Direct and Indirect costs
To sum up, direct costs are expenses that directly go into producing goods or providing services, while indirect costs are general business expenses that keep you operating.
The difference between direct costs and indirect costs
The essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. These costs are usually only classified as direct or indirect costs if they are for production activities, not for administrative activities (which are considered period costs).
The concept is critical when determining the cost of a specific product or activity since direct costs are always used to compile the cost of something, while indirect costs may not be assigned to such a cost analysis. It can be too difficult to derive a cost-effective methodology for the assignment of indirect costs; the result is that many of these costs are considered part of corporate overhead or production overhead, which will exist even if a specific product is not created or activity does not occur.
Direct costs tend to be variable costs, while indirect costs are more likely to be either fixed costs or period costs.
Using Direct Costs and Indirect Costs in Pricing
At a minimum, direct costs should always be included in the derivation of a product’s price since the established price must always equal or exceed its direct cost; otherwise, every sale will generate a loss. 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 long-term rates, where product sales must cover both direct and indirect costs.
Examples of Direct Costs and Indirect Costs
Examples of direct costs are direct labour, direct materials, commissions, piece-rate wages, and manufacturing supplies. Examples of indirect costs are production supervision salaries, quality control costs, insurance, and depreciation.
