Direct Costs - what are they?
The concept of direct costs is something we need to understand if we are going to master the basics of business finance. You'll hear the term thrown around a bit, and you'll need to know what it means in order to follow the discussion.
When we think of a cost as being direct, that means it is incurred as a direct results of making a product, performing a service or conducting a business operation. Often, these costs can be passed onto customers because it's easier to associate these costs with particular customers.
Being able to pass on these costs to customers is important because they aren't hidden in an hourly rate, but right out in the open for the customer to see. When customers absorb these costs, it reduces what would otherwise be a cost of doing business for us.
Let's look at some examples of costs that are directly associated with providing a service to a customer in a remote location. Assume for the moment that I traveled from Wyoming to North Carolina and stayed there a week to help my customer write a report. Direct costs for my services would likely include:
- personal vehicle mileage charge, to and from the airport
- daily parking charges for my personal vehicle
- plane ticket and associated charges for air travel
- car rental
- hotel accommodations
- meals for myself while away from home
- fuel for the rental car
- bridge and road tolls, if any
- consumable supplies such as paper, printer ink and CDs
This should make the idea of direct costs much more clear. Each of the items above are directly related to traveling and staying at my customer location, and working to produce a written report. With certainty, I can associate these costs with this particular job, and not the general cost of running my business.
One of the advantages of separating direct costs from indirect costs (overhead expenses) is that I don't need to artificially inflate my hourly rate to compensate for these costs. Another advantage is it's much easier to get additional money from your customer to address unforeseen costs when they can be identified as being directly associated with doing work for them.
Last but not least, with these costs out in the open, instead of buried in my general cost of doing business, I can better determine how much profit I'm making simply because my profit isn't being eaten up by costs that my customers should be paying for. Knowing costs directly associated with a particular job will help me separate them from the general costs of doing business and that allows me to better determine return on investment of my time.
So, there you have a quick discussion of direct costs and why they are important to be familiar with. If it's something that you can attribute to a particular customer or product or activity, then it's likely a cost that is "direct" in some aspect of your business. If it generally applies to your business across the board, then it's likely something that is indirect and will be categorized as part of your overhead.
Done with Direct Costs, take me back to Small Business Finance