Written by In cost accounting, all costs can be divided into direct costs and indirect costs.
While direct costs are those costs that can be economically traced and attributed directly to a specific cost unit or cost centre, indirect costs are those that cannot be traced and distributed directly to a specific cost centre.
In this post, we will look at the meaning, and types of both direct costs and indirect costs. We will also look at the differences between both.
Table of Contents
Direct costs
Direct costs are costs that can be traced and attributed directly to a specific cost unit or cost centre.
They are those costs which can be directly identified with a job, batch, product or service.
An example of direct cost is the cost of the engine in the car as the engine can be directly traced to a specific car.
Direct costs are generally classified into three categories: direct material costs, direct labour costs, and direct expenses.
Direct material Costs
Direct material costs are the cost of materials that are used in making and selling products or providing services.
They consist of all those materials that can be identified and traced with a specific product or service.
Direct materials costs often include the cost of raw materials, components, parts, and any other materials that are specifically consumed in the production process.
For example, in the production of a car, the cost of steel, tires, and upholstery would be considered direct materials costs.
As another example, the wood that is used the manufacture a table can easily be identified as part of the product and thus can be classified as direct materials.
Direct labour costs
These are the costs of the workforce specifically used to make a product or provide a service.
Direct labour costs include wages, salaries, bonuses, benefits, and other forms of compensation paid to employees who are directly involved in the production process.
That is, They are labor costs that can be directly attributed to a particular product, project, or department.
Direct labor costs also include the compensation of employees who physically work on the production line or perform specific tasks directly related to a product or service.
For example, in a manufacturing plant, the wages of assembly line workers or machine operators would be considered direct labor costs.
Direct expenses
Direct expenses are expenses that have been incurred in full as a direct consequence of making a product, providing a service, or running a department.
These expenses are specifically incurred for a particular product, service, or batch.
Direct expenses are unique to a particular cost object and incurred for its benefit.
Examples of direct expenses include royalties paid per unit for a copyright design and plant charges for a particular job or batch.
Note that the summation of all direct costs will give us prime costs.
Therefore, prime costs consist of direct labour costs plus direct material costs plus any direct expenses.
Indirect costs
Indirect costs are costs incurred in the process of producing a product, providing a service, or running a department, but which cannot be directly attributed to a specific product or service.
They are costs that are not directly traceable to a specific product, project, or department.
Indirect costs are also known as overheads.
There are three types of indirect costs, namely; indirect materials, indirect labor, and indirect expenses.
Indirect material costs
Indirect material costs are materials costs that cannot be easily identified with any one product because they are used for the benefit of all products rather than for any one specific product.
They are costs of materials that are necessary for the production of a product but cannot be directly attributed to a specific product or service.
Indirect materials cannot be easily assigned to a particular cost object since they are used across multiple products or projects.
Examples of indirect materials include lubricating oil, stationery, consumable materials, maintenance materials, and spare parts for machinery.
Indirect labour costs
These are wages, salaries, and benefits of employees who are not directly involved in the production process but provide essential support or services to the organization.
Indirect labour costs consist of the wages of all employees who do not work directly on the product but assist in manufacturing operations.
In essence, all wages and salaries paid to workers not directly related to the production of goods and services are considered indirect labour costs.
Examples of indirect labor include salaries and wages paid to factory supervisors, maintenance personnel, storemen, quality control inspectors, administrative staff, and other support personnel.
Indirect expenses
Indirect expenses are general costs that are not directly attributable to a specific product, project, or department.
Indirect expenses are generally incurred for the overall functioning and administration of the organization.
Examples of Indirect expenses include office rent, office utilities, office insurance, and depreciation of office equipment.
Differences Between Direct Costs and Indirect Costs
- Direct costs are specifically traced to a particular product, project, or department whereas indirect costs are not directly traceable to a specific cost object.
- Direct costs are allocated directly to a specific cost object with a high degree of accuracy. On the other hand, Indirect costs require allocation or apportionment methods to distribute them to different cost objects.
- Direct costs tend to vary directly with the level of activity. As a result, they are considered variable costs. In contrast, Indirect costs are usually classified as fixed or period costs.
- The sum of all direct costs is called prime costs while the sum of all indirect costs is called overhead costs.
