Cost classification is an important concept in budgeting, accounting and project management. Cost classification and categorization of expenses help project teams to understand what kind of costs will be spent during the life cycle of their project. For example, while creating the baseline budget , a cost control engineer lists the direct cost and indirect cost in the construction project. Basically, Direct costs and indirect costs are two different concepts used for budget planning and accounting operations. However, there are some key differences between them. It is not easy to make a certain list of direct and indirect costs all the time. Because direct and indirect costs are based on the nature of the product and business.
Typically, direct costs are attributable to a product, goods or service itself. Direct costs are directly related to the product. On the other hand, indirect costs are those required to produce the product however, they are not directly related to the product. This article answers this question: what are the primary differences between direct and indirect costs ?
It is important to understand classification while purchasing material or creating a project budget. Assume that you are a project manager of a house building project and the client makes a change request related to changing the perimeter walls from reinforced concrete to masonry. First thing you should do is to make unit price analysis and classify the costs according to their type. Material, labor and machinery costs are direct costs and increases as the amount of work increase. On the other hand, project management and operational costs are the indirect costs that they don’t directly relate to the amount of work but they increase as the duration of the project increase.
For better understanding, let’s analyze each concept.
A direct cost is a price that can be utterly attributed to the production of products or services. Some costs, such as direct materials, direct labor, equipment are common direct costs.
In some cases, it is possible to classify an indirect cost to a direct cost. For instance, the salary of the manager who controls multiple concrete batch plants would be considered an indirect cost for any one of those concrete batch plants. However, that manager’s salary would be a direct cost for the department comprising all of those concrete batch plants.
Direct costs are often variable costs. If the manufactured units increase, direct costs increase. Because more units need more materials and resources.
For example, you will produce 1000 m3 concrete in the batch plant. You need 300 tons of cement to produce 1000 m3 concrete and 1 ton cement costs 100 $. So you need 30,000 $ to purchase cement. This is your direct cost. As the quantity increases direct cost increase.
Indirect costs are those which affect the whole company such as depreciation, accounting services, general supplies, board salaries. They are not just for only one product. Overhead costs, ongoing costs, project management costs, operational costs are indirect costs.
Indirect costs are often fixed costs. But also they can be variable.
For instance, the rental cost of your head office is a fixed cost. Quantity of manufactured units doesn’t affect your rental price. An example of a variable cost is your heating and cooling costs which can change monthly.
For cost controlling purposes, many companies try to limit their indirect costs as a proportion of direct costs.
Let’s analyze the same batch plant example. Assume that this month you will produce 1000 m3 concrete. If you increase the production and produce 1500 m3 concrete this does not change your head office costs or marketing costs.
Examples of Direct Costs and Indirect Costs
Below are some examples of direct cost and indirect cost.
The following are a few examples of direct costs
- Laborer’s wages
- Wood, Glass, Cement, Concrete, Rebar, etc.
- Handles, locks, hinges
- Direct materials
- Consumable supplies
- Freight in and out
- Sales commissions
- Royalty Payment
- Patent Holder
The following are a few examples of indirect costs.
- Advertisement costs
- Project management costs
- Operational Costs
- Manager’ s salary
- Indirect costs related to transport
- Administration cost
- Indirect employee’s salaries
- Security cost
- Office cost
- Selling & distribution cost
What are the Primary Differences Between Direct and Indirect Costs ?
Below are some differences between direct costs and indirect costs.
- It is easy to determine direct costs considering the product or service. On the other hand, it is not easy to identify indirect costs. Detailed analysis is required to identify indirect costs.
- Direct costs are attributable to a specific product, department, goods or service. On the other hand, indirect costs are attributable to multiple products or services.
- Direct costs are variable costs that change based on the quantity of a product or service. However indirect costs are fixed costs.
Cost classification process is very important in project cost management. It enables to develop an effective cost control and profit planning system. If you don’t know which cost is direct which expense is indirect, you cannot perform cost control effectively. Also, it is helpful for decision making.
It is significant to have a clear understanding of cost classification. During the procurement of goods or a service, you can compare their direct and indirect costs to your project separately. One option may involve more indirect cost than the other. So you can select the alternative with the low indirect cost.
Classification of expenses has an important impact on federal tax payments. It also affects a company’s cash flow and financial health.
Note that this cost classification is very important for claiming tax deductions.