A business is about managing expenses. Managing costs is an integral part of ensuring profitability and business survival.
Expenses can be direct costs or indirect costs. The direct costs are tied to the product, while indirect costs do not tie directly to the product but are essential for business operations.
Today’s blog post will discuss and differentiate between these two costs.
Direct Cost Vs Indirect Cost
Running a business requires calculating every expense to ensure nothing goes to waste. Accounting direct and indirect costs will help reduce unnecessary costs and maintain cash flow.
Not only do projects and products use funds, functions, and facilities also require expenses.
What are Direct Costs?
Direct costs are expenses tied directly to the product or the project.
Direct costs can be variable or fixed, and they tie the product price. Therefore, monitor your direct costs to ensure product price control and taxes calculation.
If it is a project, controlling direct costs is vital to controlling the budget.
Direct costs vary due to ever-changing market conditions. In an income statement record, direct costs are indicated in the cost of goods sold (COGS) section.
Examples of Direct Costs
Direct costs include labor charges, raw materials, consumables, staff salaries, fuel, etc.; all the direct efforts towards a project or producing specific goods are direct costs.
What are Indirect Costs?
Indirect costs are essential for business operations but are not directly linked to the product or project. These costs are relatively stable over time, and therefore easier to control.
Indirect costs are recorded in the operating expenses segment in an income statement.
Examples of Indirect Costs
Indirect costs include utilities, consulting, legal and financial fees, administrative expenses, maintenance expenses, phone, internet, rents, insurance, etc.
More About Project Costs
Below is an example of how direct costs appear on a manufacturing company’s income statement.
In this case, XYZ Company manufactures a single product. The labor, raw materials, and depreciation expenses for each product unit are $3, $2, and $0.5, respectively.
Operating expenses are the indirect costs (fixed and semi-variable). The price for operating expenses is $35 over 3 months.
The total direct cost to make a single product is $5.50.
The total indirect cost to make a single product is $35.
If XYZ Company sold 20,000 units of its product for $15 every three months, its direct and indirect costs would be as follows:
Direct Cost vs Indirect Cost
The following table shows the difference between direct and indirect costs:
Direct and Indirect Cost Chart
Budget = Direct cost + Indirect cost
Direct costs decrease, and indirect costs increase when the project span increases. Adjust the project duration to optimize the budget or tweak direct and indirect costs for efficient cost utilization.
Why is it Important to Define Direct & Indirect Costs?
You should define your direct and indirect costs for your records.
Direct costs directly affect the product cost, taxes, and profits.
Controlling the direct costs provides the business with an edge in the market and keeps the price competitive.
For projects, controlling the direct costs allows a project manager to reduce the expenses associated with the project while delivering a superior product.
Direct costs affect product design, price, and quality.
On the other hand, controlling indirect costs is crucial in ensuring business operation for an organization, and most times, these costs are distributed among different projects.
Keeping track of your direct and indirect costs is essential when applying for government grants, investor funding, or loans from financial institutions.
Are Indirect Costs Included in Project Estimates?
Projects have a fixed budget, and when projects exceed their costs, they affect other operations. To ensure the project stays within the budget, you must track these direct and indirect costs.
Direct costs are the first type of cost included in project estimates. However, the organization must assign funds for indirect costs for a project to function.
Indirect costs are necessary for a project’s success, and they must be included in the project’s budget to avoid cost overruns.
Direct & Indirect Costs Considerations in Make-or-Buy Decisions
Sometimes, you have to decide whether to make or buy a certain component of your project. These decisions are motivated by cost, quality, speed, and technology concerns; however, the key motivation is the costs.
A business will go for outsourcing if it is cheaper. With outsourcing, you must consider the direct and indirect costs associated with producing the product or executing the project and then weigh the cost difference.
In a make-or-buy analysis, direct costs are an essential variable as they can fluctuate and significantly differ between different businesses and regions. For example, labor costs may be cheaper in developing countries.
An outside vendor can acquire the raw materials at a cheaper rate. Moreover, the required labor may not be available at your location but may be easily available at an affordable rate elsewhere.
Therefore, you can outsource tasks to an entity that can make the product at a lower cost when possible, rather than making it in-house.
Indirect costs such as rents and leases are rarely variable and generally do not mostly affect make-or-buy decisions.
Other indirect costs such as utilities, maintenance, office supplies, and insurance costs are relatively stable across most regions and businesses and thus do not affect make-or-buy decisions.
Making a make-or-buy decision has significant ramifications for an organization. Outsourcing may reduce costs but take innovation and production capability away, making you dependent on third parties.
Additionally, the business loses control over the production processes, which might affect the quality. A business leaves itself exposed to external issues such as market shocks or disruptions that may affect its operational efficiency.
While fuel, electricity, and administrative costs have been placed in the direct and indirect costs categories, you should note that their placement varies depending on the organization and the project.
If fuel is not directly involved in the production, it is not a direct cost. In contrast, administrative costs may be placed in the direct costs category due to their contribution to the production process.
Direct costs tie directly to the specific product or project, thus directly influencing the product price or the project cost. Indirect costs do not tie to a specific product or project but are essential for smooth business operations.
Reviewing direct and indirect costs can help organizations track unnecessary expenses and control them to increase efficiency.
Here is where this post on direct vs indirect costs ends. Please share your experience with dealing with these costs on your project or organization through the comments section.