Every business spends money, but do you know how your money is working for you?
When you look at your bank account or pull up a financial report, it can feel like a confusing wall of numbers. But tracking your cash flow doesn’t have to be a headache. In fact, your business expenses can be simplified into just two main categories: direct expenses and indirect expenses.
Understanding the difference between the two is the ultimate secret weapon to unlocking more profit and improving your business performance. Let’s break it down into plain English.
1. Direct Expenses: The Cost of Doing Business
Direct expenses, which are also commonly referred to as the Cost of Goods Sold (COGS), are the expenses directly tied to how your company makes revenue. Simply put: if you don’t spend this money, you can’t deliver your product or service.
Depending on your industry, direct expenses can look a bit different:
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Service Businesses: It is highly likely that your largest direct cost is actually labor. This includes the wages and salaries you pay the people who directly deliver the services your business provides.
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Retailers: It’s the exact cost you pay to buy inventory and stock your shelves.
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Manufacturers: It’s the cost of the raw goods and materials required to produce your finished product.
Why You Need to Watch Direct Expenses Like a Hawk
The most critical thing to understand is that your direct expenses must be displayed clearly on your income statement.
Sometimes, when setting up software like QuickBooks, the default settings don’t properly separate or give us a “Cost of Goods Sold” category. The major limitation of this setup is massive: if your income statement doesn’t display your direct expenses, you aren’t seeing your gross profit. And without seeing your gross profit, you are at a significant hindrance to improving the performance of your business.
2. Indirect Expenses: Keeping the Lights On
On the flip side, we have indirect expenses. You might hear these referred to as overhead or operating expenses.
Indirect expenses are all the ways you spend money in your business that have nothing to do with how you make revenue. Now, this doesn’t mean they aren’t important or that they aren’t necessary for the business to continue… they just don’t tie directly to a specific sale.
Common examples of indirect expenses include:
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Marketing and advertising costs
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Insurance policies
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Rent on an office or workspace
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Accounting and legal fees
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Travel costs
All of these costs are vital to operate the business, and some of them (like marketing) are incredibly important to help generate revenue in the long run. However, because they aren’t directly tied to the creation or delivery of a single product or service, we call them overhead.
The Bottom Line
Why should you care about sorting these out? Because getting a handle on your indirect expenses, while accurately tracking your direct expenses, is absolutely essential to understanding… and increasing… your bottom line.
Take a quick look at your accounting software this week. If everything is lumped together into one giant pool of “expenses,” it’s time to separate them. Once you know exactly what it costs to make a sale (direct) versus what it costs to keep the doors open (indirect), you’ll finally have the clarity you need to scale your business to the next level.