Analysis of direct material and direct costs

Direct cost is a cost that is involved specifically and directly in the production of a good or service (No author, 2013). For example, in the production of a hamburger direct costs would be the ingredients. If the person cooking the burger only cooks burgers, and does one burger per hour (just an example), then the direct labor cost of that burger would be one hour's worth of wages. Sometimes, however, it can be more difficult to determine the direct cost of producing a good or service, and that is where the risk of errors comes into play.

For example all costs can be taken as direct costs. This is a common error. There is a logical slippery slope involved in attributing costs. So for example, our burger flipper might flip an average of 40 burgers in an hour. The company might be tempted to average that wage over the number of burgers, coming to a conclusion that the direct labor cost of a burger is 20 cents. There are two pitfalls in this example. The first is taking the average -- in another hour there might only be 30 burgers flipped, so the average labor cost per burger is different. It can be difficult to determine an accurate figure for direct labor costs under these circumstances. For some tasks it is much easier to determine the direct labor cost. When you pay a plumber to fix your sink and he charges you $100 an hour for labor, that is a direct labor cost that is easy to measure. Many companies do like the burger joint and attempt to average out costs to determine a direct cost, but their figures are subject to fluctuations in production.

The second pitfall in the burger example is that the burger flipper might also perform other tasks. If this labor also is used to make fries and onion rings, then the direct labor cost per burger is even harder to calculate. The company would need to know how much time the person dedicated to each task. Short of putting the person on a stopwatch while they move around the kitchen, this is impossible. While there is direct labor involved in making burgers and fries, it can be difficult to know precisely how much time is dedicated to each task, making the direct cost figures inaccurate.

There is also a pitfall that is the reverse of these. Sometimes direct costs attributed as indirect costs. An example might be with the overhead cost. An overhead cost is usually considered an indirect cost, but this is not always the case. Suppose the company leases a new location to make a good, and produces one of those goods each hour. The direct overhead cost of each new unit is easy to calculate. The overhead in this case is not an indirect cost of doing business, but a direct cost of the new product. If the new product used excess space in the existing facility, any overhead allocated to it would be indirect, since that overhead would not be the direct result of the decision to make that product.

Normally, a firm can help to reduce these errors, or at least their magnitude, by conducting intensive research into the costs. The more the company knows about its cost structure, the less likely it is to misallocate costs as either direct or indirect (Peavler, 2013). The company needs to be honest about what each cost is, rather than attempting to shoehorn costs into either category. The more information the company has about its costs, the less likely it is to make mistakes. Some costing systems, like activity-based costing, force the company to understand direct costs in more detail, so are better-suited to analysis of direct costs.