Definition:
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.
The new costing techniques introduced by cost accounting divide total product costs into two 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 production volume while remaining fixed for each production unit.
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 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.
Example:
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 will partially 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 plastic. The only part of the electricity expenses is considered a direct cost.
The same electricity rental expenses should not be 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 manufacturing the product is considered a direct cost.
- Any cost related to the operation and supervision of a specific project is considered a direct cost.
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. The following are the common advantages of using direct costing methods:
- It helps make a master budget for the year as direct costing provides variable per unit cost.
- Variable costs allow you to analyze your business’s cost-volume relationship or breakeven point. 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 of organization operations as direct costing pinpoints the responsibility according to organizational lines.
Recognition:
Direct and indirect costs are considered expense elements in the financial statements, which 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.
Journal Entries:
How do we record the journal entries of direct expenses?
Are they different records from indirect expenses or costs?
As the recognition section explains, direct or indirect expenses are considered the expense element in the financial statements. Therefore, the journal entries are the same as expenses.
Here are the entries:
Dr Direct costs/expenses
Cr Cash/Bank
For example, if 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 cost around $10,000, 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.
How is Direct Costs Report In the Income Statement?
Direct costs are typically reported on the income statement as part of a company’s operating expenses. Direct costs can include materials, labor, and other expenses incurred directly in producing a product or service.
Direct costs are those that can be easily associated with the production process and can be tracked through the production cycle.
They typically do not include indirect costs such as overhead or administrative expenses. Reporting direct costs on an income statement lets investors know how much it costs the company to produce its goods or services and, thus, how profitable the business is.
What are modified total direct costs?
Modified total direct costs (MTDC) is a financial accounting method that reflects the true cost of producing goods or services.
It considers the cost of materials, labor, and other direct costs incurred in the production process and then adjusts them for any associated indirect costs.
Indirect costs include freight, transportation, taxes, insurance, overhead expenses such as advertising, utilities, and administrative salaries.
By including these additional costs in their calculations, companies can better understand their true cost of production. This provides important insights into where improvements can be made to increase efficiency and reduce waste.
What are direct Vs. indirect costs?
Direct and indirect costs are two types of expenses businesses incur as part of their operations. Understanding the difference between direct and indirect costs is important for businesses as it helps in better financial planning and management.
Direct costs are expenses that are directly related to the production of goods or services. These costs can be easily traced back to a specific product or service. Examples of direct costs include the cost of raw materials, direct labor costs, and direct expenses related to the production process.
For instance, in a manufacturing company, the cost of materials used to produce a product, the wages of the workers involved in its production, and the cost of manufacturing equipment would all be considered direct costs.
Indirect costs, on the other hand, are expenses that cannot be easily traced back to a specific product or service. These costs are incurred as part of running the business and are not directly related to the production process.
Examples of indirect costs include rent, utilities, insurance, salaries of support staff, and marketing expenses. These costs are incurred regardless of whether the business produces any products or services. For example, a company’s rent is an indirect cost because it is incurred irrespective of whether or not the company produces any goods or services.
Indirect costs are sometimes referred to as overhead costs because they are incurred by the business as a whole rather than a specific product or service. These costs are essential for running the business and supporting the production process. Indirect costs are usually allocated to the products or services the business produces based on a predetermined cost allocation method. This is done to ensure that the cost of producing each product or service includes all the necessary expenses incurred by the business.
10 Common Examples of Direct Costs with Explanation
Here are ten common examples of direct costs that businesses may incur:
- Raw materials: Raw materials are the basic materials used in production. They are typically purchased by businesses to transform them into finished goods. The cost of raw materials is a direct cost because it is directly related to the production of a specific product.
- Direct labor: Direct labor costs refer to the wages paid to employees directly involved in producing a specific product. For example, if a company produces furniture, the wages paid to the workers who assemble the furniture would be considered direct labor costs.
- Manufacturing supplies refer to the tools and equipment used in the production process. These may include items such as screws, glue, or paint. The cost of manufacturing supplies is considered a direct cost because it is directly related to the production of a specific product.
- Packaging materials: Packaging materials are used for packaging finished goods. Examples may include boxes, bags, or labels. The cost of packaging materials is considered a direct cost because it is directly related to the production of a specific product.
- Freight costs refer to the cost of shipping finished goods from the manufacturing facility to the customer. These costs are directly related to the sale of a specific product and are therefore considered direct costs.
- Commissions: Commissions are payments made to salespeople or agents who sell a specific product. Since commissions are directly related to the sale of a specific product, they are considered a direct cost.
- Royalties: Royalties are payments made to the intellectual property owner (such as patents or trademarks) for using that property to produce a specific product. The cost of royalties is considered a direct cost because it is directly related to the production of a specific product.
- Equipment depreciation: Equipment depreciation refers to the reduction in the value of manufacturing equipment over time. Since the equipment is used specifically for producing a specific product, the depreciation cost is considered a direct cost.
- Cost of goods sold: The cost of goods sold (COGS) refers to the cost of the materials and labor used to produce a specific product. Since COGS is directly related to the production of a specific product, it is considered a direct cost.
- Research and development (R&D) expenses: R&D expenses refer to the cost of developing new products or improving existing products. Since R&D expenses are directly related to developing a specific product, they are considered a direct cost.
What Kind of Industry Where Direct and Indirect Costs Used the Most?
Direct and indirect costs are used in various industries, but some industries use them more extensively than others. Here are a few examples:
- Manufacturing: In the manufacturing industry, direct costs are crucial in determining the cost of goods sold (COGS). Raw materials, direct labor, and manufacturing supplies are direct costs that are used to calculate the COGS. Indirect costs such as rent, utilities, and salaries of support staff are also important in determining the total cost of production.
- Construction: In the construction industry, direct costs include labor, materials, and equipment used to construct a building or infrastructure project. Indirect costs include expenses such as insurance, permits, and fees that are incurred during the construction process.
- Healthcare: In the healthcare industry, direct costs include medical supplies, drugs, and equipment used in patient care. Direct labor costs include the wages of doctors, nurses, and other medical professionals. Indirect costs may include administrative expenses such as rent, utilities, and marketing costs.
- Service industry: In the service industry, direct costs may include wages paid to employees who provide the service, as well as the cost of any supplies or equipment needed to provide the service. Indirect costs may include rent, utilities, and marketing expenses.
- Agriculture: In the agriculture industry, direct costs may include the cost of seeds, fertilizers, and labor needed to grow crops or raise livestock. Indirect costs may include expenses such as rent, utilities, and insurance.
