Direct vs. Indirect Costs (and Why They Matter)
If you’re a business owner continually searching for ways to increase your profitability, you’ll want to learn about direct and indirect costs. Breaking out your expenses into direct and indirect categories can help you arrive at the most profitable volume of sales for your business.
Expenses that fall into the direct cost category are ones that relate directly to the items you sell. Here are some examples:
- If you have a flower shop, the cost of the flowers is a direct cost. So are vases, ribbons, cards, and the labor to put arrangements together.
- If you are a law firm, the labor and any materials or supplies spent on serving a client is a direct cost.
- If you own a pool building company, concrete, tiles, filters, pumps, and the labor to build the pools are direct costs.
- If you run a toy store, toys are a direct cost.
Direct expenses, unlike indirect expenses, will vary proportionally to the volume of items you sell. The more you sell, the higher your direct expenses. The less you sell, the lower your direct expenses.
In general, direct expenses should be recorded in Cost of Goods Sold. You can determine your Gross Profit by calculating Sales less Cost of Goods Sold (or COGS). Gross Profit Margin is an important percentage to know in your business. It’s computed as follows: (Sales – COGS) / Sales.
Some small service companies might not bother to break out labor into direct and indirect on the Profit and Loss statement each month, but it can be useful to break out periodically or when you are re-evaluating your pricing and profitability.
Direct expenses are important when making pricing decisions, but so are indirect expenses.
Indirect expenses are costs you must incur to run your business, but are not directly related to the items you sell. Here are some examples:
- Utilities such as electricity, gas, water, and garbage pickup
- Administrative labor, such as a receptionist or supervisor
- Education and training
- Professional services, such as legal, HR, IT, or accounting
- Office supplies
- Hardware and software
- Business permits
Fixed and Variable Costs
Direct and indirect costs can be further broken down into fixed and variable costs. For example, HR expenses, education, and training will increase as your sales increase and you hire more workers. That makes them variable costs.
Other indirect expenses such as rent will remain flat no matter your sales volume. This means they are fixed costs.
Pricing Your Items
When calculating your sales prices, use direct costs to be sure your profit margin is high enough to cover an allocation of your indirect expenses. In other words, sales price should always cover all direct costs plus a profit component, plus enough to cover indirect costs when considering your sales volume.
The lower your sales volume, the higher the price per item should be. A higher sales volume gives you more room to spread out your indirect costs over more sales. This can lead to higher profits, or you can lower your price to be more competitive.
If you have questions about direct and indirect costs or want help validating your pricing decisions, please feel free to reach out any time. Learn more more about our services at firststepsfinancial.com.