direct cost VS indirect cost

A business is about managing expenses. Therefore, managing costs is integral to 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 link directly to the product but are essential for business operations. 

Today’s blog post will discuss and differentiate direct and indirect costs in project management.

Direct Cost Vs. Indirect Cost

Running a business requires calculating every expense to ensure nothing goes to waste. Accounting for direct costs and indirect costs will help reduce unnecessary costs and maintain cash flow.

Projects, functions, and facilities require expenses.

What are Direct Costs in Project Management?

Direct costs are expenses tied directly to the product or the project. 

Direct costs can be variable or fixed and tied to the product price. Therefore, monitor your direct costs to control product price 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. An income statement record indicates the direct costs in the cost of goods sold (COGS) section. 

Examples of Direct Costs

Direct costs include labor, 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 in Project Management?

Indirect costs are essential for business operations but not directly linked to the product or project. In addition, these costs are relatively stable over time and easier to control. 

They record indirect costs 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, rent, insurance, etc. 

A Real-World Example of Direct and Indirect Costs

Below is an example of direct & indirect costs appearing on a manufacturing company’s income statement. 

In this case, XYZ Company manufactures a single product. In addition, each product unit’s labor, raw materials, and depreciation expenses 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 three 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:

project cost

The following table shows the difference between direct costs and indirect costs:

direct cost and indirect cost comparison table

Direct and Indirect Cost Chart

direct cost and indirect cost graph

Budget = Direct Cost + Indirect Cost

Direct costs decrease, and indirect costs increase when the project duration increases. Therefore, 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 Cost & Indirect Costs?

You should define your direct and indirect costs for your records. 

Direct costs directly affect product costs, taxes, and profits. 

Controlling the direct costs gives the business 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.

list of direct and indirect cost

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 Cost Estimates?

Projects have a fixed budget, and when projects exceed their costs, they affect other operations. Therefore, you must track these direct and indirect costs to ensure the project stays within the budget. 

Direct costs are the first type of cost included in project cost 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 must be included in the project’s budget to avoid cost overruns. 

Direct & Indirect Costs Considerations in Make-or-Buy Decisions

Sometimes, you must decide whether to make or buy a project component. These decisions are motivated by cost, quality, speed, and availability of technology; however, the key motivation is the costs. 

A business will go for outsourcing if it is cheaper. However, with outsourcing, you must consider the direct and indirect costs associated with producing the product. 

In a make-or-buy analysis, direct costs are essential 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 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 do not mostly affect make-or-buy decisions.

Other indirect costs such as utilities, maintenance, office supplies, and insurance are 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. For example, outsourcing may reduce costs but remove innovation and production capability, making you dependent on third parties.

Additionally, the business loses control over the production processes, which might affect the quality. A business exposes itself to external issues, such as market shocks or disruptions, that may affect its operational efficiency. 

Notes:

Fuel, electricity, and administrative costs can be placed in direct and indirect costs categories depending on the organization and the project. 

If fuel is directly involved in the production, it is a direct cost. In contrast, you can place administrative costs in the direct costs category due to their contribution to the production process. 

Why You Should Know the Difference Between the Direct & Indirect Costs

You should know the difference between direct and indirect costs as it helps you understand your project, product, and services. As a result, you can control the cost better, and your accounting will be robust.

It also helps in filing taxes and claiming returns. A few direct and indirect costs are tax-deductible, and you can claim the returns.

If you are receiving government grants, you need to know your direct and indirect costs. Government funding is strict about how you spend on direct and indirect costs. They also audit the expenses, and you will be in legal trouble in case of any discrepancy.

For example, project funding mostly allows direct costs, and you cannot invest the funds in indirect costs.

Understanding these costs makes accounting robust. You will understand your cash flow better and price the product competitively.

Conclusion

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 business operations. An understanding of these costs helps you understand your business model, pricing your product competitively, and you can separate tax-deductible expenses.

Reviewing direct and indirect costs can help organizations track unnecessary expenses and control them to increase efficiency.

Fahad Usmani, PMP

I am Mohammad Fahad Usmani, B.E. PMP, PMI-RMP. I have been blogging on project management topics since 2011. To date, thousands of professionals have passed the PMP exam using my resources.