What’s the Difference Between Direct and Indirect Costs

Most business owners realize that tracking costs is an essential part of the budgeting process. New entrepreneurs, however, may not understand the difference between direct and indirect costs, or recognize the importance of tracking each separately.

Not only does categorizing expenses correctly affect a company’s cash flow, but it can also have a significant impact on federal tax payments. In the long run, understanding and tracking direct and indirect costs is a crucial part of keeping your business compliant.

Understanding Direct and Indirect Costs

Companies classify costs as direct or indirect based on whether or not they are used to produce goods and services. Direct costs refer to costs related to producing goods and can be tracked back to a specific object. Typically, direct costs fall under the control of a department manager and are constant for every unit of production.

Most of a company’s direct costs can be separated into direct labor (i.e., the cost of paying employees to produce a product) and direct materials, which include all the raw materials needed to manufacture a particular item. Keep in mind that, in certain contexts, direct costs can also include employee benefits and programs, equipment, travel and consultant services.

While direct costs are typically easy to assign, indirect costs are often far less straightforward. Indirect costs are less about product creation and more about overall company maintenance and growth, and usually not traceable to a single department or product.

Because indirect costs can be incurred jointly across departments, companies often struggle to assign them to a single department or cost center. A company’s indirect costs may include electricity and utilities, distribution and sales, building maintenance and other expenses related to running an office. For this reason, indirect costs are widely regarded as the cost of doing business.

In some cases, it may be impossible to classify a cost as either direct or indirect. For example, purchasing raw materials for the production of a specific item is a direct cost. On the other hand, if those same materials are bought in bulk and go towards other areas of the business, then they may qualify as an indirect cost for the company.

Why Track Direct and Indirect Costs?

Business owners may be tempted to neglect this task due to the time commitment involved in cost tracking. Failing to allocate your direct and indirect costs on a regular basis, however, can have a negative effect on your company’s budget, and affect your ability to price products correctly.

The fact is that the price of a product is determined by multiple factors, including production costs, workers’ salaries, marketing campaigns and other expenses. Without an accurate budget that correctly predicts costs and profits, a business may struggle to come up with a lucrative pricing model. In the long run, this failure may affect the business’ ability to meet its fiscal obligations and stay productive.

Additionally, erroneous cost tracking can affect your business standing with both clients and creditors. Since businesses use expense tracking to determine which expenses should be billed to customers and which should be paid internally, inaccurate tracking can result in clients receiving invoices in error, which can damage your business’ reputation over the long term. Businesses should use an invoice template and accounting system to accurately generate and track invoices.

Further, cost tracking is crucial for companies that receive government grants or other types of funding. Many government grant programs stipulate that funding be allocated to direct and indirect costs in specific quantities. Violating these policies can put a business’ funding in jeopardy.

Finally, cost tracking can affect a company’s cash flow by raising or lowering its tax burden. After categorizing costs as direct or indirect, a business can deduct certain expenses. In the long run, a reduced tax bill means increased cash flow for your company.

On the other hand, misclassifying direct costs as indirect and vice versa can cause issues with the IRS down the line. To comply with federal regulations and avoid audits and tax penalties, an organization needs to report indirect and direct costs separately and on the proper forms.

It can be challenging to determine whether costs are direct or indirect. Correct classification, however, enables businesses to budget and bill more accurately. It can even affect your annual tax burden. By learning how to track direct and indirect costs properly, you can help your business stand the test of time.

If this piece has you wondering what types of taxes your business can write off, look no further than these top tax write-offs for small businesses.