Direct costs in business operations and accounting

Direct costs are those that can be "attributed to the production of specific goods or services" (Investopedia, 2013). They can be labor, materials or other expenses. In contrast, indirect costs are those that cannot be directly attributed -- at least not easily -- to a specific product or service. For the most part, identifying direct costs is a straightforward, but occasionally there are pitfalls that can emerge.

One pitfall when analyzing direct costs is to attribute all costs as direct costs, on the basis of how a single cost item breaks down. For example, if direct materials are allocated to products based on the allocation of direct labor costs. A two product company could allocate direct labor 40-60, and then use that split to allocate direct materials costs. That would be risky, because there might not be a connection between the two products with respect to their usage of labor and materials. The resulting cost data would be incorrect. One solution to this problem is that instead of using one cost as the cost driver, each direct cost is analyzed individually. Cost drivers are a type of shorthand for doing the hard work of determining specific direct costs for each type of cost.

Another risk is that some direct costs might be allocated as indirect costs erroneously. This would give the management a mistaken impression about the amount of direct costs for a given good or service. An example of this would be costs associated with wear and tear on a piece of equipment, which would be taken as indirect costs listed as a general maintenance expense. However, if that equipment is used primarily for one product, and only a little bit for another, the company might well realize that most of that maintenance expense is attributable to the one product. By hiding such costs under a general maintenance expense, the company is not accounting for all of the direct costs associated with that product, but is instead spreading those costs around. Something similar occurs with the overhead associated with real estate. The company could take on an additional building for one specific product, but might allocate real estate as an indirect cost because other real estate is allocated that way. Again, the direct cost is associated with a specific product, but it is not allocated this way by the company.

There is a considerable amount of research that goes into determining which costs are direct and indirect. If one is using an activity-based system, the data for determining direct costs will be available already. In order to ensure that direct cost analysis is accurate, the company should ensure that it has taken an ABC approach or something similar in order to analyze all of the costs the company records, to ensure that items that are direct costs associated with a given product or service are being allocated as direct costs, and not erroneously being lumped in with indirect costs. If this is done, the company will have better information about what its direct costs are, which of course will allow for better pricing decisions, more effective cost management and better decisions about which products are kept and which are discontinued.