Deeptech founders' guide to contract manufacturer cost modeling and avoiding black-box quotes

How to Model Contract Manufacturer Costs

Receiving your first comprehensive quote from a contract manufacturer is a pivotal moment. It is the point where your hardware product transitions from a prototype into something with a real unit cost and a potential gross margin. Yet for many Deeptech founders, this quote can feel opaque, a single number that holds the key to your business model but offers little insight into its own construction. Without a dedicated finance team, the task of validating this price and forecasting profitability falls squarely on you. This is where a simple manufacturing cost model becomes your most powerful tool for a successful negotiation, giving you the data needed to protect your runway and secure a sustainable partnership.

See the Hardware NPI Costing & Capex hub for broader budgeting context.

Foundational Understanding: Thinking Like Your Manufacturer

To negotiate effectively, you first need to understand the cost drivers in hardware production and how your contract manufacturer (CM) arrives at their price. Their quote is not a single calculation; it is a summation of costs from three distinct buckets. Misunderstanding these categories is a common source of cash flow strain for early-stage businesses.

1. Recurring Per-Unit Costs (COGS)

This is the cost to produce each individual unit and forms your Cost of Goods Sold (COGS). It is dominated by the Bill of Materials (BOM), which is the itemized list of all raw components. The other major piece is the “conversion cost,” which includes the direct labor for assembly and testing, plus a portion of the factory’s operational overhead like electricity and line maintenance.

2. One-Time Costs (NRE & Tooling)

These are the upfront, non-recurring expenses required to begin production. Non-Recurring Engineering (NRE) covers the process engineering work to design, validate, and set up the production line. Tooling includes the custom molds, jigs, and test fixtures needed to build your specific product. A critical distinction is to treat this as a capital expenditure (capex), not something blended into your unit cost. Both US GAAP and UK FRS 102 accounting standards treat tooling as a tangible asset on your balance sheet.

3. CM's Markup

After calculating the total per-unit cost (BOM plus conversion), the CM adds a percentage for their own general overhead and profit. This markup covers their administrative staff, sales teams, and facility costs not directly allocated to production, along with their desired profit margin. The reality for most early-stage startups is that failing to separate one-time NRE and tooling from recurring unit costs leads to a distorted view of your gross margin and can cause serious capex overruns.

Building Your 'Sanity-Check' Cost Model

Creating your own manufacturing cost analysis, often called a should-cost model, does not require an advanced engineering degree. It requires a spreadsheet and a structured approach to estimation. This model gives you a data-backed baseline for evaluating production quotes and grounding your negotiation.

Step 1: Estimate Your Bill of Materials (BOM) Cost

The BOM is typically the largest cost driver. For most electronics, the Bill of Materials accounts for 60-80% of the total per-unit cost. Use public component search engines like Octopart to look up each part on your BOM and find pricing at various volume tiers, such as 1,000, 10,000, and 50,000 units. This exercise gives you a foundational estimate and illustrates how your costs should decrease with scale.

Step 2: Add Necessary Buffers for Landed Cost and Scrap

Your raw BOM cost is not the full picture. First, you must add an allowance for scrap parts. A realistic scrap allowance for components that fail quality control during assembly is usually between 1-3%. Next, you must account for logistics to get those parts to the factory. A buffer of 5-10% should be added to the total estimated BOM cost to account for component shipping, import duties, and price volatility. Tools like landed cost calculators can help estimate these charges more precisely.

Step 3: Estimate Conversion Cost

This is the cost of labor and factory overhead required to assemble your product. While it is the hardest component to estimate precisely from the outside, you can create a reasonable benchmark. A key concept here is “touch time,” which is the literal time a worker spends handling, assembling, testing, and packaging your product. For standard electronics, a 'conversion cost' (labor and overhead) that exceeds 25-35% of the total landed BOM cost warrants a request for a detailed breakdown. A complex product with significant mechanical assembly may naturally be higher.

Step 4: Apply the CM Markup

Finally, apply a typical markup to your subtotal of landed BOM, scrap, and conversion costs. The Contract Manufacturer (CM) markup for their overhead and profit is typically in the 15-30% range. The exact percentage often depends on the complexity of your product and your production volume. This final figure is your estimated “should-cost” per unit.

Example 'Should-Cost' Calculation

Consider this simple model for a hypothetical device. Instead of a table, let's walk through the calculation flow:

• Raw BOM Cost: You sum all parts from a source like Octopart and arrive at $40.00.
• Scrap Allowance: At 2%, you add an additional $0.80 ($40.00 * 0.02).
• Logistics Buffer: At 8%, you add another $3.20 ($40.00 * 0.08).
• Total Landed BOM Cost: Your subtotal for all materials is now $44.00.
• Conversion Cost: Using a 30% heuristic, you estimate this at $13.20 ($44.00 * 0.30).
• Total Cost Before Markup: This brings the subtotal to $57.20.
• CM Markup: Applying a 20% markup adds $11.44 ($57.20 * 0.20).
• Estimated 'Should-Cost' Unit: Your final estimated unit cost is $68.64.

Separately, you must track your NRE and tooling for proper capex planning for hardware startups. If your one-time NRE is $50,000, your breakeven point on that investment occurs after selling 729 units ($50,000 / $68.64). This is a critical figure for your financial projections and should be tracked as a capital asset in your accounting software, whether you use QuickBooks in the US or Xero in the UK.

Reviewing the Quote: Green Flags vs. Red Flags

How a prospective CM presents their quote tells you a lot about them as a potential partner. Your goal is to find someone who enables a data-driven conversation, not one who hides behind a single, unexplainable number.

Green Flag: A Detailed, Itemized Quote

A good partner will provide a complete hardware manufacturing cost breakdown. They will separate the BOM cost, list out conversion costs (often broken down by assembly, testing, and packing), and clearly state their markup. NRE and tooling will be listed as distinct, one-time charges on a separate schedule. This transparency is invaluable. It shows they are confident in their pricing and are open to a collaborative discussion. It allows you to compare their numbers to your own manufacturing cost model and ask specific, intelligent questions.

Red Flag: A Single 'Black Box' Price

Be extremely wary of quotes that only provide a single, all-inclusive per-unit price. It’s a black box. You have no visibility into the underlying cost drivers. Is an expensive component the issue, or is the labor estimate inflated? Worse, is the NRE being amortized into the unit cost? This practice artificially inflates your COGS, distorts your true gross margin, and makes accurate financial modeling nearly impossible. This structure severely limits your ability to negotiate effectively.

What founders find actually works is prioritizing partners who provide this transparency from the start. A slightly higher, fully transparent price from a collaborative CM is often a much better long-term choice than a lower, opaque price from a partner who resists detailed discussion.

Putting Your Model to Work: A Data-Driven Negotiation

With your should-cost analysis in hand, you can enter the negotiation with confidence. The objective is not to accuse the CM of overcharging. The objective is to use your data to ask better questions and build a shared understanding of the costs. This approach transforms the negotiation from a confrontation into a collaborative problem-solving session.

On the Bill of Materials (BOM)

If your BOM estimate is significantly different from theirs, open a dialogue about component sourcing and supply chain. Frame your question collaboratively to invite partnership:

“Our analysis, based on volume pricing from several distributors, put the BOM cost around $40. Your quote has it closer to $48. Could you help us understand the primary drivers for that difference? Perhaps there are sole-sourced components or supply chain constraints we didn’t account for?”

On Conversion Costs

If the labor and overhead portion seems high relative to your 25-35% benchmark, inquire about the assembly process itself. This shows you are thinking about manufacturing efficiency, not just price:

“The conversion cost is a bit higher than we forecast. To help us understand it better, could you walk us through the main assembly and quality control steps that contribute to the labor time? We want to make sure our design isn't creating unnecessary 'touch time'.”

On NRE, Tooling, and Terms

Always treat NRE and tooling as a separate capital expenditure. Your questions here should focus on ownership, longevity, and maintenance responsibilities:

“Regarding the $50,000 in tooling charges, can you confirm that we will have exclusive ownership of these tools? What is their expected lifespan in terms of production cycles, and what is the process for maintenance or repair?”

Finally, do not forget that you can negotiate more than the unit cost. Improving payment terms can have a huge impact on a startup’s cash flow. Negotiating a change from Net 30 to Net 45 gives you an extra 15 days of float on every production run, which is a significant operational win. In some jurisdictions, programs like postponed import VAT in the UK can also dramatically improve cash flow on imported goods.

Practical Takeaways for Hardware Founders

Navigating your first major manufacturing agreement is a defining step for any hardware company. Success hinges less on aggressive haggling and more on a prepared, data-informed approach. As you move forward, keep these core principles in mind.

First, remember your manufacturing cost model is a compass, not a hammer. Its purpose is to guide your questions and help you identify areas for productive discussion, not to demand a specific price. It provides the foundation for a collaborative, data-driven conversation.

Second, rigorously separate recurring and one-time costs. This distinction is fundamental to your financial health. You must treat this as a capital expenditure and keep it out of your per-unit COGS for accurate gross margin calculation and effective capex planning for hardware startups.

Third, transparency is your best ally. A potential partner who provides a detailed cost breakdown demonstrates a willingness to work collaboratively. This is often more valuable in the long run than a partner who offers a slightly lower black-box price but resists any discussion of the underlying cost drivers.

Finally, look beyond the headline unit cost. A successful contract manufacturer negotiation also involves clarifying tooling ownership, exploring volume breaks, and negotiating supplier terms like payment cycles. These elements can have just as much impact on your cash flow as the per-unit price itself. In some cases, you may be able to leverage programs like duty drawback schemes, which can recover duties paid on exported materials in certain jurisdictions.

Read the Hardware NPI Costing & Capex hub for detailed budgeting frameworks.

Frequently Asked Questions

Q: What is a typical contract manufacturer markup?
A: A typical CM markup for overhead and profit is in the 15-30% range. The exact percentage depends on factors like your production volume, product complexity, and the level of service required. High-volume, simple products may see lower markups, while low-volume, complex Deeptech products may be on the higher end.

Q: Should NRE and tooling costs be included in my COGS?
A: No. NRE and tooling are one-time capital expenditures (capex) and should be treated as assets on your balance sheet, not blended into your per-unit Cost of Goods Sold (COGS). Including them in COGS distorts your gross margin and makes it difficult to track profitability and asset value accurately.

Q: How can I reduce my primary manufacturing cost drivers?
A: The two biggest cost drivers are the BOM and conversion costs. You can reduce BOM costs by working with your CM to identify alternative, lower-cost components (second-sourcing). You can reduce conversion costs by focusing on Design for Manufacturability (DFM) to simplify assembly and reduce "touch time."

Q: How often should I renegotiate with my contract manufacturer?
A: It is wise to review pricing periodically, especially when key variables change. You should consider renegotiating when your production volumes increase significantly enough to unlock new pricing tiers, when there are major shifts in component market prices, or when you implement design changes that reduce manufacturing complexity.