Posted by Shivali Anand
June 3, 2022 | 7-minute read (1306 words)
Every business, no matter what industry or location, has two types of costs: direct costs and indirect costs. Understanding the difference between the two is essential for startup and small business owners to set accurate prices for their products or services.
In addition to helping to establish prices, knowing the difference between direct and indirect costs can be instrumental in preparing your tax returns. This is because certain direct and indirect costs are tax-deductible.
Finally, it is worth mentioning that in the event your firm receives a grant, most will include their own rules pertaining to the type and amount of indirect costs that can be claimed, if any. This is true for government grants and other types of external funding.
This article will cover the basics of direct and indirect costs, including their definitions and distinctions, along with examples of each.
What is a direct cost?
Simple definition: A direct cost is directly linked to the making of a product or service.
A direct cost is an expense that a business can easily attribute to a specific product or service. Labor, direct materials and equipment are common types of direct costs, with the latter two comprising the majority of direct costs for businesses.
The amount spent on direct costs is often variable, with the exception of labor costs, which tend to remain fixed. However, they can still be tied to a specific, measurable good. Another way of thinking about it is that direct costs are typically connected to observable and physical “cost objects,” which are products, services, customers, projects and activities for which costs are compiled.
Below are four examples of direct costs common to many businesses:
Labor – Labor is deemed a direct cost because a company's wages to employees can be directly linked to its payroll.
For example, wages plus overtime paid to an hourly worker are considered a direct cost for a factory owner. This is because the worker’s pay is directly responsible for producing the goods sold to the customer.
Commissions – A commission is a payment to salespeople in exchange for services rendered or products sold, usually paid in addition to a base salary.
Commissions are considered a direct cost because they can be directly linked to a specific customer or business activity.
Materials – In most cases, the costs associated with materials used in production are considered direct costs.
For example, steel is a direct cost for vehicle manufacturers because it is required to manufacture their product. In this instance, it is easy to connect the product to the cost.
Fuel – Fuel consumed to manufacture an item or to transport products or services to consumers is considered a direct cost because it can be connected with a specific good. Depending on the nature of a given product, power earmarked specifically for the production process could be deemed a direct cost as well.
What are indirect costs?
Simple definition: Indirect costs are the costs of operating a business, regardless of the volume of services or products sold or manufactured.
Expenses that cannot be traced back to a specific cost item are considered indirect costs. They comprise the costs related to running the company, beyond those expenses incurred to manufacture a product. Types of indirect costs include rent and utilities, among many others. Indirect costs tend to be more stable than direct costs amid shifting market conditions.
Below are eight examples of indirect costs common to many businesses:
Salaries for managers – Indirect costs often comprise salaries paid to managers and other employees who are not directly involved in the manufacturing process. A manager's time is not necessarily spent directly developing a product or service and therefore can't be tied to a single cost object. For this reason, wages for employees in administrative roles separate from manufacturing are considered indirect costs.
Quality control – Quality control is usually deemed an indirect cost because the services aren't tied to a specific cost object. This is true whether the work is done in-house or by an outside company.
Telecommunications – Expenses for phone, internet access and other forms of communication are typically considered indirect costs. These services do not result in the creation of a product for an end user; instead, they are usually considered an overhead cost.
Office supplies – General office supplies unrelated to the production of a good or a service are indirect costs. This is different from the cost of direct material cost, meaning the cost of the raw materials and components used to create a product.
Rent and utilities – Rent and utilities are indirect costs because they aren’t directly related to the development of your business’s product or service.
Legal charges – Costs incurred by your business for legal representation are indirect costs. Keeping a lawyer on retainer, filing legal paperwork and paying court costs all fit into this category, because they do not directly contribute to manufacturing any particular good or service.
Insurance – Insurance costs, such as those for liability, fire and other types of coverage, are indirect costs because they are not related to a specific cost object.
Financial services – Costs for services such as accounting, payroll and tax preparation, whether performed internally or outsourced, are indirect costs. Although these services are essential to a business’s operations, they have no direct connection with the concrete cost of an item or service.
Table: A comparison of direct and indirect costs
| Direct costs
|| Indirect costs
||Specifically connected to a cost object, like a product or service.
||Not linked to a cost object.
|Type of activity
||Most direct costs pertain to production.
||Most indirect costs are administrative.
||Most direct costs are variable, like fuel prices and raw materials.
||Indirect costs are more often fixed.
||Some direct costs are deductible.
||Some indirect costs are deductible.
|Benefit to project
||Direct costs are advantageous to a specific product or project.
||Indirect costs benefit several products or projects.
|Type of expense
||The sum of all direct costs is called prime cost.
||The sum of all indirect costs is called overhead.
||Only direct costs can be traced to a single cost object.
||Indirect costs cannot be traced to a single cost object.
Direct and indirect costs and your business’s finances
Correctly tracking direct and indirect costs can help you make sound business decisions about products, prices, wages and overhead. Knowing the distinction between the two types of costs can also affect which tax deductions you can claim and how you report them.
Setting prices using direct and indirect costs
When establishing a pricing plan for your business, it is vital to consider both direct and indirect costs to put your business on the road to success. Use direct costs to calculate your pricing to ensure your profit margin is still large enough to pay an appropriate portion of your indirect costs. When the number of sales is considered, the price of the item or service should always be sufficient to pay direct costs, a portion of profit and an adequate amount to cover indirect costs.
If your sales volume is low, you will of course need to charge a higher price per unit. But once you have a greater sales volume, you will have an opportunity to spread indirect expenses across a higher number of sales. At that point, you can earn more money or trim prices to compete more successfully.
Direct and indirect costs both have the potential to stay relatively fixed or to vary. We can refer to direct costs as those incurred in developing a single unit of a product or service.
Meanwhile, indirect costs occur in the ordinary course of business and benefit the entire company, not just a particular product or project. In a nutshell, direct costs are directly related to the production cycle, whereas indirect costs keep the production cycle running.