One most significant challenge a businessman come across when he starts a business is the challenge of managing expenses. In addition to significant expenses such as production expenses and raw material expenses, there are many small expenses such as office supply, building rent, insurance, etc. that might get neglected when the budget is prepared. If you neglect these expenses while preparing the budget, you make a big mistake.
Therefore, it is important to understand different types of expenses that occur in a business and how they are different from each other before you start your business.
In this article, you will learn about the two main categories expenses/costs direct costs and indirect costs and will also learn about the main differences between both of them.
What is Direct cost?
A direct cost is a cost which can directly be associated with a particular department or business project or production of goods or services. Direct costs are usually fixed in nature, but they change with the change in the amount of production.
Click here to learn more about direct costs.
Examples of Direct costs
- Material required for the production: you cannot produce something without using raw material. The raw material is the best example of direct cost as it is directly used in the production process.
- Labor Costs: Labor is required to carry out any work in the production process labor work to produce goods. The labor cost is another good example of direct cost.
- Tools, equipment, and fuel expenses: A production process requires various things such as tools, equipment, and fuel to carry out the production process. The cost of such things which are directly used in the production process is considered as direct costs.
What is Indirect Cost?
Indirect costs are the costs which cannot be directly associated with a department in the organization or a production process or business project. These indirect costs are associated with things which are used for multiple purposes in an organization.
Therefore, these costs are usually divided between all business processes. Click here to learn more about indirect costs.
Examples of Indirect costs
#1 Building rent:
A building is a must to carry out the production process. Therefore, the rent that you pay for the building or its depreciation value is considered as indirect costs. As various other processes take place in the building.
#2 Office Supplies:
Supplies such as paper, pen, etc. are important and are used not only in a single production process but in various activities taking place in the organization. Hence, these are also considered as an indirect cost to the production process.
#3 Salaries of employees who don’t work directly for the production process or project:
The salaries of employees who perform main work related to the production process are considered as a direct cost for the process. But there are still employees in the organization who perform important work but are not directly associated with any work. For example, accountants, office assistants, watchman, etc. The salaries of these employees would be considered indirect costs.
Key differences
| Direct costs | Indirect Costs |
|---|---|
| Direct costs are directly associated with a production process or business project. | Indirect costs are not directly related to a business process or production process. |
| Direct costs are easy to calculate. | Indirect costs are not easy to calculate. |
| Direct Costs can be expended on a single cost object such as a particular production process. | Indirect costs are expended on multiple cost objects as are can’t be associated with a single process. |
| Direct costs are variable in nature as it increases with the increase in the production unit. | Indirect costs are fixed in nature and they usually don’t change with the change in the production amount. |
| Direct costs are placed at the top of the cost sheet of a process. | Indirect costs are placed at the end of the cost sheet as they are included in the cost sheet once the direct costs are ascertained. |
| The total direct cost of a process is referred to as prime cost in the cost sheet. | The total indirect cost of a process is referred to as overhead cost in the cost sheet. |
| Direct costs are attributable. | Indirect costs are not attributable. |
| Examples of direct costs are cost of raw material, cost of labor salaries, etc. | Examples of Indirect costs are the cost of tools and building depreciation value or rent, advertisement, marketing, office supplies, etc. |
Why learn the difference between direct costs and indirect costs?
There are various costs associated with a single business process or production process. As we have learned, there are different types of costs which are related to a process directly or indirectly.
Costs which are directly related to a process can be calculated easily and can help in calculating profit made by the process easily, whereas the costs which are not directly associated with the process are difficult to calculate and hence, always remain uncertain.
They make it difficult to calculate the profit made by a business process. Therefore, it is important to learn both types of costs associated with the business process and key differences between both of them.
So that all types of costs from major costs such as raw material costs to the smallest costs such as office supplies can be included in the budget decided for the process. Knowing all types of expenses can help you in calculating profit made by a particular production process.
Conclusion
The direct cost might make the biggest portion of the budget, but indirect costs should not be avoided. Avoiding indirect costs might result in a loss in profit generated.
Direct costs might benefit only the project or process they are related to, but indirect costs benefit the whole organization and are important to run business processes smoothly. Make a list of all direct and indirect costs associated with a project before preparing a budget for it.
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