Direct costs and indirect costs: what is the difference?

What are the direct costs?

Direct costs are expenses that a company can easily trace to a specific “cost object,” which could be a product, department, or project. Examples include software, equipment, and raw materials. Direct labor is also included, as long as it relates to a product, department or project.

For example, when an employee is hired for a project either exclusively or for a specific number of hours, their labor constitutes a direct cost. If your company develops software and needs specific assets, such as purchased frameworks or development applications, these are direct costs.

Examples of direct costs

Direct labor and materials make up the majority of direct costs. For example, to create a product, an appliance manufacturer needs steel, electronic components and other raw materials. Two common methods of tracking these costs, depending on when your business uses materials in production, are first in, first out and last in, first out, also called FIFO and LIFO. LIFO can be useful if your material costs fluctuate during production.

Usually, most direct costs are variable. The hardware of a smartphone, for example, represents a direct and variable cost because its production depends on the number of units ordered. A notable exception is direct labor costs, which generally remain constant throughout the year. Typically, an employee’s salary does not increase or decrease in direct relation to the number of products produced.

What are indirect costs?

Indirect costs extend beyond the expenses you incur when creating a product; they include the costs of maintaining and running a business. These overheads are those that remain after the calculation of direct costs.

Materials and supplies needed for the day-to-day operations of a business – such as computers, electricity and rent – ​​are examples of indirect costs. Although these elements contribute to the business as a whole, they are not allocated to create any particular department.

Examples of indirect costs

Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones. Just like direct costs, indirect costs can be fixed (like rent) or variable (like fuel). For-profit companies typically treat “fringe benefits,” including paid time off and use of company vehicles, as indirect costs.

What are the differences between direct and indirect costs?

There is a simple trick to classifying payments as direct or indirect costs: direct costs encompass costs involved in creating, developing, and marketing a product or service, and indirect costs are expenses that are not tied to a particular product.

Direct costs

• Manufacturing Supplies
• Equipment
• Raw materials
• Labor costs
• Other production costs

Indirect costs

The importance of knowing the difference

Understanding the difference between cost types improves understanding of your products and services, leading to better pricing and more competitive offers. Accurate tracking of direct and indirect costs improves accounting oversight, facilitates future planning, and supports compliance with tax and grant regulations.

When filing your taxes, certain direct and indirect costs may be tax deductible. Common direct tax-deductible costs include repairs to business equipment. Tax-deductible indirect costs can include rent, utilities, and certain insurance premiums. However, the situation of each company is different. Consult your accountant or bookkeeper to confirm which costs are eligible.

How do direct and indirect costs impact your small business financing?

In the case of government grants or other forms of external financing, identifying direct and indirect costs becomes extremely important. Grant rules are often strict about what constitutes a direct or indirect cost and may allocate a specific amount of funding to each classification.

Often, funding for a specific project will largely cover direct costs. Some government agencies may allow you to explain why indirect costs also need to be funded, but the decision to provide funding is at their discretion.

When a company accepts government funds, the funding agency may also have several mandates in place regarding the maximum indirect cost rate and what expenses are considered indirect costs.

Classify direct and indirect costs for proper accounting

Understanding the difference between direct costs and indirect costs is an essential aspect of good accounting. Tracking each type of cost separately can help small businesses understand their cash flow, price their items correctly, and achieve the maximum tax deductions allowed. If you need help breaking down your business expenses, contact a professional accountant or choose accounting software that can support your business.

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Matt D’Angelo and David Cotriss contributed reporting and writing to this article.