This week, if you have time available, then have a look at how your costs are set up in Xero. It might seem a little irrelevant just now but in an upcoming blog we are going to look at budgeting and and you really need your costs sorted out ahead of setting up a budget in Xero.
To fully understand your profit and loss account, you need to set up direct and indirect costs correctly in your Xero chart of accounts. This is really helpful for everyday reporting and fully understanding your business performance - so doing this now will really benefit you later down the line. It also helps considerably when we begin to set up budgets but that is for next week’s blog.
Remember, direct costs are those that increase or decrease in line with increases or decreases in your sales. So, all your material purchase costs or all of the cost incurred to deliver services (eg. some staff costs or possibly some software licence costs) will all be direct costs and all included in the Costs of Sales (COS). Very simply, if you know there is a relationship between how much you spend on something and how many sales you see coming through then you can class that as direct cost.
When you have a clear set of direct costs then you can easily see your gross profit (sales less COS) and from there you can work out (or see within Xero reports) your Gross Profit Margin (Gross Profit divided by sales multiplied by 100 to give you the percentage).
All other costs that are not directly variable with sales, will show below the Gross Profit part of the Profit & Loss account and be called overheads or expenses. These are your indirect costs. These costs do not change as your sales change. For example, the rent you pay remains the same whether you sell 100 items or 1000 items.
Once you have your costs set up correctly and in a way that makes sense to you (and us), you can ask us to set up your Xero reports so that some of the overhead costs are grouped to make things clearer. For example, if you have staff, you will have a Xero account for wages, one for employer’s National Insurance, another for pension payments, possibly one for training costs and maybe employee healthcare costs. Even though you do want to see each of these separately at times, it is also useful when they are all grouped together under a summary line called “Staff”. It just makes the P&L far easier to read and for you to spot trends (more on that in future blogs).
Hope this helps!