Business has an endless amount of costs that are involved in the purchasing process and it is in your best interest to know where they are coming from. Essentially, you’re trying to figure out how much a product will cost to produce, so you can charge more than the overall cost of producing it. However, production costs are spread over a multitude of areas. Normally, you may think of the basic inventory costs including the cost of your raw materials and the equipment needed to produce a finished good. In fact, production costs will also include the salaries of all your workers, the marketing expenses used to advertise the product, and maintenance for the warehouse and equipment. When looking at these inventory costs holistically, you have a combination of direct and indirect costs that are necessary for running a business.
To simplify it, direct costs can be accurately linked to the cost of an object where indirect costs can apply range of products and therefore cannot be attributed to one specific good or service.
Direct costs are immediately connected to the production of a specific product or service provided by a business. If you could draw a line representing a direct cost, you could trace the cost to the actual product with ease. These costs are often correlated to a “cost object”.
Costs objects can be your basic raw materials, production equipment, software you buy, such as an online inventory management tool, or labour. The bulk of direct costs are made up of labour and materials to produce a finished good. The labour costs and material costs are immediately related to the end-product and you can draw a line directing the two together.
Normally, businesses record the cost of finished raw materials as a direct cost. It is common to see this recorded as last in, first out (LIFO) or first in, first out (FIFO). The raw materials and direct costs are generally variable. The variability is easily identified with an increase in production. If more products are made, the variable expenses increase as you have more direct costs to make these items. Conversely, the cost of labour is generally fixed. If you have salaried employees, their salary will stay constant over the course of the year.
On the other hand, indirect costs cannot be accurately connected to one specific product. Indirect costs can be associated with the upkeep of the entire company. The costs are widespread and help maintain the everyday operations. Essentially, all the costs leftover after the direct costs have been accounted for are indirect costs. Commonly, these are referred to as overhead costs. Depending on the size and type of the company, overhead or indirect costs can be very large. Indirect costs are the behind-the-scenes costs that make everything keep ticking on.
It is hard to sell products without developing a marketing strategy. It’s also hard to develop a marketing strategy without a computer. It’s even harder if you don’t have office equipment such as desks and phones for your employees to use to put their laptops on and get in touch with customers. Of course, these desks need to be cleaned as well, so cleaning supplies run into the mix of indirect costs. The list goes on; indirect costs are everywhere you look.
Just from this simple example, you can see how indirect costs pertain to many people and it would be impossible to directly correlate them to one cost. Of course, there are both fixed and variable indirect costs. The office building rent may be fixed for two years, but the electrical bill may vary as the seasons change.
Direct and indirect costs play a huge part in your costs and what you decide to purchase. Having tools to track these costs such as online inventory software, can make tracking both direct and indirect costs much easier.