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When pricing a product, companies go through the process of identifying all costs associated with producing it. The costs that influence pricing include both direct and indirect expenses. For example, when pricing a software application a company needs to factor in not only the programmers' salaries — a direct cost — but also the purchase of tools and equipment, the expenses of marketing, the manpower associated with supporting the company — all indirect costs. These expenses can be numerous, but are critical for pricing any product or service at a level that will sustain a company.
Direct costs are expenses a company can easily connect to a specific object, or cost object. Companies describe these as expenses where you get what you pay. This includes items such as software, equipment, labor and raw materials. If your company is designing a new building and needs to hire a project manager to oversee its construction, the manager's salary is a direct cost. If you develop software and need specific pre-generated assets, those are direct costs.
While salaries tend to be a fixed cost, many objects are variable costs. These expenses increase as more units of a product or service are created, whereas an employee’s salary remains constant throughout the year. For example, developing smartphone hardware is a variable and direct cost as its production depends on the number of units ordered.
Direct materials and labor
Direct materials — materials used in directly creating a product — and labor constitute the majority of direct costs. For example, to create kitchen cabinets, you need wood in addition to nails, varnish, paint and other raw materials.
Companies typically track the cost of the finished raw materials as a direct cost. Methods for tracking these direct costs must be chosen by a company, though common strategies include last in, first out (LIFO) or first in, first out (FIFO).
Indirect costs are expenses that affect the company as a whole and not just the product. Quite often, these are referred to as the real costs of doing business. These costs include such things as advertising and marketing, product depreciation, general firm supplies, accounting and payroll services. These constitute the overhead of maintaining the entire company and not just costs associated with creating a product.
Much like direct costs, indirect costs can be both fixed and variable in amounts. Fixed costs include things like the rent paid for the building a company operates in. Variable costs include the ever-changing costs of electricity and gas.
Indirect materials and labor
The materials and supplies needed to ensure the company’s ongoing productivity constitute indirect costs. Items such as tools, cleaning supplies, desktop computers and cell phones make the production of a company’s products possible, but aren’t assigned to the creation of any one service. For example, note pads, printer paper and pencils would constitute indirect materials.
Indirect labor costs are defined as expenses that make the production of a product or service possible, but aren’t assigned to a specific product’s creation. For example, clerical assistants help in maintaining the affairs of the office, from filing paperwork to taking phone calls. They support the company as a whole and not just one product line, and thus become indirect costs.
Organizing business expenses as either direct costs or indirect costs is a matter that transcends simple product pricing. Overhead, an indirect cost, is considered tax-deductible. The cost of a building, the utilities needed to power equipment and the inventory needed to manage the office — each of these items constitutes an expense a company can write off. In some cases, even the costs of goods sold qualify for deductions.
In cases of government grants or other forms of external funding, identifying direct and indirect costs becomes doubly important. Such programs can often have stringent policies for expenses that qualify for direct versus indirect costs and allocate specific amounts of funding to address both aspects of running a business. Justifying the handling of costs is allowable depending on the funding source, but in most cases a company is expected to classify funding honestly.