Direct vs. Indirect costs
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What are direct costs?
Direct costs are expenses that can be clearly attributed to the creation of a product, project, or service. They vary with production levels; when you make more, these costs usually increase. Businesses track direct costs closely to calculate the Cost of Goods Sold (COGS) and assess gross profit.
What are indirect costs?
Indirect costs are expenses necessary for overall business operations but not directly tied to a single product or service. These are typically fixed or overhead costs that remain stable regardless of output. Indirect costs ensure that the company can function and support production or service delivery.
How to categorize direct and indirect costs
- For Direct costs, record under Cost of Goods Sold (COGS) or Cost of Sales on the income statement.
- For Indirect costs, record under Operating Expenses as part of Overhead or Administrative Costs.
- Keep separate accounts for direct and indirect expenses to understand gross margin and operational efficiency.
- In manufacturing or project-based industries, allocate indirect costs proportionally to determine total cost per unit or project.
- Periodically review cost classifications to ensure accuracy as operations evolve.
Examples of direct costs
- Raw materials and components.
- Direct labor (production or project-based employees).
- Manufacturing supplies or tools.
- Freight and shipping tied to specific orders.
- Sales commissions for specific product sales.
- Equipment rental used for a single project.
Examples of indirect costs
- Rent for offices or warehouses.
- Utilities and facility maintenance.
- Administrative salaries and office staff wages.
- Depreciation on equipment or buildings.
- Insurance premiums.
- Office supplies and software subscriptions.
- Accounting, legal, or HR services.
Tax and reporting implications
- Both direct and indirect costs are tax-deductible as ordinary and necessary business expenses.
- Proper classification affects gross profit, operating profit, and tax reporting accuracy.
- Direct costs are deducted when goods are sold (through COGS), while indirect costs are deducted as operating expenses in the period incurred.
- Misclassifying costs can distort profitability and complicate budgeting or audit preparation.
- Maintain supporting documentation for all expenses to substantiate deductions and cost allocations.
