Direct costs are expenses associated with production and sales. The cost of raw material and labor required to manufacture a product would be categorized as direct costs.
Indirect costs are expenses a business incurs to keep the company running. These costs, often known as manufacturing overhead, include administrative and utility-related expenses.
If you’re a business owner or an aspiring entrepreneur, it’s important to know the difference between these two expenses your company will incur. Understanding how to categorize such expenses can also help you budget better and file for tax deductions.
Direct business expenses may qualify for deductions, helping you reduce the amount of taxes you have to pay for operating and profiting from your business.
What Are the Differences Between Direct and Indirect Costs?
Here are some notable differences between direct and indirect costs:
|Direct Costs||Indirect Costs|
|Direct costs are calculated per product/service package sold||Indirect costs are calculated based on monthly or yearly overhead expenses|
|The number of products manufactured directly influences direct costs||Change in the scale of production doesn’t significantly affect indirect costs|
|Direct costs tend to vary based on a number of factors||Indirect costs tend to be stable over time|
|Examples of direct costs include:
Cost of raw materials
|Examples of indirect costs include:
Administrative and legal fees
Utilities like rent and electricity
The direct expenses required to manufacture a product or offer a service can be categorized as direct costs. The overhead expenses that aren’t directly related to the product being manufactured but remain necessary to keep the business running are categorized as indirect costs.
“Direct costs are expenses you incur because you sold something—labor, materials, equipment, commissions, freight, credit card fees when customers pay by credit card, etc.,” Ruth King, a business-finance author and consultant, told The Balance via email. “Indirect costs are expenses you incur to stay in business, i.e. keep the lights on, [such as] rent, utility bills, advertising, professional fees, office salaries, office expenses, repairs and maintenance, etc.”
Using a hamburger restaurant as an example to explain the concept of direct vs. indirect costs, certified public accountant (CPA) Robert Nix told The Balance by email: “To make a hamburger, the direct cost would be the two all-beef patties, special sauce, lettuce, pickles, onion and cheese on a sesame seed bun plus the labor cost of the employee to assemble it.”
On the other hand, he said, “The cost of the restaurant manager, the utilities/gas to power the grills and ovens, a portion of the amortization of the appliances to prepare the food, etc. would be indirect costs necessary to make a hamburger.”
Business expenses can’t always be categorized separately as either direct or indirect costs. Some expenses, such as power, can fall under both categories or switch categories, depending on your company’s production system.
Electricity used to run the machinery and produce raw materials for manufacturing products would be labeled direct costs. However, the electricity required to run the lights and fans in employee cubicles may be an indirect expense.
Phones also can fall under these special considerations. For example, “You don't need a phone service to manufacture a steel rod, but you do need phones to sell them,” Ryan McEniff, a Massachusetts-based business owner, told The Balance in an email.
Another example is the salaries of administrative employees. While labor costs such as the salary of a chef in a hamburger restaurant are direct costs and administrative expenses are indirect costs, administrative-staff labor costs fit in an ambiguous category between the two.
How To Set Prices Based on Direct and Indirect Costs
If you want to build a profitable business, it’s important to consider both direct and indirect costs while defining your pricing strategy. “The total of all your sales must cover direct and indirect costs for your company to make a profit. That means some products must be priced above their direct costs to cover indirect costs,” Rob Stephens, a financial consultant advising small businesses, told The Balance via email.
Christan Hiscock, CEO and co-founder of Kardia Financial Group, offered another example: “Say you own a home renovation business and need to give a potential client a quote for a job. You know that you have your fixed costs like materials and variable costs such as the payments for your staff’s work on the job. You want to ensure that when you set your pricing, you know how long it takes your team to do certain tasks.”
Hiscock also recommended adding a “buffer” of 10% to 15% in case something goes wrong. “This will ensure you are protecting yourself and making a profit off of every single job that you do,” he told The Balance by email.
The prices your competitors charge must also factor in when you develop your pricing strategy so you aren’t under- or overcharging customers.
The Bottom Line
Direct costs are associated with the production cycle, while indirect costs keep the production cycle operating. Employee salaries and the cost of raw materials are direct costs, for example, and utilities fall under indirect costs.
Understanding and anticipating both can help you better plan your budget, effectively apply for external funding, and file beneficial tax returns.