What is the difference between direct and indirect staffing costs? provide two examples of each.

Direct and indirect costs are accounting concepts that help you separate expenditures that fluctuate, relative to how much business you transact, and costs that stay mostly the same, whether you sell one item or one thousand. Direct costs are considered direct because the expenses incurred go directly into the products or services you sell. Indirect costs are indirect because they describe items necessary for running your business but not necessarily for producing your products.

The most obvious examples of direct costs are the materials that go into producing the items you sell and the labor that goes into creating it. Rent, utilities and payroll are examples of indirect costs.

The most obvious examples of direct costs are the materials that go into producing the items you sell and the labor that goes into creating it. If you manufacture clothing, the amount of fabric and thread you use will vary directly in proportion to how many shirts you make. Even if you retail items that another business manufactures, the amount of inventory you purchase will vary, relative to how many items you sell. Similarly, you'll pay your employees for a greater number of hours if they make 200 shirts than if they make 20.

The rent you pay on your facility is an indirect cost because it does not fluctuate to your sales volume. The utilities costs you incur to keep your operation going are considered indirect costs, as well, because you have to keep your lights on and your rooms heated whether your business is thriving or struggling. Payroll for office staff that keeps track of payroll is an indirect cost, as well, because it goes into general operations, rather than specific items that you sell to generate revenue.

Although the distinction between direct and indirect costs is useful for accounting, it is rarely clear cut in real world situations. Many indirect costs such as utilities do actually fluctuate somewhat relative to your sales volume. You'll use more electricity or water if you manufacture more stock. However, the correlation between the wattage you use and the products you make is virtually impossible to untangle, unlike the correlation between material produced and shirts sewn.

Many direct costs aren't entirely direct. If you run a restaurant, you must maintain a minimum level of staffing, whether you serve customers all night or even if not one diner walked through your door. Economies of scale also cloud the distinction. Although you incur greater payroll expenses if you produce greater volume, you often spend less in labor per unit, the more you produce.

It's impossible to tease out all of these nuances when keeping your books, but it's nonetheless important to keep in mind that the distinction between direct and indirect costs is rarely clear and direct.

5 Min. Read

November 16, 2021

All businesses have expenses of some kind. These expenses are also known as costs. For the most part, they can be broken down into two categories. These categories are direct costs and indirect costs. As a business owner, knowing what business activities are direct or indirect is important. Keep reading to find out more about both of these types of expenses!

Here’s What We’ll Cover:

What Are Direct Costs?

What Are Indirect Costs?

Direct vs Indirect Costs

Key Takeaways

What Are Direct Costs?

Direct costs, or direct expenses, are easy to define for any business. They are able to be connected directly to a cost object. A cost object can refer to any number of things. It may be a specific product, project, or department. A direct cost is often a variable cost. This means that the cost fluctuates with production levels.

Some direct costs examples are listed below:

• Direct labor costs
• Direct materials costs
• Manufacturing costs
• Direct labor employees
• Fuel consumption for production

While many of these costs are variable, some direct costs are fixed costs. An example of a fixed cost would be rent for a production facility, or equipment. These costs are fixed from month to month. The cost to rent these things doesn’t change from day to day. They have to be related to production, though.

Understanding Fixed and Variable Costs

Direct costs are tied to a specific cost object. As such, not all of the costs associated with the object will be fixed. For example, an employee working on a project will normally be a fixed cost. The amount of time that they are allocated to work on the project is set, and it doesn’t change.

However, a product’s direct costs are often variable. This is because supply and demand changes over time. You won’t be producing the same amount of a product at all times. This means that the production costs and material costs will vary depending on the need.

What Are Indirect Costs?

If direct costs relate to a single cost object, then indirect costs relate to more than one. These are harder to define for businesses. They don’t relate to a single product, project, or department. As such, these cannot be assigned to a specific cost objective. Rather, they’re given joint objectives.

Some examples of indirect costs are listed below:

• Rent and utilities for storefronts
• Office equipment (office computers, furniture, etc.)
• Office supplies (less permanent than equipment, like paper and pens)
• Administrative expenses (administrative staff and other administrative costs)
• Overhead expenses

Because all of the above are required for more than one area of business, they are considered indirect.

Indirect Costs can be Fixed or Variable

Like direct costs, indirect costs can be fixed or variable, as well. Some of the fixed indirect expenses are rent for storefronts, or administrative salaries. Variable expenses include utilities for running storefronts, or monthly office supplies.

Calculating the Overhead Rates

Indirect costs can be used to determine a business’s overhead rate. The overhead rate is also known as the indirect cost ratio. This tells a business owner how much money is being spent compared to their sales. The overhead rate is easy to find.

Overhead Rate = Overhead Costs / Sales

Generally, a business wants to see a lower number for their overhead rate. This means that they are making enough money to cover their overhead costs. That indicates that profit is being made, in most cases.

Direct vs Indirect Costs

Understanding the difference between direct and indirect costs is important. Direct costs are the expenses involved in making a product or providing a service. Indirect costs are what it takes to keep a business running. The distinction matters for a few reasons.

Financial Statements

Knowing the difference between both types of costs is important for bookkeeping. Expenses should be recorded with both categories in mind. This makes a big difference on a business’s income statement. Direct costs are listed on the income statement as cost of goods sold (COGS). Meanwhile, indirect costs are listed under business expenses. Knowing how your business is spending money is crucial. Expense tracking can help with that.

Tax Purposes

Knowing the difference between production costs and business expenses may make a difference in your taxes. Not all expenses can be listed as a business expense. As such, knowing what is a direct cost and what is an indirect cost will make an impact.

Pricing Goods and Services

If you don’t use the correct costs to price your products, you may end up losing money. Direct costs are what it takes to make a product. However, if you don’t factor in the indirect costs of running your business, you may not break even.

Key Takeaways

Knowing the different kinds of costs is important for any business owner. Direct and indirect expenses play a major part in bookkeeping and business activities. Understanding each of them can help you make better business decisions.

If you’re looking for more information like this, be sure to check out our resource hub! We have more articles just like it.

RELATED ARTICLES

Direct costs are expenses associated with production and sales. The cost of raw material and labor required to manufacture a product would be categorized as direct costs.

Indirect costs are fixed expenses a business incurs to keep the company running no matter the activity level. These costs, often known as overhead, include administrative, full-time staffing, property, plant, and equipment (PP&E), and utility-related expenses.

If you’re a business owner or an aspiring entrepreneur, it’s important to know the difference between these two expenses your company will incur. Understanding how to categorize such expenses can also help you make decisions about hiring, contracting, or outsourcing manpower, buying or leasing equipment, developing in-house or sourcing products and services, budget better based on those decisions, and file for tax deductions.

Direct business expenses may qualify for deductions, helping you reduce the amount of taxes you have to pay for operating and profiting from your business.

Here are some notable differences between direct and indirect costs: 

The direct expenses required to manufacture a product or offer a service can be categorized as direct costs. The overhead expenses that aren’t directly related to the product being manufactured but remain necessary to keep the business running are categorized as indirect costs.

“Direct costs are expenses you incur because you sold something—labor, materials, equipment, commissions, freight, credit card fees when customers pay by credit card, etc.,” Ruth King, a business-finance author and consultant, told The Balance via email. “Indirect costs are expenses you incur to stay in business, i.e. keep the lights on, [such as] rent, utility bills, advertising, professional fees, office salaries, office expenses, repairs and maintenance, etc.”

Using a hamburger restaurant as an example to explain the concept of direct vs. indirect costs, certified public accountant (CPA) Robert Nix told The Balance by email: “To make a hamburger, the direct cost would be the two all-beef patties, special sauce, lettuce, pickles, onion and cheese on a sesame seed bun plus the labor cost of the employee to assemble it.”

On the other hand, he said, “The cost of the restaurant manager, the utilities/gas to power the grills and ovens, a portion of the amortization of the appliances to prepare the food, etc. would be indirect costs necessary to make a hamburger.”

Business expenses can’t always be categorized separately as either direct or indirect costs. Some expenses, such as power, can fall under both categories or switch categories, depending on your company’s production system.

Electricity used to run the machinery and produce raw materials for manufacturing products would be labeled direct costs. However, the electricity required to run the lights and fans in employee cubicles may be an indirect expense.

Phones also can fall under these special considerations. For example, “You don't need a phone service to manufacture a steel rod, but you do need phones to sell them,” Ryan McEniff, a Massachusetts-based business owner, told The Balance in an email.

Another example is the salaries of administrative employees. While labor costs such as the salary of a chef in a hamburger restaurant are direct costs and administrative expenses are indirect costs, administrative-staff labor costs fit in an ambiguous category between the two.

If you want to build a profitable business, it’s important to consider both direct and indirect costs while defining your pricing strategy. “The total of all your sales must cover direct and indirect costs for your company to make a profit. That means some products must be priced above their direct costs to cover indirect costs,” Rob Stephens, a financial consultant advising small businesses, told The Balance via email.

Christan Hiscock, CEO and co-founder of Kardia Financial Group, offered another example: “Say you own a home renovation business and need to give a potential client a quote for a job. You know that you have your fixed costs like materials and variable costs such as the payments for your staff’s work on the job. You want to ensure that when you set your pricing, you know how long it takes your team to do certain tasks.”

Hiscock also recommended adding a “buffer” of 10% to 15% in case something goes wrong. “This will ensure you are protecting yourself and making a profit off of every single job that you do,” he told The Balance by email.

The prices your competitors charge must also factor in when you develop your pricing strategy so you aren’t under- or overcharging customers.

Direct costs are associated with the production cycle, while indirect costs keep the production cycle operating. Employee salaries and the cost of raw materials are direct costs, for example, and utilities fall under indirect costs.

Understanding and anticipating both can help you better plan your budget, effectively apply for external funding, and file beneficial tax returns.