When pricing your products, you must consider the cost of making the product, including the direct costs. Find out below what direct costs are, including examples and how to calculate them.
What are direct costs in business?
Direct costs are expenses that your business can completely attribute to the production of a product. The costs are easily connected to only one project. Direct costs are not allocated, which means they are not divided among many departments or projects. A direct cost can be a fixed cost or variable cost.
A fixed direct cost might be the salary of an employee who performs direct labor. A variable direct cost might be supplies to make the product.
An example of a direct cost are the supplies used to make the product. For example, if you own a printing company, the paper for each project is a direct cost. The employees who work on the production line are considered direct labor. Their wages can also be attributed as a direct cost of the projects.
Now, consider the sales staff at the company. The sales staff is not connected to one project. Therefore, their wages are not direct costs because they cannot be attributed to any one project. Their wages must be allocated to multiple projects.
Types of direct costs
What you consider a direct cost depends on your business’s situation. Direct cost examples include:
- Manufacturing materials
- Laborers’ wages
Direct costs vs. indirect costs
Direct costs are just one of two types of costs when producing goods. You need to know about direct costs vs. indirect costs.
There are few direct costs when producing a product. Many of your business expenses are likely indirect costs.
Indirect costs are typically overhead expenses that can be allocated to many departments or products. The costs of these items are not directly related to producing the product. Indirect costs include fuel, power consumption, office supplies, and support staff labor.
Why are direct costs important?
Direct costs can help you make important pricing decisions. By determining the costs that go directly into a product, you know the minimum amount you must sell the product for to recoup the costs.
Calculating your direct costs can also tip you off when your costs are increasing without your product changing. You should know what range your direct costs typically fall in. If you notice a change, look for errors or ways to reduce costs.
Basing your product prices based on direct costs alone does have a downside. If you don’t include indirect costs, the price of your product might not be enough to cover all your business’s expenses.
How to calculate direct costs
You can do an easy direct cost calculation.
First, determine which material costs are direct costs for the product. Add these together to get the total direct materials.
Next, calculate the labor costs for all employees who worked on the product. Add these together to get the total direct labor costs.
Lastly, add together the direct materials and direct labor costs. This will give you the total direct cost of your product.
Do your direct cost accounting with small business accounting software. Patriot’s accounting software is made for the non-accountant, so you can track your business finances yourself. Get your free trial today.
This article is updated from its original publication date of March 6, 2018.This is not intended as legal advice; for more information, please click here.