As a handmade seller, it is particularly important to know the difference between Direct and Indirect expenses as they can have a big impact on your tax calculations at the end of your financial year.
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What are Direct expenses?
As a craft business, you are also a manufacturing business. This means that your Direct expenses are the costs associated with the materials used in the production of your goods for sale.
Common examples of Direct expenses for different types of craft business are:
- Yarn
- Buttons
- Ribbon
- Clasps
- Flour
You’ll notice that these items are all consumable :they are used up whenever you include them in your manufacturing process.
For most handmade businesses, Direct expenses will be the bulk of your overall expenses during the year. These expenses need to be handled and claimed differently to other expenses as they form your Cost of Goods Sold figure that you’ll need to provide to the IRS on your Schedule C form.
To do this, materials purchased need to be treated as your asset rather than just an expense. This basically means that you will not claim the expense in the financial period when you incurred it, but rather when the asset eventually converts into your COGS (Cost of Goods Sold).
This conversion from your inventory asset to COGS happens when you sell the product you have made, which may be in a different financial period altogether.
It is your COGS that will form your claimable expense come tax time for all indirect expenses (rather than a simple sum of your purchased materials).
What are Indirect expenses?
All other expenses that are not related to the making of your handmade items are thus considered Indirect costs (they are indirectly related to the production of your products).
These are expenses such depreciation, rent repairs and electricity. As these costs cannot be directly factored into your COGS, they are thus claimable within the financial period they are incurred. On a Schedule C form, they would be accounted for via your Part II.
