A business may incur several types of expenses. There are various ways of categorizing these costs. By nature, a business can classify costs into two categories; direct costs and indirect costs.
Direct cost can be directly linked to the production of a product or rendering a service. Indirect costs can be associated with the production of a product or rendering service but cannot be assigned directly.
Let us explore some key differences between the nature and treatment of the direct and indirect costs for a business.
What is a Direct Cost?
A direct cost can be directly traced or associated with a cost unit or a cost center. Direct costs are those that can be directly linked with the production of a product or rendering services of a business.
Direct costs can be categorized further into three different categories:
- Direct material costs, for example, plywood for producing door sheets.
- Direct labor costs, for example, wages paid to skilled workers.
- Direct expenses, any other expense that can be directly linked to the product.
As direct costs are directly linked with the production of products, these costs are usually variable in nature. As the production level changes, these costs change. However, there are some fixed direct costs as well. For example, if a company hires a skilled worker for an ongoing project on a contract basis. The wages paid to the skilled worker would be fixed direct costs as long the project continues.
What is an Indirect Cost?
Indirect costs cannot be linked to a specific cost unit or a cost center. However, these costs refer to the costs incurred for the production of products or rendering services. Indirect costs are referred to as overhead expenses as well. These costs cannot be traced back directly to a single product unit.
Examples of indirect costs include:
- Indirect materials such as packaging and branding
- Indirect labor, for example, a site supervisor wages
- Other indirect expenses such as depreciation, utilities, rent, etc.
The difficulty in assigning the indirect costs comes from their nature. Indirect costs relate somewhat to the production of the products but cannot be assigned to single units. Hence, it is difficult to calculate the indirect cost per unit as compared to the direct costs.
Indirect costs are usually fixed in nature. For instance, a factory rent will be an indirect cost for production but will remain fixed regardless of the production levels.
Some costs may fall into both categories. These costs can be categorized either as direct costs or indirect costs. For example, there are variable and fixed overhead costs that can fall into both categories.
Direct Costs Vs Indirect Costs – Key Differences
The accounting treatment for direct and indirect costs is crucial for calculating production costs and profits. As direct costs can be traced directly to a product, these are easier to identify and treat in account books.
Direct costs relate directly to the production, manufacturing, or development of a product. Here are some key features of direct costs.
- These costs directly relate to the product manufacturing, for example, direct material, direct labor, or direct expenses.
- These are traceable to products directly.
- These costs are variable in nature, however, can be fixed direct costs as well.
- These costs are easily measurable in terms of cost per unit.
Examples of direct costs include:
- Raw materials
- Direct labor wages and salaries
- Production equipment and machinery
- Manufacturing costs
Indirect costs, on the other hand, are the ones that cannot be directly linked to the production, manufacturing, or development of a product.
Key characteristics of indirect costs include:
- These costs do not directly relate to the production/manufacturing of a product.
- These costs are difficult to measure in terms of cost per unit.
- These costs are fixed but can be variable in some cases.
Examples of indirect costs include:
- Rent and insurance
- Indirect labor costs
- Marketing and sales
- Freight and carriage
- Accounting and depreciation costs
The key difference between direct and indirect costs can be assessed with their calculation of per-unit cost. For example, raw material costs can be easily calculated on a per-unit basis. Contrarily, indirect costs such as marketing expenses cannot be assigned easily on a per-unit basis.
Direct costs are directly attributable to a cost unit or cost center. Indirect costs relate to a cost unit but cannot be attributed directly. Direct costs are easier to measure in per unit cost terms as compared to indirect costs.