In business, there are two kinds of costs: direct costs and indirect costs.
What is Direct Cost
A direct cost is the cost of producing goods or services, including raw materials and labor. Direct costs are only reported once the goods are sold. If the goods are not sold, the goods remain as an asset under finished goods inventory on the balance sheet. Direct costs are directly related to a sale and can be incurred from different areas of the business.
For example, the Pine Furniture Company incurs direct costs every time it sells a piece of furniture. Pine Furniture buys wood, makes furniture with the wood and then sells the furniture. The wood is a direct cost because it is used to make that sale, and more sales will require more wood. If Pine Furniture has employees who manufacture the furniture, their wages are also a direct cost. Commissions awarded to salespeople are also a direct cost. Every time a Pine salesperson makes a sale, 5-10% is a commission expense—a cost directly related to the sale.
How to Calculate Direct Costs
Every cost directly related to the sale should be included in the direct costs calculation. The formula for calculating direct costs is as follows:
Direct costs = direct materials costs + direct labor costs
What is Indirect Costs
An indirect cost is an overhead that remains about the same regardless of the number of sales a company makes. Indirect costs are usually included in selling, general, and administrative (SG&A) expenses. An increase in sales will not necessarily cause these expenses to rise.
If Pine Furniture’s salespeople are salaried and do not receive a commission, additional sales do not increase the company’s payout to employees. Therefore each salary is an indirect cost. Rent is also an indirect cost; if Pine Furniture rents a showroom space to sell their furniture, the rent remains the same regardless of how much furniture is sold.
How to Calculate Indirect Costs
The formula for calculating indirect costs is as follows:
Indirect costs = overhead costs like SG&A expenses
It can be misleading to say that direct and indirect costs are the only two categories in business. There is a gray area in between the two that is often referred to as a semi-direct cost.
It is challenging to classify costs as a business expands its capacity. As a company grows, it naturally makes more sales; some expenses will increase with the expansion. The company will have to hire more people and acquire more equipment. These expenses are usually considered indirect costs. But as a company grows, these costs will increase as more sales are made, so they are somewhat related.
Some companies track expenses very closely, calculating the cost of wear and tear on equipment and allocating it against every item being manufactured, tracking the depreciation as a direct cost. Similarly, utility costs like electricity can be considered a direct cost because the more the machinery produces, the more energy costs increase. Even though these costs contribute to production, they are generally unaffected by sales, so they are considered semi-direct.
Semi-direct costs are often hard to categorize. Some costs will act as an indirect cost once the business has grown but operate 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 most of the time and categorize them accordingly.
The Importance of Understanding Direct vs Indirect Costs
It is essential to understand the differences between direct and indirect costs. This understanding will allow you to have an accurate accounting ledger and understand the complexities of selling a product for more than it costs.
Understanding basic financial terms like direct and indirect costs is crucial to developing a common language throughout your business. To build a common language, you must provide all employees with the necessary financial acumen training. At Income|Outcome, we offer five distinct levels of financial acumen training and simulations. These different levels of training enable employees to build financial acumen regardless of their position. Building financial acumen in employees will allow your team to make informed business and financial decisions for the company’s benefit.