Direct Cost Definition and Meaning Explained

When you have a business, you have direct costs and indirect costs. Tracking these expenses is key to having up-to-date books, receiving tax deductions, and making business decisions. So, what’s the difference between direct vs. indirect costs?

Direct Cost method

Direct Costs

Direct costs are those which can be identified specifically with a particular sponsored project and which can be directly assigned to such activities, relatively easily and with a high degree of accuracy.

For example, the supplies needed for a research project are easy to identify, as are the salaries of the individuals who will work on the project and travel expenses for those individuals.

Definition of direct cost

A cost that may be computed and identified directly with a product, function, or activity and that usually involves expenditures for raw materials and direct labor and sometimes specific and identifiable items of overhead —contrasted with indirect cost

Understanding Direct Costs

Although direct costs are typically variable costs, they can also include fixed costs. Rent for a factory, for example, could be tied directly to the production facility. Typically, rent would be considered overhead. However, companies can sometimes tie fixed costs to the units produced in a particular facility.

Direct Costs Examples

Any cost that’s involved in producing a good, even if it’s only a portion of the cost that’s allocated to the production facility, are included as direct costs. Some examples of direct costs are listed below:

  • Direct labor
  • Direct materials
  • Manufacturing supplies
  • Wages for the production staff
  • Fuel or power consumption

Because direct costs can be specifically traced to a product, direct costs do not need to be allocated to a product, department, or other cost objects. Direct costs usually benefit only one cost object. Items that are not direct costs are pooled and allocated based on cost drivers.

Fixed vs. Variable

Direct costs do not need to be fixed in nature, as their unit cost may change over time or depending on the quantity being utilized. An example is the salary of a supervisor that worked on a single project.

This cost may be directly attributed to the project and relates to a fixed dollar amount. Materials that were used to build the product, such as wood or gasoline, might be directly traced but do not contain a fixed dollar amount.

This is because the quantity of the supervisor’s salary is known, while the unit production levels are variable based upon sales.

Direct Cost meaning

Types of Direct Costs

There are two basic ways that direct costs are used.

The first is in calculating the production costs of a product. The cost of goods sold (COGS) is the amount of all of the supplies used for creating a product, the labor costs from employees working on a product, the space needed to create the product, packaging costs, utilities used in production, and equipment use.

All of these expenses are added together to calculate what it costs to create a product. Understanding the cost of a product is vital in creating a sales price that is profitable and ensuring the product is making money, not losing money.

The second way that direct costs are used is in calculating the operating expenses of a department or division of a company.

Direct costs that a department may incur include payroll for department employees, office or workspace for the members of the team, training expenses, travel and entertainment costs incurred by a department, and any other expenses that are specifically associated with each department.

Benefits of using Direct Cost Methods

The benefits of using the direct costing method are that it provides reasonable information to the management for decision-making about the product and pricing of the product.

Also, it is relatively easy to control direct costs by efficient management as compared to indirect costs or overhead costs. 

Following are the common advantages of using direct costing methods:

  • It helps in making a master budget for the year as direct costing provides a variable per unit cost.
  • Variable costs allow you to analyze the cost-volume relationship or break even point for your business. Breakeven is the sale volume at which there is no profit & loss for the business.
  • Once the direct and indirect costs are determined, then it becomes easy for management to decide on a good price for their product.
  • It provides more control to the management on organization operations as direct costing pinpoints the responsibility according to organizational lines.
Direct Cost explained

Analysis of Direct Cost for Business

Direct cost analysis can also be used outside the production department. For example, subtract the direct cost of goods sold to individual customers from the revenues generated by them, which yields the amount customers are contributing toward the company’s coverage of overhead costs and profit. Based on this information, management may decide that some customers are unprofitable, and should be dropped.

However, there are a number of situations in which direct costing should not be used, and in which it will lead to incorrect behavior.  Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today’s companies. 

This is a real problem when dealing with long-term costing and pricing decisions since direct costing will likely yield results that do not achieve long-term profitability. 

For example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs but is lower than the additional overhead costs that are associated with the product line.  If the company uses the $10.00 price well into the future, then the company will experience losses because overhead costs are not being covered by the price.

Using just direct costs to derive the value of inventory is not allowed under generally accepted accounting principles and international financial reporting standards, on the grounds that it does not provide a comprehensive view of every cost being incurred to create a product.

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