What is direct cost (Plus comparisons and examples)?

By Indeed Editorial Team

Published 9 June 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.

By learning how a company spends money, you can make more financially responsible and informed choices at work. This is especially useful if you're working in a senior or leadership role. One way you can do this is by calculating the direct costs of a company, as this allows you to account for all the items the business requires to function successfully on a daily basis. In this article, we answer the question 'What is direct cost?', list some of its benefits and provide some examples.

What is direct cost?

Answering 'What is direct cost?' can help you make use of it as an analytical tool. Direct costs typically refer to the expenses associated with a business's outputs. These include materials and labour, as they relate directly to production. This makes them different from indirect costs, such as rent and utilities, which don't stem directly from production. Direct costs tend to vary depending on market factors and the type of product, which is why you might also encounter the term 'variable cost', which means the same thing. Other elements to consider include:

Direct versus indirect costs

Direct costs are typically incurred in the production of outputs, which means they vary depending on supply and demand. Indirect costs are less likely to vary depending on output. For example, the rent a business pays for a warehouse won't decrease just because they're storing fewer items in it. Indirect costs also include things like depreciation, interest, maintenance, insurance and other such fees. One way to understand the difference is to associate an indirect cost with several business functions, whereas a direct one is typically associated with just one.

Direct costs might include raw materials for products, wages paid to production workers and manufacturing supplies for operations. In general, resources and energy inputs that vary according to production are direct costs. Indirect costs can include rent, office expenses, utility bills and some salaries and overheads. They often remain constant regardless of fluctuations in production. See below for two examples that illustrate the difference:

Example 1

A company manufactures trucks and cars. They would consider the bolts and steel needed for the truck or car to be a direct cost. Conversely, the company would categorise the electricity they use at the manufacturing plant as an indirect cost. Even though the electricity costs could be related to the facility itself and its production, it isn't actually tied to a specific department or project as it's used throughout the premises for various functions. For this reason, it's categorised as an indirect cost.

Example 2

A construction company builds structures for clients. Its direct costs would be things like concrete, steel beams, wood, payments to contractors and scaffolding. The company would also have certain indirect costs to consider, such as salaries for inspectors, legal fees and supplying electricity to the entire construction site. The latter are indirect because they'd be a requirement regardless of the nature of the physical output and because they affect various functions of the business or project.

Fixed versus variable costs

Direct costs aren't always constant. In many cases they're not fixed at all, which is why you may hear the expression 'variable costs' used to mean the same thing. This is because many businesses change their output levels based on supply, demand and costs. The costs that are directly associated with production of outputs are therefore the first to become affected if output levels change, whereas indirect costs like rent or insurance are less likely to vary.

Related: How to calculate fixed cost quickly and conveniently

Inventory valuation

This is another example of where direct costs can be an important factor. Since the production of a particular output incurs a direct cost, then you can consider it a form of input. It's also common for businesses to order and then store surplus inputs. This could be to reduce the risk of insufficient materials or to compensate for losses or waste. Subsequent outputs can then utilise these surplus materials, but this means that the inventory valuation is important for calculating costs. This is because inputs bought at different times can vary in price.

For instance, a factory that produces machinery might order a large quantity of copper tubing at a particular price. The factory stores surplus tubes and uses them in the next batch of machines, perhaps a month later. When the company buys more tubes a month later, the price might be higher, although they'd buy fewer than necessary because they already have leftover surplus. The difference in unit price is going to affect the direct cost, which is why it's closely related to inventory valuation.

Related: 13 essential accountant skills

The benefits of using direct cost

There are certain benefits to using direct cost as a measuring and analysis tool:

  • Budgeting: With a direct cost, it's easier to calculate budgets for the coming year. This is because direct costs can account for changes in business expenses based on projected sales.

  • Profit calculation: Direct costs can help you calculate profits according to a specific product, which can be helpful when you want to compare different products and make financial plans.

  • Price determination: With direct costs, it can be easier to establish the price of the company's services and goods.

  • Managerial control: With direct cost methods, you can ensure that some decision-making processes are well-informed and can account for fluctuations in output.

Related: How to calculate profit margin with a profit margin formula

Examples of direct cost

Below are some examples of direct costs:

Labour

The amount you're paying employees that produce a product directly usually forms part of direct cost. This is because it can relate to a specific product. The direct cost of labour that's associated with a specific price typically includes overtime, hourly wages, benefits and any additional compensation-related items.

Commission

Similar to labour, a commission is often a direct cost as it relates to a specific price object. For instance, if an individual who works as a salesperson receives a commission payment after selling a car, the amount they receive would be a direct cost for the company. This is because it's directly associated with the number of items sold.

Materials

Materials are a direct cost as they contribute directly to the production of a service or good. For example, the expense of wood could be among the direct costs in a furniture manufacturing factory as it contributed explicitly to the final product. Similarly, wages pad to service providers are a direct cost in the services industry.

Supplies

Some supplies are also in the category of direct costs. It's important that these supplies are directly related to the production process. For example, in a factory that produces and uses machinery, certain oils, fuel, lubricants and replacement parts would be necessary to keep the processes functioning. Since the factory would stop consuming them if production halted, they're a direct cost.

Transportation

The cost of transportation is often directly related to the number of items shipped. If a business produces fewer items for sale, it typically requires fewer delivery vehicles. For instance, an e-commerce website that uses a courier service to sell directly to customers might pay them according to how many items they ship, making delivery a direct cost.

Fuel and certain utilities

A certain number of fuel expenses are also considered direct costs if they're directly connected to a particular output. For instance, if you're able to calculate how much power it takes to make one output item, that could be a direct cost. Another example could be how a gas-powered mill records the fuel used to produce wood products as a direct cost.

Are lower or higher direct costs better?

Usually, it's better to have lower direct costs. This indicates that the organisation is delivering services and products that are efficient and have a good gross profit margin. Having lower direct costs can impact a business in numerous ways:

  • They can offer lower prices than competitors.

  • They can reinvest the extra funds in the company.

  • They can improve profitability.

Lower direct costs tend to have a positive impact on a company. A person in a leadership position might work hard to bring the number down, but it's important to remember that lower costs can mean lower quality. A good profit margin per product can result in lower overall profits if the drop in quality negatively impacts sales. Although lower is typically better in terms of costs, it's important to carefully assess the potential repercussions.

Related: How to reduce costs (plus common mistakes to avoid)

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