Direct costs are those expenses or costs that can be directly associated or contributed to a product, service, department, or cost object that the company could totally verify or trace.
With the new costing techniques introduced by cost accounting, total product costs are now divided into two different categories or types. One is called direct costs, and the other is called indirect costs.
Direct costs are also termed variable costs as they vary with the change in volume of production while remaining fixed for each unit of production.
For example, the direct cost of the product is fixed at USD50 per unit, but the total direct cost will vary depending on the value of products produced during the period.
The main component of direct costs is direct material, and direct labor used for manufacturing a product is direct costs.
Sometimes an overhead expense may also be considered a direct cost. For example, if a manager is directly attributed to a project or production process, his salary may also be considered as a direct cost for the specific project or department.
Yet, a common example of direct costs is labor, material, and fuel.
The indirect costs are sometimes fixed and sometimes variable, but these costs are not directly related to a cost object.
Common indirect costs include premises rent, salaries, wages for the production department, insurance, depreciation for the period, and interest rate.
Let’s discuss some examples for better understanding.
Let’s consider a plastic company named ABC. The company is making two products: plastic buckets for adults and children, and the other is disposable plates and buckets.
The cost of plastic material used to manufacture buckets is considered a direct cost because this cost is easily proportionate to one unit of the plastic bucket.
While the cost of electricity for the period, partially, will be considered an indirect cost because the electricity is not solely used for plastic tubs.
The electric city could be consumed for another purpose which is not directly contributed to producing the plastic. The only part of the electricity expenses is considered as a direct cost.
The same electricity rental expenses should not be totally recognized as direct costs. The rental expenses for the general administrative purpose should be classified or recorded under the administrative or indirect cost.
The cost of labor engage directly in the manufacturing process is also considered a direct cost. At the same time, the salaries and wages of other staff are considered indirect costs.
The common examples of direct costs are:
- Wood in making furniture
- Leather in the manufacturing of leather products like shoes and jackets.
- Direct labor is used in manufacturing and providing services.
- Any material used in the manufacturing of the product is considered a direct cost for that product.
- Any cost related to the operation and supervision of a specific project is considered a direct cost for that project.
Benefits of Using Direct Costing Methods:
The benefits of using the direct costing method are that it provides reasonable information to the management for decision-making about the product and the pricing of the product.
Also, it is relatively easy to control direct costs by efficient management compared to indirect costs or overhead costs. Following are the common advantages of using direct costing methods:
- It helps in making a master budget for the year as direct costing provides variable per unit cost.
- Variable costs allow you to analyze the cost-volume relationship or breakeven point for your business. Breakeven is the sale volume at which there is no profit & loss for the business.
- Once the direct and indirect costs are determined, then it becomes easy for management to decide on a good price for their product.
- It provides more control to the management on organization operations as direct costing pinpoints the responsibility according to organizational lines.
Direct costs and indirect costs are considered expense elements in the financial statements, and they are recognized and recorded in the financial statements when they are incurred.
It follows the accrual basis as other expenses, which means that even though the payment is not made as long as the expenses are incurred, it has to be recognized.
How do we record the journal entries of direct expenses?
Are they different records from indirect expenses or costs?
As we have explained above in the recognition section, direct or indirect expenses are considered the expenses element in the financial statements. Therefore, the journal entries are the same as expenses.
Here are the entries:
Dr Direct costs/expenses
For example, the direct labor costs are the direct cost, and it is incurred during the period equal to $10,000, then the entries would be:
Dr Direct labor costs $10,000
Cr Cash/Bank $10,000
So, as you can see above, if there is the cost of direct labor, which costs around $10,000, and the company pays in cash to the workers. Then the entry is debited to the direct labor cost of $10,000, and then we credit to the cash on hand or cash in the bank.