Direct Costs

Updated on April 11, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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.

What Are Direct Costs

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.read more 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.read more.

Key Takeaways

  • 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.

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Direct Costs (wallstreetmojo.com)

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.read more 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. read more 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.read more and selling price.

Cost Object

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Direct Costs (wallstreetmojo.com)

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.read more 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. read more 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.read more, 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. read more. 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. read more, 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.

Types

The different types of direct costs are as follows:

  1. 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. 
  2. 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.read more. It is either used in the production process or purchased for reselling purposes.
  3. Manufacturing Supplies: These refer to various consumables used in a factory—even registers, pens, paper, and other stationery goods.
  4. Transportation: Whenever goods are moved in or out of a factory, the freight paid by the company is considered a direct expense.
  5. 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.
  6. Factory Rent: Factory rent is a fixed and direct expense.

Formula

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.read more is computed with the help of the following formula:

Direct Cost Formula 1

Here,

Direct Cost Formula 1-1

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Example

Let us assume ABC Manufacturing furnishes the following cost information:

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.read more per unit.

Solution:

The Cost Statement of ABC Manufacturing is as follows:

ParticularsDetails ($)Amount ($)
Cost of Raw Material Consumed:  
Opening Stock100000 
+ Purchases225000 
(-) Raw Material(70000)255000
+ Direct Labour 120000
Prime Cost (Total Direct Cost) 375000
+ Works Overheads 35000
Works Cost 410000
+ 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

Interpretation:

  • 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)

What are some examples of direct costs?

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
7. Freight

How to calculate direct costs?

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.

What is the difference between a direct cost and an indirect 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 –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *