Having a clear comprehension of all the costs you incur when creating a product is integral to running a successful business. This includes both your direct and indirect costs.
When making a product or providing a service, it may be obvious what your direct costs are since you are paying for parts, labor, and so on. There are other costs, however, that are involved in your business that should be considered in your pricing.
Overview: What are indirect costs?
Indirect costs are the costs that go beyond the direct costs needed to create one specific product. They are costs associated with running your business as a whole.
3 drawbacks of indirect costs
There are some clear drawbacks to indirect costs that are important to recognize:
1. Variable indirect costs
Variable indirect costs such as gas and electricity can vary greatly due to factors like the seasons of the year and can greatly affect your profitability in different periods even with the same number of sales.
2. May lead to overcharging
If your indirect costs are out of control, you may need to overcharge your products in order to be profitable.
3. May not add value for the customer
When a customer receives a product, they can see many of the direct costs that went into it. What they do not see are all the indirect costs that it takes to run your business. This may cause them to see the product as having less value than it does.
Why are indirect costs important to understand?
Indirect costs are important to understand for the following reasons:
1. Pricing
It is necessary to understand both your direct and indirect costs so that you can price your products adequately.
2. Being competitive
Having an understanding of your costs is necessary to adequately compete in the marketplace.
3. Taxes
It is also necessary to understand your direct and indirect costs when filing taxes for your organization so that you can make the proper deductions.
4. Classification for accounting
Understanding how direct and indirect costs are different is fundamental to making sure the accounting in your business is done correctly.
An industry example of indirect costs
A musical instrument wholesaler has taken on a new accountant. The CEO of the company is convinced that the previous quarter was the company’s most successful yet. Unfortunately, when looking through the company’s records, the new accountant finds a lot of indirect costs that the CEO has not been taking into account when boasting of the company’s record profit. With all of the indirect costs figured into the company’s financials, it turns out that it still lost money during its most successful quarter. The new accountant decides to sit down with the CEO and brainstorm on how some of the organization’s fixed and indirect costs can be cut in order to ensure the long-term viability of the company.
3 best practices when thinking about indirect costs
Here are some best practices to keep in mind when thinking about indirect costs in your company:
1. Easily determine between a direct cost and an indirect one
An easy way to decide if a cost is direct or indirect is to look at if it is tied to the creation, development, or release of a specific product. If it is, then the cost is likely a direct cost. If the cost is more related to running your company as a whole, then it is likely an indirect cost.
2. Your indirect costs can be a virtue in pricing
Some of the indirect costs of operating your business can be used in marketing your products in order to justify higher costs. For example, if your factory is located in a unique locale that customers would find special.
3. Receiving grants for your small business
If you are a small business owner, you may be able to receive grants for your organization. Keeping clear records of what your direct and indirect costs are will be helpful when applying for funding.
Frequently Asked Questions (FAQ) about indirect costs
What are some examples of indirect costs?
Some examples of indirect costs would be equipment rentals, utilities, and supplies.
What is an example of a fixed indirect cost?
A fixed indirect cost would be an indirect cost that always stays at the same price, such as a cell phone bill that is on a monthly plan with a set price.
3. What is an example of a variable indirect cost?
Variable indirect costs are indirect costs that can fluctuate, such as gas or electricity.
Know your costs
Many businesses have a handle on their fixed costs but are less on top of their indirect costs. Do not make this mistake with your business, or else you can never be truly sure if you are pricing your goods appropriately.
