Sometimes referred to as COGS (costs of goods sold), direct costs are those costs that are entirely attributable to the production of a product or service.
When you sell a product, they are the costs associated with the manufacture and retailing of that product. Direct costs don't include things such as marketing expenses, rent, and insurance.
In this article, the Sunny Accountants team will explain what a direct cost is, why they are important for your business, and what you can do to lower them.
What does this mean for your business?
Because your direct costs have a profound impact on the amount of profit that you make, you need them to be as low as possible. Naturally, some businesses will have higher direct costs than others – it all just depends on the industry that you operate in. For example, a coffee shop will have lower direct costs than a car manufacturer but their profit margins and the prices of their products will make up the difference.
For businesses who sell services rather than products, their direct costs will be significantly lower. For instance, a consulting company can sell 500 hours of consultancy services without incurring a single penny of direct costs whereas every coffee sold by a coffee shop will have a direct cost attached to it.
The reason that labour isn't included in the calculation of direct costs is because it can be difficult to fully attribute an employee's time (and the money that you spend on employing them for that time) to the work that they do on a single product. If you have an employee who splits their time between delivering several services and working on a product, it can be very difficult to calculate what portion of their salary is linked to any one product.
How to calculate direct costs
Because direct costs give you an understanding of how much it is costing your company to deliver a product or service, it is important that you are able to work out exactly how much that is. This metric can become vital in your business if a supplier is trying to raise their prices.
To work out the direct cost of a product, you need to multiply the price of the materials by the quantity of materials that you bought. To calculate the labour costs, you take the hourly rate of the employee working on a product and multiply it by the number of hours they have worked on the product.
You may want to skip that last step because of the reasons we have previously mentioned about the difficulties you can face when calculating an employee's time on a product. Add together both the material costs and the labour costs (if you have factored that into the equation) and that will give you your total direct costs of that product.
How to improve your direct costs
In order to maximise the amount of profit you make on your products, you should focus on reducing your direct costs. Here's how:
Find a new supplier
If your current supplier is charging too much or you just feel that you could get a better price elsewhere, find a new supplier. This could mean that you are spending less on your materials to deliver the same product – which means more better margins on the same turnover.
Renegotiate with your existing suppliers
If you are apprehensive about leaving your current supplier, have a conversation with them. If your business holds enough weight with them (as in you spend a certain amount with them on a regular basis) they may be willing to provide you with their supplies at a discounted rate.
Find other ways to become more efficient
If your direct costs are as low as they possibly can be, then you should consider decreasing the other costs that your business incurs. These costs can be as simple as lowering your tax bill (by maximising the amount you can claim back or R&D tax credits, if applicable) or switching to energy efficient light bulbs.
We can help
If you are looking to bring down your direct costs, get in touch with our team, please call us on 01623 559 362 or email [email protected].
For a free chat on how we can help you, please complete the contact form below and we will be in touch.