Small Business Finance - Determining Your Direct
and Indirect Costs
There are two types of
costs "direct" and "indirect." Direct costs are also called
"variable costs" and refer to costs that are a direct result of
producing, delivering, or returning your product/service.
Examples of these are materials and labor needed to
produce/deliver the product that only occur once you sell the
product, transactions costs like visa commissions, sometimes
shipping charges, etc.
Indirect costs are also
called "fixed costs" and refer to expenses that your business will have
regardless of sales volume. Examples of these are rent, utilities, wages
that are not based upon commission, interest expense, advertising,
automobile, etc. The tricky aspect of these are that a cost may increase
with increased sales, e.g. an increase in sales may require overtime or
the addition of staff but the relationship is not direct.
A good tool for managing
direct and indirect costs is to monitor the costs on your monthly income
statement using percent of sales. Divide the cost by total sales.
Direct costs as a percent
of sales will remain within a narrow margin, e.g. materials costs if 30%
of sales at $1,000 sales then materials should be right around 30% at the
$5,000 sales level. The actual dollar amount of materials used to produce
more products will go up but as a percent of sales, it will remain close
to 30%. What would lower the percent is if you got a better deal from your
supplier.
Your indirect costs when
monitored as a percent of sales will respond differently. For example,
rent equaling $500 per month remains $500 per month even if your sales
increase to $5,000. $500 divided by $1,000 in sales equals 50%. $500
divided by $5,000 in sales equals 10%. (It is that old math axiom in
action here: A numerator divided into a larger denominator produces a
smaller fraction.)
So why is this important?
Knowing the difference between direct and indirect costs provides you with
a couple of valuable management tools, break-even analysis, and your
contribution margin. Break-even analysis is a handy management tool for
quickly determining if a solution is feasible. Contribution margin is the
remaining profit after direct costs are taken out of a sale. For example,
if you sell a bookcase for $250 and it cost you $75 to make your
contribution margin is $175 or 70%. The contribution pays for all the
Fixed expenses/overhead.
A good way of organizing
these costs is to put all the direct costs in the "Cost of Goods" section
and the indirect costs in the expense area of your income statement. By
doing this Gross Profit equals Contribution Margin and is automatically
calculated for you.
Another reason to identify
your direct costs is when bidding in a competitive environment. Ever
wonder how your competitor beat you on a bid??
Imagine a situation where
you know you have covered your overhead expenses for the month with
normally bid projects. A quick project comes up for bid around the 15th of
the month and you have a crew available to work on it. You figure it will
be very competitive and if you use your usual estimating process on it you
will not get the project. Since you have already covered all your expenses
for the month and any margin above your direct costs is profit. Plus you
have a crew that it would be better to have working on a project and being
paid by a client versus cleaning the shop being paid by your profits. You
decide to aggressively go after the project with a bid slightly above your
direct costs.
