Your forecast contains two types of cost-based entries: Direct Costs and Expenses. They are used for different purposes, and calculate into your financials differently. This article will help you decide when to use each one in your forecast.
Understanding direct costs
To deliver your product or service to your customers, you'll incur some necessary costs. If you manufacture your product, for example, you'll have to spend money on raw materials and labor. If you're a retailer, you'll likely have to spend money buying products wholesale. If you're a restaurant, you'll have to spend money on raw ingredients and servers.
Service-based businesses often have a smaller number of direct costs than product-based businesses, but they still have direct costs in most cases. If you sell hair salon services, for example, you might need to spend money on hair products such as shampoo, conditioner, and hair dyes.
Here's where the subject of direct labor comes into play as well. Certain employees in your business may be integral to delivering your product or service to customers - like the factory workers and restaurant servers mentioned previously. The cost of their labor is a direct cost.
If you're not sure whether a cost is a direct cost, here's a good rule of thumb: if you sold no product at all this month, would you still have this cost to pay? If the answer to that question is no, then the cost is most likely a direct cost.
Direct costs are also referred to as costs of sales, costs of goods sold, or just COGS.
So, isn't everything a direct cost, then?
It's tempting to start thinking of all of your costs as being necessary parts of delivering your product or service, but that isn't the case. It's important to represent only the costs that are integral to your product or service as direct costs. That way, you'll get a realistic picture of the actual profitability of your product or service.
Let's look at one last example: a coffee shop. This business would include the costs of coffee, milk, sugar, and baristas in their direct costs. But it would not include things like marketing costs, rent, Internet access, or cleaning services - those items are overhead expenses. A manager's salary is also an overhead expense.
Expenses are also referred to as overhead expenses or operating expenses. This includes things like rent, utilities, marketing, office supplies, and so on. Basically, an expense is money you spend in day-to-day business activities that isn't direct costs.
How direct costs and expenses calculate into your financials
The reason we separate direct costs from expenses in your forecast is simple:
- Direct costs affect the profit margin of your product or service.
- Expenses affect the profit margin of your company as a whole.
You can see the direct costs in the sample Profit and Loss table below. They are calculating against the Revenues to arrive at the Gross Margin, which is the overall profit margin of the product or service:
In the same Profit and Loss table, you can see the expenses calculating lower down in the table:
Your expense entries are calculated as Operating Expenses in the Profit and Loss table. They are applied to the gross margin to create a picture of the overall profitability of your business, also known as Net Profit. Notice that the gross margin is larger than the net profit.
Generally speaking, you'll want to make sure that your product or service has a wide enough gross margin so that it can accommodate your overhead expenses and still leave a net profit.