Direct vs Indirect Costs: Examples & Why It Matters

This article is part of a larger series on Bookkeeping.

1. 1 Direct Costs
2. 2 Why Direct vs Indirect Costs Matter
3. 3 FAQs
4. 4 Bottom Line

Direct costs are traceable to a specific product or business component, while indirect costs benefit multiple products or the business in general. Knowing the difference between direct vs indirect costs helps in understanding the business’s cost structure and developing a competitive pricing strategy. Moreover, understanding the nature of costs enables you to determine if all costs are accounted for correctly and if the net income reflects the business’s true performance for a particular period.

Costs that are economically traceable to cost objects * , often a product. Costs are economically traceable only when management will not have a hard time tracing these costs.

Therefore, tracing costs involves a cost-benefit analysis. Does tracing these costs produce useful information for decision-making? If yes, then the cost is direct. Otherwise, it’s indirect.

A “catch-all” category for costs that are hard to trace to cost objects * because it is difficult to pinpoint which business components benefited from indirect costs. They can’t be traced, so accountants need to allocate them to cost objects * .

Read our article about managerial accounting and its importance for small businesses. Our guide will show you the different managerial accounting tools and how to apply them for small businesses.

Direct vs Indirect Costs Examples

Here are some direct vs indirect costs examples based on industry:

• Cost of inventory purchased
• Insurance paid on inventory purchased
• Shipping costs shouldered by the buyer
• Subscription and other fees paid for payment processing channels and terminals, point-of-sale systems, and other retail technology
• Subscription to inventory management software

• Rent paid on storage warehouse
• Utilities such as electricity, water, and telecommunication
• Depreciation of storage warehouse and warehouse equipment
• Insurance of storage warehouse
• Salaries of the warehouse manager, assistants, cashiers, store assistants, floor managers, and inventory manager
• Taxes and legal fees
• Payroll, accounting, and bookkeeping services
• All other costs that are not economically traceable to the final product

• Raw materials that go into the final product
• Labor hours spent in converting raw materials into the product
• Directly traceable conversion costs
• Depreciation and insurance of machines and equipment used in production
• Packaging costs
• Inspection and quality assurance (QA) costs
• Shipping costs
• Commission of sales personnel

• Rent paid on manufacturing facility
• Utilities, such as electricity, water, and telecommunication
• Depreciation and insurance of the whole production facility
• Salaries of managers and supervisors
• Cost of compliance with health and safety standards
• Taxes
• Payroll, accounting, and bookkeeping services
• All other costs that are not economically traceable to the final product

• Salaries of nonprofit employees in charge of nonprofit activities and programs
• Rent paid on buildings and offices
• Utilities, such as electricity, water, and telecommunication
• Costs traceable to the nonprofit’s program services and activities
• Depreciation of equipment used for nonprofit activities

• Payroll, accounting, and bookkeeping services
• Depreciation of nonprofit office or building
• Salaries of administrative employees
• Office supplies

• Wages and salaries paid for time billed to customers
• Supplies used that are necessary to perform tasks
• Mileage expenses for meeting with the client or visiting the client’s office
• Depreciation of equipment used for performing tasks, such as laptops, printers, desktops, and monitors
• Salaries of managers and supervisors, whether client-facing or specifically assigned for a particular client only
• Agreed-upon costs with clients, such as staff meals, transportation allowances, and overtime allowances

• Wages and salaries paid for time not billed to customer
• Rent of office space or building
• Utilities, such as electricity, water, and telecommunication
• Depreciation of office building
• Insurance of office building
• Maintenance expenses, such as janitorial and security services
• Entertainment expenses when meeting clients
• Expenses paid for by the company but not allowed by the client to be part of the professional service fee

Why Do Direct vs Indirect Costs Matter?

In cost accounting and managerial accounting, costs play a significant role in analyzing business profitability and resource usage. There are two major reasons why distinguishing between direct and indirect costs is important.

1. Pricing Goods

Cost is an important component of price, especially when using the cost-plus pricing strategy. Determining all direct and indirect costs helps you set a desired markup on goods and services. If you have a consistent ratio of indirect to direct costs, you can set a purchase price based on a percentage of direct costs that will both cover your indirect costs and provide needed profit.

In strategic cost management, there is a practice called target costing, wherein businesses determine product cost by deducting the desired profit margin from a competitive market price. For example, a good sells for $50 in the market. If the company’s desired profit is $15, the target cost should be $35.

With $35 as the goal, you can do a deep dive in product development and understand how the business can achieve this target cost. This strategy is not only about minimizing or reducing costs but also enhancing product quality and adding more value for customers. By focusing on the direct costs, you can concentrate on controlling the costs that will have the greatest impact on both total cost and quality.

2. Allocating Resources

Determining direct costs to a product also helps you in allocating resources. In an ideal world, there are no constraints or scarcity. However, small businesses face scarcities in resources due to different limitations—such as financial capabilities, difficulty in accessing materials, and other external factors.

In managerial accounting, there is a decision-making tool called the best product combination analysis. This tool uses the contribution margin (CM) per scarce resource as a basis for allocating resources. You should allocate more resources to the product that has the highest CM.

To illustrate, let’s assume that ABC Company has labor hours limited to 1,000 hours and two products, Cyan and Magenta:

• One unit of Cyan takes two direct labor hours to process
• CM per unit of Cyan is $9
• One unit of Magenta takes three direct labor hours to process
• CM per unit of Magenta is $12

Given that ABC Company has limited labor hours, let’s perform a best product combination analysis: