In any business, you have two kinds of costs: direct costs and indirect costs.
A direct cost is the cost of producing goods or services (e.g. raw materials and labor). Direct costs are only reported when the goods are sold. If the goods are not sold, the goods remain as an asset (FGI or Finished Goods Inventory) on the balance sheet.
An indirect cost is an overhead that remains about the same whether you make any sales or not. An example would be rent–it stays the same whether a restaurant serves 50 people or 150 people. SG&A expenses are indirect costs.
Both kinds of cost are strictly income statement items; they aren’t reflected on a company’s balance sheet.
Let’s take a look at each in a little more detail.
The Pine Furniture Company incurs direct costs every time it sells a piece of furniture.
The direct costs could be incurred from different areas. Pine Furniture, for example, buys wood, then makes furniture and sells it. The wood is a direct cost because it is used up as a result of making that sale. In other words, more sales will require more wood.
If Pine Furniture has employees who are manufacturing the furniture, their wages are also a direct cost. So, too, are commissions awarded to salespeople. Every time a Pine salesperson makes a sale, 5-10% is a commission expense—a cost directly related to the sale.
Indirect costs are those expenses that do not fluctuate according to the amount of sales a company makes. A spike in sales will not necessarily translate to an increase in these particular expenses.
If Pine Furniture’s salespeople are salaried and do not receive commission, additional sales do not increase the company’s payout to employees. Therefore each salary is an indirect cost.
Indirect costs are located further down on income statements. An indirect cost is most accurately considered an expense rather than a cost, or an overhead, rather than the cost of sales. For example, the wages owed to the delivery truck driver who transports Pine furniture will be paid regardless of how much furniture is sold.
Here is where we have to admit something: it was a little misleading to say that direct and indirect costs are the only two categories in business. The truth is that there is a sort of gray area in between. We might call this type of cost a semi-direct cost.
For instance, it is difficult to classify costs as a business expands its capacity. As a company grows, it naturally closes more sales; some of its expenses will increase with the expansion. The company will have to hire more people and have more equipment on hand.
These expenses are usually considered indirect costs, since they do not have bearing on sales on a case-by-case basis. Yet, these costs must increase in order to keep up with growing sales, so they are tied to the sales in some way. Hence the adjective “semi-direct.”
Some companies will track expenses very closely, even calculating the cost of “wear and tear” on equipment and allocating it against every item that’s being manufactured, tracking the depreciation as a direct cost. Utility costs like electricity can be handled in the same way because the more the machinery produces the more the energy costs increase as well. But these costs may also be considered semi-direct, since they are generally unaffected by sales but still contribute to production.
Semi-direct costs are often hard to categorize. Some costs will “behave” in the manner of an indirect cost once the business has grown but work like a direct cost while the business is growing.
For all costs that fall outside the neat categories of “direct” or “indirect,” look at how they function the majority of the time and categorize them accordingly.
It is important to understand the classification of different costs, not just to have an accurate accounting ledger, but to truly understand the complexities of selling a product for more than it costs to produce.
Understanding the categories is also a key step in developing a common language across your business.
For excellent further reading on the difference between direct and indirect costs, check out this article from Business News Daily.