For example, it may not be possible or financially feasible to precisely determine how the activities of company directors benefit a particular product, service or project.
Similarly, a company may not be able to easily assign a utility bill (e.g., electricity, water, waste collection) to a particular cost object (e.g., department) because the utilities were used by the whole building.
The most commonly used examples of direct costs are direct labor, direct materials, manufacturing supplies and sales commissions.
Common examples of indirect costs include rent, utilities, office expenses, as well as expenditures associated with general administration, selling and distribution.
The most common examples of direct costs include the following expenditures, assuming they are specific to a cost object, such as a product, service, department or project.
The most common examples of indirect costs include the following expenditures, assuming they are not specific to a cost object, such as a product, service, department or project.
Combined, direct and indirect costs represent all of the expenses incurred to run a company’s day-to-day business operations.
The key difference between direct and indirect costs is in how closely they relate to business output:
In an example of a car manufacturer, the materials like steel, plastic or glass used in the car production line are classified as direct costs.
Indirect costs would be the utilities, administrative and marketing expenses and salaries involved in running of the overall business that cannot be easily assigned to a specific car production unit.
In practice, it is possible to justify the classification of almost any expense as both direct and indirect.
To make the matter even more complicated, direct and indirect expense categories can vary among different industries and even within the same business.
Continuing with the example of a car manufacturer, the factory staff could be categorized as direct labor if they are working on a production line of one car model, whereas a supervisor overseeing multiple production lines and processes would likely be in the indirect labor category.
So, how do you tell them apart? Here’s the trick:
The rule of thumb for distinguishing direct and indirect costs is to ask two questions:
Looking more closely, there are 7 main differences between direct costs and indirect costs:
| Direct Costs vs. Indirect Costs: Top 7 Differences | ||
|---|---|---|
| Difference | Direct Costs | Indirect Costs |
| 1. Also known as | Overhead Costs, Cost of Goods Sold (COGS; manufacturing), Cost of Sales (COS; retail), Cost of Revenue (COR; services) | Operating Expenses; SG&A (Selling, General and Administrative Expenses) |
| 2. Allocation | Directly and easily attributable to a single one specific cost object without the need for allocation. | Allocation required as they apply to multiple cost objects or an entire entity. |
| 3. Examples | Direct materials, direct supplies and direct labor | Selling, general and administrative expenses (SG&A) |
| 4. Calculation formula | Direct Costs = Direct Materials + Direct Labor + Other Direct Expenses | Indirect Costs = Total Costs - Total Direct Costs |
| 5. Fixed or variable | More likely to be variable and change with output levels | More likely to be fixed and remain the same independently of output levels |
| 6. Financial statements | Sold: Income Statement >>> Cost of Goods Sold | Sold and allocated to cost object: Income Statement >>> Cost of Goods Sold |
| Unsold: Balance Sheet > Assets | Unallocated: Operating Expenses | |
| 7. Profit Margin | Gross Profit Margin | Operating Profit Margin |
Keep reading to find out more about each of these differences >>>
Indirect costs are sometimes referred to as fixed costs, which is not necessarily an accurate classification. Let’s debunk this myth right now >>>
Direct and indirect costs can be fixed or variable depending on how they change based on output of production or service provision. Indirect costs are more likely to be fixed, meaning they remain the same over time regardless of output. Direct costs are typically variable and fluctuate with output.
Both direct and indirect costs can be fixed and variable, depending on how likely or regularly the cost is to change as business output grows:
Fixed costs remain the same no matter what volume of goods and services a business generates, such as rent, insurance or salaries paid irrespective of hours worked.
Variable costs vary based on the output volume of units produced or services provided, such as materials and wages used in the production process.
Although most direct costs tend to be variable, there are exceptions to the rule and some direct costs may be considered fixed.
Let’s take a look at the example of labor costs, which is an expense that is notoriously difficult to label >>>
Labor can be direct or indirect cost depending on how directly the work is related to delivering sales.
| Labor Costs: Direct or Indirect? Fixed or Variable? [Examples] | ||
|---|---|---|
| Examples | Fixed | Variable |
| Direct | Salary of a production supervisor who oversees the manufacturing of one specific product. The manager’s salary is fixed regardless of how much of the product the company makes and sells. | Factory hires hourly workers to assemble one specific product. As the workers are paid per hour, the total of wages paid is variable and fluctuates with the volume of units of that particular product manufactured in the facility. |
| Indirect | Salary of a production supervisor who oversees the full manufacturing process of a company’s entire product line encompassing many different products. The manager’s salary does not change based on how much product the factory makes and sells. | Hourly-paid employees or contractors working in administrative roles (e.g., accounting, legal, IT) who need to work more hours during the busy season (e.g., Christmas). |
| Salaries administrative employees who make the overall production process possible, such as accountants, lawyers, IT staff, marketing staff, and senior managers. | The equipment maintenance expense and the temporary shipping clerks could be a variable indirect product cost, since this cost will vary with production volume. | |
| In both cases, it would be difficult or impossible to determine how much of their salaries should be allocated to producing a specific product. | In both cases, the increase in wages is driven by the increased production, but the payroll cannot be directly attributed to a particular product or service. | |
Direct costs are calculated by adding up all the materials, labor and other expenses that directly contribute to the production of a single cost object, such as a unit of product or service.
The direct cost formula is as follows:
Indirect costs, or overheads, are calculated by adding up all the costs of running a business that go beyond the production of a product or service, after all direct costs have been computed and attributed.
The indirect cost formula is as follows:
Which is equal to:
Keep reading to find out! >>>
While direct costs can be easily attributed to a single cost object, indirect costs need to go through an allocation process to be assigned to a product, service, project, department, or other cost object.
Direct costs need to be properly tracked, measured and valued so they can be correctly attributed directly to a specific cost object, such as a product, service or business unit.
For example, if the price of an essential component used in the production of goods fluctuates over time, the value of a cost item can be assigned based on which item was added to inventory first (method known as FIFO or first-in-first-out) or last (LIFO or last-in-first-out). Accordingly, the unit cost of production would be measured using the newest or oldest inventory items.
Although indirect expenses tend to be more difficult to allocate because their connection to a specific cost object is not always readily apparent, every business needs a reliable way to identify, quantify, assign and control them to achieve optimal financial health. This is especially true for entities with high ratio of indirect to direct costs.
Indirect costs first need to be added together into a cost pool and then allocated out to cost objects pro rata in a fair and proportionate way, typically by dividing up the total shared pool of expenses based on cost drivers, such as usage, revenue generated or physical dimensions.
For example, factory overhead costs can be apportioned to each unit produced by the total number of products manufactured, or based on the number of hours it took to manufacture each product. This helps a company to calculate the overhead cost per unit so that prices can be set accordingly to ensure a profit is made on each product even after incorporating all indirect expenses.
In practice, there are several costing methods used to allocate indirect costs, such as activity-based costing (ABC) or fixed cost classification. Each method has its own pros and cons, for example in terms of impact on pricing, financial reporting and taxation.
Direct and indirect costs are reported under two separate line items on an income statement:
This is an example of how direct and indirect costs appear on a company’s income statement.
| Income Statement: Example of Direct & Indirect Costs | ||
|---|---|---|
| Profit & Loss Item | Direct/Indirect Costs | Amount ($) |
| Revenue | $100,000 | |
| Cost of Goods Sold (COGS) | = Direct costs and allocated indirect costs | ($20,000) |
| Gross Profit (Gross Profit Margin) | $80,000 | |
| Operating Expenses | = Unallocated indirect costs | ($40,000) |
| Operating Profit (Operating Profit Margin) | $40,000 | |
| Non-operating Expenses (e.g., tax, interest) | ($5,000) | |
| Net Profit (Net Profit Margin) | $35,000 | |
Let’s take a look at Cost of Goods Sold, Operating Expenses and Profit Margins in more detail >>>