Direct Costs vs Indirect Costs

Managing your business cash flow isn’t just about keeping track of your revenue. You also need to be proactive in accounting for your operational costs. Failing to track your expenses correctly can paint an unrealistically rosy portrait of your business finances.

However, some business expenses are more obvious and easier to quantify than others. So, it’s vitally important to track both direct and indirect costs to get a comprehensive overview of your operational expenses. Understanding the costs associated with providing your goods and services will also directly impact your pricing. 

Let’s take a look at the difference between direct and indirect costs.  

Direct costs explained

Direct costs are costs that are directly involved in the development, manufacture or releasing of products to market. Any cost that is essential to these aspects of production is classed as a direct cost.

Direct costs examples

Your direct costs will vary depending on the nature of the products or services you offer, and the processes involved in bringing them to market. Direct costs can often be variable in nature, making them important to quantify in order to maintain cash flow. 

Some common examples of direct costs include:

• Raw materials

• Machinery or plant needed for production or delivery

• Packaging and shipping costs

• Sales commissions

Indirect costs explained

Of course, your business has many functions that contribute indirectly to the development, production and delivery of the goods and services you offer. Beneath the surface, there is a wide range of administrative processes that allow you to do what you do, all of which incur their own expenses. Indirect costs are often fixed.

These are all classed as indirect costs. 

Indirect costs examples

• Utilities (electricity, gas, water, telecoms)

• Rental on your business premises

• Office supplies and technology

• Insurance costs

• Marketing costs (whether outsourced or in-house)

• Payroll, accounting and bookkeeping services

What’s the difference & why do both matter?

As we can see, direct costs are those that are directly involved with bringing your product to market, while indirect costs are those incurred during the processes that support this. 

Both are important, as they are part of your bottom line, and provide an insight into your company’s profitability. Direct and indirect costs can have different tax implications, although some instances of both are tax-deductible. They can also have different implications if you are applying for grant assistance from the government. Your accountant will be able to advise you further. 

Although their relationship isn’t always obvious, both direct and indirect costs contribute to the cost of goods sold, and as such will also have an impact on your pricing. Having a comprehensive understanding of your costs allows you to price your offerings competitively without sacrificing your profit margins. 

Are employee wages direct or indirect costs?

Whether employee wages are classed as direct or indirect costs depends on the employee’s role and the service they provide for you. Direct labour (labour involved in the hands-on production of goods and services) is classed as a direct cost. Indirect labour (such as support or supervisory staff) is classed as an indirect cost. 

In a factory, for instance, the wages for assembly-line workers and those operating the machinery are classed as direct labour, because their labour directly impacts the availability and quality of the finished product. The wages of line managers or administrative staff, however, is an indirect cost because it does not directly impact the product.  

Sales commissions are also considered a direct cost because they play a vital role in delivering the product to the customer. 

We Can Help

If you’re interested in finding out more about direct costs, indirect costs, and managing your expenses, then get in touch with our financial experts. Discover how GoCardless can help you with ad hoc payments or recurring payments.