When analyzing business expenditure, it's common to categorize expenses as either direct or indirect costs.
But what exactly are the main differences between these two kinds of business expenses, and why do we separate them in the first place?
In this article, we’ll be exploring the core differences between direct costs and indirect costs, explaining the importance of tracking both types of expenses, and exploring practical examples and best tips for managing business spending.
Direct costs vs. indirect Costs
Definition of direct costs
Direct costs are expenses that can be traced to a specific cost object and are directly related to the product or service you produce.
They are incurred as a direct result of producing the product or delivering a service and can be traced back to a specific product, project, or department.
Definition of indirect costs
Indirect costs are expenses that cannot be directly linked to a specific cost object, though they may be necessary for overall operations.
They’re typically shared across multiple cost objects and include overhead expenses like rent.
Key differences between direct and indirect costs
Here’s a brief summary of the main difference between direct costs and indirect costs:
Examples of direct costs & indirect costs
Let’s get a better idea of the difference between direct and indirect costs by exploring some common examples.
Direct costs examples
Here are a few examples of direct costs across different industries.
Manufacturing
- Raw materials such as wood and steel
- Wages of factory workers directly involved in production
- Machinery parts used for a specific product
Service industry
- Consultant fees for a specific client project
- Travel costs for employees scoping out a new site
- Software license purchase for a specific client or project
Construction
- Bricks and cement
- Wages of construction labor
- Equipment rental for a specific project
Indirect costs examples
Some examples of indirect costs that businesses typically incur include:
- Rent or lease payments for office or factory space
- Utilities
- Salaries of administrative and management staff
- Depreciation of company-owned vehicles and office equipment like computers
- Office supplies
- IT support costs for company-wide systems
- Insurance for company assets and liabilities
The importance of tracking both costs
Keeping on top of both direct and indirect costs has a number of important benefits, including:
- Improving your ability to budget correctly
- Allowing you to price your goods or services profitability
- Understanding how much it costs to produce a specific product or service
- Preventing profit margins from being eroded by hidden costs
- Driving better decisions about scaling production, introducing new products, or discontinuing unprofitable ones
- Maintaining compliance with financial reporting requirements
- Ensuring accurate tax deductions, credits, and allocations
- Preventing overuse or underuse of resources
- Identifying areas of inefficiencies or overspending
How to calculate direct costs
Calculating direct costs is quite straightforward since they are specifically tied to a cost object like a service, product, or department.
Here’s a brief overview of how to calculate direct costs:
- Identify all direct inputs, such as materials, labor, and other resources directly required to produce a product or service
- Track costs for each input
- Sum up all of the costs involved
Let’s illustrate with an example.
Say you’re producing a wooden table. The wood required costs $50, and you’ll also use another $10 worth of nails and glue. It’s going to take you five hours to build at a rate of $20 an hour. You’ll also need to use a special machine for this table, which will cost you $15 to work on.
Here are the direct costs involved:
- Direct material costs: $50 (wood) + $10 (nails, glue) = $60
- Direct labor costs: $20/hour × 5 hours = $100
- Other direct costs: $15 (machinery used exclusively for this table)
Then, we just add that up: $60 + $100 + $15 = $175
How to calculate indirect costs
Compared to direct costs, indirect expenses are a bit more complex to calculate since they are allocated across multiple cost objects. To determine what the indirect costs are for a given project, product, or service, you’ll need to use an appropriate allocation method.
Here’s a rundown.
First, you need to identify all of your indirect costs, including rent, utilities, administrative salaries, and depreciation.
Then, you choose an allocation base, such as:
- Labor hours or wages
- Machine hours
- Square footage
Then, you divide the total indirect costs by the total units of the chosen allocation base and multiply that rate by the number of units used by the costs object.
Here’s an example to make better sense of that.
A company has the following overheads with a total indirect cost of $10,000.
- Rent: $5,000
- Utilities: $1,000
- Administrative salaries: $4,000
To calculate indirect costs for a given project, the company uses machine hours as an allocation base. That machine has a total usage for the same financial period of 500 hours.
To calculate the per unit cost, they take the total indirect costs ($10,000) and divide that by the 500 machine hours:
$10,000 / 500 = $20
This means that for any given project, the indirect costs associated are $20 per hour of machine use. If a given project requires 30 hours of machine use, the company would calculate the associated indirect costs as:
$20 x 30 hours = $600
Common challenges in calculating direct costs
Business owners and financial leaders encounter a number of distinct challenges in calculating their direct costs.
Some of the most common include:
- Accurately tracing costs to specific cost objects
- Tracking and controlling fluctuations in material costs
- Overlooking smaller ancillary costs like consumables or equipment maintenance that result in an underestimation of total costs
- Variability in labor costs due to factors like overtime pay or varying employee efficiency
- Inefficient cost-tracking systems that lead to errors in categorization
- Complexity in multi-product or multi-project environments that lead to a misallocation of costs and skew financial metrics
- Determining how to account for wasted materials or scrap that is part of the production but doesn’t contribute to the final product
- Accounting for discount or bulk purchases and assigning those varying costs to individual products
- Change in product specifications and design requirements during production
- Allocating fringe benefits (like health insurance and bonuses) for workers who are directly involved in the production of a good or service
Managing direct costs effectively
Looking for a way to improve the way you manage direct costs?
Here are 8 strategies to implement right away.
1. Understand the impact of fixed and variable costs
Another way in which we divide business expenditure is to determine whether the expense is fixed or variable.
Fixed costs remain constant regardless of production levels, like equipment rental for a specific project. Variable costs change based on production, like the raw materials required to produce a certain good.
Understanding these distinctions helps in forecasting costs, budgeting, and making decisions about scaling production or pricing.
2. Implement real-time cost tracking
One of the best ways to take control over your direct costs is to improve your spend visibility by using specialized software to track costs in real time.
Expense management solutions can help you monitor cost fluctuations, forecast spending, and track how expenses influence profitability.
3. Negotiate supplier contracts
Focus on building strong relationships with suppliers and negotiate long-term contacts to secure better pricing for raw materials or components.
By locking in costs now, you’ll reduce exposure to price volatility and improve the predictability of your direct costs.
4. Optimize workforce efficiency
Invest in training and tools to improve the productivity of your direct labor.
For example, you can use scheduling and workload balancing tools to avoid employee burnout and avoid overtime costs.
By reducing labor inefficiencies, you can significantly lower the direct costs associated with wages and benefits.
5. Leverage bulk purchasing and discounts
Purchase raw materials or components in bulk where possible to take advantage of volume discounts.
You may even consider taking on debt or using a line of credit to access heavy discounts on regularly used materials to reduce your per-unit costs and prevent production delays.
6. Establish budgets for direct costs
Set a detailed budget for direct costs for each product or project and monitor actual costs against it to identify cost overruns and take corrective action early.
7. Evaluate product or service profitability
Make it a habit to regularly assess whether the direct costs of a product or service align with its pricing and profitability. You might consider discontinuing low-margin offerings or look for ways to increase pricing whilst maintaining competitiveness, such as adjusting marketing messaging.
8. Use data to drive decision-making
Leverage historical data and cost trends to make informed decisions about things like pricing, production schedules, and resource allocation.
Stay plugged into the local market and industry to predict upcoming changes, such as new legislation or economic conditions impacting the cost of critical components.
Tools and software for monitoring direct costs
The most important step in improving your control over both direct and indirect costs is to set yourself up with a software stack that allows you to track current behavior.
A simple spreadsheet might suffice for smaller businesses, but as your organization grows, you’ll need a more robust system.
BILL Spend and Expense combines a powerful company card with expense management software to streamline reporting and give you unparalleled insight into where your cash is going.
It’s plugged right into our accounts payable software and cashflow forecasting tool, giving you a connected ecosystem for financial management.
