What is a direct cost?
A direct cost is a price that can be directly linked to the production of specific goods or services. A direct cost can be traced to the cost object, which can be a service, product, or service. Direct and indirect costs are the two main types of expenses or costs that businesses can incur. Direct costs are often variable costs, which means that they fluctuate with production levels such as stocks. However, some costs, such as indirect costs, are more difficult to allocate to a specific product. Examples of indirect costs include depreciation and administrative costs.
Understanding direct costs
Although direct costs are generally variable costs, they can also include fixed costs. The rent of a factory, for example, could be linked directly to the production site. Generally, rent would be considered overhead. However, companies can sometimes link fixed costs to units produced in a particular installation.
Examples of direct costs
Any cost involved in producing a good, even if it is only part of the cost allocated to the production facility, is included in direct costs. Here are some examples of direct costs:
- Direct labor
- Raw materials
- Manufacturing supplies
- Salaries for production staff
- Fuel or electricity consumption
Since direct costs can be specifically attributed to a product, there is no need to assign direct costs to a product, service, or other cost objects. Direct costs generally only benefit one cost object. Items that are not direct costs are grouped and allocated based on cost drivers.
Direct and indirect costs are the main costs involved in producing a good or service. While direct costs are easily attributable to a product, indirect costs are not.
Key points to remember
- A direct cost is a price that can be directly linked to the production of specific goods or services.
- A direct cost can be traced to the cost object, which can be a service, product, or service.
- Examples of direct costs include direct labor and direct materials.
- Although direct costs are generally variable costs, they can also be fixed costs. The rent of a factory, for example, could be directly linked to a production unit.
Direct and indirect costs
Direct costs are simple enough to determine their cost object. For example, Ford Motor Company (F) manufactures automobiles and trucks. The steel and bolts needed to produce a car or truck would be classified as direct costs. However, an indirect cost would be electricity for the manufacturing plant. Although electricity costs can be linked to the installation, they cannot be directly linked to a specific unit and are therefore classified as indirect.
Fixed vs variable
Direct costs need not be fixed in nature, as their unit cost can change over time or according to the quantity used. An example is the salary of a supervisor who worked on a single project. This cost can be directly attributed to the project and relates to a fixed amount. The materials that were used to make the product, such as wood or gasoline, can be traced directly but do not contain a fixed amount. Indeed, the amount of the supervisor’s salary is known, while the unit production levels are variable depending on sales.
Measure the value of stocks
The use of direct costs requires strict management of the stock assessment when stocks are purchased for different amounts. For example, the cost of an essential component of an item being manufactured may change over time. As the item is manufactured, the price of the part must be directly linked to the item.
For example, when constructing a building, a business may have bought one window for $ 500 and another window for $ 600. If only one window must be installed on the building and the other must remain in the inventory, a consistent application of the accounting assessment must take place.
Businesses generally track these costs using two methods: first in, first out (FIFO) or last in, first out (LIFO). FIFO involves allocating costs, such as purchasing inventory, based on which items arrive first. As the inventory is exhausted in the production of goods, the first or oldest items in stock are used first when measuring the cost of the item. Conversely, LIFO assigns the value of a cost item based on the last item purchased or added to the inventory.