Small business owners are an underserved group. Tax planning and tax preparation should not be the only skills offered by the business’ advisors. And to small business owners, don’t be so stubborn. Read carefully to understand this discussion. This just might save your life long dream from collapsing.
Construction, roofing, and custom manufacturing are all business types that will benefit from a discussion of direct and indirect expenses. Most already know that direct expenses for a given job or project have to be considered in the cost. Direct expenses include the labor and materials used. It is the indirect expense that is most often forgotten or mistakenly allocated to job cost. The indirect expense is a cost that relates to all jobs or projects and not to one job specifically.
Examples of indirect expenses include: depreciation on machinery and equipment in the production process, depreciation on plant facilities if owned by the small business, rent on the plant facilities, shop supplies, vehicle expenses, utilities, insurance, and the compensation of supervisors, plant managers, and owners of the business. And of course, don’t forget about payroll taxes. There could be other indirect expenses in a given business, but the aforementioned will serve to demonstrate my point. It is also important to mention here the compensation of the business owner or owners. If the owner participates in the production process, a portion of compensation (or all) should be treated as an indirect expense to be allocated to the job cost.
Now that there is a list of indirect expenses, how should they get allocated to the job cost? Typically, indirect expenses are allocated based on direct labor dollars, direct labor hours, or direct materials. My personal favorite method of allocation is based on direct labor hours. If there are 20 direct laborers in a given business, and each is projected to work 1,900 hours annually, there will be 38,000 hours of total direct labor in a given year. If the summation of indirect costs is $1,500,000, this business will have an indirect cost per direct labor hour of $39.47. If my average hourly wage for direct laborers is $25.00, then total cost per direct labor hour is $64.47. If this particular business desires an industry average gross margin of say, 36%, it will need to charge $100.73 per labor hour. This billing rate is determined by using the full absorption method of accounting. Full absorption accounting is a required “generally accepted accounting principle” and must be used in all external financial statements unless otherwise disclosed.
Now, I can hear the naysayers from the cheap seats, “what if the market won’t bear this”? Well then, the business will have to accept a smaller margin, shop around for lower direct and indirect costs, or understand the behavior of fixed costs and “economies of scale”(a discussion for another article). The point of this article is to ensure that a business covers all of its production costs. I hope that I never hear again a small business owner say: “I am busier than ever, but I don’t have any money”! As always, the small business owner is free to do as he or she pleases. However, it is important to remember that my way is better.