Direct Costs can be traced back to its specific product offerings, whereas Indirect Costs cannot as these types of costs are not directly tied to production.
The total costs incurred by companies can be put into two categories:
Understanding the distinction between direct costs and indirect costs is necessary to properly keep track of a company’s expenses, as well as for pricing products appropriately.
The spending by a company directly tied to producing its product offerings are collectively defined as “direct” costs.
For example, a manufacturing company clearly cannot generate revenue without first purchasing the inventory parts (“raw ingredients”) and materials integral to the overall production process and end-product.
Moreover, the company likely had to pay expenses related to rental payments and the maintenance of the manufacturing facility, but these costs are not considered direct costs.
The general expenses related to the day-to-day operations are called “indirect” costs.
Unlike the purchase of raw materials, rent and facility maintenance fees are more related to supporting the operational needs of the company, as opposed to producing specific products.
While indirect costs contribute significant value to a company as a whole, these costs cannot be assigned to the creation of a single product.
To determine if a cost should be classified as either a direct or indirect cost, the question to ask is whether the cost is directly needed to create and develop the product/service.
The income statement lists a company’s revenue and expenses during a specific period.
For purposes of either manually creating an income statement or assessing it, the concept of direct/indirect costs must be understood to allocate operating costs correctly.
While there are certainly exceptions to the rule, the majority of direct costs are recorded under the cost of goods sold (COGS) line item while indirect costs fall under operating expenses.
Direct costs are typically variable costs, which means the cost fluctuates based on the production volume — i.e. projected product demand and sales.
Indirect costs, on the other hand, tend to be fixed costs, so the expense amount is independent of the production volume.
For example, if the cost of renting an office space is $5,000, the amount charged remains constant whether 100 or 1,000 products are sold.
For purposes of forecasting, indirect costs like insurance, rent, and employee compensation tend to be more predictable compared to direct costs.
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