Fixed, variable, direct, indirect: What the heck is my accountant talking about?

Your accountant isn’t speaking a secret language when they talk about fixed costs, variable costs, direct costs, and indirect costs. Here’s the secret decoder ring to know what they are talking about (and in a minute I’ll tell you why it matters to you):

Your business incurs costs. (You know that already!)

Your costs can be either fixed or variable, which is a description of how they change over time. (A fixed cost doesn’t change a lot; a variable cost changes quite a bit).

AND…

Your costs can be either direct or indirect, which is a description of how they are associated with production. (Direct costs are associated with specific units while indirect costs are a lump sum that goes into doing business in general and cannot be easily measured with the production of a specific thing).

Every cost is some combination of these elements:

Owning a building is a fixed cost (because it won’t change unless you build another building) and it’s an indirect cost (because you can’t measure it according to the product of a single unit of whatever you make or do).

Product packaging (if you sell a product) is a variable cost, depending on how many products you make, and it’s a direct cost because you can associate each package to a unit made.

Labor is often a fixed cost (unless you run a really seasonal business) and it is a direct cost (because you can see how the effort of your staff are directly associated with the production of a unit of your product or service).

So why does it matter?
Understanding whether your costs are fixed or variable and whether your costs are direct or indirect will help you to run a more profitable business. (Also, it will help you to understand your accountant when they talk to you).

In general, you want to make as many of your costs direct rather than indirect (because direct costs are easier to measure and manage) and you want to reduce your fixed costs as much as possible (because fixed costs don’t change whether you produce 1 unit or 1,000 units).