For budgeting and accounting purposes, it's crucial not only to document your business expenses but to classify them properly. The distinction between "direct" and "indirect" costs may appear intuitive and self-explanatory. While it's true neither word takes on a dramatically different meaning when categorizing the various costs of doing business, there's a bit more nuance in practice.
Direct costs are traceable to the production of a specific good or service. The operative word is "specific." Indirect costs may be necessary to production, but they are not traceable to the act of production. Indirect costs are those necessary to keep your business in operation. Think of them as the prerequisites for the production of any specific good or service.
It's important to have a solid understanding of the distinction between direct and indirect costs when pricing your products. When you know the true costs of production, you can price both competitively and accurately. You'll also demonstrate, more clearly, the efficiency of your business practices to potential investors. The distinction is equally important when filing your tax returns. You'll save time, and more than likely, money: Certain costs, both direct and indirect, are tax-deductible.
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 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 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. Two popular ways of tracking these costs, determining whether and when your company actually uses materials in production, include last in, first out (LIFO) or first in, first out (FIFO). This can be helpful when the costs of materials fluctuate in the course of production.
The majority of direct costs are variable. When direct costs vary, it's because they increase as additional units of a product or service are created. For example, smartphone hardware is a direct, variable cost because its production depends on the number of units ordered. A notable exception is direct labor costs, which are usually fixed, and remain constant throughout the year. Typically, an employee's wages do not increase or decrease in direct relation to the quantity of a product.
Indirect costs go beyond the expenses 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 of indirect 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 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.
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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 that 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; they reflect expenses incurred from selling products. 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 are often strict about what constitutes a direct or an indirect cost and will allocate different amounts of funding to each classification.
Often funding is for a specific project and will largely support direct costs. Certain funders will allow companies the opportunity to justify the necessity of indirect costs for specific projects, but they will expect honesty and rigor, and the decision to grant funding as requested is still at their ultimate discretion.
For many companies, costs such as consultants, travel, communication, postage and printing, and computers may fall into a gray area. It may be difficult for a company to quantify their use of these resources for a designated purpose. In those instances, to determine whether it is a direct or indirect cost, each company should carefully consider if they need these costs for day-to-day operations or for a specific project, department or product.
Once expenses are classified, many companies calculate the indirect cost rate, sometimes called the overhead rate, to determine how to allocate administrative costs between programs or departments.
For each program or department, the indirect cost rate is the proportion of applicable direct costs to the company's total indirect costs. The company can then determine what percentage of indirect costs each program or department should bear.
In an effort to maintain efficiency and transparency, some companies set a target value for the indirect cost rate. If a department's indirect costs exceed 20 percent of the direct costs, the company may investigate the department or product to determine if the proportion should be lower. When a company accepts government funds, the funding agency may also mandate a maximum indirect cost rate for the department or project.
Additional resources about direct and indirect costs are available on the following websites:
- Indirect Cost Overview (U.S. Department of Education)
- Direct Costs and Indirect Costs (AccountingExplained)
- Direct and Indirect Costs (Marketing Teacher)
- Variable Costs and Fixed Costs (Fundamental Finance)
- Learn about Direct and Indirect Costs in Product Pricing (The Balance)
Additional reporting by Katherine Arline.