Direct costs are traceable to a specific product or business component, while indirect costs benefit multiple products or the business in general. Knowing the difference between direct vs indirect costs helps in understanding the business’s cost structure and developing a competitive pricing strategy. Moreover, understanding the nature of costs enables you to determine if all costs are accounted for correctly and if the net income reflects the business’s true performance for a particular period.
| Direct Cost | Indirect Cost | |
|---|---|---|
| What It Is | Costs that are economically traceable to cost objects*, often a product. Costs are economically traceable only when management will not have a hard time tracing these costs. Therefore, tracing costs involves a cost-benefit analysis. Does tracing these costs produce useful information for decision-making? If yes, then the cost is direct. Otherwise, it’s indirect. | A “catch-all” category for costs that are hard to trace to cost objects* because it is difficult to pinpoint which business components benefited from indirect costs. They can’t be traced, so accountants need to allocate them to cost objects*. |
| Examples | Products or product lines, geographical territories, branches, and facilities | Salt and pepper in a restaurant and grease in a car manufacturing facility |
| *A cost object is something that collects or accumulates costs. | ||
Direct vs Indirect Costs Examples
Here are some direct vs indirect costs examples based on industry:
Direct Costs | Indirect Costs |
|---|---|
|
|
Direct Costs | Indirect Costs |
|---|---|
|
|
Direct Costs | Indirect Costs |
|---|---|
|
|
Direct Costs | Indirect Costs |
|---|---|
|
|
Why Do Direct vs Indirect Costs Matter?
In cost accounting and managerial accounting, costs play a significant role in analyzing business profitability and resource usage. There are two major reasons why distinguishing between direct and indirect costs is important.
1. Pricing Goods
Cost is an important component of price, especially when using the cost-plus pricing strategy. Determining all direct and indirect costs helps you set a desired markup on goods and services. If you have a consistent ratio of indirect to direct costs, you can set a purchase price based on a percentage of direct costs that will both cover your indirect costs and provide needed profit.
In strategic cost management, there is a practice called target costing, wherein businesses determine product cost by deducting the desired profit margin from a competitive market price. For example, a good sells for $50 in the market. If the company’s desired profit is $15, the target cost should be $35.
With $35 as the goal, you can do a deep dive in product development and understand how the business can achieve this target cost. This strategy is not only about minimizing or reducing costs but also enhancing product quality and adding more value for customers. By focusing on the direct costs, you can concentrate on controlling the costs that will have the greatest impact on both total cost and quality.
2. Allocating Resources
Determining direct costs to a product also helps you in allocating resources. In an ideal world, there are no constraints or scarcity. However, small businesses face scarcities in resources due to different limitations—such as financial capabilities, difficulty in accessing materials, and other external factors.
In managerial accounting, there is a decision-making tool called the best product combination analysis. This tool uses the contribution margin (CM) per scarce resource as a basis for allocating resources. You should allocate more resources to the product that has the highest CM.
To illustrate, let’s assume that ABC Company has labor hours limited to 1,000 hours and two products, Cyan and Magenta:
- One unit of Cyan takes two direct labor hours to process
- CM per unit of Cyan is $9
- One unit of Magenta takes three direct labor hours to process
- CM per unit of Magenta is $12
Given that ABC Company has limited labor hours, let’s perform a best product combination analysis:
| Cyan | Magenta | |
|---|---|---|
| Individual Contribution Margin per Unit | $9 | $12 |
| Divided by: Number of Labor Hours Needed | 2 hours | 3 hours |
| CM per Labor Hour | $4.5 per hour | $4 per hour |
From the computations above, we can see that Cyan has a higher CM per direct labor hour than Magenta. It means that Cyan is earning $0.5 more per labor hour than Magenta. Hence, it’s best if we allocate more to Cyan than to Magenta. Even if Magenta has a higher individual CM per unit, it takes one hour more to produce one unit of Magenta; thus, it’s unwise to use more labor hours for Magenta if we can generate more profit by producing more Cyan.
Frequently Asked Questions
Can indirect costs be eliminated?
No, because some indirect costs are necessary to keep the business running. Examples include accounting and bookkeeping fees, rent, and utilities, to name a few.
How can you trace direct costs?
Understanding your main products is the key to knowing which costs can be conveniently computed and measured. If it’s impossible or too time-consuming to quantify the exact amount, these costs are untraceable and are indirect costs.
Bottom Line
Distinguishing direct vs indirect costs helps small businesses set product prices, determine product margins, and allocate limited resources. Since direct costs can be traced to particular products or services, there is little difficulty in attributing them to cost objects. The main challenge for small businesses is distinguishing which costs are indirect and if such costs need to be allocated to products and services.
