Direct Costs vs. Indirect Costs: What Are They, and How Are They Different?

Understanding direct costs and indirect costs is important for properly tracking business
expenses.

As the owner of a startup or small business, there are crucial aspects you should understand to
put your business on the path to success. One of those aspects is understanding the distinction
between direct and indirect costs when pricing your products or services.

When you know the true costs involved with producing and providing your goods or services to
consumers, you can price both competitively and accurately. There's another benefit as well:
Certain costs, both direct and indirect, are tax-deductible. And if you ever apply for and receive a
grant, there are several rules around the types of indirect costs – and the maximum amount – you
can claim.

What are direct costs?

Direct costs are expenses that a company can easily connect to a specific "cost object," which
may be a product, department or project. This can include software, equipment and raw
materials. It can also include labor, assuming the labor is specific to the product, department or
project.

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. If your company develops software
and needs specific assets, such as purchased frameworks or development applications, those are
direct costs.

Labor and direct materials constitute the majority of direct costs. For example, to create its
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, include last-in, first-out (LIFO) or first-in, first-out (FIFO). This can be helpful if the
costs of your materials fluctuate in the course of production.

Usually, most direct costs are variable. Smartphone hardware, for example, is a direct, variable
cost because its production depends on the number of units ordered. A notable exception is direct
labor costs, which usually remain constant throughout the year. Typically, an employee's wages
do not increase or decrease in direct relation to the number of products produced

What are indirect costs?

Indirect costs extend beyond the expenses you incur creating a product to include the costs
involved with maintaining and running a company. These overhead costs are the ones left over
after direct costs have been computed.
The materials and supplies needed for a company's day-to-day operations are examples of
indirect costs. While these items contribute to the company as a whole, they are not assigned to
the creation of any one service.

Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell
phones. Much like direct costs, indirect costs can be both fixed and variable. Fixed indirect costs
include things like rent. Variable costs include the fluctuating costs of electricity and gas.

Differences between direct and indirect costs, and why it's important

A simple trick to classifying payments as direct or indirect costs is that direct costs encompass
the costs involved with creating, developing and releasing a product.

Direct costs include:

 Manufacturing supplies
 Equipment
 Raw materials
 Labor costs
 Other production costs

Conversely, indirect costs encompass costs not directly related to the development of your

business's product or service.

Indirect costs include:

 Utilities
 Office supplies
 Office technology
 Marketing campaigns
 Accounting and payroll services
 Employee benefit and perk programs
 Insurance costs

As a business owner, knowing the difference between both types of costs is important, because,
one, it helps you have a greater understanding of your product or service, which can lead to more
competitive pricing; two, you have a better grasp of your accounting and can better plan for the
future of your business.

It also matters when it's time to file your taxes. Some direct and indirect costs are tax-deductible.
Examples of tax-deductible direct costs include repairs to your business equipment, such as your
production line. Tax-deductible indirect costs may include rent payments, utilities and certain
insurance costs.
Each business's situation is different, however. Your accountant can advise you which costs
qualify.

Rules about direct costs and indirect costs impact funding for your small business

In cases of government grants or other forms of external funding, identifying direct and indirect
costs becomes doubly important. Grant rules are often strict about what constitutes a direct or an
indirect cost and will allocate a specific amount of funding to each classification.

Often, funding for a specific project will largely support direct costs. Certain government
agencies might allow you an opportunity to explain why indirect costs should be funded, too, but
the decision to grant funding is at their discretion.

When a company accepts government funds, the funding agency may also have several strict
mandates in place regarding the maximum indirect cost rate and what expenses qualify as
indirect costs.

Manufacturing Costs and Non-manufacturing Costs

Costs, when categorized according to function, can be classified into: (1) manufacturing
costs and (2) non-manufacturing costs.
Manufacturing Costs
Manufacturing costs refer to those that are spent to transform materials into finished
goods. Manufacturing costs include direct materials, direct labor, and factory overhead.
Direct materials - cost of items that form an integral part of the finished product. They
refer to the major parts or ingredients. Examples include wood in furniture, steel in
automobile, water in bottled drink, fabric in shirt, etc.

Direct labor - cost of labor expended directly upon the materials to transform them into
finished goods. Direct labor refers to salaries and wages of employees who work to
convert the raw materials to finished goods.

Factory overhead - also called manufacturing overhead, refers to all costs other than
direct materials and direct labor spent in the production of finished goods. Factory
overhead includes indirect materials such as cost of nails, thread, glue, etc.; indirect
labor such as salary of the supervisor; and factory expenses such as rent of the factory
space, depreciation of factory equipment, utilities expense of the factory, factory
supplies, etc.
Manufacturing costs are also known as factory costs or production costs.
Non-manufacturing Costs
Non-manufacturing costs refer to those incurred outside the factory or production
department. These are costs are not needed in transforming materials into finished
goods. Non-manufacturing costs include: selling expenses and general expenses.
Selling Expenses - also called Selling and Distribution Expenses. Examples include
advertising costs, salaries and commission of sales personnel, storage costs, shipping
and delivery, and customer service.
General Expenses - also called General and Administrative Expenses. Examples are:
executive salaries, salaries of administrative staff, accounting expenses, legal
expenses, research and development, and other costs related to general administration
of the organization.
Example
Classify the following costs as either M: manufacturing (DM: direct materials, DL: direct
labor, FOH: factory overhead) or N: non-manufacturing (SE: selling expense, GE:
general expense).
1. Factory supplies
2. Salary of production supervisor
3. Legal expense
4. Freight-out (delivery expense)
5. Marketing samples
6. Glue used in production
7. Wood in producing furniture
8. Salary of the company president
9. Advertising
10. Administrative office rent
11. Salary of factory workers
12. Depreciation of factory building
13. Depreciation of office equipment
14. Depreciation of display racks inside the store
15. Freight-in