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When you're determining the price of a product, it's obvious that you need to charge more than the total cost of producing it. But production costs go beyond the materials and equipment — you also need to factor in workers' salaries, marketing campaigns, overall company maintenance, and the like. Taken all together, these expenses make up the direct and indirect costs of running your business.
It is easy to classify the basic difference between direct and indirect costs. Direct costs are immediately associated with the production of a product or service, while indirect costs include such things as rent — which may be associated with many products — or they may be several steps back in the production process. Though it is tempting to ignore the nuances of this accounting principle, spending some time correctly allocating your costs can improve your accounting ledger — and your clout with potential investors.
Direct costs are expenses that a company can easily connect to a specific "cost object," which may be a product, department or project. This includes items such as software, equipment, labor and raw materials. If your company develops software and needs specific pregenerated assets such as purchased frameworks or development applications, those are direct costs.
Labor and direct materials, which are used in creating a specific product, constitute the majority of direct costs. For example, to create its product, an appliance maker requires steel, electronic components and other raw materials.
Companies typically track the cost of the finished raw materials as a direct cost. Two popular ways of tracking these costs include last in, first out (LIFO) or first in, first out (FIFO).
While salaries tend to be a fixed cost, direct costs are frequently variable. Variable expenses increase as additional units of a product or service are created, whereas an employee's salary remains constant throughout the year. For example, smartphone hardware is a direct, variable cost because its production depends on the number of units ordered.
Indirect costs go beyond the costs associated with creating a particular product to include the price of maintaining the entire company. These overhead costs are the ones left over after direct costs have been computed, and are sometimes referred to as the "real" costs of doing business.
The materials and supplies needed for the company's day-to-day operations are examples ofindirect costs. These include items such as cleaning supplies, utilities, office equipment rental, desktop computers and cell phones. While these items contribute to the company as a whole, they are not assigned to the creation of any one service.
Indirect labor costs make the production of cost objects possible, but aren't assigned to a specific product. For example, clerical assistants who help maintain the office support the company as a whole instead of just one product line. Thus, their labor can be counted as an indirect cost.
Other common indirect costs include advertising and marketing, communication, "fringe benefits" such as an employee gym, and accounting and payroll services.
Much like direct costs, indirect costs can be both fixed and variable. Fixed indirect costs include things like the rent paid for the building in which a company operates. Variable costs include the ever-changing costs of electricity and gas.
Organizing business expenses as either direct costs or indirect costs is a matter that goes beyond simple product pricing — it affects your tax payments, too. Overhead expenses such as the utilities needed to power equipment and the inventory needed to manage the office are tax-deductible. In some cases, even the costs of goods sold qualify for deductions. It can be tempting to misclassify direct costs as indirect, but this can get you in a lot of trouble if you're audited by the IRS.
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 they 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.
For many companies, costs such as consultants, travel, communication, postage and printing, and computers may fall into a gray area. In those instances, to determine whether it is a direct or indirect cost, each company should carefully consider the majority use for each resource.
Once expenses are classified, many companies use the indirect costs ratio, sometimes called the overhead rate, to maintain accountability and to help determine how to allocate administration costs between programs or departments. The indirect cost rate is the ratio of total indirect costs to the applicable direct costs. The higher the ratio for a given department, the greater the share of indirect costs that program should bear.
In an effort to maintain efficiency and transparency, some companies set a target value for the indirect cost ratio. If a department's indirect costs exceed 20 percent of the direct costs, additional investigation into the department or product to justify the indirect expense may be warranted. The value of the indirect cost ratio is also sometimes mandated when a company accepts government funds to complete a project.
Additional resources about direct and indirect costs are available on the following websites:
- Indirect Costs and the Indirect Cost Ratio (U.S. Department of Education)
- Direct Costs and Indirect Costs (AccountingExplained)
- Direct and Indirect Costs (Marketing Teacher)
- Fixed and Variable Costs (Fundamental Finance)
Additional reporting by Ryan Goodrich, Business News Daily contributor.
Originally published Nov. 21, 2013. Updated March 31, 2015.