Cost Structure: Direct, Indirect, and the Space Between
ehl
Published Date
Understanding your cost structure isn’t just an accounting exercise—it’s a fundamental business skill. If you misclassify costs, you risk bad pricing, poor budgeting, and lower profitability.
If you’ve taken the Income|Outcome workshop, you already know this. But even for those who haven’t, let’s break it down: What are direct and indirect costs? Why do they matter? And what happens when costs don’t fit neatly into one category?
Revisiting the Workshop Lesson
If you attended an Income|Outcome workshop, you’ve seen this firsthand. Here’s a quick refresher:
Direct costs are tied directly to producing goods or services—think raw materials and production labor.
Indirect costs are overhead expenses that exist regardless of production, such as rent, marketing, or HR salaries.
Why Cost Structure Matters: A Quick Example
Imagine you sell a product for $12 per unit. Your direct costs are $6 per unit (materials + labor), and your overheads are $11 per month.
- Selling 2 units: Sales of $24, minus $12 in direct costs and $11 in overheads, leaves you with $1 profit.
- Selling 4 units: Sales of $48, minus $24 in direct costs and the same $11 in overheads, gives you $13 profit.
Why did profit more than double when sales merely doubled? Because indirect costs remained fixed, and more sales helped absorb that cost. That’s the power of understanding your cost structure.
What Are Direct Costs?
These are expenses directly tied to producing a specific good or service.
- Raw materials
- Wages for production workers
- Manufacturing supplies
Important note: Not all labor is direct. A baker’s wages, if paid per loaf baked, would be a direct cost. But the store manager’s salary? That’s indirect—it doesn’t change with production volume.
What Are Indirect Costs?
Indirect costs support the business but aren’t tied to specific products.
- Rent and utilities
- HR and admin salaries
- Marketing expenses
It’s easy to overlook these costs in decision-making, but they matter. Ignoring indirect costs in pricing decisions can shrink your margins or result in underpricing. For example, cutting marketing to save money might lead to lower sales—because some indirect costs actively support revenue growth.
Where Should You Cut Costs?
If a business needs to cut costs, the question isn’t just how much—it’s where.
Would you rather reduce direct costs by 10%, or indirect costs by 20%? The answer depends on your cost structure.
Cutting direct costs can improve margins—but not without risk. Switching to cheaper materials may lower quality and affect sales.
Cutting indirect costs might reduce overhead—but could also weaken operations. Eliminating customer support roles, for instance, may save money but drive customers away.
Financial decisions are rarely simple. It’s not just about reducing costs—it’s about understanding which costs matter most to your business.
Beyond Direct and Indirect: The Space Between
Some costs don’t fall neatly into either the direct or indirect category. To understand them better, it helps to look at another way of categorizing costs: fixed, variable, and semi-variable.
What do we mean by that?
- Direct costs are also known as variable costs—not because they change every month, but because they’re reported based on the level of sales or production. Even if your raw material cost per unit stays the same, the total reported cost varies with how much you sell.
- Indirect costs are often referred to as fixed costs—not because they never change, but because their reporting doesn’t depend on your sales volume. Rent, for example, may fluctuate slightly year to year, but it’s not tied to how many units you sell in a given month.
Now, what about those costs that don’t behave consistently one way or the other?
This is where semi-variable costs come in. These are expenses that have both a fixed and a variable component. For example:
- A salesperson’s pay might include a fixed base salary plus a variable commission.
- A utility bill could include a flat monthly fee plus a usage-based charge.
These semi-variable costs live in the "space between" fixed and variable—or between direct and indirect—and they require careful handling.
Final Thoughts
- Direct and indirect costs play different roles in business performance.
- Cutting costs without understanding their impact can backfire.
- Semi-variable costs need to be analyzed carefully to avoid misclassification.
Understanding your cost structure is key to making smarter decisions, setting sustainable prices, and driving profitability.
Want to Apply This to Your Business?
Understanding cost structure is one thing—seeing how direct and indirect costs affect your own business is another.
Continue the Learning with our hands-on guide:
- Identify and classify real costs in your department or business
- Evaluate how they impact pricing and profitability
- Reflect on your simulation decisions vs. real-world choices
👉 Try the Cost Structure Analysis Exercise Here
