Direct vs Indirect Costs: What’s the Difference?

For example, to create a product, an appliance-maker requires steel, electronic components and other raw materials. Two popular ways of tracking these costs, depending on when your company uses materials in production, are first-in, first-out and last-in, first-out, also known as FIFO and LIFO. LIFO can be helpful if the costs of your materials fluctuate in the course of production. For example, if an employee is hired to work on a project, either exclusively or for an assigned number of hours, their labor on that project is a direct cost.

Finally, the company multiplies the hourly cost by the number of labor hours spent to manufacture a product to determine the overhead cost for that specific product line. Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs. Fixed costs are costs that remain unchanged regardless of the amount of output a company produces, while variable costs change with production volume. Unlike direct costs, indirect costs cannot be tied back to a specific product or productions. For example, when you pay administrative costs, such as support staff salaries or insurance, that expense cannot be tied directly back to a specific product or activity, which makes it an indirect or overhead cost. Indirect or common costs include expenses such as rent, salaries of support staff, and utilities, which are shared across multiple projects or activities.

Direct Cost VS Indirect Cost

Certain government agencies might allow you to explain why indirect costs should be funded, too, but the decision to grant funding is at their discretion. In cases of government grants or other forms of external funding, identifying direct and indirect costs becomes extra important. Grant rules are often strict about what constitutes a direct or an indirect cost and may allocate a specific amount of funding to each classification. Direct costs are expenses that a company can easily connect to a specific “cost object,” which may be a product, department or project. It can also include labor, assuming the labor is specific to the product, department or project.

Fixed indirect costs, such as monthly office rent or the one-off cost of establishing a project site office, remain relatively constant. Differentiating between these cost indirect costs are also referred to as types is essential for thorough and precise budget forecasting. A company with a cost pool of manufacturing overhead uses direct labor hours as its cost allocation basis.

Direct vs. Indirect Costs: What’s the Difference?

Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, factory burden, or burden. In an industry where past trends can inform future decisions, data analytics and predictive tools can play a large role. By analyzing historical data, these tools can identify patterns in indirect cost overruns or savings, providing valuable insights for future projects. Predictive analytics can help forecast potential cost deviations, allowing project managers to proactively adjust budgets or strategies to mitigate risks. To maximize profits, businesses must find every possible way to minimize costs.

In an example of a car manufacturer, the materials like steel, plastic or glass used in the car production line are classified as direct costs. It will also give you a much clearer picture of the financial health of your business. Your products will be accurately priced so you can earn a profit, and you’ll have a much better idea of areas in which your business is performing well, along with areas where costs need to be lowered. While all of the above costs are necessary for business operations, none of them can be directly tied to one specific product. Having an understanding of which costs are direct and indirect would help in recording them in your books and income statements. For example, rent is a fixed cost, but the wages of the administrative staff are a variable cost.

So You Want to Know About Indirect Costs

Some common examples include temporary site facilities and utilities as well as tools and equipment rentals. Indirect costs in construction refer to expenses that, while not directly tied to a specific building or structure, are essential for the overall execution of a project. Understanding indirect costs is key for accurate project budgeting, strategic bidding, and maintaining project profitability. Indirect costs incurred in manufacturing operations are known as manufacturing overhead, while indirect costs incurred in the general and administrative area are known as administrative overhead. It is useful to identify indirect costs, so that they can be excluded from short-term pricing decisions where management wants to set prices just above the variable costs of products. This is an important issue when a customer wants the lowest possible price on a special order.