Direct costs are the costs you incur to sell one of your products. You might, for example, need to buy raw materials to create the product. You might also have to hire employees to make or deliver the product. Or, maybe you buy a ready-made product wholesale to sell at retail - that purchase is a direct cost, too.
If you sell services, you probably also have direct costs, but they'll generally be fewer than those of a product-based company.
If you're not sure whether a particular cost is a direct cost, here's a good rule of thumb: When your sales increase or decrease, direct costs will increase or decrease at the same time. For example, a coffee shop would include the costs of coffee and milk in their direct costs, because those are needed to create the product. But this business would not include overhead expenses like marketing, rent, or Internet access as direct costs. (For more, see What is the difference between direct costs and expenses?)
You can add direct costs in one of two ways:
- As flat amounts, entered manually
- Calculated as a percent of a revenue stream, so that they scale automatically with sales growth
You can also add direct labor — that is, personnel such as factory workers or commissioned salespeople —whose expenses you want to treat as direct costs.
Why are direct costs important?
Tracking direct costs helps you keep an eye on how much it's costing your company to deliver its product or service -- a metric that's key to your overall profitability. If your direct costs are going up, you're earning less profit. Perhaps your suppliers are starting to charge you more, or perhaps fuel costs are going up. It might be time to start looking for new suppliers or to try and cut costs in your business.
Separating direct costs from other expenses also lets you understand your gross margin. This metric, which appears in the Profit and Loss statement, is calculated this way:
Gross Margin = Revenue – Direct Costs
Gross margin is a good top-line measure of how efficient your company is at delivering its products and services. Not only that, it tells you how much profit your business has on hand to cover its overhead expenses. (A larger gross margin means that after those overhead expenses are paid, you'll still have profit left over.)
Also, on the Benchmarks tab, you can compare your gross margin to other compaines in your industry to see how your costs compare to those of your competitors.
Entering costs for a specific revenue stream
We recommend using this method when possible.
- On the Forecast tab, select Direct Costs:
- Click the Add Direct Cost button:
- Enter a name for the direct cost:
- Choose Cost for a specific revenue stream:
- Select the revenue stream that these direct costs apply to:
- Decide how you want to enter the cost. You can enter a constant cost or a varying cost, or you can designate a % of the stream's revenue to this direct cost:
- If you choose constant amount, enter the amount of this cost (per unit, per customer, per hour):
- If you choose varying amounts, enter the amount of the cost for each month:
- If you choose % of stream's revenue, enter the % of this stream's revenue that should be considered a direct cost:
- Click Save & Close.
Entering an overall direct cost
- Click the Add Direct Cost button:
Enter a name for the direct cost:
- Choose general cost (for an overall direct cost):
- Choose Constant amount (if the amount of your direct costs doesn't change) or Varying amounts over time (if the amount changes over time):
- If it is a constant amount, enter the amount and the frequency (per month, or year):
Then, enter when the cost will begin:
- If it is a varying amount, enter the amount in the field for each month:
Editing or deleting a direct cost
To edit or delete a direct cost, click on it in the table:
- To edit the direct cost, make any desired changes in the overlay, and click Save & Close when you're finished.
- To delete the direct cost, click the trash can icon, and then click Confirm:
Where does this entry appear in the financial statements?
The only financial statement in which you'll see your direct costs listed by name is the Profit and Loss:
The direct costs do calculate into the Balance Sheet and Cash Flow table, but not explicitly. Instead, your direct costs are used to calculate your available cash, which appears in the Assets portion of the Balance Sheet:
In the Cash Flow table, your direct costs are part of the highlighted lines below: