As the owner of a startup or small business, you should understand 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 customers, you can price both competitively and accurately. Additionally, certain costs are tax-deductible, so properly tracking both direct and indirect costs can help you maximize deductions. Finally, 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.
Direct costs are expenses that a company can easily connect to a specific “cost object,” which may be a product, department or project. This category 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 a 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, are first-in, first-out and last-in, first-out, also known as FIFO and LIFO. LIFO 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.
Indirect costs extend beyond the expenses you incur when creating a product; they 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 – such as computers, electricity and rent – 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 fixed or variable. Fixed indirect costs include expenses such as rent; variable indirect costs include fluctuating expenses such as electricity and gas.
There’s a simple trick to classifying payments as direct or indirect costs: Direct costs encompass the costs involved with creating, developing and releasing a product or service, and indirect costs are expenses that are not tied to a particular product.
It’s important to know the difference between the types of costs because it gives you a greater understanding of your product or service, thus leading to more competitive pricing. In addition, when tracking direct and indirect costs, you will have a better grasp on your accounting and be better equipped to plan for the future.
You also need to know the difference between direct and indirect costs when filing 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. Consult your accountant or bookkeeper to see which costs qualify.
Classifying your costs is important because it will help you understand your business model, price your products more competitively and identify tax-deductible expenses.
In cases of government grants or other forms of external funding, identifying direct and indirect costs becomes extra important. Grant rules are often strict about what constitutes a direct or an indirect cost and may 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 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 which expenses qualify as indirect costs.
Understanding the difference between direct costs and indirect costs is a critical aspect of proper accounting. Tracking each type of cost separately can help small businesses understand their cash flow, price their items properly and attain the maximum allowable tax deductions. If you need assistance with breaking down your business’s expenses, contact a professional accountant or choose accounting software that can support your business.
Matt D’Angelo and David Cotriss contributed to the writing and research in this article.