Direct costs can be linked directly to a product, service or project; all other costs are indirect costs. There are very few direct costs. The chips and hard drives represent direct costs for a computer manufacturer, as do the salaries for the assembly line workers. However, the accounting and marketing salaries are indirect costs because they are not directly traceable to the computers. Understanding the differences between direct and indirect costs is key to controlling them.
A cost objective is the purpose for which a cost is being measured. The determination of direct and indirect costs depends on the choice of a cost objective. For example, an accountant's salary at an electronics manufacturer would be an indirect cost because he is most likely involved in support functions (such as preparing financial statements). However, his salary would be a direct cost at a bank if he is processing loans and mortgages, which are generally key revenue sources for a bank.
Direct labor costs are usually measured using time sheets and time cards. In a service company (such as a law firm), employees will usually track the weekly hours by project or client. In a manufacturing company making large quantities of identical products, the direct labor cost is allocated equally to the units produced. On the income statement, direct costs are recorded as cost of goods and subtracted from sales to result in gross profit. Indirect costs are used for multiple products and services and, therefore, cannot be assigned individually to each unit produced. They are subtracted from gross profit to result in operating profit.
Financial Analysis: Fixed and Variable Costs
A cost is fixed if it is incurred regardless of production volume; otherwise, it is a variable cost. Direct costs are generally variable because they are linked directly to the quantity produced. Indirect costs can be fixed or variable. For example, assembly line maintenance costs and administrative staff salaries are fixed because most of these costs are incurred regardless of how many units are produced. The electricity costs for the manufacturing plant could be a variable cost because the electricity used will depend on the number of shifts. (See Reference 5)
Considerations: Internet Companies
An Internet company typically generates at least half of its sales online. Deciding which costs are direct and indirect can be difficult because, unlike traditional brick-and-mortar companies, there may not be tangible materials or labor tied directly to a product or service. In the publication "Distinguishing Between Direct and Indirect Costs Is Crucial for Internet Companies" on Aalborg University's website, University of Maryland professors Lawrence Gordon and Martin Loeb have suggested that the customer should be the primary cost objective for Internet companies. Therefore, costs that are traced directly to customers are direct costs; otherwise, they are indirect costs. Examples of direct costs include the cost of the products sold -- books and music files -- and the cost of the advertising that pulls in customers to the online store. An example of an indirect cost would be the lease and maintenance of the hardware infrastructure -- servers and storage devices.
- Accounting Tools: What Are Direct Costs?
- Accounting Tools: What Are Indirect Costs?
- Accounting Tools: What Is Direct Material Cost?
- Accounting Tools: What Is Direct Labor Cost?
- AccountingCoach: Are Direct Costs Fixed and Indirect Costs Variable?
- Aalborg University: Distinguishing Between Direct and Indirect Costs Is Crucial for Internet Companies
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.