Consider the scenario; If you are building the product out of your garage, the power bill of the garage would be an indirect cost of your startup.
Cost(s) of Human Capital
Unless you are skilled and experienced enough to build the entire product by yourself, you will need help which comes at a price. Startups often overlook this cost, giving rise to unpredictable outcomes. The founders need to calculate the cost of human capital for the entire duration of the MVP product development cycle. For example, if you require a web developer, find hourly rates and the estimated time for project completion. You will then have a fair idea of the cost of the human capital required for the project.
While building your prototype, it is wise to opt for contractual employees. In this scenario, you only pay the team when they complete the contractual obligations or achieve the pre-agreed milestones. This is an advantage for startups because salaried employees will need to be paid every month, regardless of their performance.
Moira Vetter, a columnist for Entrepreneur, says that it is better to get people from incubators or universities because they are available to work for a much lower cost.
“Not every startup has access to scientists and engineers to help them noodle on a concept at no charge. It’s important to take advantage of what you can, while you can, but don’t push your luck for a long-term operating model.”
Time vs Cost Penalty
Startup trainers say three months is the optimum time to build a startup product or an MVP. If the product fails, you have wasted only three months which is not that bad considering starting a venture of your own. If it works, however, you can focus on the next iteration with renewed motivation. Three months is the right amount of time to keep you on track, and understand costs, and help roll out MVP faster.
Remember that as you exceed the three-month mark, you run the risk of increasing the total cost that will continue to mount up in the future.
2. Calculate Startup Inventory Cost
An MVP is not the end. Rather, it is the beginning, an iterative process that you might end up repeating time after time to reach closer to what the public actually wants. And, once you have reached that phase, it is time you start focusing on the startup’s inventory cost.
What is Startup Inventory Cost?
Startup inventory cost is the amount of inventory you have manufactured to help take the project further. It is important to calculate the inventory cost in the start because most of the startups fail only because they have overstocked themselves without realizing the actual amount of orders they are going to get.
For instance, a startup aims to sell a 1000 units in a month. It orders 1000 units. But due to certain reasons, it is only able to sell 100 units of the product. So, 900 units are now left. This stock will, therefore, keep piling up and might end up leaving the startup cash drained. There is a simple solution to that as well.
Estimating Startup Costs of Inventory
The best way to avoid losses due to inventory stockpiling is to start small and keep a track of the overall inventory. You can achieve this by starting small and calculating the inventory turnover ratio on a regular basis.
To begin with, startups that have an MVP and are now moving towards the production phase, if they aim towards 1000 sales in the beginning month, they should order 100 units only. This may increase the initial manufacturing cost, but it will still help them keep assets liquid. Once the first batch is sold, they can order more products from the manufacturer. Here is a simple formula to calculate the startup inventory leftover ratio.
First, find the Cost of Goods Sold (COGS) and Average Inventory.
COGS = Beginning Inventory + Purchases – Ending Inventory
Your purchases include necessary costs related to inventory management such as handling, shipping, and packaging during the period under calculation.
Second, find the average inventory.
Average Inventory = Beginning Inventory + Ending Inventory / 2
Third, calculate the inventory turnover.
Inventory Turnover = COGS / Average Inventory
Now you can calculate the days of inventory held.
Days Inventory Held = Days in Accounting Period / Inventory Turnover Ratio
Usually, the accounting period is of 90 days.
Also note, an inventory holding period of fewer than 30 days is considered as a high turnover ratio.
Factors that affect Inventory Turnover
There are certain factors that can lead to a change in inventory turnover ratio. Read what they are.
As most startups have a small budget, it is difficult for them to market their products properly. This often leads to a lower inventory turnover.
The good thing is that finances are only a problem in the start. As a startup becomes stable with time, it is better able to manage a financial crunch.
The time it takes for a product to reach from the manufacturer to the customer is known as the lead time. Though this time varies from one manufacturing process to the next, it can reduce the overall turnover rate if the delay is longer than usual.
Successful businesses require reliable suppliers. An unreliable supplier can destroy the whole business. That’s why in an ideal situation, it is better to have a backup supplier that could help in case of product delays.
One major factor that influences turnover ratio is management problems. Management problems occur when people managing the inventory don’t have a major stake in the business. For startups, apart from the founders, no other person has a real stake in the business. This problem can be solved by monitoring the inventory and getting updates from managers from time to time.
Remember Your Goal
According to CB Insights, 48% of startups fail because the products they were making had no value in the market.
So, your goal with an MVP should be to build a product that you can roll out to the public while keeping a check on the startup production cost. Don’t just build an MVP with the intention that it is NOT the final product. This decision is best left to the customers. In almost all cases, you will have to go back to the drawing board to make necessary changes to the MVP
Yevgeniy (Jim) Brikman puts it best:
“In a trial-and-error world, the one who can find errors the fastest wins. Some people call this philosophy “fail fast.” At TripAdvisor, we called it “Speed Wins.” Eric Ries called it Lean. Kent Beck and other programmers called it Agile. Whatever you call it, the point is to find out which of your assumptions are wrong by getting feedback on your product from real users as quickly as possible.”
So, keep yourself focused on your goal and be prepared to rework the startup production costs if needed in order to bring them down.
Expect a Loss
It is okay to fail. But it’s not okay to not learn from your mistakes and repeat them.
All successful startups have experienced failure, and they don’t regret it at all. When you fail, you learn and that’s how you build better products.
If for some reason your MVP fails to delight customers or you have a lower turnover ratio in the start, don’t worry. Just take a deep breath, think of all the things that went wrong, and start thinking about the solutions. Talk to the experts about how you can improve things further.
I hope this article helped you in coming up with realistic estimates of building an MVP, the startup costs of the leftover inventory and inventory management processes.
If you need to add to the discussion, or need more information on the topic, let me know in the comments below.
Arsalan is a business graduate and digital marketer by profession. He works as a Startup Community Manager at Cloudways. He loves to create value for the Startup community. He is a big fan of cricket and does Netflix and chill in his free time.
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