Indirect costs are costs that can’t be directly identified within a specific product or service. Examples include rent and utilities, litigation, office equipment rental, insurance, accounting, security costs, etc.
This article will unveil the difference between direct and indirect costs and cover the ways to estimate indirect costs.
Why are indirect costs important?
Indirect costs are essential for the proper functioning of a business. Electricity, equipment, and office rent support company operation and allow business owners to create high-quality products and provide appropriate services. Indirect costs help entrepreneurs maintain and run a business properly.
Examples of indirect costs include expenses on computers, rent, smartphones, and security needed for a brand’s day-to-day activities. Their role can’t be underestimated because the existence of a company isn’t possible without them.
Now that you know why indirect costs are essential for maintaining your business, it’s time to uncover the difference between direct and indirect costs. It’ll help you identify and calculate them for various projects and activities of your company.
Direct Costs vs Indirect Costs
Since distinctive features of direct and indirect costs are often ignored, we need to explain their differences. After reading this section, you’ll be able to identify these costs for your business.
Direct costs are expenses directly tied to the manufacturing of specific products. They are usually variable costs. Examples include direct labor, materials, fuel, power consumption, wages of workers, etc. It’s easy to trace the relation of these costs to the production of products and services. Direct costs can be easily tied to a specific unit. For instance, when manufacturing cars, a company needs brakes, batteries, pistons, etc. They are necessary to produce a vehicle and are associated with this product.
Indirect costs are expenses that can’t be associated with the manufacturing of a certain product, but they contribute to the operation of a business. Examples include costs for electricity, office equipment rental, gas, rent, etc. You can’t track the relation to specific goods, but a company can’t produce products without them. For example, when a brand manufactures cars, it needs experts who will control the process. A brand owner has to pay salaries to employees to do their work.
Simply put, direct costs are expenses for manufacturing products or providing services, while indirect costs are expenses that help keep your company operating.
Now that you know how to define indirect costs, it’s time to figure out how to calculate them. It’ll help you unveil your expenditures and estimate revenues.
How to calculate indirect costs?
When you have low indirect costs, your company brings high-profit margins. However, you need to learn how to calculate your indirect costs before figuring out how to reduce these expenses. In this section, we’ll show you how to do it fast.
To estimate the percentage of your indirect costs, identify and list all your indirect costs for one month. When searching for such expenses, remember that they aren’t directly related to your product. Find out costs for electricity, gas, water, administrative costs, etc. These costs let your company exist. The next step is to identify monthly sales during the same period.
(Indirect Costs / Monthly Sales) x 100 = Indirect Costs Percentage
Let’s imagine that the indirect costs of your company are $2,000, while your monthly sales are $10,000. We’ll now calculate the percentage of the indirect costs.
($2,000 / $10,000) x 100 = 0.2 x 100 = 20%
It means that 20% of sales your company spends on indirect costs.
Now that you know how to estimate the measure, it’s time to walk you through the examples. They will hint at how to find indirect costs for your business.
Examples of Indirect Costs
You can find many examples of indirect costs in every operating business. Every company needs specific expenses to ensure its performance.
In case a company has property damage and liability claims, it should have business insurance. The insurance will help cover associated costs and prevent a business owner from paying out-of-pocket. Costs a brand spends on business insurance belong to indirect costs.
Administrative expenses like office supplies, consulting, utilities, building rent, and depreciation on office equipment are indirect costs. They are essential for business operations.
If your company relies on using special equipment to produce your products, you’ll also need to cover the possible repair and maintenance costs of various vehicles, machinery, and equipment. Moreover, these expenses will become your responsibility when you purchase all equipment.
Now that you know the examples, it’s time to figure out how you can save money by cutting indirect costs. Let’s dive in.
How to reduce indirect costs?
Although optimizing some expenses might seem unreal, it’s still possible if done wisely. Reducing indirect costs will help you increase your profits and save some money for business improvement. So, let’s figure out how to do it.
- Hire an accountant. Having a professional in your team will help you manage your resources properly and avoid unnecessary spending. Your accountant will keep an eye on your finances, costs, and revenues to identify gaps and eliminate them. This person will prevent you from having more indirect costs and financial mistakes.
- Find an affordable place for your office. Since working space and manufacturing place often make up a big part of indirect costs, you need to pay attention to it. Review the costs for your office space. If the place is huge and costs big money, it’s worth considering a cheaper place. Search for a smaller space, choose a less popular location, and consider remote workers. Remember, these cutting costs strategies work only if they don’t influence your brand reputation, revenues, and productivity.
- Rent equipment. If you want to purchase all equipment for your company, think twice because it’s a serious investment. This step will require you to allocate many resources without any guarantee that your company will succeed and prosper. You can rent equipment first to see how your business will operate and the profits it will bring. This way, you’ll avoid additional expenses on maintenance and repair costs.
- Revise contracts with vendors. If you aren’t new to the business and have established relationships with suppliers, consider reviewing contracts and conducting negotiations in terms of prices. You can revoke some unnecessary contracts that are no longer in use. Besides, you can ask suppliers for discounts for long-term partnerships and some special deals.
- Hire remote workers. The profitability of your business doesn’t depend on office workers. They can perform their tasks from home as well. That’s why you can search for people to do specific tasks and pay part-time wages. This way, you can save office supplies costs. Nevertheless, remember, you need to find experts who have experience in the field.
- Consider going eco-friendly. Going green is an expensive process that contributes to your long-term goals. You’ll need to invest big money to use eco-friendly alternatives. However, they will allow you to reduce utility costs. You’ll be able to save money by going paperless, using LED bulbs and saving electricity, and avoiding using plastic bags.
Now that you know what indirect costs are and why they are essential, you can calculate them for your business and avoid unnecessary expenses. Although it might seem difficult to optimize your budget, you’ll contribute to the achievement of your long-term goals.
- This article provides readers with the difference between direct and indirect costs.
- In this article, you’ll find out how to calculate indirect costs.
Last Updated: 01.12.2022