Direct Costs vs. Indirect Costs - Complete Controller

When defining a product’s price, you need to set it at a point that covers total production costs. Production costs, however, include more than just the cost of raw materials or equipment. Payroll, marketing, and every expense of the company need to be factored in. Direct costs and indirect costs are a combination of all expenses and resources expended by a business to run its operations.

The basic difference between direct and indirect costs is their relation to the product or service being produced. The costs that directly relate to the product and service’s production are referred to as direct costs, such as direct labor, direct material, etc. In comparison, the indirect association is closely related to costs that cannot be directly assigned to the production of a product, such as payroll, cost of employees, depreciation, general expenses, etc. Indirect costs are also known as overhead expenses. The concept may sound simple, but understanding the key differences between direct and indirect costs will allow you to allocate them in your accounting ledger correctly. Check out America's Best Bookkeepers

Direct Costs

Direct costs can be easily attributed to a specified cost object, a product, service, project, or department—for example, raw material, manufacturing equipment, software, and direct labor costs. Raw material and direct labor costs are two of the major direct production costs. For instance, making furniture would include acquiring the wood and labor charges of the carpenter.

The costs of finished raw material are usually counted as directly incurred costs. FIFO tracks them (first in, first out) and LIFO (last in first out), two of the most popular accounting methods to record the product’s availability in stock.

To further understand how direct costs and indirect costs work, you must first understand fixed and variable costs. As the name suggests, fixed costs remain the same over time, while variable costs may alter periodically. Direct production costs are usually variable costs. However, payroll cost is one of the few exceptions that is fixed. Similarly, buying hardware for a smartphone would be counted as a direct, variable cost because it depends on the number of units produced. Check out America's Best Bookkeepers

Indirect Costs

Indirect costs are associated with all of the expenses that go beyond the production of a product. This is the cost of running the business after all the direct costs are attributed. Everything required by a company to run its operations, such as indirect labor, rent, utility bills, and supplies, is indirect costs. These costs are not specified in the production of a single product or service.

Labor costs can also be counted as direct or indirect costs, depending upon the situation. If an HR resource is specifically assigned to the production of a product, the costs are direct. However, the salaries of cleaners and guards are indirect labor costs.

Marketing and advertising are also indirect costs because they do not directly relate to a product’s production. Employee benefits and costs of acquiring accounting services are also indirectly related to production. The indirect cost can also be fixed or variable, depending on how they occur. Rent is a fixed indirect cost, while utility bills are indirect variable costs. Check out America's Best Bookkeepers

Ambiguity

Certain costs lie in the grey area to be counted as a direct or indirect cost. Hiring a consultant, printing, postage, and traveling costs are sometimes the cause of concern because it’s hard to place them in any category. Based on their usage and relevance, what companies do is place these costs in their respective categories.

Companies’ overhead rate is used to preserve liability and help determine the allocation of administrative costs between various departments. It is a ratio of total indirect costs and related direct costs. Departments that bear the highest ratio are allocated a greater share of the indirect cost.

Significance

The way you allocate costs as direct or indirect affects your tax payments as well. All overhead charges such as your electricity and gas bill to run the equipment and machinery are tax-deductible. Therefore, according to IRS rules and regulations, you are supposed to classify all direct and indirect expenses accordingly.

Classifying government grants and funds as direct or indirect costs is highly important as they come with strict policies, which must be adhered to. Failing to do so can have significant consequences for your business at the time of auditing.

Indirect and direct costs are the key to calculating your cost of goods sold, and you cannot set a price of the product unless you figure out the manufacturing cost. Understanding each of them is vital for every business as it helps them to make key strategic decisions.

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