Direct and Indirect Costs and Their Effect on Pricing your Product

How to Include Direct and Indirect Costs When Pricing Your Product

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Part of the process of pricing your product is including the costs of producing that product. Those costs include the direct and indirect costs associated with producing your product.

Direct Costs

Direct costs are costs that can be easily traced to a particular object (also called a cost object), such as a product, the raw materials used to manufacture a product or the labor associated with the work to produce the product.

If your company produces a widget and a production manager is hired to oversee production of that widget, then the production manager's salary is a direct cost. If you own a carpet cleaning business, which is a service organization, and you hire hourly workers employed only to clean carpets, their wages are direct costs.

Direct costs are often, but not always, variable costs. Variable costs increase as more units of the product are manufactured. As a result, raw materials are variable and direct costs. But, if there is a supervisor overseeing the manufacturing of this particular product, here salary is probably the same regardless of how much of the product is manufactured, so it is a fixed cost.

Direct Materials and Direct Labor

The most common direct costs are direct materials and direct labor. Direct materials are the materials that can be specifically identified with the product. If you are a furniture maker, your direct materials would be the wood that goes into making your furniture along with the nails, varnish, and other products used to make furniture.

But, you wouldn't count the gasoline that the loggers use to drive the trucks to get to the forest to cut down the trees as direct materials.

Direct materials are all the materials required to produce a product such as raw materials. Direct materials costs are assignable to that particular product, such as the cost of each raw material.

To track these direct costs, you will normally choose one of two accounting methods, "last in, first out" or "first in, first out." Although the explanation of these two methods goes beyond the scope of this article, you can find more about them and the advantages of disadvantages of each here: LIFO or FIFO

Indirect Costs

Indirect costs are those which affect the entire company, not just one product. They are costs like advertising, depreciation, general supplies for your firm, accounting services, etc. They are services, and costs, for your entire firm, not just one product. Indirect costs are often called, simply, overhead. Overhead is another name for all the ongoing costs of operating a business that aren't directly associated with the making the product of the offering of the service. 

Indirect costs can be fixed or variable costs. Often, they are fixed costs — an example being the rent you pay on your building. Sometimes, they are variable. An example of a variable cost use your electricity or water bill, which can change monthly.

Indirect Materials and Indirect Labor

Materials such as tools, cleaning supplies, and office supplies make production of a company's products possible, yet can't be assigned to just one product.

These are classified as indirect materials costs. These costs are usually variable because the materials needed will change with the production output.

Labor costs that make production of a product or products possible but can't be assigned to one particular product are also classified as indirect costs. An example of an indirect labor cost would be the salary of a manager who manages an entire production operation and not just one product line. Some indirect labor costs are fixed and others are variable. If the salary is a monthly or annual salary and does not change based on production, it is a fixed cost. If it is based on production, it is a variable cost.

It is important for a business owner to correctly classify direct and indirect costs, in order to determine where production cost reductions can be affected, for example.

Another important reason for keeping track and correctly classifying these costs is that overhead — your indirect costs — are tax-deductible items. Some of the overhead expenses will be in be included in cost of goods sold, business deductions, inventory, and other categories and getting these figures right also helps improve the operation of the business. 

Direct Labor Budget

The direct labor budget shows the direct labor cost and the total direct labor hours needed to produce the number of units in the production budget. The budgeted hours of direct labor are determined by the relationship between labor and output, just as in the direct materials budget, which you should refer back to. Direct labor costs are part of cost of goods sold.

Exercise

As an exercise, assume that a product uses two hours of direct labor per unit. Expected production for the year is 1,250 units. The average wage cost per hour is $8. What is the budget for direct labor cost?

Answer:

Budget = (2 X 1,250)3 X $8 = $20,000

Direct Labor Budget for ArtCraft Pottery

Referring back to our example, suppose that it takes 0.12 hours to make a single pot and that the average wage rate is $10 per direct labor hour.

Below is the direct labor budget for ArtCraft Pottery, the example we use in the development of our operating budget example and explanation.

ArtCraft Pottery

Direct Labor Budget
Quarter1234Year
Units to be Produced1,0601,2601,6001,8005,720
Direct Labor Time Per Unit in Hrsx0.12x0.12x0.12x0.12x0.12
Total Hrs Needed1,0601,2601,6001,8005,720
Avg Wage per Hrx$10x$10x$10x$10x$10
  
Total Direct Labor Cost$1,272$1,512$1,920$2,160$6,864