Direct versus Indirect Costs: Defined and Examples

Direct costs are costs that can be traced to one cost object and are material enough to be worthy of tracing. An indirect cost is a cost that cannot be traced to one cost object, meaning it belongs to more than one cost object. Or it belongs to one cost object but is not material enough to be worth tracing.

Examples

One way to understand direct versus indirect cost is to go through some examples. As you can see here, you have to first define the cost object.

If we are talking about a product cost object, direct materials can be directly traced to the product. Each car has around 2,000 pounds of steel, a windshield, seats, and other various components. The direct labor can also be traced to the particular product. As they go down the assembly line, each car uses, say, 11 hours of direct labor.

Indirect costs would include most of the manufacturing overhead. For example, take the plant depreciation. You have to have a plant to build your product, but the plant depreciation cannot be traced to the particular units of product built, so it has to be allocated among the units. The same would be true of the utility bill for the plant, the janitorial services for sweeping the plant, and most of the other costs of operating the plant.

Now, consider an accounting department cost object. The salaries of the accountants can be directly traced to the accounting department. The depreciation of computers and office equipment used solely by the accountants can be traced to the accounting department. However, what about the cost of human resources? After all, human resources personnel handle the hiring and termination of accountants, as well as take care of the accountant's employee benefits while employed. The cost of human resources, which also handles the non-accounting departments in the company, would have to be allocated among the various departments that benefit from the use of human resources. What about the cost of the payroll department? The payroll department pays all the employees and the cost of running the payroll department would have to be allocated among all the departments benefiting.

Finally, let's take a customer cost object, here numbered as Customer 21. We can trace the cost of goods sold to Customers 21; that is, we know what merchandise was sold to Customer 21. We can trace the shipping to Customer 21, assuming we used an outside shipper; that is, we know how much we paid the shipper to take merchandise to Customer 21. The sales commissions on sales to Customer 21 are also direct. If we sold $1,000,000 to Customer 21 and paid 5% in commissions, the $50,000 in sales commissions is clearly traceable to Customer 21.

Now, what if the sales department individuals, besides commissions, get a salary, Assume sales staff are paid $2,000 a month, and they call on various customers. So, the person who called on Customer 21 also called on 30 other customers during the year. We would have to allocate the base salary of the sales individual to the various customers who benefited. And most of the sales department overhead, like the depreciation of the equipment used by the sales department would also be indirect and require allocation. Returning to the shipping example, it would not be direct if the company used its own internal delivery trucks that delivered something to Customer 21 and then continued down the highway and delivered something to Customer 22. Then, delivery expense would be an indirect cost.

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