Direct Cost Vs. Indirect Cost: How Can One Determine Whether a Cost Is Direct or Indirect

Quynh Pham

Quynh Pham | 20/12/2023

Direct Cost Vs. Indirect Cost: How Can One Determine Whether a Cost Is Direct Or Indirect

Starting a business in today’s economy isn’t as challenging as it used to be. With only $2,000 to $5,000, according to the United States Small Business Administration, it is possible to start a business of your own. Before delving into the specific processes, however, you need to understand the costs associated with an operating business. Two of the most important costs you need to be aware of are direct and indirect costs.

This article will outline the differences between direct vs indirect costs, detailed examples, and put your understanding to the test by the end of the article.

First, What is a Cost Structure?

First, What is a Cost Structure?

The term “cost structure” describes the different kinds of expenses that a firm faces. It is typically made up of direct and indirect costs or fixed and variable costs. Variable costs vary with the level of production, while fixed costs stay the same regardless of how much an organization produces.

Having a firm grasp of the different kinds of costs is crucial since it shapes how businesses price their products and services, allocate resources, and manage cash flows.

Understanding Direct Costs

Understanding Direct Costs

Definition

Direct costs are costs that can be traced to a specific cost object or particular sponsored project, such as services, products, or departments. They are typically variable costs that change with production volume but can also be considered fixed costs. Direct costs are directly involved in the development, manufacturing, and release of products.

Direct Costs Examples

What are the cost objects in direct costs, to be specific? Here are examples of direct costs to help you better visualize what the term means:

  • Direct Labor Costs: The hourly wages, overtime pay, and employee benefits are related directly to the particular production lines, so direct labor is considered a direct cost.
  • Manufacturing Supplies: Machines, tools, or other equipment used for manufacturing products are direct costs since they tangibly contribute to the production.
  • Raw Materials: Direct materials explicitly contribute to the production of goods or services and are direct expenses.
  • Fuel/ Power Consumption: If you can calculate the power it takes to make one item, that power is considered direct cost. Overhead power, however, is not considered a direct cost since this is the cost you owe your power provider and does not tie directly to the production of goods or services.
  • Transportation: Transportation, or freight, is a direct cost if you pay for shipping or transportation between production and sales locations. It might not be a direct cost, however, when the transportation stays the same regardless of the volume of production. It is then an indirect cost instead.

Understanding Indirect Costs

Understanding Direct Costs

Indirect Costs Definition

Indirect costs are costs not directly associated with a sponsored project, instructional activity, or institutional activity but are incurred in support of common or joint objectives.

In other words, it refers to costs that do not relate directly to a cost object, such as a function, a product, or a department. Instead, they refer to costs that are necessary for the operation and health of the company. Other types of indirect costs are overhead costs, administration costs, and security costs.

These costs are identified, aggregated, and then assigned to particular cost objects within an organization.

Examples of Indirect Costs

Indirect costs are the opposite of the previously mentioned ones. The following are examples of the most common indirect expenses:

  • Rent: Rent is part of every business operation - it is the fee you pay to provide your employees with a space to work. It can’t be tied directly to the production or manufacturing of a specific unit of product; thus, it is an indirect expense.
  • Utilities: Even though utilities don’t directly produce goods, paying for the utility means there is electricity, light, and water so that your employees have a functional office space to work in.
  • General Office Expenses: General office expenses may include office supplies, desktop computers, or cell phones. Again, these indirect expenses aren’t directly related to the production process. They are, however, essential items for a smooth office operation. For instance, your administrative team might need to send out physical emails to clients, or your marketing team needs to print posters for a certain marketing campaign.
  • Selling Expenses: In addition to administrative expenses, selling expenses are also considered an indirect cost. They involve the cost of marketing, social media, travel and trade shows, sales team benefits, and bonuses.

Difference Between Direct and Indirect Costs

Understanding Direct Costs

What Are the Differences Between Direct and Indirect Costs?

The most notable differences between direct and indirect costs are their tangibility and measurability.

  • Tangibility: Direct costs are easy to identify, track, and manage. They are directly related to outputs or services and can be assigned to individual clients or products. Generally, direct costs are easier to forecast and manage than indirect costs, as they are not directly linked to specific activities. Indirect costs include expenses that aren’t directly associated with a specific product or service.
  • Measurability: Direct costs, such as commissions and raw materials, are easily quantifiable and allocable to customers. On the other hand, indirect costs, including utilities and property expenses, pose greater challenges in terms of tracking and allocation. The assignment of indirect costs to specific products and services presents a notable challenge.

Why Does Knowing the Difference Matter?

Did you know that approximately 10% of startups fail within their first year? As said by the U.S. Bureau of Labor Statistics (BLS), the likelihood of startup failure increases over time, with the highest proportion of failures occurring in businesses younger than ten years old. Ultimately, around 90% of startups do not succeed in the long run. In summary, only about one in ten traditional startups will survive over their lifetime.

Seeing such statistics, it is crucial for a business to thoroughly understand the costs associated with a business operation to increase its chance of survival. Even if you are an established business, it will never hurt to refresh your memory when it comes to general business expenses.

By distinguishing the differences between direct costs and indirect costs, businesses enjoy the following benefits:

  • Accurate income statements
  • Tax deductibles
  • Accurate and competitive pricing
  • A stronger grasp of accounting
  • Improved budgeting, resource allocation, and forecasting
  • Insight into the company’s profits.

Direct Vs. Indirect Costs in Software Ownership Quiz

Direct costs are expenses that are straightforwardly related to the production of goods or services, whilts indirect costs are expenses that support the general operations of the business but cannot be directly attributed to a specific product or service.

To wrap up this article, we would like to present you with a quick test regarding direct and indirect costs in software ownership. If you are a product leader thinking about developing or purchasing custom software solutions for your company, this quiz will be especially helpful.

1. What does the total cost of ownership include in the context of digital products?

A. Only indirect expenses
B. Both direct and indirect expenses
C. Only direct expenses
D. None of the above

The correct answer is B. It doesn’t matter if your product is digital or physical; you always need to account for both direct and indirect expenses.

2. What are direct costs in software development directly attributable to?

A. Building and implementing software solutions
B. Marketing the software
C. Maintaining the software
D. Training employees to use the software

The correct answer is A. The process of training, marketing, or maintaining isn’t directly tied to the building and development of the final product, which, in this case, is the software.

3. What are some of the indirect costs associated with software projects?

A. Implementation and maintenance
B. Electricity costs
C. Legal fees
D. All of the above

The correct answer is D. Maintenance, utilities, or legal fees are all essential for the general business operation but do not play a hands-on role in software development.

4. Bonus question: Why is it important to consider the total cost of ownership for software projects?

A. To ensure the success of the project over several years
B. To understand the value of software assets
C. Be aware of the costs that are often overlooked
D. All of the above

The correct answer is D.

How did you do on our quiz? Did you find all the answers you were looking for regarding direct and indirect costs? If you still have lingering questions, even if they’re not related to software ownership but still software-related, the Orient Software Team is happy to help you find the best solution. We’re always here to help!

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