In finance, direct costs are those costs that are associated with a specific project, department, or activity. Sometimes referred to as hard costs, expenses of this type are found with just about every type of business activity, beginning with research and development, moving through sales and marketing campaigns, and into the production of different types of goods and services. A direct cost is often some type of fixed expense, but there are some situations where a variable expense may also fall into this category.
The key to understanding what does and does not constitute direct costs is to identify costs that apply only to a specific project, and have nothing to do with any other activity that is taking place concurrently. In order to be a true hard cost, the expense must be for resources that benefit that one project. For example, if the project is to construct a telephone, the costs for the handset casing, internal circuit boards, and the wiring would all fall into the category of direct costs. In addition, the wages paid in exchange for the labour to build the telephone would also be a direct cost.
In situations where expenses do not go to benefit a specific task or project, the cost would be considered indirect. Utilities, such as electricity, used to operate a facility that houses several different product lines or other activities would not be considered direct costs, since those utilities benefit more than one specific project. Expenses of this type would be shared among the different projects, rather than be tied directly to any one activity.
Not every business operation will evaluate direct costs in exactly the same way. Depending on the structure of the company, something that is considered a hard cost in one business culture may be classified as an indirect cost in a different culture. As long as the internal guidelines for determining what is and is not a direct cost remain consistent, it is still possible to properly determine the historical cost or the cost of goods sold with a high degree of accuracy. That same consistency makes it possible to compare the absorption costing from one period to the next, and determine if there has been an increase in direct costs associated with a particular function or project.
Indirect costs are business expenses that are not directly related to a particular product or function within the general operation. Costs of this type tend to have an impact on the overall operation of the business, making it very difficult to charge the costs to a specific department or associate them with one function. Costs of this type are sometimes referred to as overhead, a term that helps to describe the broad application of these costs.
There are many examples of indirect costs that occur in both small and large businesses. A general supply for the administration of the business is one example. Items such as paper, pens, and other essentials that are utilized in the record keeping and general clerical functions of each department are often classified as an indirect cost. In like manner, services such as auditing the accounting books or the preparation of legal documents are expenses that impact the entire operation and are usually considered indirect in nature.
Several of the expenses related to the upkeep and maintenance of business facilities are considered indirect costs. Utilities such as electricity, water, and Internet access are expenses that benefit the business in general and thus are classified as overhead expenses. In like manner, the cost of renting or leasing business space is also part of the overhead, making it an indirect cost.
There are examples of what may appear to be an indirect cost actually being a direct cost. One example has to do with employee salaries. When the employees are performing their usual functions, they are benefiting the business as a whole; their wages and salaries are considered indirect costs. However, if those same employees are assigned to a specific project that is the sole focus of their workday for a period of several days or weeks, their wages or salaries can be considered a direct cost, with that cost directly applied to that project.
A business may take in one sum of money, but it is not likely that all of it can be considered profit. This is because a business is generally required to pay expenses. Those expenses are commonly referred to as overhead costs. Examples of an overhead cost include salaries, maintenance, and production expenses.
It is common for businesses to track their net and gross income. This is important because these figures represent two different values. Gross income refers to all of the money that a business takes in. This figure may be very large.
Some businesses have a wide variety of expenses to pay, while others only have a few expenses. In either case, almost every business will have at least some overhead costs. Net income refers to the amount of money that remains once overhead costs have been deducted.
This amount can be significantly lower and may not exist at all. This is because it is possible for a company to have overhead costs that consume all of its income. In some instances, a company’s expenses can even cause them to be in debt.
Without calculating overhead costs, a business cannot know exactly how much money it is making. If ABC Toys buys its merchandise from a factory, some of the money that it receives from the merchandise must be used to not only buy more merchandise but also to pay for items such as electricity, transportation, and salaries. Even if ABC Toys manufactures its own merchandise, there will still be costs such as purchasing machinery and raw materials.
How overhead costs are categorized depends on a company’s accounting methods. Some businesses are very basic in the figuring of their expenses. Other businesses, however, have very complex methods that may require various departments to individually access their overhead costs. Some businesses access their overhead cost by category. For example, manufacturers may calculate their manufacturing expenses and their non-manufacturing expenses separately.