The best profit decisions are happening with your time, energy, and money, which means more pay, play, and profit in your business and life. And a huge part of that is understanding your financials.
Direct Cost vs Expense
Your financials are three-dimensional – profit, tax, and cash flow. You also need to think about direct costs versus expenses in all these three dimensions. “Direct cost” refers to the cost directly tied to your sales. You incur them directly with your sales. “Expense” refers to the operation cost. These are the things you do and spend money on that are not directly tied to the sales. Everything you spend obviously supports the sales but they're not directly tied to the sale.
Now, the IRS has a very defined structure on how they want to see your costs and expenses filed on the tax return. This is part of the tax compliance.
We are going to dive into direct costs versus expenses, and why you should care about knowing the difference. And as a small business owner, you should definitely care!
Setting The Foundation
Now, you have to get the foundation in place first, because if you don't understand the foundation of direct cost versus expenses, it's hard for you to navigate the three-dimensional conversation.
We say this all the time with technical things, it depends. If you listen to our podcast, you will hear this often. The reason why we have to say things like it depends, it’s situational or circumstantial is because with every business, it truly depends on the situation.
There's your financials for profitability analysis and understanding. There’s your financials for cash flow analysis and understanding. And then there's financials for your tax return tax return because the IRS definitely has a very defined structure on how they want to see those costs and expenses on your tax return. That is not situational, that’s code. We call it tax compliance when we do tax prep for the year.
We have to file the return, which closely mirrors what the IRS intended you to report. Then that way it's being consistently reported year to year to all the agencies. Consistency year to year is important.
The reason why the answer to this question is basically three dimensional is because with your finances there's the profit, the tax and the cash flow. Those are all three different situations. You have to look at the money in three dimensions, three lanes, three lenses. This is what just continues to increase the complexity. We feel so passionate about getting the foundation in place first, because if you don't understand the foundation of direct cost versus expenses, it's hard for you to navigate the three dimensional conversation.
A lot of people would just throw up their hands and say, I just don't understand. We want to really encourage people to take it slow, talk about it often and eventually it will click. We've seen it.
We're almost tenured with serving this particular community of online business owners and eCommerce business owners. Marilyn has been a CPA since 1996. Marilyn and I have been having these conversations for two decades now. From my own perspective, especially when I didn't work inside The Bottom Line®. I remember Marilyn mentoring me and guiding me for at least five years about just balance sheet conversations.
It just takes time. It is frustrating. It is intimidating, but you can't quit. This is why Marilyn and I started this thing and we exist to create opportunities for other people. It's hard to explore opportunities when you just don't get your finances. It is a 365 day a year activity. It's hard to get movement, traction and get growth when you don't understand those things.
There is a limiting belief that your finances are just so you can get my tax return filed. Nobody likes doing that even when they have the money to pay the bill. I don’t like writing checks but I do it because that's what we do as citizens to comply with the law.
We want to walk the line but we don't want to cross the line. That's basically how we want to operate. So having said that direct costs, when you're trying to understand the makeup of your business, could be things that you want to include up there from a technical perspective like considering the cost of goods when it comes to taxes.
We see that a lot when we help clients navigate profit first and understand their costs so they can get to their real revenue. Real revenue is what they have to eat from. That's the cash that they have to do all the things, like setting money aside for profits, setting money aside for tax, setting money aside for owners pay and setting money aside for operating expenses.
We work with our clients to create a template with their financial statement with their chart of accounts. Then we get to know them and how they operate so that we can help them create the best income statement that's gonna give them the operational visibility that they need and help them be successful with the management of their cash.
Talk To Your Tax Accountant
Your tax accountant should know when you create an income statement, which you need in order to operate your business, how to appropriately consider and map those accounts to file your tax return. If they don't you need to find another tax account.
It also means you have to talk to your tax accountant. They cannot read your mind or your income statement either if you don't have a collaborative conversation about how you're structuring your finances.
They will take that income statement as it is. They're gonna take it quite literally and they are not going to know that you had some meeting, even with yourself, and they will decide that they are going to throw all this stuff in here.
I also want to stress that you should not do miscellaneous expenses or general expenses. Don't do that, please. Whatever is on your income statement is what they're going with. They may not have a conversation with you about it so you need to have the conversation with them.
Take responsibility for your finances and take responsibility for your income tax returns, because guess what? They are yours.
It doesn’t matter if you pay someone to help you, or pay someone to do it with you or do it for you, if do it on your own and you decide to get your cousin's brother to help you with your books, your financials, and the state of them… your tax returns are your responsibility.
This is a real serious conversation, because so many people really do wanna blame their accountant when things go wrong on their tax return. If you don't understand your tax return, you need to keep asking questions until you do.
We have an ethical responsibility to do our part, but doing your part and our part is not on the agenda. You still have to do your part and we have to do our part. And if you're in a relationship and a partnership, it looks one way.
If you are just wanting to hire someone to get it done, I promise you it's going to look another way and you are going to always regret it. At some point you'll learn the expensive lesson. Even in partnerships, you're going to learn expensive lessons because no partnership is perfect, but this is why you need to know the difference between direct cause versus expenses.
The root issue is you have to understand your financials. When the IRS comes knocking at your door, especially if you are no longer with that accountant, guess who's going to have to answer all the questions and guess who's going to have to support the documentation and guess who's gonna have to pay the extra tax and penalties.
Yes, you are. You might have a tax accountant that's willing to understand what their part in that situation was. What is more common is for you to come across a tax accountant that's going to be like you signed your return. I'll help you any way I can, but you signed your return. Right? And the reality is that's the truth.
It Starts With Taxes
In the last 10 years, we’ve discovered that it all starts with taxes. We're starting to understand that it's more about the operational visibility and the prediction of what's happening in the business while using the data that your finances represent.
One thing I can say about the entrepreneurs I know is that they love data. They just don’t love the financial data. I’m so guilty of that, especially if it’s not going well.
The IRS wouldn't necessarily say merchant processing fees are the cost of goods sold, but we often put that up in direct cost for our client's financials, because if you're accepting credit cards, you are going to pay that in order to produce a sale. If you don’t have sales, you won’t have that cost. You should understand that as a percentage of your sales so that you know exactly how much money is walking out the door before you even sell the thing.
If you're a service based provider and you discover that 60% of your income is walking out the door before you even get to take care of the client because you've built all these costs into your packages and things that you have to pay for which doesn't always include labor.
Labor is a hard one because sometimes you can attribute it directly to sales and the same person. Then sometimes it doesn't and it's administrative or it's support and it depends on your business and it depends on your goals and it depends on understanding your cash flow. Anything you do when you put in those costs, you're essentially reducing the overall real revenue, which means you as the business owner are gonna get paid less.
So if you decide to just lump everything up there, because you somehow adopt the rationale that it takes all of this to create the revenue, that's not going to help you either. You're gonna be really, really upset, and you're not gonna feel like you're being compensated.
You're not gonna know where to start working through your costs to basically improve the overall and profitability of your business. When we go under the frame of let's raise revenue and increase profitability and do it with as less labor intensity as possible you’re going to start with what are you calling direct costs and what can you do to have an impact on direct costs. That's where the real money is.
It is where the real money is because anything in the expenses as you grow becomes economy of scale expenses, which means is a percentage of revenue they should be going down. But if you don't deal with your direct cost, which is where all the dollars are not the pennies, then you're never going to have enough to pay for your expenses.
What I find that people want to do is they want to go down and they want to deal with all the nickel and dime decisions and they don't actually want to deal with the dollar decisions. Why? Because that's harder to figure out, but it's still just a problem to solve. This is why your profitability and why your cash flow is not improving.
It's important to have the foundation, right? We need to understand what those costs are so that we can file a proper, accurate tax return.
You have to be in a relationship with your accountant because they don't know all these decisions you're making in your day to day. So you have to have some time to spend with them to help make sure they understand. And please, make sure you get their guidance and you're open to what they tell you. They are the experts, after all.
And you need to make sure when you're getting them into relationships with people in your business, that you understand their value system, their philosophy, and their service mindset around how they're going to take care of you when it's good and how they're gonna take care of you when it's just frankly, not so great.
Because there's gonna be both. It matters with this conversation because t's a direct cost and an expense conversation, and every decision that gets made that doesn't get you closer to what you're looking for transformationally is gonna cost you time, energy, and money.
If you want to learn more about direct cost vs expense, check out Episode 097: Direct Costs vs. Expenses & Why You Should Care About Knowing The Difference.