Direct Costs vs. Indirect Costs: What Are They, and How Are They Different?

What are direct costs?

Direct costs are expenses that a company can easily trace to a specific “cost object,” which may be a product, department or project. Examples include software, equipment and raw materials. Direct labor is also included, as long as it relates to a product, department or project. 

For example, when an employee is hired for a project either exclusively or for a set number of hours, their labor is a direct cost. If your company develops software and needs specific assets, such as purchased frameworks or development applications, those are direct costs.

Examples of direct costs

Labor and direct materials constitute the majority of direct costs. For example, to create a product, an appliance-maker requires steel, electronic components and other raw materials. Two popular ways of tracking these costs, depending on when your company uses materials in production, are first-in, first-out and last-in, first-out, also known as FIFO and LIFO. LIFO can be helpful if the costs of your materials fluctuate in the course of production.

Usually, most direct costs are variable. Smartphone hardware, for example, is a direct, variable cost because its production depends on the number of units ordered. A notable exception is direct labor costs, which usually remain constant throughout the year. Typically, an employee’s wages do not increase or decrease in direct relation to the number of products produced.

What are indirect costs?

Indirect costs extend beyond the expenses you incur when creating a product; they include the costs involved with maintaining and running a company. These overhead costs are the ones left over after direct costs have been computed.

The materials and supplies needed for a company’s day-to-day operations – such as computers, electricity and rent – are examples of indirect costs. While these items contribute to the company as a whole, they are not assigned to the creation of any one service.

Examples of indirect costs

Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones. Much like direct costs, indirect costs can be fixed (like rent) or variable (like fuel). For-profit businesses generally treat “fringe benefits,” including paid time off and use of company vehicles, as indirect costs.

What are the differences between direct and indirect costs?

There’s a simple trick to classifying payments as direct or indirect costs: Direct costs encompass the costs involved with creating, developing and releasing a product or service, and indirect costs are expenses that are not tied to a particular product.

Direct costs

• Manufacturing supplies
• Equipment
• Raw materials
• Labor costs
• Other production costs

Indirect costs

• Utilities
• Office supplies
• Technology
• Marketing campaigns
• Accounting and payroll software
• Business insurance

The importance of knowing the difference

Understanding the difference between cost types increases insight into your products and services, leading to better pricing and more competitive offerings. Accurate tracking of direct and indirect costs improves accounting oversight, aids future planning and supports compliance with tax and grant regulations. 

When filing taxes, some direct and indirect costs may be tax-deductible. Common tax-deductible direct costs include repairs to business equipment. Tax-deductible indirect costs may include rent, utilities and certain insurance premiums. Each business’s situation is different, however. Consult your accountant or bookkeeper to confirm which costs qualify.

How direct costs and indirect costs impact funding for your small business

In cases of government grants or other forms of external funding, identifying direct and indirect costs becomes extra important. Grant rules are often strict about what constitutes a direct or an indirect cost and may allocate a specific amount of funding to each classification.

Often, funding for a specific project will largely support direct costs. Certain government agencies might allow you to explain why indirect costs should be funded, too, but the decision to grant funding is at their discretion.

When a company accepts government funds, the funding agency may also have several mandates in place regarding the maximum indirect cost rate and which expenses qualify as indirect costs.  

Classifying direct and indirect costs for proper accounting

Understanding the difference between direct costs and indirect costs is a critical aspect of proper accounting. Tracking each type of cost separately can help small businesses understand their cash flow, price their items properly and attain the maximum allowable tax deductions. If you need assistance with breaking down your business’s expenses, contact a professional accountant or choose accounting software that can support your business.

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Matt D’Angelo and David Cotriss contributed to the reporting and writing in this article.