Being a business owner, you need to keep proper track of the cash flow on a regular basis. It does not matter whether you are taking help from accounting software or doing all the calculations manually.
You need to know what is happening with the money that you are dealing with. And in this process of tracking the cash flow, many owners struggle while categorizing direct vs indirect costs.
So, it is really vital to understand the similarities along with the differences between indirect and direct costs. Once you get a piece of detailed knowledge about direct vs indirect costs accounting, you will be able to point out those problem areas and solve them.
In order to understand indirect vs direct costs, first, you need to know what fixed costs and variable costs are.
From the name, it is understandable that it is fixed. The costs which do not change or remain the same from month to month are considered fixed costs. Insurance, building rent, administrative salaries are examples of fixed costs.
It does not depend on the production. This cost remains the same whether 100 or 10,000 products are manufactured. Most indirect costs fall under the category of fixed costs.
In most cases, the production level directly regulates the variable costs. Most direct costs, for example, production supplies, materials come under the term of variable costs.
These will increase with the increasing number of productions. When the production level drops, these costs will also drop in a particular month or time period.
What Are Direct Costs?
Those costs, which are directly related to producing a product, belong to the category of direct costs. Direct material costs, direct labor costs along with all the manufacturing supplies are on the list of direct costs.
It is important to understand the concept of direct vs indirect costs.
In order to easily identify direct costs, you can consider the components that are directly connected with finishing the product.
Let’s understand the concept with an example of manufacturing a cricket bat.
While manufacturing a cricket bat, your direct cost will include the wood, composite, or any metal that is needed, along with the salaries of all line workers who made the bat.
The examples of direct costs are,
- Direct labor.
- Direct materials.
- Manufacturing supplies.
- Direct power or fuel (cost of running machines).
Though in most cases, direct costs are variable, there are some instances when some fixed costs also come in the category of direct costs, such as property taxes or rent, especially for manufacturing plants.
What Are Indirect Costs?
Have you heard of overhead costs? Yes, it is often referred to as an indirect cost. Just focus more on day-to-day business expenses in place of the cost of product production. So, it should be clear what direct vs indirect costs are.
For example, in order to properly manage the business, the cost of facility rentals, office supplies, and administrative staff are important. But they are indirectly related to the process of production. So, they are considered indirect costs.
In general, indirect costs include
- Office supplies.
- Legal fees.
- Salaries (non-labor).
- Utilities (some).
- Human resource costs.
- Administrative and accounting expenses.
When all of the above-mentioned costs are necessary for running a business, but none of them are directly connected with any specific product.
The Differences Between Direct And Indirect Costs
Now you know what is called direct costs vs indirect costs. I hope you will not face any difficulty in categorizing them and calculating them. But in case the concept is still vivid, here is a chart of direct vs indirect costs for your better understanding.
|Direct Costs||Indirect Costs|
|These are used in order to calculate the cost behind the goods that are sold.||These are considered overhead expenses.|
|These are always directly connected or related to the products.||These are related to multiple business activities.|
|These costs will vary with the production level.||These costs will remain the same from month to month.|
In the accounting of any type of business, direct costs are always considered into the cost of goods sold. On the other hand, indirect costs are reported as overhead costs.
The direct costs are recorded as a variable, which will change with respect to the production level. In the case of indirect cost, it is considered as fixed costs as they will not change from month to month.
How Classifying Direct vs Indirect Costs Will Help In Your Business
Classifying direct vs indirect costs may seem like a lot of unnecessary work for your accountant or bookkeeper, but in actuality, it will benefit your business in multiple ways.
1. More Precise Pricing
Tracking indirect vs direct cost will help you in determining the cost of manufacturing a product. If you do not know how much the product cost, how will you know what you should charge from your customers?
2. Potential Tax Benefits
There are many expenses that are directly associated with the business are tax deductibles. So, in order to bring any tax deductions or savings, you need to calculate the direct vs indirect costs properly.
3. More Precise Budgeting
When you are not aware of accounting for the direct vs indirect costs, how will you be able to set the budget for next year? So, for calculating a more accurate budget, you need to know how much you are paying for materials, direct labor along with all the operating expenses, such as rent, office supplies, and taxes.
4. Precise Financial Reporting
Accurate financial statements are too vital for small businesses while making informed decisions. If direct vs indirect costs are not properly accounted for, the information that the financial statement will have will be wrong.
So, it is really crucial for understanding the accurate business finances that your business is experiencing. Inaccurate financial reports may also affect your ability to attract investors and get loans.
So, now you know what direct and indirect costs are. You also get to know the importance of accounting for direct vs indirect costs. While direct cost is directly associated with the product, indirect costs are essential for managing the business.
Both are vital for running a business and keeping the financial report neat. In case you are not considering direct vs. indirect costs till now for your business. I would tell you to do that from now on.