How do direct and indirect costs impact projects? This is the good question a fellow reader asked us and we would like to answer it in this article.
Cost classification is an important concept in budgeting, accounting and project management (you may find this article about project management tools).
- What are direct costs? Definition and examples
- What are indirect costs? Definition and examples
- Differences between direct and indirect costs
- Main differences between direct and indirect costs
- Why it is important to define direct and indirect costs
Cost classification and expense categorization helps the project team to understand what type of costs will be faced during the life cycle of a project.
When creating your base budget, you should list your costs, both direct and indirect.
Essentially, direct costs and indirect costs are two different concepts used for budgeting and accounting purposes. However, it is not always easy to come up with a definite list because direct and indirect costs are based on product and activity nature.
Typically, direct costs are ascribed to a product, good, or service. In other words, direct costs are directly related to the product.
Conversely, indirect costs are those costs required to produce the product and are therefore not directly related to the product.
Understanding direct and indirect costs is key to ensuring that business expenses are adequately monitored.
What are direct costs? Definition and examples
Direct costs are expenses that an organization can easily associate with a specific cost object, which can be a specific product, department, or project.
This can include software, equipment, and raw materials, but it also can include manpower, assuming that this manpower is specific to the product, department, or project.
For example, if an employee is recruited to work on a specific project, either exclusively or for an assigned number of hours, their work on that project is a direct cost.
If an organization develops software and needs specific resources, such as development applications, these are also direct costs.
Thus, direct labor and materials make up the majority of direct costs.
For example, an appliance manufacturer requires steel, electronic components, and other raw materials to create its product.
Typically, most direct costs are variable. Smartphone hardware, for example, is a variable direct cost because its production depends on the number of units ordered.
One notable exception is direct employment costs, which usually remain constant throughout the year. In fact, an employee’s wage generally does not increase or decrease in direct relation to the number of outputs produced.
What are indirect costs? Definition and examples
Indirect costs are more than expenses involved in creating a product to include costs related to maintaining and operating a business.
These overhead costs are those that remain after factoring in direct costs.
Materials and supplies needed for the everyday operations of a business are examples of indirect costs.
Even though these items contribute to the business as a whole, they are not attributed to the creation of any services.
Indirect costs include supplies, utilities, office equipment rentals, computers, and business phones.
Just like direct costs, indirect costs can be either fixed or variable. Fixed indirect costs include things like rent, while variable indirect costs include fluctuations in power and gas costs.
Differences between direct and indirect costs
A simple catch for classifying payments as direct or indirect costs is that direct costs include the costs involved in creating, developing, and releasing a product.
Direct costs include:
- Production supplies
- Raw materials
- Manpower cost
- Other production costs
Conversely, indirect costs include costs that are not directly related to the development of an organization’s product or service.
Indirect costs include:
- Office supplies
- Office tech equipment
- Marketing campaigns
- Employee benefits and incentive programs
- Insurance costs
As a project manager, understanding the difference between both types of costs is critical because this helps you have a better understanding of the product or service you are producing and because you will be able to have a better understanding of accounting and better plan for the business’ future.
There are some costs that are in the gray area that should be counted as direct or indirect costs, however.
Shipping or the cost of an accountant’s work are sometimes difficult to put into a specific category, as they can relate to different activities.
What companies do is see what their use and relevance is and put these costs into their respective categories.
Main differences between direct and indirect costs
Here are the main differences between direct and indirect costs:
- The best way to determine if a cost is direct is to compare changes in the cost with changes in the associated cost object. Indirect costs are costs that are used by multiple activities and therefore cannot be attributed to specific cost objects.
- The direct cost concept is immensely useful for short-term decision making, but can lead to negative results when used for long-term decision making because it does not include all of the costs that can be applied to long-term decisions. Conversely, the indirect cost concept is useful for short and long-term decision making. Indirect costs are those required to keep a business or organization running.
- Direct costs vary significantly within a given product volume and therefore are considered a variable cost. Indirect costs do not vary significantly within certain product volumes or other activity indicators and therefore are considered a fixed cost.
- The operating leverage concept measures an organization’s set-up from fixed cost and variable cost to total cost. If a major portion of the organization’s costs are fixed cost (indirect cost), then it has a high operating leverage and can earn a large profit on each incremental sale, but must achieve enough sales volume to exceed breakeven. On the other hand, if a major portion of the organization’s costs are given by variable costs (direct cost), then this has low operating leverage and the company earns a smaller profit on each incremental sale, but it does not have to generate much sales volume to cover its lower fixed cost.
- Direct costs are easily identifiable by cost object, while indirect costs cannot be easily identified.
Why it is important to define direct and indirect costs
It may look like a futile job from an accounting standpoint, however, properly classifying direct and indirect costs will benefit an organization and project in several ways.
- More accurate pricing: Tracking direct and indirect costs is key for determining the final product cost. If you are unaware what it costs to produce the product, how can you know how much to charge your customers? When setting prices for products, it’s important not to forget to factor in indirect costs as well to make sure you have a decent profit margin.
- Potential tax benefits: Many business expenses are tax-deductible, but these costs will need to be accurately accounted for in order to obtain any deductions or possible funding. In the case of government grants or other forms of external funding, for example, identifying direct and indirect costs becomes doubly important. Subsidies rules are often very strict about what qualifies as a direct or indirect cost, and each classification will be assigned a specific amount of funding. In some cases, this funding can largely support the direct costs of a project, which is why it is very important to classify them correctly.
- More accurate budgeting: It is impossible to create an accurate budget without properly accounting for direct and indirect costs. If you are in the process of preparing a budget for the upcoming year, it is important to know how much you are currently paying for materials and supplies, as well as how much your direct labor costs are. You will also need to budget for any other operating expenses such as rent, insurance, taxes, and office supplies.
- Accurate financial reporting: Particularly in the case of small businesses, if direct and indirect expenses are not properly accounted for, costs may be underestimated, which will lead to mistakenly overestimating one’s net income believing that one has more income than one actually does.
By being aware of direct and indirect costs, project managers can gain a better understanding of the financial health of their project and, why not, the organization as a whole.
You can swiftly identify areas where money is being wasted and areas where costs need to be reduced.
In other words, the cost classification process is very important in project cost management, as it allows you to develop an effective cost control system and proper profit planning.