Want to turn your passion project into a profitable business? Understanding your direct costs is one of the first steps. From raw materials to labor, every penny you spend to create your product or service directly impacts your bottom line.
By clearly understanding your direct costs, you can make more informed decisions about your pricing strategies and overall business plans. If you want to gain better insight into the financial health of your company, learn more about what kinds of direct costs can impact your business as well as how they differ from indirect costs.
What are direct costs?
Direct costs, also called cost of goods sold or cost of sales, are the costs incurred to produce a product or provide a service. This includes any expenses directly related to the production process, like raw materials and direct labor, or the order fulfillment process for ecommerce businesses. Direct costs also include any costs your company incurs when scaling your production (for example, producing 1,000 dog toys will cost more than producing only 100).
Here are some common examples of direct costs that can impact your business:
- Raw materials. This includes the cost of raw materials you use in your production process—for example, the wax for a candle business or the wool for a company manufacturing scarves.
- Direct labor. Direct labor includes the costs of wages tied directly to producing a product (like factory workers producing cleaning products) or providing a service (like a cleaner working for a janitorial company).
- Production equipment. This direct cost includes purchasing and maintaining the equipment necessary for producing a product or service, like a 3D printer for an ecommerce merchant making and selling figurines.
- Energy costs. This includes any energy costs associated with producing products or services, including monthly electric bills for production warehouses or fuel for machinery used in the production process.
- Transportation and shipping. This includes the costs associated with transporting goods or providing services, as well as the costs of shipping products directly to customers or retailers.
- Inventory. For businesses that don’t produce the products they sell (like resellers or dropshipping merchants), the cost of purchasing inventory to sell is considered a direct cost.
- Research and development (R&D). There are direct costs associated with researching and developing a new product or service, including software used for product development and the materials required for prototyping.
- Sales commissions. Since commissions earned by salespersons tie directly to the sale of a product or service, they count as direct costs.
Direct vs. indirect costs
Whereas direct costs are directly tied to the production process, indirect costs are the overall expenses associated with operating a business that are not for producing a product or service. Examples of indirect costs include overhead costs like rent and business insurance as well as administrative costs like salaries for marketing, accounting, and customer service departments. Both direct and indirect costs contribute to the total cost of running your business.
Whether you’re dealing with direct or indirect costs, your business expenses can fluctuate depending on whether they’re variable or invariable. This means they change based on your production levels. However, indirect costs tend to be less variable than direct costs.
For example, the indirect cost of rent for a production facility can stay the same, whereas the direct energy costs for producing a product in the facility change based on the production output.
Benefits of calculating and tracking direct costs
- Informed pricing strategies
- Accurate information for accounting
- Improved budgets and financial plans
- Optimized production processes
By calculating and tracking the direct costs associated with producing a product or service, you can make informed decisions and benefit your business in the following ways:
Informed pricing strategies
Keeping track of your direct costs provides you with the information you need to price your products or services to be profitable while remaining competitive. Direct costs determine the baseline for your selling price, which must be high enough to cover those costs. Controlling direct costs can boost your gross profit margin, giving you more room to manage overhead and other costs as you work your way toward a net profit.
For example, if you’re selling custom mobile phone cases for $25 and your direct costs are $15 per case, lowering those costs to $12.50 would boost the gross margin to 50%. If you maintained your selling price, that could also increase your operating and net profit margins. At the same time, lower direct costs can give you more flexibility to lower prices if necessary to stay competitive in the market.
Failing to carefully monitor direct costs can put you at risk:
- Underpricing: Not covering all your costs.
- Overpricing: When your product becomes too expensive relative to competing products.
Use Shopify’s profit margin calculator to calculate a price that includes an appropriate markup.
Accurate information for accounting
When running your own small business, accounting for expenses starts with direct costs. Take the time to carefully evaluate your inventory because the prices of materials or wholesale products can fluctuate.
Track the direct costs of your inventory either by the first in, first out (FIFO) method, or last in, first out (LIFO) method. FIFO accounts for costs based on which items came into inventory first. As materials are used in production, the first or oldest items are the cost basis. LIFO does the opposite, accounting for costs based on the last item purchased.
This is especially important for tax purposes. Precise bookkeeping practices help you prepare reports for investors and stay compliant with regulations. Additionally, you may be able to deduct some of your direct expenses from your income when filing your taxes, depending on where you operate. Consult an accountant or tax professional to learn more about which direct costs count as write-offs.
Improved budgets and financial plans
By tracking your direct costs, you can better understand the true cost drivers behind your business expenses. You can assign direct costs to a specific cost object, like a new product line, and track those costs to find out how much it costs your business compared to other product lines.
With a clear understanding of all of the costs going into production, you can make more informed decisions about what resources to allocate to a particular final cost objective. This means you can create more accurate budgets for each of your projects, products, or services.
Monitoring the direct costs your business incurs can also help you make smarter financial plans about hiring new employees, expanding operations, and investing in marketing campaigns.
Optimized production processes
Recording all of the costs specifically identified with your production process can provide you with insights into how to improve your production process. For example, you may realize the majority of your production expenses come from energy costs and decide to invest in a more energy-efficient warehouse.
Similarly, you might save money by carefully tracking direct labor and materials costs to improve efficiency. For example, a clothing manufacturer could find a cheaper supplier or substitute a less expensive fabric—or it might change production procedures to get more apparel items done with fewer workers. By calculating your direct costs, you can identify areas for improved efficiency and potential cost reductions.
Direct costs FAQ
What are examples of direct costs?
Examples of direct costs include raw materials, production equipment, energy and transportation costs, commissions, research and development (R&D), and wages for the labor required to produce a product or provide a service.
How do you calculate direct costs?
Calculate direct costs by listing out all of the costs that go directly into your production process (from materials and equipment to labor and commissions). Add all of those expenses together to find the total of your direct costs.
What is the difference between direct costs and expenses?
Direct costs are types of expenses directly tied to the production process. Other types of expenses include indirect costs like overhead and administrative costs.
