When constructing your chart of accounts, it is usually a good idea to, at least, create two major categories of expenses:
- Overhead (Indirect Costs)
- Cost of Goods Sold (Direct Costs)
Direct costs and indirect costs are differentiated in the following ways:
- Direct costs are spent because they are used to create revenues for your business:
- Example: Employees you hire to perform consulting services that you can bill your clients for later on.
- Indirect costs are spent because they are needed to help maintain overall business operations:
- Example: Utilities you pay for on a monthly basis to keep the lights on. You would not bill your clients for your electricity usage.
When reviewing your Profit & Loss statement, it is a good idea to understand what your direct costs were and what your indirect costs were. If you take your revenues and subtract out your direct costs, the end result is your spending money that is needed to be able to afford your business living costs (indirect costs). Remember, your business has its own living costs, just like you do for your own personal stuff.
I have seen small business with very little money left over to be able to afford their business living expenses. So be careful if you want to begin a major marketing campaign and ask yourself: Can the business afford this right now? If the business takes out a loan to have the money for its living expenses, then the business will need an additional plan to pay this loan back and also be able to afford the interest payments in what will be yet another living expense (indirect cost).
Overall, it is always a good idea to dissect your financial statements and perhaps look at them in different ways to fully understand the health of your business.
Note: AccuraBooks is a bookkeeping firm only, so please consult with your C.P.A. for verification and clarification about the contents of this article.