A Small Business Guide to Direct vs Indirect Costs

It can also include labor, assuming the labor is specific to the product, department or project. Understanding the distinction between direct costs and indirect costs is necessary to properly keep track of a company’s expenses, as well as for pricing products appropriately. If you manufacture clothing, the amount of fabric and thread you use will vary directly in proportion to how many shirts you make.

• For example, utilities provide electricity to all of the departments in Troy’s.
• Unlike direct, indirect expenses are not directly related and assigned to the core business operations of a firm.
• For example, if the cost of renting an office space is $5,000, the amount charged remains constant whether 100 or 1,000 products are sold.
• If you don’t, you could end up owing more than your actual income.
• To create the toys, the employee needs wood, which is considered a direct material.

The type of expense and timing at which it is incurred by the business frames the key points of difference between direct and indirect expenses. Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones. Fixed indirect costs include expenses such as rent; variable indirect costs include fluctuating expenses such as electricity and gas. Labor costs can also be counted as direct or indirect costs, depending upon the situation. If an HR resource is specifically assigned to the production of a product, the costs are direct.

Direct and indirect costs and your business’s finances

Examples of indirect costs are production supervision salaries, quality control costs, insurance, and depreciation. Pricing based just on direct costs makes the most sense in situations where there is an opportunity to sell a few extra units on a one-time sale with excess production capacity. Indirect costs should also be included in the derivation of a product’s price when setting businesscommunicationblog com long-term rates, where product sales must cover both direct and indirect costs. Indirect expenses are debited in profit and loss account, to arrive at net profit. Rent, utilities, office supplies, legal fees, and insurance are all indirect expenses because they benefit the entire company. For example, utilities provide electricity to all of the departments in Troy’s.

You can do it with spreadsheets, but as your business increases it might get tedious to maintain. This is  an example of how direct and indirect costs appear on a company’s income statement. You wouldn’t record an indirect cost under COGS on the income statement. While there are certainly exceptions to the rule, the majority of direct costs are recorded under the cost of goods sold (COGS) line item while indirect costs fall under operating expenses. The way you allocate costs as direct or indirect affects your tax payments as well.

How to Keep Your Direct vs. Indirect Costs Straight

The main logic to categorising any expense as indirect is to ask yourself, “is the cost directly linked and attributable to the primary income-generating product of the company? If the answer is “No”, then it is most likely an indirect expense. Direct expenses are shown on the debit side of a trading account because costs related to the production, procurement, buying and selling of goods/services should appear in this account. Indirect expenses are similar to direct expenses in that some are fixed (e.g., insurance) while others vary (e.g., utilities). Like most other companies, Troy’s has more indirect than direct expenses. For example, Troy’s spends the same amount for employee wages each week.

Hence, mastering cost management is an important part of running and growing a business. Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos. Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year. Wages, on the other hand, are payments made for a specific period of time. In the modern scenario, this can be related to freelancers and part-time workers.

Direct Costs vs. Indirect Costs: Understanding Each

An indirect expense is not related to the company’s business operations; however, they are as important as direct costs to run an organization. This is especially true for entities with high ratio of indirect to direct costs. Indirect costs are expenses that apply to more than one business activity.

The term “direct” refers to expenses that are directly linked to and attributable to a company’s main lines of business. They are mostly concerned with the acquisition and manufacture of goods and services. A company’s principal costs include direct expenses or the price of its goods or services. Direct income is the money that is received from doing tasks directly related to your business to make money. In contrast, indirect income is revenue derived from sources other than your business. Similar to direct expenses, indirect expenses can vary depending on the type of organization.

Examples of Direct and Indirect Costs

For example, it may not be possible or financially feasible to precisely determine how the activities of company directors benefit a particular product, service or project. To find out how much it truly costs you to produce a product or perform a service, you might also consider an activity-based costing (ABC) system. Business expenses like rent and employee wages are just some of the deductions you can claim. But to do so, you need to have accurate and detailed records to back up your claims.

The process of costing your products should include the indirect and direct expenses accrued in the production of a product. Indirect expenses are the costs incurred in the daily operation of a business. Companies that manufacture their products will assign the costs of materials to direct expenses. To easily identify direct costs, think of the components that go into the finished product that you’re selling. If you’re manufacturing baseball bats, your direct costs would include the wood, composite, or metal needed to make each bat, as well as the salaries of the line workers making the bats.

Direct costs tend to be variable costs, while indirect costs are more likely to be either fixed costs or period costs. Direct and indirect costs are the major costs involved in the production of a good or service. While direct costs are easily traced to a product, indirect costs are not.