Direct costs are the costs which are entirely assigned to a particular project. These costs are not divided between different processes taking place in an organization like indirect costs. Direct cots make the most significant portion of the budget of a project.
These are considered as the most critical cost of the production process. In this article, you will learn about the definition of direct cost, different examples, and a method to calculate direct costs.
A direct cost is an expense which is directly associated with a specific cost object such as a business project, production process or department, etc. direct cost is usually a fixed cost, but it varies with the change in the amount of production output.
Meaning of Direct Costs
There are mainly two main broad categories of costs involved in a business which are direct costs and indirect costs. Indirect costs are the costs which are not directly associated with a particular project. Click here to read more about indirect costs.
Direct costs take the topmost position in the cost sheet, and they make the 80% part of the total budget allotted to a project. For example, expenses required to buy raw material for the production process is an example.
The raw material can only be used for the production process and cannot be used in any other way. Therefore, the cost of raw material cannot be divided between different processes taking place in an organization like indirect costs.
Examples
| Raw Material | Raw material is classified as a direct cost since it a must for the production process. The cost of raw material is associated with the production process directly. |
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| Labor cost | The wages provided to the labors assigned with the production process is an example of the direct cost associated with the production of a particular product. It is most common cost incurred by most industries. |
| Machinery cost | Machinery and tools are essential in any and every industry and without machinery almost no industry can work which is why the cost of these two is directly associated with the production process. while this is the scenario in case of product-based industries, machinery cost may also be associated with service industry. In case of service industry although the major cost is wages and salaries of employees a part of it is also spent on machinery. For example, microwave and coffee machines are used in restaurants. |
| Sales Commission | Commission is provided to sales person in order to boost the sales. The cost of the commission provided to sales persons for the sale of a particular product is directly associated with the product and hence, it is an example of direct cost. |
| Freight In and out | The expenses involved in delivery material in and delivering finished goods out is also a direct cost associated with the production process. |
Difference between direct and indirect costs
As we have learned before, direct costs are directly associated with the process, such as the cost of raw material, labor, consumable supplies. These things are only used for the production of a particular product and are irrelevant for any other process in the organization.
Whereas indirect costs are the costs involved for supplies which are used by more than one process. For example, office supplies, salaries of accountants and office assistants, rent of building, electricity and internet expenses, etc.
These expenses are also referred to as overhead expenses and are not associated with one process.
How to calculate direct costs?
Direct costs make the largest portion of the budget. Therefore, it is important to learn and calculate them so that they can be minimized and profit can be increased.
The calculation process of indirect cost is simple and is less complex than calculating indirect costs. Click here to learn how to calculate indirect costs.
As direct costs are directly associated with a single process and cannot be used for any other process, the direct costs involved in a project can be calculated by simply adding all direct costs in the process.
Next, you will learn step by step process to calculate the direct costs with the help of an example.
#1 List all the direct costs involved in the process:
There are various direct costs involved in the production process. It is advisable to make a list of all possible direct costs before you prepare a budget. Let us take an example of an XYZ company which is going to start the production process of product ABC.
A budget is needed to be allotted for the production process. The budget can be prepared by calculating all types of direct costs such as cost of raw material, labor cost, machinery cost, consumable supplies’ cost, packaging cost, and sales commission.
#2 Mention the direct cost of each expense:
In the next step, assign the value of direct cost for each expense. The value can’t bee picked randomly. It should be calculated as per the requirement of the production output. Let us assign a cost to each expense involved in the production of product ABC of our example.
The raw material is the most important part of the production process. The production process can’t even begin without having the raw material. Let us assume the raw material required for the production of product ABC is of value $20,000. Similar, let us assign the value to each production expense.
Here, we are assuming the values. Otherwise, these values are taken after analyzing previous projects and comparing supplies from different vendors. The budget allotted for labor is $10,000.
The cost of the machinery required is $50,000, and the cost of consumable supplies, packaging, and sales commission is $8000, $3000, and $10,000 respectively.
#3 Add up all the direct costs associated with the production process:
The total direct cost of the production process will be calculated by adding up all the direct costs of the production process.
Cost of raw material = $20,000
Cost of labor = $10,000
Cost of machinery = $50,000
Cost of consumable supplies = $8000
Cost of packaging = $3000
Cost of sales Commission = $10,000
Total Direct cost = $101,000
The total direct cost of production of the production process of product ABC is $101,000, and the total cost of production of product ABC will also contain the indirect costs. The sum of direct costs and indirect costs will make the total cost of production.
The project can only be profitable if only revenue generated will exceed the total cost of production.
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