Business owners have a lot on their minds. They have to consider if there are enough raw materials on hand to produce their products. They have to make sure there is money in the bank to pay their employees. They need to know that all of their customers are satisfied. However, while your cash flow statement tells you if you have the money to cover your expenses, you need to understand direct vs indirect costs to calculate profitability accurately. After all, businesses exist to make money.
When reviewing your expenses, it is important to understand the differences between a direct and an indirect cost. Today, we will discuss what direct costs and indirect costs are and how to distinguish between direct vs indirect costs so you can properly classify your business expenses and gain a true understanding of your business's profitability.
What Is A Direct Cost?
A direct cost is one that can be attributed completely to the production of a specific good or service. The aggregate of all the direct costs for a job is known as prime costs.
Types Of Direct Costs
There are two primary types of direct costs. These are fixed costs and variable costs. Fixed costs, as the name suggests, are fixed in nature. This means the cost incurred does not change from month to month. For example, if you have a salaried supervisor who only oversees the production of a specific product, his salary can be attributed to that product alone as a direct cost. No matter how many units you produce, you have to pay for the supervisor's salary.
Variable costs change every month based on output. For example, if you are in the business of manufacturing shirts, the fabric is a direct variable cost. The more shirts you manufacture, the more you spend on fabric. Similarly, if you manufacture fewer shirts, the variable cost of fabric will be lower.
Direct costs may also be semi-variable. This means a portion of the cost is fixed. However, another portion of the cost varies based on production levels. For example, it is not uncommon for a company to pay its sales representatives a salary. However, if sales increase because of the sales rep, he usually gets a commission. This commission is a cost that varies based on productivity but can be traced back to a particular product.
Components Of Direct Costs
At its core, a direct cost can be defined as direct material, direct labor, or direct expenses. An example of direct material is the trackable raw material that is consumed to produce a particular unit. Direct labor refers to wages that can be associated with a cost object. Finally, direct expenses are all other expenses that can be attributed directly to the production of a product, like subcontracting expenses and job processing charges.
What Is An Indirect Cost?
An indirect cost is defined as any cost that cannot be allocated to a specific cost object. It is untraceable and benefits multiple projects. The aggregate of indirect costs is known as oncost or overhead. Examples include indirect material (like lubricants), indirect labor (like employee salaries that cannot be allocated to one product or project) and indirect overhead, like rent, mortgage payments or property taxes.
Types Of Indirect Costs
Like direct costs, there are three types of indirect costs. The two primary types are fixed and variable costs. However, there may also be semi-variable (or mixed) costs.
For example, a mixed indirect cost is your power bill. Regardless of how much revenue you bring in, the lights in your building must be on and your building must be heated or cooled. A production facility may attribute $1,200 to keeping the building functioning at a minimal level.
However, if production drastically increases and you run more machines to keep up with production needs, the same production facility may attribute an additional $800 to variable indirect costs related to an increase in production. But, this electricity cannot be tracked to the production of a specific product.
Direct VS Indirect Costs: How Do I Know Which One?
To tell if a cost is direct or indirect, ask yourself if it can be attributed to a particular product. Take the cost of wages you pay your workers, for example. Suppose eight technicians and one supervisor are responsible for the maintenance and repairs on all of your machinery. This work cannot be tracked to a specific job cost.
The supervisor's salary is a fixed indirect cost. The hourly wages of the technicians are considered semi-variable costs. You pay them an hourly wage for 40 hours a week, but if you produce more goods, your machines will break down faster. As a result, you may need to pay a few of your technicians' overtime to maintain or repair your machinery. Thus, a portion of your technicians' wage cost rises with a significant increase in production.
Towing Company: Another Example
Let's say you own a towing company. You have fixed costs including a lease or loan payments on your trucks, commercial auto insurance, insurance on your place of business, and property taxes. You have variable costs like fuel for your trucks and maintenance and repairs on your trucks. The more calls your drivers take, the more of your fuel is burned, and the more wear and tear is incurred by the trucks.
So, how do you distinguish between direct vs indirect costs? Let's consider fuel. For simplicity, let's say you spend $4 per gallon of diesel and it takes 50 gallons to fill up the two fuel tanks in the truck. Your cost per tank is $200. After analyzing months of previous data, you have found that each time you fill up your truck, it can run for 750 miles before requiring another fill-up. Thus, your fuel economy is 15 miles per gallon.
Each driver tracks his total trip mileage and type of call. One operator drives your truck 18 miles to respond to a lock-out. Divide 18 miles by 15 miles per gallon to find that your driver burned 1.2 gallons of fuel. Then, multiply 1.2 gallons burned by $4 per gallon of fuel to discover it cost $4.80 in fuel to respond to that lock-out. You can assign that fuel cost to the job "Service Call: Lock-out." Thus, fuel is a direct cost.
How To Identify Direct VS Indirect Costs
Telling the difference between direct vs indirect costs is easy. Generate a P&L (profit and loss) statement. Depending on the industry you are in, you may recognize this report by the name income statement, earnings statement, revenue statement, operating statement, statement of operations, or statement of financial performance.
Your P&L will have a section for your expenses. It lists each type of cost, including water, phone, depreciation expenses attributed to your assets, the employer portion of health insurance, and the employer portion of employment taxes. If you can imagine a type of cost applicable to your business, your general ledger accountant or financial accountant has added it to your general ledger, and it will show up on your profit-and-loss statement (if any expenses have been charged to that expense account in the period you are running your P&L).
How To Track Direct VS Costs
Depending on your ERP software, you can assign "classes" or "jobs" to each expense you enter. If you own a tow truck company, your "jobs" may be lock-outs, tire changes, tows billed to insurance companies, tows billed to vehicle owners, and steering column unlocks. Your "classes" might include direct fixed, indirect variable, direct mixed, and indirect mixed.
Let's say you have a truck that only responds to lock-outs. There is a unique credit card that stays with the truck and pays for the fuel that goes in that truck. When you are entering the transactions for that credit card, debit fuel expense and credit cash or the liability to pay your credit card bill. Whether you make one journal entry or two, when you debit fuel expense, categorize it as a direct variable cost. This is because fuel is an expense that is directly related to you bringing in revenue (responding to a call). Also, knowing fuel costs, fuel economy, and mileage for each type of job, fuel costs can be tracked to each one.
Distinguishing between direct vs indirect costs is simple. Generate a profit-and-loss statement. Then, look at each general ledger line item one by one. Ask yourself if you can assign a given cost to a specific job. If you can, it is a direct cost. If you cannot, it is an indirect cost. You only have to understand the defining characteristics of one type of cost to deduce whether you have a direct or indirect cost.
Remember, a direct cost is one that can be apportioned to a specific cost object. These costs benefit a single product or project. While the indirect costs are known as overheads, the sum of all direct costs is known as the prime cost. Direct cost is traceable. It is also subdivided into direct material, direct labor, and direct expenses. Similarly, indirect cost is subdivided into production, administration and selling and distribution overheads.