When making a product or providing a service, it may be obvious what your direct costs are since you are paying for parts, labor, and so on. There are other costs, however, that are involved in your business that should be considered in your pricing.
Having a clear comprehension of all the costs you incur when creating a product is integral to running a successful business. This includes both your direct and indirect costs.
Indirect costs are the costs that go beyond the direct costs needed to create one specific product. They are costs associated with running your business as a whole.
There are some clear drawbacks to indirect costs that are important to recognize:
Variable indirect costs such as gas and electricity can vary greatly due to factors like the seasons of the year and can greatly affect your profitability in different periods even with the same number of sales.
If your indirect costs are out of control, you may need to overcharge your products in order to be profitable.
When a customer receives a product, they can see many of the direct costs that went into it. What they do not see are all the indirect costs that it takes to run your business. This may cause them to see the product as having less value than it does.
Indirect costs are important to understand for the following reasons:
It is necessary to understand both your direct and indirect costs so that you can price your products adequately.
Having an understanding of your costs is necessary to adequately compete in the marketplace.
It is also necessary to understand your direct and indirect costs when filing taxes for your organization so that you can make the proper deductions.
Understanding how direct and indirect costs are different is fundamental to making sure the accounting in your business is done correctly.
A musical instrument wholesaler has taken on a new accountant. The CEO of the company is convinced that the previous quarter was the company’s most successful yet. Unfortunately, when looking through the company’s records, the new accountant finds a lot of indirect costs that the CEO has not been taking into account when boasting of the company’s record profit. With all of the indirect costs figured into the company’s financials, it turns out that it still lost money during its most successful quarter. The new accountant decides to sit down with the CEO and brainstorm on how some of the organization’s fixed and indirect costs can be cut in order to ensure the long-term viability of the company.
Here are some best practices to keep in mind when thinking about indirect costs in your company:
An easy way to decide if a cost is direct or indirect is to look at if it is tied to the creation, development, or release of a specific product. If it is, then the cost is likely a direct cost. If the cost is more related to running your company as a whole, then it is likely an indirect cost.
Some of the indirect costs of operating your business can be used in marketing your products in order to justify higher costs. For example, if your factory is located in a unique locale that customers would find special.
If you are a small business owner, you may be able to receive grants for your organization. Keeping clear records of what your direct and indirect costs are will be helpful when applying for funding.
Some examples of indirect costs would be equipment rentals, utilities, and supplies.
A fixed indirect cost would be an indirect cost that always stays at the same price, such as a cell phone bill that is on a monthly plan with a set price.
Variable indirect costs are indirect costs that can fluctuate, such as gas or electricity.
Many businesses have a handle on their fixed costs but are less on top of their indirect costs. Do not make this mistake with your business, or else you can never be truly sure if you are pricing your goods appropriately.