How To Determine Indirect Costs For Small Businesses?
Indirect Costs For Small Businesses
Small business owners are usually starting small with limited capital and resources.
Even with this, their sales aim to recover their production cost and earn a generous return on investment. Therefore it is important to closely analyse and manage different types of costs involved in running your business.
Now here, unfortunately, most businesses entirely focus on calculating the direct costs while neglecting the others. Somehow they are too inclined towards slicing and dicing the direct costs that the indirect ones get overlooked. However, to effectively track and manage your financial data, it is equally important to calculate the indirect spend alongside.
What are direct and indirect costs?
To recover savings and build up your business value, it is mandatory to identify and allocate all the incurred costs correctly. If you are too occupied with your role, you may take the help of small business accounting services. The details are mentioned ahead to give you a clear perception of the direct and indirect costs.
Direct cost
Direct costs are relatively straightforward. They include expenses that are connected to your company’s products, such as:
- Raw material
- Finished goods
- Direct salaries
- Professional services
- Office/manufacturing supplies
- Labor wages
Indirect cost
Indirect costs are focused more on your day-to-day business. They are not directly related to the product’s production process, but they are essential for completing your daily operations. Some of the examples can be:
- Salaries (non-labor)
- Computers
- Legal fee
- Human resource cost
- Office supplies
- Administrative expenses
- Utilities
To make it more transparent, let’s suppose you’re a manufacturer. The amount you spend on purchasing the raw material would be calculated as a direct cost. The direct cost keeps varying depending on different factors such as production levels.
On the contrary indirect costs are considered fixed as they remain the same regardless of the production levels. However, handling your indirect expenses can be tricky as they aren’t always readily transparent.
Ways to determine and allocate your indirect costs
Maintaining track of your expenses can benefit your small business in many ways. Initially, it might be harrowing for small business owners to track down their indirect costs, but it is worth all the hassle. Hiring an accountant expert to determine and allocate your indirect cost is encouraged to seize control of your business costs.
However, if you want to identify and allocate your indirect cost personally, these methodologies might come in handy.
Cost allocation for each individual business-activities
This method acquires a little more effort and time for cost allocation but helps to produce accurate results.
You can compile the required data by:
- Classifying the activity under direct or indirect costs
- Keep listing the accounting records for each department in their designated column
- Set an accounting period (bi-monthly or monthly) to scrutinize and designate your indirect costs
Categorizing inflexible costs
As the name indicates, this method suggests calculating all the fixed business expenses, such as jotting down the marketing team’s salary under the marketing budget. Similarly, transportation charges can be classified under the shipment category. Finally, to sum it up, you can specify the charges for an asset or service under their designated account.
Proportional allocation
This is one of the most reliable and accessible methods for indirect cost allocation. You roughly estimate and allot the indirect cost for each project/unit/ department/ Service etc., once a fiscal year. Each department shares a project’s indirect cost, which is then calculated and reviewed once a year.
Why is it even important to calculate the indirect costs?
Now that you know the types of costs involved in running your small business, you should allocate all your expenses correctly. Still, wondering if determining and calculating the indirect cost is even worth all the trouble it takes? Definitely, it can help set the product prices stable enough to cover the production cost, earn profits and thrive financially. Moreover, can small organizations practice effective spend management?
Cutting down on your indirect costs without compromising on your product quality should be your end goal. In addition, maintaining a healthy check on your overhead costs will help you streamline your business operations.
Moreover, determining and allocating the indirect costs means a trimmed budget and improved revenue.
If you still find it unnecessary, here are a few benefits a small business can achieve through determining indirect costs:
- Setting up profitable margins
- Possible tax savings
- Optimized financial statements
