As business owners there is one thing we all understand…EXPENSES!  But do we understand the various types of expenses or that categorizing and properly understanding them is essential to how we operate our businesses and manage our profitability.

Generally, there are two types of expenses or costs that we incur: direct and indirect.  Direct costs are those directly related to the product or services that your business might offer.  If you manufacture a product, your direct costs would include raw materials and the labor associated with manufacturing your product.  If you are a service provider, your largest direct cost would represent salaries and wages and then the supplies that might be used in providing your service.  An electrician or plumber would have supplies used in installing or repairing service for their customers where an attorney or consultant would understandably have a very small direct supply expense.  A retailer’s direct cost would largely be the cost of the product being sold as well as the cost to get that product into the store and on the shelves.  These direct costs are generally referred to as cost of goods sold or cost of sales.

On the other hand, indirect costs represent costs incurred that are not directly attributable to a specific product or service but provide you the opportunity to conduct your business.  These costs are often referred to as “overhead” expenses.  In some cases, a portion of these costs may be allocable to cost of goods sold if it can be directly attributable to providing either the product or service.  This is most common in a manufacturing environment and is referred to as an overhead allocation.  Indirect cost can also be identified as either selling or general and administrative expenses.  Selling cost is the total cost of marketing, advertising and selling a product while general and administrative expenses essentially represent the cost of keeping a company running.  General and administrative costs would generally include rent, utilities, telephone, salaries and office supplies.  These costs do not generate profits but are a necessary cost of doing business.

All of these costs can be fixed or variable in nature.  Variable costs are those that vary in direct proportion to the quantity of output.  Unlike fixed costs, which remain constant regardless of output, variable costs are a direct function of production volume, rising whenever production expands and falling whenever it contracts. Examples of common variable direct costs include raw materials, packaging, and labor directly involved in a company’s manufacturing process.  Similarly, examples of common variable indirect costs include utilities used in production, delivery or travel expense and rent based on variable factors such as sales volume.

Making matters more complicated, categorizing these types of expenses will vary depending on the type of business that is being operated.  Salaries for example would vary based on the functions being performed by specific employees and should be properly allocated amongst cost of sales, selling and general and administrative expenses.  Are the owners and employees spending their time performing services that directly produce revenue, or are they largely involved in managing the business and providing administrative support?  Are they the primary rain makers of the company who are out and about selling and promoting the business?  In many cases there may need to be an allocation of these costs amongst various expense categories.  Otherwise, how would you determine the need and expense of hiring additional staff or determine the costs associated with these various types of functions?

Understanding the various types of expenses is a crucial first step to determining your bottom line and managing your profitability.

Tags: COGS, cost, expenses, operations, organization

This entry was posted on Wednesday, December 9th, 2009 at 4:19 pm by Joe Sillo and is filed under Accounting, Small Business Finance 101. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.