What Are Direct Costs?
Direct costs refer to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.
Direct costs are output costs and operational costs. They contrast with indirect costs. Indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc. are not concerned with the production or purchase of merchandise. Indirect costs are attributed to the running and managing of a business entityBusiness EntityThe business entity concept declares that a business stands independently from its owner, and hence the two should be treated as separate entities when recording transactions. Therefore, all business transactions (income, expenses, assets, liabilities, and equity) must be kept separate from the owner’s account to ensure accurate accounting records..
Table of contents
- Direct cost comprises all manufacturing expenses incurred in producing final goods or services. Alternatively, it could be the procurement of goods for wholesale reselling.
- It includes various overheads like direct labor, direct material, manufacturing supplies, freight, and fuel or power consumption.
- Direct cost is used to determine the per-unit cost of production. The aggregate of direct expenses is called prime costs.
Video Explanation of Direct Costs
Direct Cost Explained
Direct cost refers to any expense that is directly associated with a company’s production facility. These expenses vary, depending on quantity, but certain fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. like factory rent can also be considered direct expenses.
Costs objects about direct expense are output costs and operational costs. Cost objectsCost ObjectsA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. determine the exact product costProduct CostProduct cost refers to all those costs which are incurred by the company in order to create the product of the company or deliver the services to the customers and the same is shown in the financial statement of the company for the period in which they become the part of the cost of the goods that are sold by the company. and selling price.
The output cost object determines the per-unit costPer-unit CostCost per unit is defined as the amount of money spent by a corporation over a period of time to produce a single unit of a specific product or service, and it takes into account two components in its calculation: variable and fixed costs. It aids in determining the selling price of the company's product or services. of production of each product or service. Overall production costProduction CostProduction Cost is the total capital amount that a Company spends in producing finished goods or offering specific services. You can calculate it by adding Direct Material cost, Direct Labor Cost, & Manufacturing Overhead Cost. is distributed among departments, projects, and processes—operation cost objects. Thus, we can say that the company’s direct expenses can be allocated to each unit of the cost object.
Direct expense is essential for budgetingBudgetingBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time., decision making, selling price estimation, and profit evaluation. A firm’s direct expenses determine the cost of goods sold (COGS)Cost Of Goods Sold (COGS)The Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. . When companies attain economies of scaleEconomies Of ScaleEconomies of scale are the cost advantage a business achieves due to large-scale production and higher efficiency. , they successfully reduce COGS. Alternatively, direct expenses can be reduced by finding suppliers who provide higher discounts. Also, manufacturers try to eliminate inefficiencies in production processes.
The different types of direct costs are as follows:
- Direct Labour: Wages paid to factory workers directly involved in the production of goods or services add to the direct expenses accrued by a business. Such expenses vary—increase or decrease depending on production quantity.
- Direct Material: Raw material is a variable costVariable CostThe variable costing formula evaluates the direct cost and other variable manufacturing expenses incurred on each product unit. It is computed as the sum of direct labor cost, direct raw material cost, and variable manufacturing overhead divided by the total number of units produced.. It is either used in the production process or purchased for reselling purposes.
- Manufacturing Supplies: These refer to various consumables used in a factory—even registers, pens, paper, and other stationery goods.
- Transportation: Whenever goods are moved in or out of a factory, the freight paid by the company is considered a direct expense.
- Consumption of Power, Fuel, and Utilities: The various sources of fuel and power used for running the machinery and equipment are direct expenses—diesel, gasoline, natural gas, electricity, or coal.
- Factory Rent: Factory rent is a fixed and direct expense.
In accounting, the total direct cost or prime costPrime CostPrime cost is the direct cost incurred in manufacturing a product and typically includes the direct production cost of goods, raw material and direct labour costs. It is an essential part of total manufacturing expenses. Costing and effective pricing of the goods are primarily determined on their basis. is computed with the help of the following formula:
Let us assume ABC Manufacturing furnishes the following cost information:
- Raw materialsRaw MaterialsRaw materials refer to unfinished substances or unrefined natural resources used to manufacture finished goods. – Opening stock: $100,000;
- Closing stockClosing StockClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.: $70,000;
- Purchases: $225,000
- Direct laborDirect LaborDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services. – $120,000
- Work Overhead – $35,000
- Administration overheadAdministration OverheadAdministrative overheads are expenses that are not directly linked to the production & distribution of goods & services but are indirect in nature, such as expenses incurred in the policy formulation, employee cost, legal and audit fees, telephone and electricity expenses. – $26,000
- Selling & distribution overhead – $38,000
- Finished units – 200,000
Now, based on the given data, calculate the overall direct expense and cost of salesCost Of SalesThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales. per unit.
The Cost Statement of ABC Manufacturing is as follows:
|Particulars||Details ($)||Amount ($)|
|Cost of Raw Material Consumed:|
|(-) Raw Material||(70000)||255000|
|+ Direct Labour||120000|
|Prime Cost (Total Direct Cost)||375000|
|+ Works Overheads||35000|
|+ Administrative Overheads||26000|
|Cost of Production||436000|
|+ Selling and Distribution Overheads||38000|
|Total Cost of Sales||474000|
Cost of Sales Per Unit = Total Cost of Sales/Finished Units
Cost of Sales Per Unit = 474000/200000 = $2.37
- Each component of prime costs is a direct cost. It included explicit material and direct labor—easily attributed to finished products.
- The overheads mentioned after prime costs are indirect and do not contribute to the production of goods—work overhead, administrative overhead, and distribution overhead.
Frequently Asked Questions (FAQs)
Examples are as follows:
1. Direct labor
2. Factory or warehouse rent
3. Cost of raw material
4. Cost of merchandise
5. Manufacturing supplies
6. Fuel consumption
Given below is a step-by-step method of computing:
1. First, Identify the cost items that facilitate the manufacturing of goods or services. Make a list of the costs.
2. Segregate direct expenses and indirect expenses from cost items. Some expenses like electricity costs cannot be divided into costs per unit of production.
3. Finally, add all the individual costs to determine the total direct cost.
The direct expense comprises manufacturing overhead on the production of goods or services. In the case of reselling, direct expense comprises expenditure made for wholesale purchases—direct labor and raw material.
On the contrary, indirect cost refers to expenses incurred for the functioning, management, and maintenance of a business. Overheads like showroom rent and manager’s salary are not considered for the computation of unit cost of goods or services.
This article has been a guide to what are Direct Costs. Here we explain the concept with examples, formulas, types, and its interpretation. You may learn more about accounting from the following articles –