When you start and run a business, you have all sorts of expenses. Being able to classify the types of costs you have is necessary to maintain your accounting books for small business, receive tax deductions, and make business decisions. You must know the difference between direct vs. indirect costs.
Direct vs. indirect costs
What are direct costs?
Direct costs are business expenses that can be directly applied to producing a specific cost object, like a good or service. Cost objects are items that costs are assigned to. Examples of direct costs include direct labor, direct materials, and manufacturing supplies.
Let’s say you have an employee who puts together toys. The employee’s work is considered direct labor. To create the toys, the employee needs wood, which is considered a direct material. And, the employee must use wood glue, which is a manufacturing supply.
Direct costs can be variable or fixed costs. Variable costs are costs that change based on how many items are produced or how many services offered. For example, you would spend more money producing 200 toys as opposed to 100 toys. Fixed costs are expenses that remain the same each month.
Understanding direct costs can help you determine your product or service pricing. Because they are variable costs, you want to make sure that customers pay you more than what you paid to produce your products or offer your services. But, you also need to factor in indirect costs.
What are indirect costs?
Indirect costs are expenses that apply to more than one business activity. Unlike direct costs, you cannot assign indirect expenses to specific cost objects. Examples of indirect costs include rent, utilities, general office expenses, employee salaries, professional expenses, and other overhead costs.
For example, you make rent and utility payments to keep your business going. And, you must buy computers. These costs are not directly related to producing a specific product or performing a service, so they are indirect costs. Indirectly, they help you produce goods and perform services, but you can’t directly apply them to a specific product or service.
Because indirect costs cannot be applied to a specific item, they generally do not change as a result of production volume. They can be considered fixed costs, which means the expense does not change in the short term. You can plan on fixed costs being the same from month to month. However, some indirect costs, like utilities, are variable because they change each month.
Although indirect costs are not applied to specific cost objects, you can allocate costs to determine how much you are spending on expenses compared to your sales. This can help you set prices that will result in a net profit. To do this, find the overhead rate, or indirect cost ratio.
Here is the overhead rate formula:
Overhead Rate = Overhead Costs / Sales
Let’s say you had $4,000 in indirect costs and $16,000 in sales. Your overhead rate would be 0.25, or 25% ($4,000 / $16,000). This means that you spend 25 cents on indirect costs for every dollar you earn. If your direct costs are also high, you won’t be turning much of a profit.
Overhead rates vary from industry to industry. But, you should try to keep your overhead rate minimal. The smaller your overhead rate, the better.
What is the difference between direct and indirect costs, and why does it matter?
As you now know, direct costs are expenses that directly go into producing goods or providing services while indirect costs are general business expenses that keep you operating. But why does the difference matter?
Knowing which costs are direct vs. indirect helps you with recording expenses in your books and on your financial statements. For example, you shouldn’t record an indirect cost under “cost of goods sold” on the income statement. Instead, you should list indirect costs under business expenses.
Difference between direct cost and indirect cost for taxes
You must understand direct and indirect costs when it comes to claiming tax deductions. If you don’t classify direct cost vs. indirect cost and try to claim deductions, you can come under IRS scrutiny. And if you don’t claim deductions for certain direct expenses and indirect expenses, you could be missing out on a tax deduction.
Business expenses like rent, employee wages, and new office equipment are just some of the deductions you can claim. You must correctly classify expenses so you don’t get into trouble with the IRS. For example, do not pass direct costs off as indirect costs just to claim a deduction.
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