Understanding direct costs and indirect costs is important for properly tracking business expenses.
As the owner of a startup or small business, there are crucial aspects you should understand to put your business on the path to success. One of those aspects is understanding the distinction between direct and indirect costs when pricing your products or services.
When you know the true costs involved with producing and providing your goods or services to consumers, you can price both competitively and accurately. There's another benefit as well: Certain costs, both direct and indirect, are tax-deductible. And if you ever apply for and receive a grant, there are several rules around the types of indirect costs – and the maximum amount – you can claim.
What are direct costs?
Direct costs are expenses that a company can easily connect to a specific "cost object," which may be a product, department or project. This can include software, equipment and raw materials. It can also include labor, assuming the labor is specific to the product, department or project.
For example, if an employee is hired to work on a project, either exclusively or for an assigned number of hours, their labor on that project is a direct cost. If your company develops software and needs specific assets, such as purchased frameworks or development applications, those are direct costs.
Labor and direct materials constitute the majority of direct costs. For example, to create its product, an appliance maker requires steel, electronic components and other raw materials. Two popular ways of tracking these costs, depending on when your company uses materials in production, include last-in, first-out (LIFO) or first-in, first-out (FIFO). This can be helpful if the costs of your materials fluctuate in the course of production.
Usually, most direct costs are variable. Smartphone hardware, for example, is a direct, variable cost because its production depends on the number of units ordered. A notable exception is direct labor costs, which usually remain constant throughout the year. Typically, an employee's wages do not increase or decrease in direct relation to the number of products produced.
What are indirect costs?
Indirect costs extend beyond the expenses you incur creating a product to include the costs involved with maintaining and running a company. These overhead costs are the ones left over after direct costs have been computed.
The materials and supplies needed for a company's day-to-day operations are examples of indirect costs. While these items contribute to the company as a whole, they are not assigned to the creation of any one service.
Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones. Much like direct costs, indirect costs can be both fixed and variable. Fixed indirect costs include things like rent. Variable costs include the fluctuating costs of electricity and gas.
Differences between direct and indirect costs, and why it's important
A simple trick to classifying payments as direct or indirect costs is that direct costs encompass the costs involved with creating, developing and releasing a product.
Direct costs include:
- Manufacturing supplies
- Raw materials
- Labor costs
- Other production costs
Conversely, indirect costs encompass costs not directly related to the development of your business's product or service.
Indirect costs include:
- Office supplies
- Office technology
- Marketing campaigns
- Accounting and payroll services
- Employee benefit and perk programs
- Insurance costs
As a business owner, knowing the difference between both types of costs is important, because, one, it helps you have a greater understanding of your product or service, which can lead to more competitive pricing; two, you have a better grasp of your accounting and can better plan for the future of your business. [We can help you choose the best accounting software for your business.]
It also matters when it's time to file your taxes. Some direct and indirect costs are tax-deductible. Examples of tax-deductible direct costs include repairs to your business equipment, such as your production line. Tax-deductible indirect costs may include rent payments, utilities and certain insurance costs.
Each business's situation is different, however. Your accountant can advise you which costs qualify.
Rules about direct costs and indirect costs impact funding for your small business
In cases of government grants or other forms of external funding, identifying direct and indirect costs becomes doubly important. Grant rules are often strict about what constitutes a direct or an indirect cost and will allocate a specific amount of funding to each classification.
Often, funding for a specific project will largely support direct costs. Certain government agencies might allow you an opportunity to explain why indirect costs should be funded, too, but the decision to grant funding is at their discretion.
When a company accepts government funds, the funding agency may also have several strict mandates in place regarding the maximum indirect cost rate and what expenses qualify as indirect costs.
More info on direct costs and indirect costs
Learn more about direct and indirect costs at the following websites:
- "Indirect Cost Overview" (U.S. Department of Education)
- "Variable Costs and Fixed Costs" (Fundamental Finance.com)
Matt D'Angelo contributed to the reporting and writing in this article.