Direct costs vs Indirect Costs

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I am writing a daily blog series on how to start a business.  If you’d like to review previous posts on this series, you can find them here:

So You Want to Start a Business
Revenues, Direct Costs and Expenses… Oh My!
Hourly Rates
How Can You Earn More Revenue without Spending More Time

We have covered a few topics on how to calculate Revenue.  Revenue is known as your top-line; because it is the first thing that is calculated in any financial forecast.  The next financial estimate you must make for your new business is the calculation of Direct Costs.  In our simple financial forecast, there are two types of costs, Direct Costs and Expenses.  A Direct Cost is any cost that is directly associated with work you do for clients.  These costs are sometimes called Variable Costs, because they vary with the amount of customers you have.

Let’s say that your small business is a construction company.  Direct Costs associated with a construction company are often construction materials and labor that is hired to directly support a specific construction project.  If your business is a restaurant, then direct costs would include food costs.  You can quickly see that direct costs will increase almost directly with your revenue.  In the restaurant example, you will buy more food to serve more customers.   In the construction example, you will purchase more lumber as you build more homes that are sold to customers.

Labor Direct Costs

When calculating labor for your direct cost category, it is recommended that you include any added benefits and taxes associated with each employee who is considered a direct cost employee.   If you were to consider your $20/hour worker we discussed in our previous post on hourly rates, the total direct cost labor rate would be:

Base Pay $20.00/hr

Added FICA (6.2%) $1.24/hr

Added Benefits (30%) $6.00/hr

Vacation (10%) $2.00/hr

100% Billable Hourly Cost $29.24/hr

Labor costs are somewhat tricky.  In some cases, you have hourly employees who only get paid for direct labor for projects in which case all of their time is considered a direct cost.  In other cases, you may have employees who mostly work on projects, but get paid an annual salary.  It is common for you to count their entire salary in direct costs.

Owner’s Salary

Let’s say that you are starting out doing all of the work in your small company on your own.  If you are paying yourself a salary, you need to put your salary in either expenses or direct costs.  For the purpose of creating a financial forecast to start your business, I do not recommend splitting your salary into expenses and direct costs.  In most cases, the owner doesn’t pay themselves a salary.  Instead, they simply keep profits made by the company as their salary.  In this case, you should not put any compensation into direct costs for the owner’s salary.

Material Direct Costs

In addition to labor, it is common to have material direct costs.  We already talked about the idea of including food costs in this category if you are a restaurant owner.  Other direct costs could include inventory that you purchase for resale.  Inventory can be a little tricky.  Let’s say you buy 10 widgets to be sold, but you only sell 7 widgets.  This means that the cost of 7 widgets would be considered direct costs; not the 10 that you actually purchased.  In this example, you have 3 widgets left in inventory that can be sold at a later time.   Material direct costs have to be actually consumed or purchased by customers that pay money for such materials.

Gross Margin

In your financial forecast, you have now calculated your revenue and your direct costs.  Gross margin is your Revenue minus your Direct Costs.  If you divide your Revenue by your Gross Margin, you will get your Gross Margin Rate.  Gross Margin is the life-blood of most companies.  It is a measure of how much your customers value your company.  Let’s say that you have Revenue of $100,000; and Direct Costs of $60,000, this means that you have a gross margin of $40,000 and a gross margin rate of 40%.  This means that customers are willing to pay you more money for your goods and services than if they purchased all of these goods and services on their own.

Operating a business is not as easy as simply convincing your customers to pay more for your products and services.  All companies need to add some value to the products they sell their clients.  Let’s take a house builder for example.  A person can buy lumber, nails, concrete, carpet, paint, sheet rock, and other materials at the store.  They can then pay some laborers.  However, if they don’t have the expertise on how to put all of these materials together in the right way; and direct their laborers in the right way; they will have wasted their money.  Most people understand the value the home builder provides with their expertise and ability to purchase the right materials, and coordinate all workers to build a quality home for a reasonable price.  For any company, this value is represented in their gross margin.

In my next blog post I will talk about expenses.  These are the costs that eat up a lot of that gross margin we just discussed.