The difference between direct costs and indirect costs
/What are Direct Costs?
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.
What are Indirect Costs?
Indirect costs are costs used by multiple activities, and which cannot therefore be assigned to specific cost objects. Examples of cost objects are products, services, geographical regions, distribution channels, and customers. Instead, indirect costs are needed to operate the business as a whole. Indirect costs do not vary substantially within certain production volumes or other indicators of activities, and so are considered to be fixed costs.
Comparing Direct Costs and Indirect Costs
The key differences between direct costs and indirect costs are as follows:
Traceability to cost objects. Only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. Indirect costs are shared among multiple cost objects - they cannot be traced to a specific cost object.
Costing usage. Direct costs are almost always used to compile the cost of goods sold or project costs, while indirect costs may be charged to administrative expenses or included in overhead costs.
Relevance to decision-making. Direct costs are essential for pricing decisions, budgeting, and profitability analysis, while indirect costs are important for understanding overall operational costs and efficiency.
Nature. Direct costs tend to be variable costs, while indirect costs are more likely to be either fixed costs or period costs.
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Using Direct Costs and Indirect Costs in Pricing
At a minimum, direct costs should always be included in the derivation of a product’s price, since the established price must always equal or exceed its direct cost; otherwise, every sale will generate a loss. Pricing based just on direct costs makes the most sense in situations where there is an opportunity to sell a few extra units on a one-time sale with excess production capacity. Indirect costs should also be included in the derivation of a product’s price when setting long-term rates, where product sales must cover both direct and indirect costs.
Examples of Direct Costs and Indirect Costs
Examples of direct costs are direct labor, direct materials, commissions, piece rate wages, and manufacturing supplies. Examples of indirect costs are production supervision salaries, quality control costs, insurance, and depreciation.