To turn a profit in your business, you need to make sure your products or services bring in more money than what you put into them. But if your business expenses are greater than your revenues, you won’t stay afloat. Learn about indirect cost and how to calculate and reduce it.
What is indirect cost?
Indirect expenses, or overhead costs, are expenses that apply to more than one business activity. You cannot apply an indirect cost directly to the production of a specific good or service. Instead, they are costs that go into running your business as a whole. If you want to determine the portion of your indirect costs that go towards producing certain items, you must distribute the costs.
Fixed costs are expenses that are the same regardless of how many goods or services you produce. An example of a fixed indirect cost would be rent.
On the other hand, variable costs are expenses that change depending on how many goods or services you produce. An example of a variable indirect cost includes equipment maintenance.
For more examples of indirect costs, see the list below.
Indirect cost examples
Every business has indirect costs. Here are just some of the indirect expenses you might have:
- Professional fees
- Administrative expenses
- Office supplies
- Employee salaries
- Equipment maintenance
The above expenses are considered indirect if they cannot be applied toward a single product or service. Office supplies, for example, are indirect if they are not direct materials to create products.
Let’s look at rent. You need to pay rent to keep your business building. But, the money you pay towards rent does not go towards producing a specific product. Instead, rent payments make it possible to produce all your products and run your business.
What is the difference between indirect and direct costs?
Indirect expenses aren’t the only costs you will have at your business. You will also have direct costs, which are expenses you can assign to the production of a specific product or service.
Unlike indirect costs, you do not divide direct costs among different departments or projects. You must know your business’s direct and indirect costs when pricing products and updating your accounting books so your records are accurate. And, you need to separate costs to claim tax deductions.
Examples of direct expenses include manufacturing materials, direct materials, and direct labor.
Identifying your indirect expenses might be a little tricky. What is considered an indirect cost for one company might be considered a direct cost for another. And, one employee’s salary might be an indirect cost while another’s is a direct cost. For example, an employee on an assembly line receives wages that are considered direct costs. But an employee who works as a secretary in the same company would receive wages that are considered indirect expenses.
Indirect cost rate calculation
If you want to determine your indirect cost rate, you need to use cost allocation. Cost allocation is the process of distributing your indirect costs among specific departments or projects.
You can use the indirect rate calculation to price your products. You want your offerings to generate enough money to cover your expenses. By considering your indirect and direct expenses, you can determine a reasonable cost for your products or services so you don’t underprice.
Another reason to use the indirect cost rate formula is so you can decide whether your expenses are too much. If your indirect costs are too high, you can find ways to reduce your expenses.
You can allocate indirect costs by taking your total indirect expenses and dividing them by some sort of allocation measure, like direct labor expenses, direct machine costs, or direct material costs.
Here is the indirect cost formula, or overhead rate:
Indirect Rate = Indirect Costs / Allocation Measure
The formula gives you a ratio. Let’s say that you want to find your overhead rate using your direct labor expenses.
Your total indirect costs are $10,000 and your direct labor expenses are $5,000. Your formula would look like:
Indirect Rate = $10,000 / $5,000
In this example, your indirect rate is 2:1, meaning you spend $2 of overhead per $1 of direct labor expenses. The lower your indirect rate, the better.
How to reduce indirect expenses
Knowing how to reduce expenses in business is essential if you need to increase your profits. You can reduce your indirect expenses using the following strategies.
Compare vendors to make sure you are getting the best deal. Expenses like office supplies can vary from provider to provider, so see if there are others who are less expensive.
If you want to reduce indirect expenses like utilities, cut your bills down by conserving energy. You can power down equipment when you aren’t using it, purchase energy-conserving equipment, or switch utility providers.
You can reduce other indirect costs, like advertising, by engaging customers through social media or using other inexpensive marketing ideas.
There are many ways you can reduce your indirect expenses. Consider how valuable the expense is to operating your business and come up with ways to slash the price.
Use Patriot’s online accounting software to track all of your business expenses. Our software is made for the non-accountant, so you can update your books on your own. Try it for free today!
This article is updated from its original publication date of March 13, 2018.This is not intended as legal advice; for more information, please click here.