Coin Tower

Understanding direct and indirect costs


Since direct and indirect costs affect the price you charge for a product, an understanding of the difference between the two can be pivotal to maximising your cash flow. To determine the final cost of a product or service, you must take into consideration the costs of equipment and raw materials, along with the expenses involved with running the company.

It’s crucial that these figures are correctly recorded, as incorrect information will ultimately affect the accuracy of forecasting and your cash flow. Careful recording of the costs can improve the performance of the business, enhancing effective decision making as part of a management accounting role.

Direct costs

Your direct costs are those associated with the manufacture of the product, like the raw materials, equipment and labour. These are the items you must have in order to provide a product or service. Direct and indirect costs are generally split into three categories: labour, materials and expenses. The total of direct costs can often be referred to as ‘prime costs’.

Indirect costs

All companies have indirect costs, which are those the business would incur whether goods were produced or not. These typically include the cost of overheads like rent, utilities and office equipment. All supplies and materials required for the company to function on a daily basis are classed as indirect. Other indirect costs may include marketing, advertising and accounting services. Indirect costs are referred to as ‘overheads’.

Behaviour of costs

Costs can be accounted for according to ‘behaviour’. Various levels of activity will have an effect on input costs, which is how cost behaviour is determined.

Cost behaviours are often classified in four groups:

•    Variable costs – these usually increase or decrease in accordance with activity levels
•    Fixed costs – these will occur within an accounting period but don’t change within certain levels of activity
•    Semi-variable – these have elements of both variable and fixed, and therefore may be partially affected by activity levels
•    Stepped fixed costs – these are fixed for a specified level of activity, and will increase once the activity does

How does costing affect the business?

Variations in costs have an impact on the company, with employee absence being an obvious example of this in that it increases the costs of a business. The cost of labour, on the other hand, may be indirect or direct, depending whether it’s directly linked to the production of a product or service.

With costing being complex field in which many business owners fall short and hamper their cash flow, why not contact Sollertia to arrange an informal chat?