Direct costs definition
/What are Direct Costs?
A direct cost is totally traceable to the production of a specific item, such as a product or service. There are very few direct costs. For example, the materials used to produce an automobile are a direct cost, whereas the electrical cost of the metal stamping machine used to convert sheet metal into body panels for the automobile is not, because the machine must still (presumably) be powered up throughout the working day, irrespective of any changes in production volume.
Examples of Direct Costs
Examples of direct costs are noted below:
Direct material costs. Includes the raw materials used in production, components and parts, packaging materials, and any consumables directly tied to products.
Direct labor costs. Includes the wages of employees who manufacture products or deliver services, as well as the benefits and payroll taxes of these employees.
Direct equipment costs. Includes the maintenance and repair costs for machinery used solely for a product or project, as well as the leasing cost of equipment that is dedicated to a specific product or project.
Project-specific costs. Includes the subcontractor fees for tasks directly tied to a project, as well as any direct transportation costs.
Other direct costs. includes the costs of specialized software or technology used for a specific project or product, the fees for licenses or permits specific to a product or service, and the inspection and quality control costs tied to specific goods or services.
Each of these costs is traced directly to the cost object (e.g., a product, service, or project), distinguishing them from indirect costs, which are harder to allocate to a single output.
However, production labor is frequently not a direct cost, because employees usually are not sent home if there is one less incremental item being produced; instead, they are paid for the duration of their work shifts, irrespective of the volume of production. Other costs that are not direct costs include rent, production salaries, maintenance costs, insurance, depreciation, interest, and all types of utilities. Thus, when in doubt, assume that a cost is an indirect cost, rather than a direct cost.
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Direct Cost Analysis
Direct cost analysis can be used outside the production department. For example, subtract the direct cost of goods sold to individual customers from the revenues generated by them, which yields the amount customers are contributing toward the company’s coverage of overhead costs and profit. Based on this information, management may decide that some customers are unprofitable, and should be dropped.
When Not to Use Direct Costing
There are a number of situations in which direct costing should not be used, and in which it will lead to incorrect behavior. Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today’s companies. This is a real problem when dealing with long-term costing and pricing decisions, since direct costing will likely yield results that do not achieve long-term profitability. For example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs, but which is lower than the additional overhead costs that are associated with the product line. If the company uses the $10.00 price for well into the future, then the company will experience losses because overhead costs are not being covered by the price.
Can I Value Inventory with Direct Costs?
Using just direct costs to derive the value of inventory is not allowed under generally accepted accounting principles and international financial reporting standards, on the grounds that it does not provide a comprehensive view of every cost being incurred to create a product. A variety of factory overhead costs must also be included in the recorded value of inventory.