Everything you need to know about direct and indirect costs [explained by a Certified Accountant]
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.
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.
The 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.
The 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.
Combined, 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.
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:
Looking more closely, there are 7 main differences between direct costs and indirect costs:
|Direct Costs vs. Indirect Costs: Top 7 Differences|
|Difference||Direct Costs||Indirect Costs|
|1. Also known as||Overhead Costs, Cost of Goods Sold (COGS; manufacturing), Cost of Sales (COS; retail), Cost of Revenue (COR; services)||Operating Expenses; SG&A (Selling, General and Administrative Expenses)|
|2. Allocation||Directly and easily attributable to a single one specific cost object without the need for allocation.||Allocation required as they apply to multiple cost objects or an entire entity.|
|3. Examples||Direct materials, direct supplies and direct labor||Selling, general and administrative expenses (SG&A)|
|4. Calculation formula||Direct Costs = Direct Materials + Direct Labor + Other Direct Expenses||Indirect Costs = Total Costs - Total Direct Costs|
|5. Fixed or variable||More likely to be variable and change with output levels||More likely to be fixed and remain the same independently of output levels|
|6. Financial statements||Sold: Income Statement >>> Cost of Goods Sold||Sold and allocated to cost object: Income Statement >>> Cost of Goods Sold|
|Unsold: Balance Sheet > Assets||Unallocated: Operating Expenses|
|7. Profit Margin||Gross Profit Margin||Operating Profit Margin|
Keep reading to find out more about each of these differences >>>
Indirect costs are sometimes referred to as fixed costs, which is not necessarily an accurate classification. Let’s debunk this myth right now >>>
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:
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 Costs: Direct or Indirect? Fixed or Variable? [Examples]|
|Direct||Salary of a production supervisor who oversees the manufacturing of one specific product. The manager’s salary is fixed regardless of how much of the product the company makes and sells.||Factory hires hourly workers to assemble one specific product. As the workers are paid per hour, the total of wages paid is variable and fluctuates with the volume of units of that particular product manufactured in the facility.|
|Indirect||Salary of a production supervisor who oversees the full manufacturing process of a company’s entire product line encompassing many different products. The manager’s salary does not change based on how much product the factory makes and sells.||Hourly-paid employees or contractors working in administrative roles (e.g., accounting, legal, IT) who need to work more hours during the busy season (e.g., Christmas).|
|Salaries administrative employees who make the overall production process possible, such as accountants, lawyers, IT staff, marketing staff, and senior managers.||The equipment maintenance expense and the temporary shipping clerks could be a variable indirect product cost, since this cost will vary with production volume.|
|In both cases, it would be difficult or impossible to determine how much of their salaries should be allocated to producing a specific product.||In both cases, the increase in wages is driven by the increased production, but the payroll cannot be directly attributed to a particular product or service.|
The direct cost formula is as follows:
The indirect cost formula is as follows:
Which is equal to:
Keep reading to find out! >>>
Direct 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 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.
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.
|Income Statement: Example of Direct & Indirect Costs|
|Profit & Loss Item||Direct/Indirect Costs||Amount ($)|
|Cost of Goods Sold (COGS)||= Direct costs and allocated indirect costs||($20,000)|
|Gross Profit (Gross Profit Margin)||$80,000|
|Operating Expenses||= Unallocated indirect costs||($40,000)|
|Operating Profit (Operating Profit Margin)||$40,000|
|Non-operating Expenses (e.g., tax, interest)||($5,000)|
|Net Profit (Net Profit Margin)||$35,000|
Let’s take a look at Cost of Goods Sold, Operating Expenses and Profit Margins in more detail >>>
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.
Cost 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.
|Profit Margin: Direct/Indirect Costs|
|Profit Margin||Profit Margin Calculation||Direct/Indirect Costs|
|Gross Profit Margin||Gross Profit Margin = Revenue - Cost of Goods Sold (COGS)||COGS = direct costs + allocated indirect costs|
|Operating Profit Margin||Operating Profit Margin = Gross Profit Margin - Operating Expenses (SG&A)||SG&A = unallocated indirect costs|
|Net Profit Margin||Net Profit Margin = Operating Profit Margin – Non-operating Expenses||Non-operating expenses = interest + tax + other|
Hence, mastering cost management is an important part of running and growing a business.
Understanding 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.
A 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.
Continuous monitoring of direct and indirect expenses provides valuable insights into the efficiency of business operations to identify areas for improvement and cost optimization.
Correct 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.
Proper 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.
When 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.
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