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Financial Advice

Why You Need To Know The Difference Between Direct Costs And Indirect Costs

By November 2019November 18th, 2020No Comments
Beyond Accounting advice Why You Need To Know The Difference Between Direct Costs And Indirect Costs

Can you name one of the biggest costs for most businesses? Here’s a hint – it takes into account every single one of the employees in your company, from management to salespeople to administration to those on the support desk and the factory line. Any ideas? Yes, it’s wages and salaries, of course.

Given its significance, it’s unfortunate that so many businesses fail to record it in any meaningful way in their accounts. We recommend that you start thinking about how you can differentiate between salaries in your books so you can better keep track of your performance. One great way to achieve this is to know the difference between direct costs and indirect costs.

Firstly, let’s see how wages and salaries can feed into your KPIs

Let’s say you’re wondering how much gross profit you’re making per labour euro, because you wish to adhere to a pricing rule in which your sales price is 300% of your direct labour cost. You may record, as a KPI, your gross profit for each euro spent on direct salaries. For example, let’s say the labour costs for those employees directly involved in producing a product or delivering a service comes to €30,000, then your revenue should be €90,000 and your gross profit should be €60,000. This amount is needed to cover overheads and leave a surplus for profit.

The only way you can easily assess if this KPI is doing well is to have the numbers clearly available in your accounts. Differentiating between your direct costs and other labour costs (indirect costs) is essential to being able to do that in this case.

What are Direct Costs and Indirect Costs?

The traditional way to separate wages and salaries is by direct costs and indirect costs. Let’s clear up the difference between the two:

Direct Costs

Direct costs refer to the people whose work is directly related to a product or service to be sold. Their labour is directly related to sales. If you had no sales, then you’d have no direct cost employees. Sales and direct costs are co-dependent in that if one goes up the other should go up as well. Wondering where it slots into on your accounts? Direct costs go into cost of sales. When you take cost of sales away from your revenue you get your gross profit.

Indirect Costs

Indirect costs include the likes of director salaries, receptionist salaries, the IT person’s salary and the sales people’s salaries. Why? This is because although these roles facilitate the company’s ability to makes sales, they still do not directly deliver a service. This is the essential difference between direct costs and indirect costs.

An easy way to understand the difference between direct costs and indirect costs is to remember that direct labour pays for itself because its output is sales. To know how effectively it is doing this, you could look at productivity and ask questions such as:

  • How many sales do my direct labour make?
  • What price can I get for my direct labour?
  • What price am I charging clients for the work my direct labour does?

Having these numbers accessible in your accounts means that you can focus on influencing your gross margin by making changes to these three variables.

Another term people use for the gross margin, besides gross profit, is contribution. This is because when you take your direct costs away from your revenue, you are left with a sum that acts as a contribution to cover your overheads so you can determine your net profit. In your accounts, overheads may also be termed indirect costs or administrative costs.

An easy way to understand the difference between direct costs and indirect costs is to remember that direct labour pays for itself because its output is sales.

When does an Indirect Cost become a Direct Cost?

Yes, despite making a lovely clear clarification between direct costs and indirect costs above, it is still possible for the line between the two to be blurred. For example, we work with an IT company that has two directors. One director, despite being involved in management meetings and administration, spends more than 80% of his time working on client projects as a programmer. As a result, this would qualify him as a direct cost. However, his partner, who mostly manages staff, billing, organising accounts, etc., would be considered an indirect cost. This doesn’t mean he doesn’t work with clients at all, but rather that the majority of his work is in administration and therefore this is the best way to categorise his salary.

This is a judgement call that you and your bookkeeper would have to make. Although both partners in this example do indirect as well as direct labour, it’s more helpful to fully allocate people to one or the other category rather than trying to work out the percentages of how much time they spend in each role. Striving for perfection in this area of your accounting is a messy endeavour and generally unnecessary.

Splitting Directors’ Costs and Non-Directors’ Costs

Within overheads, most accounts choose to keep directors’ costs separate to non-directors’ costs and there is a good reason for this. When you are doing your accounts, accounting conventions require you to have a figure for directors’ costs that is separate from other wages and salaries. But this is not essential; you can have your management accounts organised whichever way works best for your business. In my opinion, splitting directors’ costs and non-directors’ costs does make pulling out those figures a lot easier.

It is important that at the end of the year these numbers are clearly defined. Modern accounting systems such as Xero are so flexible that you can organise them as you need to, when you need to. In the end, your accounts should be a useful tool for you and your business.

Have you considered making the move to cloud accounting? Xero is modern accounting software designed so that non-accountants can use it with ease! Beyond is a Xero Platinum Partner so we’re sure we can answer all of your questions. Get in contact today!