Direct Cost Vs. Indirect Cost: How Can One Determine Whether a Cost Is Direct or Indirect

Definition

Direct costs are costs that can be traced to a specific cost object or particular sponsored project, such as services, products, or departments. They are typically variable costs that change with production volume but can also be considered fixed costs. Direct costs are directly involved in the development, manufacturing, and release of products.

Direct Costs Examples

What are the cost objects in direct costs, to be specific? Here are examples of direct costs to help you better visualize what the term means:

• Direct Labor Costs: The hourly wages, overtime pay, and employee benefits are related directly to the particular production lines, so direct labor is considered a direct cost.
• Manufacturing Supplies: Machines, tools, or other equipment used for manufacturing products are direct costs since they tangibly contribute to the production.
• Raw Materials: Direct materials explicitly contribute to the production of goods or services and are direct expenses.
• Fuel/ Power Consumption: If you can calculate the power it takes to make one item, that power is considered direct cost. Overhead power, however, is not considered a direct cost since this is the cost you owe your power provider and does not tie directly to the production of goods or services.
• Transportation: Transportation, or freight, is a direct cost if you pay for shipping or transportation between production and sales locations. It might not be a direct cost, however, when the transportation stays the same regardless of the volume of production. It is then an indirect cost instead.

Indirect Costs Definition

Indirect costs are costs not directly associated with a sponsored project, instructional activity, or institutional activity but are incurred in support of common or joint objectives.

In other words, it refers to costs that do not relate directly to a cost object, such as a function, a product, or a department. Instead, they refer to costs that are necessary for the operation and health of the company. Other types of indirect costs are overhead costs, administration costs, and security costs.

These costs are identified, aggregated, and then assigned to particular cost objects within an organization.

Examples of Indirect Costs

Indirect costs are the opposite of the previously mentioned ones. The following are examples of the most common indirect expenses:

• Rent: Rent is part of every business operation - it is the fee you pay to provide your employees with a space to work. It can’t be tied directly to the production or manufacturing of a specific unit of product; thus, it is an indirect expense.
• Utilities: Even though utilities don’t directly produce goods, paying for the utility means there is electricity, light, and water so that your employees have a functional office space to work in.
• General Office Expenses: General office expenses may include office supplies, desktop computers, or cell phones. Again, these indirect expenses aren’t directly related to the production process. They are, however, essential items for a smooth office operation. For instance, your administrative team might need to send out physical emails to clients, or your marketing team needs to print posters for a certain marketing campaign.
• Selling Expenses: In addition to administrative expenses, selling expenses are also considered an indirect cost. They involve the cost of marketing, social media, travel and trade shows, sales team benefits, and bonuses.

What Are the Differences Between Direct and Indirect Costs?

The most notable differences between direct and indirect costs are their tangibility and measurability.

• Tangibility: Direct costs are easy to identify, track, and manage. They are directly related to outputs or services and can be assigned to individual clients or products. Generally, direct costs are easier to forecast and manage than indirect costs, as they are not directly linked to specific activities. Indirect costs include expenses that aren’t directly associated with a specific product or service.
• Measurability: Direct costs, such as commissions and raw materials, are easily quantifiable and allocable to customers. On the other hand, indirect costs, including utilities and property expenses, pose greater challenges in terms of tracking and allocation. The assignment of indirect costs to specific products and services presents a notable challenge.

Why Does Knowing the Difference Matter?

Did you know that approximately 10% of startups fail within their first year? As said by the U.S. Bureau of Labor Statistics (BLS), the likelihood of startup failure increases over time, with the highest proportion of failures occurring in businesses younger than ten years old. Ultimately, around 90% of startups do not succeed in the long run. In summary, only about one in ten traditional startups will survive over their lifetime.

Seeing such statistics, it is crucial for a business to thoroughly understand the costs associated with a business operation to increase its chance of survival. Even if you are an established business, it will never hurt to refresh your memory when it comes to general business expenses.

By distinguishing the differences between direct costs and indirect costs, businesses enjoy the following benefits:

• Accurate income statements
• Tax deductibles
• Accurate and competitive pricing
• A stronger grasp of accounting
• Improved budgeting, resource allocation, and forecasting
• Insight into the company’s profits.