Revenues, Direct Costs and Expenses... Oh My!

Posted on August 24, 2016 by Jeff Schuster, One of Thousands of Business Coaches on Noomii.

If you are providing a consulting service, your costs ought to be quite low. However, if you decide you want to own a restaurant, your costs will be substantially higher.

I want to start with the general layout of your revenues and expenses. In order to match your financial forecast with your accounting system (no matter how complicated or simple); you need to organize your numbers into three major categories: 1) Revenue; 2) Direct Costs; and 3) Expenses. These three categories can be found on any profit and loss statement and should be used for forecasting.

Revenues

Revenues are any sources of income the company makes by selling its products and services. There are two types of accounting systems that I will essentially ignore during this series on financial statements. But it is important that you understand them, if confronted by an accountant at some point. The two types of accounting are ‘cash basis’ and ‘accrual basis’. Cash basis means that you count income as it hits your bank account; and expenses when money leaves your bank account. Accrual basis accounting means that you count revenue when you send a client a bill; and you count expenses when you incur the obligation to pay a bill. I will talk about these systems more when we discuss cash flow… but for now, all revenues will be considered paid when billed for simplicity.

If you have multiple types of services or products you plan to sell, it is helpful to have individual revenue line items for each product or service.

Direct Costs

Direct Costs are often called Costs of Goods Sold (COGS). Direct Costs are costs directly associated with your revenue. Let’s say that you plan to build a house for a client. All of the lumber, materials and labor directly associated with building would be considered a direct cost. Just like Revenues, you will need to separate direct cost line items to match your Revenue line items. This way, you will be able to calculate profitability of individual products and services.

Gross Margin

The Gross Margin is the total Revenue minus the total Direct Costs. Gross Margin is a good indicators of the health of any business. This indicates the amount of money your customer is paying you above the actual costs it takes you to deliver products and services to that customer. In order to calculate % Gross Margin, you divide your Gross Margin amount by the total Revenue. Let’s say that you sell $100,000 worth of services; and it costs you $60,000 in direct costs to provide those services to your customers. Your Gross Margin will be $40,000 ($100,000 – $60,000); and your % Gross Margin will be 40% ($40,000 / $100,000). The higher the % Gross Margin, the higher value your customers perceive the value your company offers.

Expenses

Expenses are all of the other costs it takes to operate your company. Expenses can also be called Indirect Costs or Overhead. Some companies differentiate between Indirect Costs, Overhead and Expenses; but most small companies include all of these items as one category called Expenses. Expenses include items such as building rent, management labor costs, administrative costs, office supplies, etc. Expense costs cannot be directly assigned to a project, and so they fall into their own general category.

Net Profit

Net profit is the amount of money the company is making after it has paid all of its expenses. Net Profit = Gross Margin – Expenses. In our example, if you had expenses of $15,000, your Net Profit would be $25,000 ($40,000 – $15,000). Your % Net Profit would be the Net Profit divided by the total revenue. In the case of our example, % Net Profit = 25% ($25,000 / $100,000).

Forecast

In order to know that you will be okay on your business start up, you need to create a financial forecast. I will discuss this in more detail in a future article. Suffice it to day, this forecast will show you how much revenue you will need to make your business work.