Direct costs are the costs you incur to sell one of your products. These costs include the cost of materials used to create the product and potentially any labor costs that are exclusively used to create the product. To put it another way, you had to either make or buy the product you sold. You may have had to purchase raw materials that you then turned into a product. The costs of producing what you sell are your direct costs. If you sell services, you probably also have direct costs, but they will be a much smaller percentage of your revenue than they will be for a product company.
Common examples of direct costs (also known as costs of sales, costs of goods sold, or just COGS) are the raw materials you need to manufacture your products, wholesale purchases of products you are reselling, and sales commissions.
As a general rule of thumb, if you can’t directly associate a specific cost with the sale of a single product, then that cost should NOT be a direct cost. That’s why things like rent and marketing expenses are typically not included as direct costs. For example, a coffee shop would include the costs of coffee and milk in their direct costs. The coffee shop would not include things like marketing costs, rent, and Internet access in their calculation of direct costs.
You can add direct costs as flat amounts or set them to a percentage of your revenue, so that they scale evenly with 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?
Understanding direct costs helps you keep an eye on how much it is costing your company to deliver its product or service. If your direct costs are going up, perhaps your suppliers are starting to charge you more, or perhaps fuel costs are going up. When your direct costs go 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. Shown on the profit and loss statement, gross margin shows the portion of your revenue — as a monetary value and a percentage — that is left over after paying your direct costs, but not your other expenses:
Gross Margin = Revenue – Direct Costs
Because gross margin is a good top-line measure of how efficient your company is at delivering its products and services, keeping an eye on your direct costs helps you understand how efficient your company is. This gives you a sense of how much potential profit your company has to work with. Also, on the Benchmarks tab, you can compare your gross margin to others in your industry to see how your costs compare to those of your competitors.
In LivePlan, you can break down your direct costs by revenue stream (recommended) or enter overall direct costs.
Entering costs for a specific revenue stream
- 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:
Note: The wording of these options will vary depending on the type of revenue stream you choose (unit based, revenue only, recurring, or hourly). This example shows the wording for an overall (revenue-only) revenue stream:
- 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. Your direct cost will be shown in the output table:
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:
Click Save & Close. Your direct cost will be shown in the output table:
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: