What are direct costs and how do they differ from indirect costs?

It’s surprisingly cheap to start a business today – as little as $ 5,000, Fortunly reports. As encouraging as this is to aspiring business owners, the cost of running this business on a day-to-day basis is a little more complex.

Before doing any research and development, and before even renting an office space, you might want to know how much money you will need to make your product. This is your direct cost.

What are direct costs?

You spend direct costs specifically on the development and maintenance of your product or service. This cost can vary over time as the product improves. The direct costs range from the salaries of the employees to the price of the items needed to build each unit of your product.

Direct costs are especially important when pricing your listings, as they serve as the minimum breakeven point in production. From the break-even point, you can determine the margin you need to cover your company’s indirect costs (overheads) and make a profit.

An increase in direct cost may be caused by an increase in material or manufacturing cost, decreased production efficiency, or delays and other similar problems. For this reason, it is good to have your finger on the pulse of your direct costs to avoid major problems.

Additionally, direct costs can help managers determine whether new products or projects are profitable and whether it makes more sense to outsource or tackle them internally.

Are direct costs different from fixed and variable costs?

In fact, direct costs are a type of fixed or variable cost. These costs are not mutually exclusive. Whether or not direct costs are fixed, variable or not depends simply on how likely (or regularly) the costs are to change as your business grows. Here are two examples:

  • Variable direct costs: A SaaS company that sells cloud-based software is responsible for storing the data that its customers put into their software. This information is stored on servers. The more customers the company has, the more servers the company has to buy to store customer data so that the product can continue to operate. Server costs in this case are variable direct costs for the company.
  • Fixed direct costs: Consider the variable cost example above. This company also employs an IT administrator to manage the storage of customer data. Subject to changes in their compensation, the salary the Company pays that Administrator will remain unchanged each month. IT salaries are a fixed direct cost to the company.

Direct vs. indirect costs

Direct costs are invested “directly” in the development of a product or service. Indirect costs can affect the company’s overhead costs but do not directly contribute to the creation and quality of this service. These costs include office space rental, office security, and staffing requirements.

Direct costs get their name because they have a “direct” line to create and manage your goods and services. You pay cost A in exchange for item B, you use item B to make product C. Cost A is a direct cost, as Product C can be traced back to Cost A you paid.

Indirect costs are more complicated and have no direct bearing on the bottom line of your product. You pay cost A in exchange for Facility B, you use Facility B to host Machine C, and Machine C is used by Team D to make Product E. Cost A is an indirect cost as product E cannot be directly attributed to cost A that you paid. There are other direct costs incurred between A and E.

Direct costs help you produce your goods or services, while indirect costs help you support your business in other ways

Examples of direct costs

  1. Physical materials
  2. Employee salaries
  3. Sales commission
  4. server
  5. Data center room
  6. Product transport
  7. power

It’s easy to attribute your direct costs to the money you spend physically producing your goods and services. For example, an automotive company could pay a steel maker for the material from which each body is made. This is a direct cost to the car company.

However, there are other direct costs that can be put into a product, even if those costs are not related to the material your product is made of. Here are some examples of direct costs that you can assign directly to your product:

1. Physical materials

The raw materials, ingredients, and parts needed to make your product are a direct cost to your business.

For example, if you sell computers, you need to consider the materials needed for the screen, keyboard, and hard drive, as well as any other materials needed to build the device, when determining the cost of them.

2. Employee salaries

The individual salaries, especially those you pay to those who make and sell your product, are a direct cost.

When hiring freelancers or contractors, you should also consider how much money you will have to spend on their work.

3. Sales commission

This is different from salary and is usually specific to salespeople who often work partially on commission.

Every time a seller sells a unit of your product, they receive a commission. This is a direct cost of maintaining value or your product. Compare how many units you want to sell against the commissions you pay on each sale.

4. Server

In 2020, almost every business will need some kind of website. Every website now needs a server. The servers needed to store customer data on your product, especially if your product is in the form of software, are a direct cost to your business.

While you can potentially reduce the cost of building your website on a CMS that has server support, you should still consider the cost of protecting and storing your data.

5th place in the data center

Just paying for your servers isn’t the only thing you need to consider. You may also need to consider where to put them and how much it might cost. The space in the data center that you rent or own to store these servers is a direct cost factor.

6. Product transportation

How does a customer get to him after buying a product? Will it come in the mail or will it be delivered by your company’s delivery engineer? You need to determine which strategy you are using and add up the costs involved. While mail incurs regular shipping costs, having your own business delivery incurs labor costs and costs associated with purchasing your own means of transport, e.g. B. Trucks.

7. Power

Electricity or fuel consumption is an example of costs that can be incurred either directly or indirectly. On the one hand, the entire company (including the company’s indirect functions) consumes electricity. So if you don’t split up how much goes into indirect functions for direct production, your best bet is left as indirect costs. However, you may be able to easily do this mapping if your company’s arms operate in different facilities or use different types of electricity.

How to calculate direct costs

direct costs = direct material costs + direct labor costs + costs

Direct material costs

This is the amount of materials needed to make the item or complete the project. Add up all the materials needed to make a unit.

Direct labor costs

This is the amount of work required to produce an item or complete the project. List all employees who directly contribute to the production of a single unit. Then determine how much time each of them is likely to take to make a single unit. From there, you can use their salaries to determine the labor cost of a unit.

Other issues

Use the list above to identify other expenses that can contribute directly to production.

You can measure the direct cost on a monthly basis by taking the cost of making a single unit and multiplying that number by the number of units you want to produce per month. Or you can analyze quarterly or annually. Just make sure that you are comparing apples to apples to measure the cost of materials, labor, and other costs in that regard. For example, you don’t want to add a monthly number with a quarterly number as it will affect your calculations.

When you understand your direct and indirect costs (overheads), you are well on your way to building a pricing structure and making a profit. These are important components of your business plan as you determine how you plan to operationalize and grow.

Editor’s note: This blog post was originally published in March 2019, but has been updated for completeness.

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