|
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.
|
