Using Direct vs. Indirect Expenses on the Profit and Loss Statement

Let’s examine the pros and cons of having a Chart of Accounts and, therefore, a profit and loss statement (P&L), which separates Direct vs. Indirect expenses for professional services providers.

If your client provides professional services, such as consulting, website or graphic design, handyman, housekeeping, gardening/landscaping, or perhaps even legal services, they may have in-house expenses (such as employees on payroll).

They may also hire and pay independent contractors to assist in their business, but they are not employees. They will also have costs directly related to producing their services and other everyday costs such as high-speed internet, rent, insurance, and utilities.

Profit and Loss Statement Example

It can be helpful to a business owner to be able to answer these questions:

How much does it cost me to provide my services?
How much are my other expenses, those required to keep the ‘doors open and the lights on’?

A normal profit and loss report (P&L, also known as an Income Statement), which is based on the Chart of Accounts, is organized like this:

Income or Revenues

Cost of Goods Sold
Job Materials/Parts
Payroll - Field Labor
Gross Profit

Expenses

Advertising
Bank Service Charges
Dues & Subscriptions
Insurance
Legal & Professional
Meals & Entertainment
Outside Services – 1099 Vendors
Payroll – Office Staff
Taxes
Travel
Web-Internet
Total Expenses

Net Operating Income

Other Expenses
Other Income
Net Other Income & Expense

Net Income (the proverbial “bottom line”)

Professional service providers don’t really have cost of goods sold, or COGS. COGS is generally defined as, “the direct costs of producing the goods sold by a company.” Since professional services providers provide services, not goods, COGS and gross profit generally don’t appear in their business P&L.

However, just because there are no COGS doesn’t mean that you can’t separate out those expenses that are attributable to providing the services versus those expenses required to keep the doors open and the lights on. This distinction can be shown by using accounts segregated into direct expenses and indirect expenses.

Direct Expenses can be defined as the costs directly tied to producing the services.

Indirect Expenses can be defined as the costs related to maintaining and running a business. This is often referred to as Overhead.

If using direct and indirect expenses, the P&L would look more like this:

Income or Revenues

Direct Expenses

Job Supplies
Job Travel
Payroll [see further discussion below]
Subcontractor Expense
Total Direct Expenses

Indirect Expenses

Advertising
Bank Service Charges
Dues & Subscriptions
Insurance
Legal & Professional
Meals & Entertainment
Outside Services – 1099 Vendors
Payroll [see further discussion below]
Taxes
Travel
Web-Internet
Total Indirect Expenses
Total Expenses

Net Operating Income

Other Expenses
Other Income
Net Other Income & Expense

How to Post Payroll Expenses

It’s okay for payroll costs to appear in both the Direct Expense and Indirect Expense sections of the P&L. The catch is how you submit and track the payroll data with your payroll service provider.

If your client has some employees who only work in the field (such as gardeners) and others who work only in the office (such as the office manager or the payroll clerk), then you can set up “Departments” with the payroll service. Then, when the payroll is entered into the books, it can be itemized from the payroll reports like this:

Direct Expenses

Payroll – Gross Wages, Field Labor
Payroll Taxes – Field Labor
Workers Comp Insurance – Field Labor

Indirect Expenses

Payroll – Gross Wages, Office Staff
Payroll Taxes – Office Staff
Workers Comp Insurance – Office Staff

How to Post Independent Contractors’ Expenses

Independent Contractors (or ICs)

People who are paid non-employee compensation for services provided.

Direct Expenses for ICs

People working with the business owner to provide the business’s core service would fall under Direct Expenses. You can get a specific or generic as you like.

Indirect Expenses for ICs

Vendors who provide more back-end services, such as bookkeepers and tax preparers—and other independent contractors such as an IT person, a website developer, or an office cleaning crew—would go here.

Virtual Assistants (VA)

One of my clients uses a virtual assistant, or VA. The VA provides some front-end services, such as helping the client develop her business presentations, and some back-end services, such as helping the client manage her calendar, organize paperwork, etc.

Since the VA provides two kinds of services, we asked the VA vendor to itemize their invoices (or Vendor Bill in QuickBooks parlance) into two sections: External Admin—which is posted to Direct Expense—and Internal Admin, which is posted to Indirect Expense.

Why Bother?

Now that we’ve reviewed the "how" let’s return to the "why": Why bother going through all this fuss?

I find that when reviewing the financials with my clients, the breakdown of Direct vs. Indirect expenses really helps them see how much they are spending to produce their services versus how much they are spending on overhead costs.

The physical breakdown of Direct vs. Indirect, each with their own totals on the P&L report, helps make the report less of an “eye chart.” In addition, the actual breakdown of the Direct vs. Indirect expenses, particularly in a P&L report with Prior Year Comparison (the year-to-date in one column side by side with the same months last year), helps them eyeball revenues, what it costs to create those revenues, and what all the other expenses were.

This design has a few caveats. First, not all professional service providers, especially Sole Proprietors, have payroll.

Since Sole Proprietors normally pay themselves by taking a draw, the books generally do not reflect how much time they have put into providing their own services, and there is no associated cost for their own time. I will discuss ideas to address this in a separate post.

A second caveat is that not all tax preparers like the Direct vs. Indirect breakdown. When speaking with the CPA for one of my clients, I mentioned that I was planning to reorganize the Chart of Accounts to reflect Direct vs. Indirect costs, and the CPA groaned. They simply were not in agreement that the change would provide added value.

The third caveat is that if you are considering implementing this for an existing QuickBooks file, you will want to be aware that changes to the Chart of Accounts impact prior/closed year’s reporting.

Changes to the Chart of Accounts layout in 2023 will change how reports appear for 2022 and earlier. This may or may not matter, but I highly recommend that the business owner, the bookkeeper, and the tax preparer discuss this together before any changes are made.

Of course, if you are setting up a new client or a brand new set of books, it’s quite easy to create a Chart of Accounts with Direct and Indirect expenses built in from the start.