Everything you need to know about direct and indirect costs [explained by a Certified Accountant] Show
Emilie N.- FCCA, CB, MBS Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups. Explanation: What Are Direct and Indirect Costs?Definition: What are Direct Costs?Direct costs are business expenditures directly attributable to a specific cost object–such as a particular product, service, customer, project, department, facility or region–which include direct labor, materials, supplies, and products for resale. For example, retailers spend money buying products wholesale and manufacturers spend money on raw materials and labor. All other costs are considered to be indirect costs. Definition: What are Indirect Costs?Indirect costs, or overheads, are operating expenses that are not directly traceable to a single product, service or other specific cost object. Instead, indirect costs affect several cost objects, or support the overall company operations, such as administrative, insurance or utilities expenses. Indirect costs are also referred to as:
For example, it may not be possible or financially feasible to precisely determine how the activities of company directors benefit a particular product, service or project. Similarly, a company may not be able to easily assign a utility bill (e.g., electricity, water, waste collection) to a particular cost object (e.g., department) because the utilities were used by the whole building. Top 20 Examples: What Are Examples of Direct and Indirect Costs?The most commonly used examples of direct costs are direct labor, direct materials, manufacturing supplies and sales commissions. Common examples of indirect costs include rent, utilities, office expenses, as well as expenditures associated with general administration, selling and distribution. Top 8 Direct Costs ExamplesThe most common examples of direct costs include the following expenditures, assuming they are specific to a cost object, such as a product, service, department or project.
Top 12 Indirect Costs ExamplesThe most common examples of indirect costs include the following expenditures, assuming they are not specific to a cost object, such as a product, service, department or project.
Direct vs. Indirect CostsCombined, direct and indirect costs represent all of the expenses incurred to run a company’s day-to-day business operations. The key difference between direct and indirect costs is in how closely they relate to business output:
In an example of a car manufacturer, the materials like steel, plastic or glass used in the car production line are classified as direct costs. Indirect costs would be the utilities, administrative and marketing expenses and salaries involved in running of the overall business that cannot be easily assigned to a specific car production unit. Tip: How to Distinguish Direct Costs from Indirect Costs?In practice, it is possible to justify the classification of almost any expense as both direct and indirect. To make the matter even more complicated, direct and indirect expense categories can vary among different industries and even within the same business. Continuing with the example of a car manufacturer, the factory staff could be categorized as direct labor if they are working on a production line of one car model, whereas a supervisor overseeing multiple production lines and processes would likely be in the indirect labor category. So, how do you tell them apart? Here’s the trick: The rule of thumb for distinguishing direct and indirect costs is to ask two questions:
Top 7 Differences Between Direct and Indirect CostsLooking more closely, there are 7 main differences between direct costs and indirect costs:
Keep reading to find out more about each of these differences >>> Are Direct Costs Variable & Indirect Costs Fixed?Indirect costs are sometimes referred to as fixed costs, which is not necessarily an accurate classification. Let’s debunk this myth right now >>> Direct and indirect costs can be fixed or variable depending on how they change based on output of production or service provision. Indirect costs are more likely to be fixed, meaning they remain the same over time regardless of output. Direct costs are typically variable and fluctuate with output. Both direct and indirect costs can be fixed and variable, depending on how likely or regularly the cost is to change as business output grows: Fixed CostsFixed costs remain the same no matter what volume of goods and services a business generates, such as rent, insurance or salaries paid irrespective of hours worked.
Variable CostsVariable costs vary based on the output volume of units produced or services provided, such as materials and wages used in the production process.
Although most direct costs tend to be variable, there are exceptions to the rule and some direct costs may be considered fixed. Let’s take a look at the example of labor costs, which is an expense that is notoriously difficult to label >>> Labor Example: Is Labor Direct or Indirect Cost?Labor can be direct or indirect cost depending on how directly the work is related to delivering sales.
Formula: How to Calculate Direct and Indirect Costs?Direct Cost Calculation FormulaDirect costs are calculated by adding up all the materials, labor and other expenses that directly contribute to the production of a single cost object, such as a unit of product or service. The direct cost formula is as follows:
Indirect Cost Calculation FormulaIndirect costs, or overheads, are calculated by adding up all the costs of running a business that go beyond the production of a product or service, after all direct costs have been computed and attributed. The indirect cost formula is as follows:
Accounting: What Are Direct & Indirect Costs in Financial Statements?
Keep reading to find out! >>> Measurement & Valuation: How to allocate direct and indirect expenses?While direct costs can be easily attributed to a single cost object, indirect costs need to go through an allocation process to be assigned to a product, service, project, department, or other cost object. Direct Costs = AttributionDirect costs need to be properly tracked, measured and valued so they can be correctly attributed directly to a specific cost object, such as a product, service or business unit. For example, if the price of an essential component used in the production of goods fluctuates over time, the value of a cost item can be assigned based on which item was added to inventory first (method known as FIFO or first-in-first-out) or last (LIFO or last-in-first-out). Accordingly, the unit cost of production would be measured using the newest or oldest inventory items. Although indirect expenses tend to be more difficult to allocate because their connection to a specific cost object is not always readily apparent, every business needs a reliable way to identify, quantify, assign and control them to achieve optimal financial health. This is especially true for entities with high ratio of indirect to direct costs. Indirect Costs = AllocationIndirect costs first need to be added together into a cost pool and then allocated out to cost objects pro rata in a fair and proportionate way, typically by dividing up the total shared pool of expenses based on cost drivers, such as usage, revenue generated or physical dimensions. For example, factory overhead costs can be apportioned to each unit produced by the total number of products manufactured, or based on the number of hours it took to manufacture each product. This helps a company to calculate the overhead cost per unit so that prices can be set accordingly to ensure a profit is made on each product even after incorporating all indirect expenses. In practice, there are several costing methods used to allocate indirect costs, such as activity-based costing (ABC) or fixed cost classification. Each method has its own pros and cons, for example in terms of impact on pricing, financial reporting and taxation. Presentation: How are direct and indirect costs reported on an income statement?Direct and indirect costs are reported under two separate line items on an income statement:
This is an example of how direct and indirect costs appear on a company’s income statement.
Let’s take a look at Cost of Goods Sold, Operating Expenses and Profit Margins in more detail >>> Cost of Goods Sold (COGS)Cost of goods sold (COGS) on a company’s income statement is the accumulated total of direct expenses and allocated indirect expenses used to produce the specific products and services that were sold in a certain reporting period. Variations of the cost of goods sold line item in an income statement include:
Compared to direct costs, COGS/COS/COR is a broader term that encompasses all the cost related to production of an item, including not only the direct cost of materials and labor, but also any allocated overhead expenses.
Any finished goods that remain unsold are kept on a balance sheet as an asset. For that reason, a company may decide to classify certain costs as operating expenses instead of COGS. For example, a business may incur some direct labor costs even if it does not sell a single product/service. Operating Expenses and SG&AIndirect costs that are not included in the cost of goods sold (COGS), because they are not easily attributable to the production of specific goods and services, are instead recorded in the income statement under Operating Expenses or Other Selling, General and Administrative Expenses (SG&A). Profit MarginsCost of goods sold (= direct costs + allocated indirect costs) is subtracted from sales revenue to calculate gross profit and gross profit margin; with the operating expenses (= unallocated indirect costs) then being subtracted from gross profit to arrive at operating profit and operating profit margin. Profit margins serve as a good measure of how efficient and profitable a company is at providing its products and services. The profit margins should be healthy enough to comfortably accommodate both direct and indirect expenses–and generate a net profit.
Analysis: Are High or Low Direct & Indirect Costs Better?While acceptable rates vary from industry to industry, lower direct and indirect costs are generally preferable because they indicate efficient operations and solid profit margins, allowing a company to either pass the savings on to customers through lower prices or reinvest into the business. Hence, mastering cost management is an important part of running and growing a business. Importance: Top 5 Benefits of Cost ManagementUnderstanding the true total cost of producing goods and services enables a business to make sound decisions, particularly in the areas of pricing, budgeting, operational efficiency, and taxation. 1. ProfitabilityA business that accurately classifies and consistently tracks both indirect and direct expenditures can set its pricing to make sure that its customers pay more than it costs to offer the products or services (e.g, break-even point plus profit margin), with the aim to turn a profit while remaining competitive. 2. EfficiencyContinuous monitoring of direct and indirect expenses provides valuable insights into the efficiency of business operations to identify areas for improvement and cost optimization. 3. BudgetingCorrect allocation of direct and indirect costs leads to more accurate and transparent budgeting, forecasting and cash flow planning, as well as reporting for management and financial purposes. 4. TaxationProper cost classification will also come in handy when it is time to file a business tax return as some direct and indirect expenses may be tax deductible. 5. GrantsWhen an entity accepts a grant, such as government funding, the funding guidelines typically stipulate what qualifies as a direct versus indirect cost, along with any threshold amounts for each cost type.
Emilie N., FCCA, CB, MBS Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups. Sign up for our Newsletter Get more articles just like this straight into your mailbox. |