What is a Direct Cost?

A direct cost is a cost that can be clearly associated with specific activities or products. These costs are commonly used in incremental decision making, where the sales manager needs to know the direct cost of a product in order to ensure that a one-time sale transaction can be made at a price that exceeds the total of all direct costs. There are very few direct costs, since there is usually not a clear association between a cost and an activity or product.

Examples of Direct Costs

Examples of the most common direct costs are noted below:

Raw materials. Includes the raw materials and components that are consumed in the production of goods.
Manufacturing supplies. Includes the incidental supplies used in the production process, such as grease and oil.
Commissions. Includes the amounts paid to salespeople only if they close a sale with a customer.
Direct labor. Includes the wages of employees who are directly involved in the production, such as assembly line workers or machine operators.
Freight and shipping. Includes the transportation costs for raw materials that are directly related to the production process.

Indirect Costs

Costs that cannot be directly associated with specific activities or products are called indirect costs. Several examples of these costs are rent expense, machinery maintenance, and utilities expense.

Direct Costs in Inventory Valuation

Direct costs are not sufficient for constructing an ending inventory valuation. The various accounting frameworks mandate that factory overhead costs also be allocated to ending inventory in order to derive the total ending inventory valuation. Otherwise, the logic is that all overhead costs will be charged to expense in the period incurred, rather than when the goods with which they are associated are sold.