When looking at your profit & loss report, you’ve probably noticed that it’s in three major sections: Income at the top, then one set of expenses (direct costs), then another set of expenses (overheads).
Have you ever wondered why there is this split between different kinds of expenses?
It’s to help manage the business, essentially.
In this series of blog posts, we’ll look at what direct costs and overheads are and what you can do with them.
Starting with the foundations, this post is focused on what they are.
Vocabulary
There are lots of synonyms for these two terms. Here are a few.
Direct costs can also be called
- COGS (Cost of goods sold)
- COS (Cost of sales)
- Production costs
Overheads can also be called
- Indirect costs
- Expenses
- Operating Expenses
- SG&A (selling, general, and administrative expenses)
In this entry, we’ll stick with Direct Costs and Overheads.
The big idea
The general idea is that direct costs are directly related to producing what you’re selling; everything else is overheads.
Usually, you can ask yourself, “Would I have this expense if I didn’t sell a thing?” and if the answer is yes, it’s an overhead.
- Card processing fees – the amount you pay on each transaction – are a direct cost, because those don’t happen unless you make a sale.
- However, if your card processor also charges a monthly fee, that’s an overhead – you need to pay it even when there are no sales.
In practice, the direct costs list is usually quite short; the overheads list is usually quite long. You’ll have noticed this on your own profit & loss report.
Some difficulties
Some things are easy to see where they fall; others aren’t.
- Your general annual business insurance is an overhead; you pay it whether you make any sales or not.
- But if you pay for insurance for a specific event (say, a market organizer includes it in the fee to attend a specific market), is that a direct cost or an overhead? After all, you might not make a single sale at that market.
Plus, what’s a direct cost in one business may well be an overhead in another business.
- One business may consider that electricity is used in creating what they sell – be that a factory, a coach who’s using Zoom to meet with clients, or a stained-glass artist. That business would put electricity into their direct costs.
- Another business may consider it too difficult to split their electricity between that used to create what they sell (say, on the factory floor) and that used for their admin (their HR, finance team, management, sales, marketing, etc). That business would make electricity an overhead.
Because of these difficulties, it can seem pointless to draw the distinction; we’ll look in later posts at what you can do with the information you get from doing it.
Consistency is key
For now, know that the most important thing in bookkeeping is consistency. Choose how to classify each and then stick with it.
On the nitty gritty level, when I did bookkeeping coaching, I usually taught my clients to find the last time they paid that expense or made that income and make a copy of it. This ensured it would be entered the same way. I also showed them how to set up recurring bills and invoices where that was appropriate.
If you make it standard practice to copy what’s been done before in your own finance department, it means you end up with useful numbers for comparing historical figures.
An example
Imagine you run a manufacturing firm. You make various widgets for a variety of clients.
What kind of expenses might you have?
- Materials used to make your widgets
- Salaries for the assembly line workers who make the widgets
- Salaries for your managers
- Salaries for your admin staff, including HR, accounting, payroll, etc.
- Marketing – either your own staff or perhaps you pay an agency
- Marketing – the costs of placing print ads, digital ads, radio spots, etc.
- Networking costs for upper management – which helps with securing contracts, so it’s a form of advertising
- Rent, rates, energy, water
- Insurance
- Bank fees
- Cleaning
- Printing & stationery
- Repairs & maintenance
- Equipment
There will be more, but this will do us for illustrative purposes.
Direct costs
So, from that list, which might be direct costs?
- Materials used to make your widgets
- Salaries for the assembly line workers who make the widgets
That’s it. I did say that this list is usually short!
Overheads
That means that everything else is an overhead, right?
Well, these things would probably be overheads:
- Salaries for your managers
- Salaries for your admin staff, including HR, accounting, payroll, etc.
- Marketing salaries or agency fees
- Marketing – the costs of placing print ads, digital ads, radio spots, etc.
- Networking costs
- Rent, rates, energy, water
- Insurance
- Bank fees
- Cleaning
- Printing & stationery
- Repairs & maintenance
This firm could decide that part or all of their energy costs will go under direct costs. So long as they decide at the beginning and stick with it.
Other
What got left off those two lists?
- Equipment
You remember buying a new £30k machine for your factory this quarter, but you can’t see it anywhere on your profit & loss report. What gives?
It’s actually on your balance sheet as a fixed asset.
You’ve probably come across the idea of depreciation. In case you’re not fully sure how it works, let’s pause and look at that.
What is depreciation, really?
Depreciation is an accounting exercise to spread the cost of an expensive piece of equipment (for example) across a number of years.
The big idea is that we want each accounting report to be an accurate reflection of costs and income related to that period.
So, when you buy a machine for your factory floor that you expect to last 10 years, you want to show the cost over 10 years.
Otherwise, it looks like you have a really expensive year 1 and much more profitable years 2-10.
This is a big reason why sometimes you may have looked at your profit & loss report, and seen a profit, and then looked at your bank account, and seen much less on that date.
Continuing with our example, you spent £30k on this machine that you expect to last 10 years. So, what you’ll see on the profit & loss report is £3k – at the end of the year, when the final accounts are prepared. You could also show £250 per month. This is less common, but more helpful in managing your business.
Either way, you’ll see that amount under Equipment Depreciation (or a similar phrase). Equipment will still show £30k – but it will only show up on your Balance Sheet, not your profit & loss report.
(This is why cash flow forecasts are so vital – that’s where the full £30k will show up and help you make sure you can pay that and still cover payroll and all your other bills. But that’s another post.)
Other, revisited
Going back to Equipment on our list now, we realise what we’ll see on our profit & loss report is Equipment Depreciation.
Depreciation is an overhead – even though you can’t make your widgets without that piece of equipment.
Sometimes, the decision about how things are classified has been made for you by an accounting standard (whichever one applies to your company). This is one of those times.
Conclusion
So that’s an overview of what constitutes a direct cost versus an overhead, some of the difficulties we run into in the wild when applying the idea, some of the different terms you might use for those two categories, and a run through of an example so you can see it in action.
Next time, we’ll get on to the much more interesting bit: What you can do with these numbers now that you have them.
Hi, I’m Sara-Jayne Slocombe of Amethyst Raccoon. I help your small business thrive using the power of your numbers, empowering you so that you have the confidence and knowledge to run your business profitably and achieve the goals you’re after.
I am a UK-based Business Insights Consultant, which means I look at your data and turn it into information and insights. I separate the noise from the signal and translate it all into actions that you can actually take in your business.
I also facilitate the Power Pod Roundtable, which is a business discussion group.
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