Direct Costs vs. Indirect Costs: Understanding Each


    For budgeting and accounting purposes, it’s crucial not only to document your business expenses but to classify them properly.

    The distinction between “direct” and “indirect” costs may appear intuitive and self-explanatory. While it’s true neither word takes on a dramatically different meaning when categorizing the various costs of doing business, there’s a bit more nuance in practice.

    Direct costs are traceable to the production of a specific good or service. The operative word is “specific.” Indirect costs may be necessary to production, but they are not traceable to the act of production. Indirect costs are those necessary to keep your business in operation. Think of them as the prerequisites for the production of any specific good or service.

    It’s important to have a solid understanding of the distinction between direct and indirect costs when pricing your products. When you know the true costs of production, you can price both competitively and accurately. You’ll also demonstrate, more clearly, the efficiency of your business practices to potential investors. The distinction is equally important when filing your tax returns. You’ll save time, and more than likely, money: Certain costs, both direct and indirect, are tax-deductible.

    Direct costs are expenses that a company can easily connect to a specific “cost object,” which may be a product, department or project. This includes items such as software, equipment and raw materials. It can also include labor, assuming the labor is specific to the product, department or project.

    For example, if an employee is hired to work on a project, either exclusively or for an assigned number of hours, their labor on that project is a direct cost. If your company develops software and needs specific pregenerated assets, such as purchased frameworks or development applications, those are direct costs.

    Labor and direct materials, which are used in creating a specific product, constitute the majority of direct costs. For example, to create its product, an appliance maker requires steel, electronic components and other raw materials. Two popular ways of tracking these costs, determining whether and when your company actually uses materials in production, include last in, first out (LIFO) or first in, first out (FIFO). This can be helpful when the costs of materials fluctuate in the course of production.

    The majority of direct costs are variable. When direct costs vary, it’s because they increase as additional units of a product or service are created. For example, smartphone hardware is a direct, variable cost because its production depends on the number of units ordered. A notable exception is direct labor costs, which are usually fixed, and remain constant throughout the year. Typically, an employee’s wages do not increase or decrease in direct relation to the quantity of a product.

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