Direct vs. Indirect Costs

Direct costs

Direct costs are costs that can be economically traced, identified and matched to the product being produced or service provided,; Indirect costs (also called overheads) are those costs that cannot be are not identified to the product being produced or service provided, they effectively can be thought of as support and infrastructure costs.

For a manufacturing company direct costs would consist of raw materials (direct materials), wage and salary costs of those individuals making the product (direct labour) and (say) royalty and patent costs (direct expenses); for an airline company, direct materials would include the fuel used in the aircraft; direct labour would be the wage costs of the pilot and crew; for a restaurant, the direct materials would include the cost of the food and drink purchases, direct labour would include the wage costs of the chefs/cooks; for a theatre company, direct materials would include the costs of state set and scenery, direct labour would include the fees for the performers, direct expenses would include copyright and royalty fees.

Direct costs are normally divided into direct materials, direct labour and direct expenses.  Whilst the first two are straightforward it is not always immediately clear what direct expenses are.   The sum of the direct costs for a product or service is often referred to as prime cost.

Indirect costs

Indirect costs are also referred to as overheads; the term overhead itself has assumed a negative connotation in some circles.  Indirect costs can be thought of those costs which are incurred to support to an organisations main activities For a manufacturing company indirect costs would consist of glues, screws, consumables, supervisory wages, depreciation and factory rent; for an airline company, indirect costs would include the wage costs of the ground crew, IT and HR costs; for a restaurant, indirect costs would include the costs of condiments, sauces, the wage costs of the waiting and front of house staff; for a theatre company, indirect costs wound include the depreciation of office computers, the wages of the admin staff and the rent payable on the building.

The production overhead cost of $400 represents a share of many different production overheads.  Ways of determining how much production overhead should be added to the cost of a product are dealt with in the units on absorption costing and activity-based costing.

Non-production overheads are shared costs that do not directly relate to production of a product.  These can include such items as administrative staff salaries, marketing costs and sales team salaries.