Difference Between Direct Cost and Indirect Cost

Direct costs are company costs associated with a specific product or service, whereas indirect costs are business costs associated with the overall firm. The concept is important when determining the cost of a specific product or activity because direct costs are always used to calculate the cost of something, whereas indirect costs may not be considered in such a cost analysis. It can be difficult to develop a cost-effective methodology for assigning indirect costs; as a result, many of these costs are classified as corporate overhead or production overhead, which exists even if no specific product is created or an activity is performed.

Direct costs are typically variable, whereas indirect costs are more likely to be fixed or periodic. Let's examine direct costs and indirect costs more closely, with examples, analysis, and explanations of why it's important to know the difference.

Direct Cost

In accounting, direct costs are those that are directly related to a cost object (such as a specific project, facility, function, or product) . The comparable term in economics is specific cost. Direct costs can be constant or variable, but they often include materials, labor, and specialized charges, such as a royalty payment to a patent holder for a specified production process. all of which are directly traceable to a cost object. Thus, by industry,

• Direct costs in construction include the costs of materials, labor, equipment, and any other directly associated efforts or expenses for the cost object itself.
• Direct costs in project management refer to activities or services that benefit specific projects, such as project staff salary and materials. Because these activities may be easily linked to projects, their expenses are typically charged to projects on an item-by-item basis.
• In manufacturing or other non-construction businesses, the portion of operating costs that can be directly assigned to a single product or process called a direct cost.

In contrast, indirect costs are those that are not directly related to a cost object. (such as a specific project, facility, function, or product). These include administrative, staff, and security expenses. A joint cost is a cost incurred during the manufacture or delivery of multiple items or product lines. For example, in civil aviation, significant flight costs (pilots, fuel, plane wear and tear, landing and takeoff fees) are shared by carrying passengers and freight, resulting in economies of scope across passenger and freight services. In contrast, some prices are exclusive to the services; for example, meals and flight attendants are specific costs of transporting passengers. Direct costs are directly related to revenue; if no sales are made, no direct costs are generated. Other expenses, like as running expenses, occur regardless of sales or revenue. Office rent, for example, would be an operating expense but not a direct cost, but raw materials would be a direct cost because they are related to income. Operating expenses affect a company's net profit, whereas direct costs effect the net profit.

Indirect Cost

Indirect costs are those that cannot be explicitly attributed to a cost object (such as a specific project, facility, function, or product). Like direct costs, indirect costs might be constant or variable. Indirect expenditures include administrative, staff, and security expenses. These are expenses that are not directly tied to production. Some indirect expenses may be overhead, but others can be clearly connected to a project and are considered direct costs.

There are two categories of indirect costs. One is fixed indirect costs, which are unchanged for a particular project or company, like transportation of labor to the working site, building temporary roads, etc. The other category includes regular indirect expenditures that repeatedly occur for a certain organization, such as record keeping or salary payments.

Understanding the Difference

According to Jane de Vos, a self-employed strategy and operations consultant at the Association for Project Management, a direct cost is 100% attributable to a specific good or service you offer. "Everything else you need to run your business is an indirect cost." If determining the overall cost of goods sold (COGS), you may need to account for both direct and indirect costs. Why is it crucial to distinguish between direct and indirect costs? Being aware of the difference could improve your ability to determine your company's profit margin and give you a more comprehensive grasp of all of your costs. De Vos says, "If you know your direct costs, you can work out the profit margin for each product or service to find out how much profit you're making." Direct costs are expenses that are directly related to the production of a product and can be directly associated with it. Direct costs are typically variable costs, with the possible exception of labor costs. Indirect costs are those that are not directly related to a particular cost object. Indirect costs can be fixed or variable. "Therefore, you can determine which product is most profitable is there something that is truly more profitable to sell because it is cheaper to produce?"

Direct and Indirect Costs on the Income Statement

The income statement summarizes a company's revenue and expenses over a specific period. The concept of direct/indirect costs must be understood when manually creating or assessing an income statement in order to allocate operating costs correctly. While there are exceptions to the rule, the majority of direct costs are recorded under the cost of goods sold (COGS) line item. In contrast, indirect costs are recorded under operating expenses.

Key Differences Between Direct and Indirect Costs

The basic differences between direct and indirect costs are given as follows:

• Direct Cost refers to the cost that can be easily assigned to a specific cost object. Indirect cost is the cost that cannot be attributed to a specific cost object.
• Direct Costs benefit a single product or project. In contrast, indirect costs benefit multiple products or projects.
• Prime cost is the sum of all direct costs, while overheads are the sum of all indirect costs.
• Direct cost is traceable, whereas indirect cost is not.
• Direct costs are divided into three categories: direct material, direct labor, and direct expenses. Indirect costs are classified as production overheads, administration overheads, and selling and distribution overheads.

Special Considerations

Business expenses can sometimes be divided into direct and indirect costs. Some expenses, such as power, may fall into both categories or switch between them, depending on your company's production system. Electricity used to power machinery and produce raw materials for manufacturing products would be classified as direct costs. However, the electricity used to power the lights and fans in employee cubicles may be an indirect expense. These special considerations can also apply to phones. For example, "You don't need a phone service to manufacture a steel rod, but you do need phones to sell them," Ryan McEniff, a Massachusetts-based business owner, told The Balance via email. Another example is the pay of administrative staff. Labor costs, such as a chef's salary in a hamburger restaurant, are direct costs, whereas administrative expenses are indirect costs, and administrative-staff labor costs fall somewhere in between.

Difference Between Direct and Indirect Costs

Conclusion

Understanding the direct and indirect costs is critical. Without proper cost allocation and attribution, businesses cannot calculate profit per unit when selling their products or services. As you are aware, direct costs are identifiable. The business faces a challenge with indirect costs. For unidentifiable costs, the company can determine how much it can expand long-term and then calculate the benefit. It's similar to understanding fixed and variable expenses. Understanding how they work will make it easier for you as a business to use them effectively.