As a business owner, you need to manage all aspects of your business, including accurately accounting for various costs. Whether you’re using accounting software or recording expenses manually, one area where business owners may struggle is properly categorizing direct costs and indirect costs.
Understanding the similarities and the differences between the two makes it easier to account for each cost properly, which in turn helps you pinpoint problem areas in production or operations. To fully understand direct and indirect costs, it’s helpful to understand fixed and variable costs:
- Fixed costs: Fixed costs remain the same from month to month and are not affected by a change in production levels. Building rent, insurance, and administrative salaries are considered fixed costs because they will remain the same whether 100 or 1,000 items are manufactured. Most indirect costs are considered fixed costs.
- Variable costs: In most cases, variable costs are directly related to production levels. Most direct costs, such as materials and production supplies are considered variable costs, as they will increase in months when production is higher, and drop when production levels drop.
The easiest way to tell the difference between direct and indirect costs is by determining whether the cost is specific to a product.
For instance, you currently rent a building that houses a small production area where your employees create gift baskets, with sales and administrative staff working in the building as well.
Any of the gift basket ingredients, as well as the baskets themselves, would be considered a direct cost, but the $2,000 rent expense would be considered an indirect cost since the building is used by all employees, not just the production staff.
What are direct costs?
Any cost that is directly associated with producing a product is considered a direct cost. The majority of direct costs include direct labor, direct materials costs, and manufacturing supplies.
To easily identify direct costs, think of the components that go into the finished product that you’re selling. If you’re manufacturing baseball bats, your direct costs would include the wood, composite, or metal needed to make each bat, as well as the salaries of the line workers making the bats.
Other direct costs examples include:
- Direct materials
- Direct labor
- Manufacturing supplies
- Direct fuel or power (cost of running machines)
While most direct costs are variable, there can be instances when direct costs are fixed costs, such as rent or property taxes specifically for a manufacturing plant.
What are indirect costs?
Indirect costs, often referred to as overhead costs, focus less on product production and more on day-to-day business expenses.
For instance, costs such as administrative staff, facility rental, and office supplies are needed to properly manage the business, but they are only indirectly related to the production process and are considered an indirect cost. In general, indirect costs include:
- Accounting and administrative expenses
- Legal fees
- Office supplies
- Utilities (some)
- Salaries (non-labor)
- Human resource costs
While all of the above costs are necessary for business operations, none of them can be directly tied to one specific product.
Direct costs vs. indirect costs: What's the difference?
Both direct and indirect costs have an effect on your net income, but for very different reasons.
|Direct Costs||Indirect Costs|
|Are used to calculate cost of goods sold||Are considered an overhead expense|
|Are always directly related to a product||Will relate to multiple business activities|
|Will vary in cost with production levels||Remain the same from month to month|
For accounting purposes, direct costs are always factored into your cost of goods sold, while indirect costs are recorded as an overhead expense. Direct costs must also be tied to a specific product. For instance, when you purchase wood to manufacture more bats, the cost of the wood is directly tied to bat production.
The same principle holds true if you buy products directly from a manufacturer for resale, with the cost of purchasing those products considered a direct cost, which should be calculated as part of the cost of goods sold.
When recording direct costs, in most instances, these costs will be variable, meaning that they can change according to production levels. If your production ramps up in the summer, it’s likely that your materials costs and labor costs will increase as well.
Unlike direct costs, indirect costs cannot be tied back to a specific product or productions. For example, when you pay administrative costs, such as support staff salaries or insurance, that expense cannot be tied directly back to a specific product or activity, which makes it an indirect or overhead cost.
Most indirect costs are considered fixed costs, as they remain the same from month to month regardless of production levels.
How classifying direct and indirect costs helps small businesses
It may seem like a lot of unnecessary work for your bookkeeper or accountant, but classifying direct and indirect costs properly will benefit your business in multiple ways.
1. More accurate pricing
Tracking both direct and indirect costs is essential for determining your final product cost. If you don’t know how much it costs to manufacture your product, how will you know what you should charge your customers?
When setting pricing for your products, don’t forget to factor in indirect costs as well in order to ensure that your profit margin is sufficient.
2. Potential tax benefits
Many expenses associated with the cost of doing business are tax deductible. But those costs will have to be accurately accounted for to bring you any additional deductions or possible tax savings.
3. More accurate budgeting
It’s impossible to create an accurate budget without properly accounting for direct and indirect costs. If you’re preparing a budget for next year, you’ll need to know what you’re currently paying for materials and supplies as well as how much your direct labor costs are.
In addition, you’ll also need to budget for other operating expenses such as rent, insurance, taxes, and office supplies.
4. Accurate financial reporting
Small businesses rely on accurate financial statements to make informed decisions. If direct and indirect expenses are not properly accounted for, the information contained in the statements will be wrong.
For example, if you fail to record the cost of materials for manufacturing bats, your cost of goods sold will be understated, which will erroneously overstate your net income, leading you to believe that you have more income than you actually do.
Inaccurate financial statements can also affect your ability to obtain a loan or attract investors.
Recording direct and indirect costs properly will help your business
Though it may feel like a lot of extra work, taking a few moments to properly account for direct and indirect expenses is important.
It will also give you a much clearer picture of the financial health of your business. Your products will be accurately priced so you can earn a profit, and you’ll have a much better idea of areas in which your business is performing well, along with areas where costs need to be lowered.