As a small business owner, you need to understand the difference between direct costs and indirect costs. Doing so will ensure that you are properly setting your prices and generating a profit – I mean if you’re into that sort of thing.
If you’ve ever watched an episode of Shark Tank, you’ve probably seen someone get absolutely annihilated because they didn’t have a damn clue what their margins were. They didn’t know what it cost to make their products. They didn’t know the difference between direct and indirect costs.
Don’t let this be you.
What are Direct Costs?
Direct costs can be traced back to the products sold or the services provided because they are directly related to the revenue that is being generated. Typically, direct costs will vary depending on the activity in a business. When sales increase, direct costs increase and when sales decrease, direct costs will decrease.
Your direct costs are things like…
- Direct Labor
- Be careful with this one – don’t go down the rabbit hole trying to trace back every second of every day to a revenue-generating activity. There must be balance. At the very least though, you should be classifying employees/contractors that do client work as direct costs, vs. those that do company-based admin work.
Direct costs are important because they’re used in calculating the cost of goods sold for product-based businesses or the cost of sales for service-based businesses.
If a cost can be traced directly to a product or service that is sold, it is a direct cost.
What are Indirect Costs?
Indirect costs cannot be easily traced back to the revenue generated since these costs relate more to the general costs of running a business. Indirect costs are often referred to as overhead and are necessary to keep the business running. Indirect costs tend to remain pretty level regardless of fluctuations in revenue since they aren’t directly related to revenue.
Your indirect costs are things like…
- Professional Fees (like your CPA! Hii!)
- Office Supplies
Indirect costs are important because since they aren’t related to generating revenue, they’ll need to be paid no matter what. Therefore, you’ll want to keep these costs lean and mean! Lose a client? You still gotta pay rent. Make sure your indirect costs can be paid easily no matter what.
If a cost cannot be traced directly to a product or service that is sold, it is an indirect cost.
How Can Making Sense of Costs Help Business Owners?
Dude. The numbers are the foundation of every business. By plugging into the numbers more and becoming better acquainted with them, shifts will happen! Sometimes small business owners are so wrapped up in the day to day, and have invested so much of their lives into the business that they put blinders on. It’s totally fine. But, it’s also totally necessary to check-in with data in black and white on the reg to make sure the story you have in your head matches the way things really are.
Knowing the difference between a direct and indirect cost can help support your pricing strategy. By looking at the products you’re selling or the services you’re providing as a function of all the costs it takes to produce it, you can set margin goals and make sure you’re meeting them.
Without knowing the difference between cost types, you won’t know how much it actually costs to produce. Setting your prices will take some educated guessing, or better yet, a crystal ball.
Having your expenses properly categorized between direct and indirect costs will give you a clear look at the financial health of your business. You’ll know if you’re meeting your margins, where you need to scale back, and where you need to invest more.
You’ll also know when you should expect costs to increase! This will help ensure you’re maintaining a healthy cash flow and creating even better forecasts. Every small business owner goes through cash flow fluctuations – it’s normal – but it doesn’t need to dictate your path.
As you grow and scale your business, being able to drill down into exactly what it takes to make your business grow will become even more valuable. If you ever want to seek funding, or sell your business, you’ll need to know what your margins are. Knowing the difference between direct and indirect costs is the first step of that.
Please reach out, we’d love to help!
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Countless assumes no liability for actions taken in reliance upon the information contained herein.