What is Direct Cost?
Direct cost is the cost incurred by the organization while performing their core business activity and can be attributed directly in the production cost like raw material cost, wages paid to factory staff, power & fuel expenses in a factory, etc. but doesn’t include indirect costs like advertisement expenses, administrative expenses, etc.
These costs can be identified easily as per the expenditure on cost objectsCost ObjectsA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. . For example, if we pick how much expenditure a business has had on purchasing the raw materials inventory, we will be able to directly point out.
What is Cost object in Direct Costs?
- A cost object is a particular unit for which cost can be identified. The most common form of a cost object is the company’s products/services. It is the output of the company. Other than that, we can also identify process, production line, department as costs objects since they can be identified as cost units.
- Cost objects can be outside the company as well. For example, a cost unit can be accumulated costs for suppliers or customers.
Direct Cost Examples
Example: ABC Factory has the following information, and from the below-furnished information, you need to calculate per unit cost of sales.
- Raw Materials – Opening Stock: $100,000; Closing Stock: $70,000.
- Purchases during the period: $225,000.
- Direct labour – $120,000
- Works overheads – $35,000
- Administration overheads – $26,000
- Selling & distribution overheads – $38,000
- Finished units – 200,000.
Find out the cost of sales per unit.
In this direct cost example, every input is given. We just need to put the figures in the right place.
Statement of Cost of ABC Factory
|Particulars||Amount (In US $)|
|Raw Materials – Opening Stock||100,000|
|Add: Purchases during the period||225,000|
|Less: Raw Materials – Closing Stock||(70,000)|
|Cost of material consumed||255,000|
|Add: Direct Labour||120,000|
|Add: Works overheads||35,000|
|Add: Administration overheads||26,000|
|Cost of Production||436,000|
|Add: Selling & Distribution overheads||38,000|
|Total Cost of Sales||474,000|
|Finished Units||200,000 units|
|Cost of Sales per unit||$2.37 per unit|
- In the above example, we will look at a prime cost, which is the aggregate of direct costs.
- If you look at each component of prime cost, you will see that each one is a direct cost. Here we used direct materialDirect MaterialDirect materials are raw materials that are directly used in the manufacturing process of a company's goods and/or services and are an essential component of the finished goods manufactured. and direct labor, which can easily be attributed to finished products.
- But if you look down, you would see that after prime costs, all are overheads. Overheads mean they are expended for providing multiple benefits. That means they are not easily attributable. That’s why they are indirect costs.
Let’s say that Company Q has two departments. The first department A consumed 1000 units of electricity for August, and the second department B consumed 1200 units. Electricity Board charges typically $1 per unit. How many departments A and B would cost?
For two departments, Company Q would pay –
- Department A = (1000 * $1) = $1000.
- Department B = (1200 * $1) = $1200.
That means here we can see that the cost of each department (cost object) can be identified, and at the same time, the cost is variable because the cost would increase/decrease as per the units consumed (variable cost).
Direct Cost vs. Variable Cost
Direct costs are often called variable costs. But how true is it?
If we look at a business, we will see that the business has two types of costs for producing goods or services, and they do not concern cost objects. These two kinds of costs are called – fixed costs and variable costs.
- Fixed costs don’t change until a certain point of production. For example, if you pay rent for a factory, no matter how less or how much you produce, it won’t matter. You still have to pay the same amount. To illustrate this further, we can say that if you pay $4000 as a factory per month, it won’t change whether you produce one unit or 10,000 units. That’s why fixed costs always vary per unit.
- On the other hand, variable costs are costs that are charged per unit. For example, you pay electricity charges for business consumption. And it’s dependent on how much you consume as a business. If you consume fewer units, you will pay less; and if you consume more units, you will pay more.
We know that there’s an element of attribution in the direct costs, which we can see in the variable costs too since the variable cost will only increase or decrease as per the units consumed/produced.
So, we can label direct costs as variable costs.
This article has been a guide to Direct Cost definition and its meaning. Here we take its examples along with the concept of cost objects as direct costs and indirect costs. You may learn more about accounting from the following recommended articles –