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When defining the price of a product, 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 needs to be factored in. Direct costs and indirect costs are a combination of all expenses and resources that are expended by a business in order to run its operations.

The basic difference between direct and indirect costs is based on their relation to the product or service being produced. The costs that have an immediate relation to the product and service’s production are referred to as direct costs, such as direct labor, direct material, etc. While the indirect association is closely related to costs that cannot be directly assigned to the production of a product such as a 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 costs and indirect costs will allow you to correctly allocate them in your accounting ledger.

Direct Costs

Direct costs are the costs that can be easily attributed to a specified cost object which can be a product, service, project or a 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 the cost of acquiring the wood and labor charges of the carpenter.

The costs of finished raw material are usually also counted as directly incurred costs and they are tracked by FIFO (first in first out) and LIFO (last in first out), which are two of the most popular accounting methods to record availability of the product in stock.

To further understand how direct costs and indirect costs work, you must first gain an idea about 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 a hardware for a smartphone would be counted as a direct, variable cost because it depends on the number of units to be produced.

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 that is required by a company to run its operations such as indirect labor, rent, utility bills, and supplies are counted as indirect costs. These costs are not specified in the production or 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 have any direct relation to the production of a product. Employee benefits and costs of acquiring accounting services are also indirectly related to the production. 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.

Ambiguity

There are certain costs that 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 for concern because it’s hard to place them in any one category. What companies do is, based on their usage and relevance, place these costs in their respective categories.

An overhead rate by companies is used to preserve liability and to assist in determining the allocation of administration costs between various departments. It is basically 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 has an effect on 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 really set a price of the product unless you exactly 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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