General business finance

The difference between direct and fixed costs

Two types of expenses are deducted from the income of a business. This simple guide covers what they are, why they’re separated, and how they can help keep your business on track.

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Direct costs and fixed costs

In broad terms, direct costs are the costs of producing your goods or services, also known as cost of sales or cost of goods sold (CoGS). For example, if you make wooden furniture, you buy things like timber, glue, paint, and screws.

If you run a service business (such as a financial consultancy), you might not have any CoGS, because you don’t need to buy in raw materials to process and sell. You sell only your time.

Fixed expenses (also known as overheads) are the costs of running your business. For example, if you lease an office building, you’ll be charged a set amount of rent (typically weekly, fortnightly, or monthly). 

These two expense categories are made up of totals that are calculated from your financial records. For example, your office expenses total might include:

  • Stationery
  • Tea and coffee
  • Stamps. 

The costs are reflected on your profit and loss statement.

Why your direct and fixed costs are separated

Separating your direct and fixed costs helps you to keep track of how your business is performing. This is because direct costs are variable and will change on a regular basis, whereas fixed costs are stable and predictable.

Direct costs are variable

Cost of sales is a variable expense because it goes up and down according to your sales. For example, if you sell more chairs, you’ll need to buy in more raw materials.

Separating out your direct costs will help you keep an eye on the difference between your sales and your cost of sales. The lower you can keep your cost of sales in relation to your sales, the more profitable your business is likely to be.

For example, if the price of timber rises because of shortages in the market, you’ll notice your cost of sales increasing, while your sales may remain the same. In response, you might choose to raise your selling price to compensate for the increased cost of your raw material. That way, the difference between your sales and your cost of sales stays the same.

Fixed costs are just that – fixed

Your overheads represent the relatively fixed costs of running your business. 

Whether you manufacture one chair or 1,000 chairs, you’ll still have to pay for things like rent, electricity, telephone, and other office expenses. You don’t pay more or less according to your sales.

Separating out your fixed expenses can help you see if there have been any unusual increases. For example, postage costs may have skyrocketed. By comparing this year’s postage expenses to last year’s, you can investigate and remedy any costs that are getting out of hand.                               

It’s also important to keep an eye on your overheads as a percentage of total sales. For example, if it costs you $20,000 to run your office, and your sales are $200,000, your fixed expenses represent 10% of sales. But if you can increase your sales next year to $300,000, while keeping your overheads at $20,000, your fixed expenses will represent only 6.67% of sales – a more efficient achievement that will show in your bottom line.

When separating direct and fixed costs are not obvious

Sometimes the dividing line between direct costs and fixed costs is a little grey. Consider this scenario. It’s winter, and your business’ monthly power bill has shot up from $200 to $800. Should that increase be shown as a variable cost of sales? Similarly, if your (reasonably steady) delivery truck expenses suddenly increase because you’re delivering more sold items, how should these be categorised? 

When the answer isn’t straightforward, it might come down to a judgment call. You can decide this with the help of your accountant.

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