Direct Cost Definition
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As we near the end of the year, it is time once again to really dive into those financials and start setting budgets and targets for next year. While your attention is there, I would like to encourage you to also review your overall accounting classifications and methods to ensure you are tracking in a manner that gives you timely and accurate reports you can use to manage your business.
Earlier this year, Emma Shinn ran the following article in our newsletter. As you may know, Emma wrote the book on Accounting and Financial Management for the industry and so I would like to share her article with you. If you can set up your direct construction cost codes to reflect what Emma outlines in this article, I am sure you will see some telling information in your future financial reports.
The first step to produce accurate and valid reports and measurements is the proper classification of the financial information collected and summarized in the accounting system. Trash-in; trash-out cannot be truer than when related to the processing of financial information. At the same time, when proper classification of each financial transaction occurs, you end up with a gold mine from where to pull meaningful measurements and reports.
We recommend you classify financial transactions using the structure set up by the NAHB chart of accounts which identifies the functional areas present in each and every home building company. By classifying the transactions by functional areas, management can evaluate the performance of each one of their business components.
Starting with revenues, make sure each source of revenue is identified and separate revenue accounts are used for different sources of revenue; ie: lot sales, house sales, remodeling, commercial, etc. Cost of sales classifications need to follow the revenue accounts accumulating the cost by source to properly compare with the revenue amount and be able to identify the efficiency of each activity.
Cost of sales might include more than one cost component, such as cost of the lot and the building cost. Even though both are part of cost of sales, it is important to be able to segregate both components into two separate accounts to facilitate performance analysis. The building cost should include only the direct construction cost. This measurement then indicates the effectiveness and efficiency of building the structure in terms of materials and labor to erect the structure. Indirect construction cost, financing expenses, sales and marketing expenses, and general and administrative expenses represent the four major functional areas in any home building company. Accumulating cost and expenses under each one of the functional classifications allows management to measure how efficiently each area is performing.
One common area of confusion is what should be classified as direct construction cost and what as indirect construction costs. The difference between direct and indirect costs is pretty clear except for a few instances. Direct cost includes the sticks and bricks and labor to put them up. On the other hand, indirect costs are the cost associated with managing the construction process. Other functional expenses often refer to as soft cost, typically financing charges and sales commissions are neither direct nor indirect costs; they are what they are, financing expenses and sales and marketing expenses.
In some instances however, we take some of the direct cost and treat them as indirect cost to facilitate the cost tracking process; for example, common labor, temporary electric, portable toilets, trash removal and other miscellaneous type of costs. It is very time consuming for a large volume production builder to tract these cost on a per unit basis as in many instances one invoice relates to more than one house. For the small custom builders it might make sense to allocate these costs to each house especially when they are building under a cost plus contract. For the production builders it is more expedient and easy to track and manage if these costs are accumulated by community and not brought to the house level.
We like to keep the different classifications in the accounting system very clean with just one type of cost or expense per classification to facilitate the management of each area. --
Emma Shinn, Shinn Consulting
Emma S. Shinn wrote the book on Accounting and Financial Management for the home building industry, which is now in its 5th Edition. For over 30 years, as a prominent speaker and consultant for the industry, Emma has assisted many builder clients clarify and streamline their financials to get clear, accurate reports that management can use to make tough decisions and increase profitability within their organizations. For more information, contact Emma Shinn at 303.972.7666, or eshinn@leeevansgroup.com.