Guide to Direct vs. Indirect Costs (With Uses and Comparison)

By Indeed Editorial Team

Published June 2, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Companies of all sizes incur expenses. Some are direct, like materials, whereas others are indirect, such as security expenses. Knowing how to identify and record the different kinds of costs is essential to maintaining accurate financial documents. Understanding these different expense classifications can help you file tax returns accurately and assist you with general accounting tasks. In this article, we define direct vs. indirect costs, explore the differences between the two, detail examples of these types of costs, and explain the applications of each cost type.

What are direct vs. indirect costs?

Learning about direct vs. indirect costs involves understanding how to allocate expenses. Some costs relate to maintaining business operations, while others contribute to the actual product or service the company offers. Assigning them correctly is a key part of accounting because it ensures that the business records an expense only once. Generally, direct costs are easy to allocate because they apply specifically to the business's goods or services.

These figures are important when a business makes financial decisions, including hiring processes, wage increases, or pricing products and services. While both types of expenses represent the company spending money, proper annotation helps ensure financial records are properly maintained.

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Differences between indirect and direct costs

Direct costs are any expenses that contribute to the production of a good or service. Indirect costs refer to the general expenses the company incurs to maintain operations. Both types of costs can be found in a business income statement. This financial document itemizes the business's profits and losses for a fixed period. There are different components of this income statement, including sections for revenue, operating expenses, and the cost of goods sold. Properly differentiating these expenses has direct implications for completing a business valuation.

Another important distinction between direct and indirect costs is the tax implications. As of April 2022, Revenue Canada requires a company to differentiate its expenses when making tax deduction claims. The direct cost of goods sold is not a deductible expense, whereas indirect expenses count towards deductions. To optimize tax deductions, itemizing your indirect costs is essential.

Read more: How to Calculate the Cost of Goods Manufactured (COGM)

Direct costs defined

Direct costs refer to any expense that connects to a cost object. The object isn't necessarily tangible because it includes both goods and services. Specific sources of direct costs vary based on the business, but the two most common are materials and labour expenses. Materials include any technology or raw supplies that the business requires. Labour is a direct cost, provided the time goes towards a cost object rather than a general office purpose. It applies to all aspects of the product's life cycle.

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Examples of direct costs

If the expense directly impacts the process of creating a good or service, it counts as direct. This includes the creation, development, or implementation components of the product cycle. These costs include:

Equipment

The equipment a company uses to create a product is a direct cost. Some examples include a conveyor belt in a manufacturing facility and a tractor on a farm. Costs of leasing or purchasing this equipment are direct expenses because the equipment is essential to creating a product.

Labour

Labour refers to the human resources that contribute to a work product. When employees receive payment to perform a task that contributes to a cost object, that's a direct labour expense. For example, if a company hires an employee to perform machine maintenance at a production facility, the price of that labour connects directly to production. Were that same employee also to perform administrative tasks relating to scheduling that maintenance, the cost of those hours is indirect.

Read more: Manual Labour Jobs (With Salaries and Primary Duties)

Raw materials

If the product is primary or intermediate and contributes directly to manufacturing goods or services, it counts as a raw material. Some examples include the steel used in vehicle manufacturing and the corn used to make breakfast cereal. Another example is a string of code that allows a company to develop a program. While not necessarily tangible, raw materials are required for primary goods and service production.

Manufacturing supplies

While manufacturing supplies share similarities with raw materials, they do not go into the final product itself. For example, if a food processing plant purchases a cleaner, this product doesn't reach the end consumer. Since it contributes directly to producing the food, it represents a direct expense.

Production

A production cost can apply as a direct expense when it measures the variable expense from labour, supplies, and materials. To qualify, these costs increase directly proportionate to production. Depending on the sector or industry, a company can itemize manufacturing, raw materials, and other direct expenses. In other situations, companies claim the total of these expenses as direct production costs.

Indirect costs defined

Indirect costs refer to any expense that a company incurs to maintain its regular operations. While many professionals refer to these concepts as overheads, indirect cost and direct cost are technical accounting terms. Indirect expenses can pose a calculation challenge. The most common way to calculate them is to add total business expenses and subtract direct expenses, which are usually easier to calculate. Because indirect costs are essential to business operations, they're tax-deductible.

Examples of indirect costs

When the expense does not explicitly relate to the production of a good or service, it's an indirect cost. Maintaining a thorough record of your indirect expenses can optimize your tax returns because each is a deductible expense. Here are some common examples of this cost type:

Office supplies

Office supplies include items like pens and paper, toner for the printer, and post-it notes. These supplies represent an indirect cost because their primary purpose involves running the business instead of creating a cost object. If a company purchases equipment for the office, they can claim that expense on a tax return.

Administrative technology

Administrative software and the technology needed to operate it both count as indirect costs. Subscriptions to informational magazines that contribute to the office's operations count as administrative material. This also applies to any payroll software or content management technology the company uses in the regular course of business.

Read more: A Guide to What an Administrative Assistant Does

Marketing

When marketing generates awareness for the business, it counts as an indirect expense. Conversely, if that marketing was specific to a cost object, such as an advertisement for a specific product, it becomes a direct expense. Marketing campaigns can include the actual cost of the advertisement and the time that contributes to strategy and implementation.

Accounting

As any accounting that the business performs is for the whole company, it represents an indirect expense. Some accounting software charges a fee for transactions, which is a tax deduction because it's a cost of doing business. The salary of an in-house accountant is an indirect expense. If the company outsources its tax filing to a third-party contractor, this is also an indirect cost.

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Benefit plans

Employers often contribute to benefits programs, using the group structure to reduce the co-payment for employees. These may include health, dental, disability, and life insurance coverage. The amount that an employer pays into the benefit plans represents an indirect cost.

Insurance

Any type of insurance payment that the business pays is an indirect expense. This includes comprehensive business insurance that protects against theft and damage. These costs are indirect expenses, and companies can claim them as a tax deduction.

Incentives

To increase employee satisfaction and consumer loyalty, many businesses use incentive structures. These incentives can be gift cards given to employees as bonuses, where the value is tax-deductible. As another example, if a coffee shop has a loyalty card, they may stamp each purchase and offer a free coffee after ten purchases. The expense of implementing this program is indirect. This extends to the cost of producing the cards and the expense of the coffee that the business supplies as a reward.

Utilities

Any cost of utilities is a tax-deductible expense. It's indirect because the lights and power don't go towards a specific cost object. Utilities typically include hydro, natural gas, phone services, and internet access.

Please note that none of the companies, institutions, or organizations mentioned in this article are affiliated with Indeed.

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