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Are Payments Always Expenses in My Business and It Not, What is the Difference?

by Brett Backues on September 13, 2016

What Are Direct and Indirect Expenses?
Tracking costs are an essential part of your business reporting process. Having a business is a big responsibility, and you want to make sure you get every expenditure allocated to the proper department. Having proper allocation methods will ensure you’re not paying more than you should. You must learn the difference between direct and indirect expenses, or payments and expenses. The budgeting process is an essential part of the business, and to budget properly you must learn how to cost track correctly. Both direct and indirect costs must be accounted for separately. While a bit time consuming, it saves a lot of headaches in the end. 

Understanding Direct and Indirect Costs
Most business owners know all about payments and expenses. In the accounting world, these two items fall under classifications known as direct or indirect expenses. When you make a purchase, you should log it into your accounting system as a direct or indirect purchase. Ask yourself the question, was the item used to produce goods and services? Was this item used to increase revenues? Be careful, the copier you just bought is to help increase revenue too. However, it would fall under operational costs, which is an indirect purchase. Unless you own a printing company, the copier is just a necessary aspect of the business. You can claim depreciation and such on your taxes, but it needs to be allocated properly. 

A direct cost can always be tracked backward to a specific project. Under normal circumstances, the direct cost is controlled by the unit supervisor as they are accountable for every aspect of production. Most companies have two categories in their direct costs, labor, and materials. There is a cost associated with paying employees to produce your products, and then there are raw material costs. In some cases, direct costs may also include employee benefits, travel, and equipment service. 

The Complexities of Indirect Costs 
Direct costs are fairly easy to assign. However, when dealing with indirect costs, it is a bit more complex. These costs fall under the payment category. They are not as much about the creation of a product, but they are more about the company’s overall maintenance and growth. These items are not usually traceable to a department or product, thus, they fall into a category all their own. These charges can be joint, and it is often hard to decipher the correct department to assign them too. Some common indirect costs are electric bills, sales and distribution, maintenance, and office supplies. Because they are not directly associated with the production of materials, their considered part of the expenses of running a business. All overhead goes into the indirect costs or is allocated as a payment. 

Some items may be difficult, if not impossible, to classify as either direct or indirect. For instance, if you purchased materials needed for the direct production of an item, the materials may go to more than one area of the business. Buying in bulk would be a good example of a product that could be labeled as direct or indirect at the same time. While some of the products may be used for a specific campaign, the overflow would go into the warehouse for later use. If another customer needs the product a year from now, you would have to pull supply from your warehouse. But, for the sake of entering it incorrectly when you purchase the product, you need to classify some as direct and some as indirect. 

Is It Necessary To Track Expenses and Payments Separately? 
It may seem foolish, or even a waste of time, to categorize each item as a direct or indirect expense. There is a time commitment involved in cost tracking, but it helps the overall company budget when things are assigned correctly. The cost of an item is determined by many factors like production costs, salaries, marketing, and other expenses. If you don’t have an accurate budget that correctly projects your costs analysis, you could end up failing to meet fiscal obligations. 

Additionally, if your costs tracking system is erroneous, it can affect your creditors and clients alike. Businesses use expense tracking. These programs allow you to see the costs that need to be billed to customers, and you can classify the costs that need to be paid internally. Tracking errors can cause inflated invoices, and not charging your customers correctly can damage the company’s reputation over time. 

The Government Requires Cost Tracking
If your company receives governmental grants or other special funding, cost tracking is a required for your business. Most grant programs require funds to be allocated correctly to both direct and indirect costs. If your company fails to keep accurate records, it puts you in violation of the grant agreement, and the funding will be in jeopardy. Don’t think that the government won’t be checking up on you. When they hand out money, they want to make sure that their money is being used wisely. 

Lastly, cost tracking affects the overall cash flow of a business. It can increase or decrease the company’s tax burden, and it matters to almost every facet of the business. Once you have categorized both the direct and indirect costs, you can deduct certain expenses on your taxes. When tax season rolls around, you will be glad that you took the time to cost track your expenses. At the end of the year, you may end up paying more than you need to, due to poor tracking methods. 

A reduction in your tax bill means that your company has more cash flow. Having a good accounting software package and accountant that helps with allocation is critical. The last thing you want is the IRS breathing down your neck. They tend to be picky about misclassification of your expenses and payments. As a business, you must comply with all federal regulations to avoid being audited. You could face tax penalties and worse. If you don't understand cost tracking your expenses and payments, talk to a CPA or a CFO for more information.