Direct Costs vs Indirect CostsDefined, Examples & Comparison

Written By:
Adiste Mae

In running a business, you’ve probably come across various expenses.

You’ve also probably noticed that some expenses can be directly attributed to the products or services your business is offering, while the other expenses, although necessary, you really can’t connect to any of your products or services.

These are what we refer to as direct costs and indirect costs.

As a  business owner, it’s important to know what expenses you’re spending on.

If you’re a frequent visitor of this page, you may have already read about “cost of sales” (also referred to as cost of goods sold or cost of service).

While it is often easy to identify which costs can be directly attributed to a product, business owners oftentimes mistakenly lump all indirect costs as operating expenses.

While this is not an issue when using variable costing, it could be when using absorption costing (which is required by GAAP for external reporting).

Under absorption costing, the cost of goods sold includes both direct costs (e.g. raw materials, direct labor) and indirect costs (e.g. indirect labor, factory supplies, manufacturing overhead).

Having an understanding of which costs are direct or indirect will make it easier for you to account for your costs properly.

It also helps in identifying problem areas in operations or productions.

For example, if you notice an unusually large expense that can be traced to one of your products, then it’d be easier for you to think of courses of action.

Direct cost- what is it?

Direct cost refers to an expense that can be directly attributed to a business’s product or service.

Direct costs will always form part of a business’s cost of sales.

Common examples include materials and labor that are directly involved in the manufacturing of a product, the cost of products sold, or the costs of materials needed to complete a service.

While it is common for direct costs to be variable, it should be noted that direct costs are not always necessarily variable costs.

Take for example the pay of employees directly involved in the production of a product.

While it is common to be paid with hourly wages, it could be that some of them are being paid monthly salaries (which is a fixed expense).

What’s considered as a direct cost will greatly depend on the type of business.

For example, in a factory setting, direct costs will include direct materials, direct labor, and other expenses that can be directly associated with the production of a product.

In a retail setting, direct costs would include the cost of products being sold and freight if it is paid for by the business.

In a school setting, the salaries and wages of the teaching staff, and the cost of teaching materials and supplies will form part of the direct cost.

Indirect cost – what is it?

Indirect cost refers to an incurred expense that cannot be directly attributed to a business’s product or service.

Indirect costs apply to more the just one business activity. By that, it means that it cannot be assigned to a specific product, service, or business activity.

Common examples include rent, the cost of utilities, salaries and wages of employees not directly involved in the manufacturing of a product, etc.

Indirect costs are often fixed expenses but they can also be variable expenses.

For example, rent is a fixed cost, but the wages of the administrative staff are a variable cost.

Indirect costs can be further categorized into two sub-categories: indirect costs that were incurred in manufacturing operations referred to as manufacturing overhead, and indirect costs that were incurred for general and administrative functions referred to administrative overhead.

Manufacturing overhead will form part of the cost of sales under absorption costing.

Administrative overhead will always form part of a business’s operating expenses.

Examples of manufacturing overhead are as follows:

• Indirect labor such as the salary of the plant supervisor, wages of janitorial staff, wages of the maintenance crew, etc.
• Indirect materials and supplies used in the manufacturing of products such as oil, cleaning supplies, lubricants, glue, etc.
• Depreciation on the assets used for manufacturing of products
• Utilities for the plant/factory (note that utility costs that can be directly attributed to certain machinery and equipment are considered direct costs instead)
• Rent on the assets used for manufacturing of products

Manufacturing overhead is typically incurred by businesses involved in the manufacturing of products. Businesses that do retail and/or wholesale typically won’t have manufacturing overhead.

Examples of administrative overhead are as follows:

• Salaries and wages of office staff and other employees not involved in the manufacturing of products
• Office supplies
• Rent and utility costs on the building or space where the administrative function is held
• Internet and communication costs
• Travel and transportation expenses of office employees, sales personnel, or any employees that are not involved in the manufacturing of products
• Repairs and maintenance expenses on vehicles used by sales personnel

Basically, any expense that is not, in any way, involved in the manufacturing of products is an administrative overhead.

In a way, administrative overhead relates to a business’s operating expenses.

They may not contribute directly to the cost of a product, but they are still necessary expenses for the continued existence of the business.

Direct Cost VS Indirect Cost

The main difference between direct costs and indirect costs is that only one of the two can be directly attributed to a product, service, or business activity – direct costs.

As such, direct costs will always form part of a business’s cost of sales. Indirect costs on the other hand can form part of either cost of sales, or operating expenses.

Although direct costs are often variable and indirect costs are often fixed, both direct and indirect costs can be fixed, variable, or mixed. For example, indirect labor, which is an indirect cost, can either be variable (hourly wages) or fixed (monthly salaries).

Let’s have an illustration to make the distinction clearer.

Let’s use a sandwich shop as an example.

To start things of, a sandwich shop would serve sandwiches.

To make a sandwich, you would need bread, the filling (it could be ham, shredded chicken, pulled pork, etc.), the spread or accompaniment, and someone who would make the sandwich.

The cost of all these things will form part of the sandwich shop’s direct costs.

To run the sandwich shop, a space for the actual shop would be needed.

Let’s assume that the sandwich shop rented space for its actual shop.

The shop will then incur utility costs for the freezer, oven, display rack, etc.

In addition to the person responsible for making the sandwiches, the owner also employed someone to man the counter.

The cost of all these will form part of the sandwich shop’s indirect costs.

As can be seen from above, all expenses were necessary for the operations of the sandwich shop.

However, it is made clear that some expenses can be directly attributed to the making of the sandwich, while some expenses cannot be.

Direct and Indirect Costs and Income Statements

Having an understanding of which costs are direct and indirect would help in recording them in your books and income statements.

As previously mentioned, direct costs will always form part of a business’s cost of sales.

Indirect costs will either form part of the cost of sales (manufacturing overhead) or operating expenses (administrative overhead).

An income statement is usually presented as follows:

If you have an understanding of which expenses should go to which (Cost of Sales or Operating Expense), preparing an income statement would be much easier.

Direct and indirect cost and taxes

The IRS is particular when it comes to expenses.

According to this particular page, business owners must separate their expenses used to figure the cost of goods sold, capital expenses, business expenses, and personal expenses.

It’s more likely targeted at small business owners and self-employed individuals though since large businesses probably won’t have personal expenses mixed in them.

Be careful when identifying which of your expenses are direct costs and indirect costs (manufacturing or administrative overhead).

Improperly classifying them might trigger the IRS to audit your business.

Additionally, you might miss out on certain tax deductions if you fail to properly break down your costs.

Direct and indirect cost and pricing

In pricing a product, you need to make sure that the price of the product should always exceed its direct costs.

Making it equal does not cut it unless somehow your business does not have indirect costs (and even then, you still won’t be earning a profit).

This is because if the price is equal to or less than direct costs, sales will always result in losses, to which at that point, why bother selling right?

If there is excess production capacity, it’s okay to base pricing only on direct costs as that would mean that the indirect costs are already covered.

Otherwise, direct costs and indirect costs must be considered when pricing your product. Basing only on direct costs might generate gross profits, but it may ultimately amount to a net loss.

Even worse if pricing is equal to direct costs.

That is not to say that you should compare the prices of your competitors.

Use them as the basis on whether you’re under-pricing or overpricing.

Just make sure that you are earning at least a gross profit with each sale.