If your gross margin feels “off”, it’s usually a classification problem. This guide explains direct costs in plain English, shows what to put in Cost of Sales (COS/COGS) for service businesses, and gives you a simple COS policy you can adopt today.
Direct costs are the expenses that exist only because a client job exists; everything else is overhead.
Who this guide is for
UK service-based SMEs, professional services, consultancies, creative/marketing agencies, IT/MSPs, recruitment, education & training, and other office-based services.
1) Direct vs indirect costs (the simple version)
- Direct costs are expenses directly linked to delivering a specific service or job for a client. In most small businesses, direct costs are the same thing as Cost of Sales (COS/COGS).
- Indirect costs (overheads) are the background expenses to run the business (rent, admin salaries, core software, insurance, marketing). A cost is either direct or indirect — it can’t be both.
See our core finance formulas for where COS sits in the P&L, and the Gross margin guide for targets and levers.
2) What belongs in COS for service businesses
Think: costs that would disappear if the client/job didn’t exist.
Typically direct (COS) in services:
- Subcontractors/freelancers doing project delivery
- Direct delivery staff time (billable work on the engagement)
- Project-specific software/licences, usage fees, or equipment hire used for that job
- Project travel and out-of-pocket expenses that are client-specific
- Per-transaction/merchant fees that you treat as specific to the sale
3) What does not belong in COS (treat as overhead)
- Directors’ salaries not delivering client work
- Admin/support salaries; HR; finance
- Sales & marketing; business development
- Core software stack used across the firm (email, CRM, PM, bookkeeping)
- Rent, utilities, insurance, training and recruitment
Overheads are not directly related to delivering a specific client job; keep them below gross profit.
4) Grey areas (decide once, write it down)
- Account management: If it’s part of the scoped deliverable, treat the scoped portion as COS; otherwise it’s overhead.
- Salaried delivery teams: Time spent on delivery is COS (tracked to jobs). Admin/BD time is overhead.
- Shared tools: If a licence is bought only for a job (e.g., a one-month specialist plugin), it’s COS; if it’s part of your normal stack, it’s overhead.
- Service cost centres: Support teams that help delivery (QA, tooling) are typically overheads re-apportioned internally for management views, not COS for statutory P&L.
For the pricing impact of these choices, see our Pricing & Markup explainer.
Write a one-page COS policy (by service line) so coding is consistent and your Profit & Loss stays comparable month to month.
5) Worked example, how misclassification distorts margin
Scenario A: Consistent policy (correct coding)
- Revenue £100,000
- COS (subs £22k + delivery time £18k + job software £2k) = £42,000
- Gross profit £58,000 → Gross margin 58%
Scenario B: Sloppy policy (overheads dumped into COS)
- Same revenue and costs, but you put account management (£6k) and core software (£3k) into COS
- New COS £51,000 → Gross margin 49% (-9pp)
One coding choice and your margin looks 9 percentage points worse, leading to under-pricing and bad decisions.
6) A simple COS policy you can copy
- Scope first: Define what “delivery” includes for each service.
- Time rules: Delivery time is COS; admin/BD time is overhead. Timesheet or allocation required.
- Subs & suppliers: Delivery subs are COS; internal contractors (ops/admin) are overhead.
- Software: Project-specific → COS; firm-wide stack → overhead.
- Expenses & fees: Job-specific → COS; general → overhead.
- Approval & review: Finance signs off changes; revisit the policy quarterly.
7) Monitoring (so it sticks)
- Weekly: job/sprint gross profit — revenue, delivery time, subs, job-specific costs.
- Monthly: client and service-line margin in the management pack, published within seven working days.
- Quarterly: sample test coding vs the COS policy and retrain where needed.
For the reporting rhythm, see Management accounts in seven working days.
FAQ: quick answers for service-sector owners
Q1) Are salaried staff “direct”?
Only the time spent on delivery. Track delivery time to jobs and post it to COS; their non-delivery time is overhead. (A cost is either direct or indirect — not both.)
Q2) Are freelancers/subcontractors always COS?
If they’re delivering client work, yes, COS. If they’re admin, ops or marketing, treat as overhead.
Q3) Is software a direct cost?
Project-specific software (short-term, per-job) is COS; your core stack is overhead. Overheads are costs not directly related to creating/delivering the service.
Q4) Are direct costs the same as variable costs?
Not always. Some direct costs can be fixed (e.g., a dedicated contractor on a retainer). “Direct vs indirect” is traceability to a job; “variable vs fixed” is how costs behave.
Q5) Do direct costs equal COS?
For most small businesses, yes, direct costs are the COS/COGS line in the P&L.
Book a 20-minute planning call and we’ll map what truly belongs in your COS, set a gross-margin target by service line, and build a reporting rhythm so you see margin by job, client and service, every month.