Factors to consider when modelling direct costs.
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“Gentlemen, watch your costs” – Andrew Carnegie
What are direct costs?
Direct costs are those costs that you must incur to make a sale.
For example, Apple sells iPhones. iPhones need screens, which Apple sources from various suppliers (including Samsung). The cost of these screens is a direct cost.
Direct costs could also include items such as transport for raw materials, and overheads incurred to produce goods for sale, such as factory worker salaries and factory electricity costs.
The key thing is – these costs are specifically tied to the goods or services a business sells, rather than to general administration for example internet expenses.
What you should do while projecting direct costs
1. Separate the major components.
Identify the major components of your direct costs and model them separately. This helps you analyse the impact of each component so you can control the cost better.
Splitting the overall cost into these components helps you understand the cost per unit and identify potential areas to cut costs and improve efficiency.
For example, below is the breakdown of the direct costs of the East African Breweries Plc, a subsidiary of DiageoPlc. From the below we can work out that raw materials and machine maintenance costs are the two main components of the direct costs, collectively making up 70% of the total direct costs.
Source: East African Breweries Plc results booklet for the year ended 30 June 2023
2. Build in flexibility for price changes.
Sometimes costs turn out to be different to what they were expected to be.
In the best-case scenario, the costs will be lower than anticipated. In the worst-case scenario, the costs will be higher than expected.
While projecting your direct costs, build in the flexibility to adjust the costs upward or downward, depending on the scenario. For example, you could build in an automated 10% increase in direct costs for the worst-case scenario and say a 5% decrease in direct costs in the best-case scenario.
3. Account for annual inflation.
Generally, costs tend to increase. Suppliers will typically adjust their prices upward year after year in line with the general inflation rate in the economy (or not).
While projecting your direct costs, to ensure your costs remain in line with reality, build in automated cost increases due to inflation. Inflation rate projections for the countries your business operates in will generally be available from a variety of sources. Use these to get an expected % rate increase in costs and have your model automatically apply this.
4. Consider the working capital implications.
Working capital is a broad topic that requires its own newsletter. However, for the purposes of direct costs, it is crucial to consider when you pay your suppliers for the goods or services provided.
Depending on the size of your business and your relationship with your suppliers, you might either pay for goods or services in advance or in arrears.
Big businesses will typically get credit terms from suppliers, so they only pay after goods and services have been provided. Smaller businesses typically have to pay before the goods and services are provided.
It is critical to consider the cash flow implications that this has. If you must pay in advance, you must have that cash ready before you make the sale to your customers. If you pay in arrears, you have more flexibility and can use cash received from your customers to pay your suppliers.
It is critical that the correct cash flow impact is modelled because most businesses die because they run out of cash. Knowing your cash flows will help you avoid such a death.
Happy modelling!