Breaking Down Direct and Indirect Costs
If you’re continuously looking for ways to increase your profitability, then 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 sales volume for your business.
Expenses that fall into the “direct cost” category relate directly to the items you sell. Below are a few examples:
- If you owned a flower shop, the cost of the flowers would be a direct cost. So would the vases, ribbons, cards, and labor required to create your beautiful floral arrangements.
- If you’re a partner at a law firm, the labor, and any materials or supplies spent on serving a customer would be a direct cost.
- If you operated a pool construction company, the concrete, tiles, filter, pump, and labor costs to build the pool would be direct expenses.
Direct 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 get your Gross Profit figure by calculating Sales less Cost of Goods Sold (or COGS). Gross Profit Margin is an essential percentage to know in your business. It is computed as follows: (Sales – COGS) / Sales.
Some small service companies might not bother to break out labor into direct or indirect on the Profit and Loss statement each month. Still, it can be helpful to periodically do so, especially when re-evaluating your pricing and profitability.
Direct expenses are important in making pricing decisions but so are indirect expenses.
Indirect expenses are those you must incur to run your business but are not directly related to the items you sell. Here are some examples:
- Accounting software
- Rent & utilities for a brick-and-mortar store
- Administrative labor, such as a receptionist or supervisor
- Education and training
- Professional services, like your HR personnel or IT specialist
- Office supplies
- Business permits
Fixed and Variable Costs
Direct and indirect costs can each be further broken down into fixed and variable costs. For example, HR expenses, education, and training will increase as you sell more and hire more workers. That makes them variable costs.
Other indirect expenses (such as rent) will remain flat, or fixed, no matter your sales volume.
Pricing Your Items
When calculating your sales prices, use your direct costs as a benchmark to ensure 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. Alternatively, higher sales volume gives you more room to spread out your indirect costs. That allows you to do one of two things: earn higher profits or lower your price to become more competitive.
If you have questions about direct and indirect costs or want help validating your pricing decisions, please feel free to reach out at any time.