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 ithese 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.
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