- Elon Musk, Investor & Entrepreneur
Understanding the difference between direct and indirect costs is vital to your business’s success. Many small businesses depend on government funding. The amount a business receives in government funding is dependent on costs.
As a small business owner, it is your responsibility to understand the costs related to manufacturing your product or providing your service. Most people consider the cost of equipment, raw materials, and labor.
But, there are other costs at play too. The company may need to pay rent, this is a business cost. The office will likely need supplies, gas, and electricity. These costs relate to the product’s production as well.
Which of these costs are direct and which are indirect? If you are in the same boat as other small business owners, you may not know. It can be difficult to tell. That’s why we decided to share the information we had on the subject. Learn about the direct and indirect costs below.
INDIRECT COSTS: WHAT ARE THEY?
Indirect costs are the less obvious expenses associated with production. These costs are often overlooked because they do not directly fund the project. But, these costs are still necessary to run a successful company.
In fact, many of these expenses are imperative to the project itself. Imagine you are the owner of a tee-shirt company. The company owns a factory and an office building. Would you consider the office staff a vital part of the organization? They handle customer service, business operations, and human resources. But their labor is an indirect expense.
If the office workers are important to the continuation of the business, then the office they work out of is too. But the utilities and equipment needed to run the office are also indirect expenses. The computers located in the business office are a necessity. These machines hold the employee information, the company’s financial help, and the factory operations. But, these computers are also indirect costs.
So what does this mean? Basically, any financial expense the business pays that does not directly result in a product is an indirect cost. Even the utilities that power the plant are indirect costs. This is because the cost of electricity applies to the entire building. There is no way to trace it back to a single product.
DIRECT COSTS: WHAT ARE THEY?
Once you understand indirect costs, you are set. Direct costs are the most straight-forward. There are two main direct costs. These are raw materials and labor costs. Both of these expenses contribute directly to the manufacturing of a product. You could consider software and equipment a direct cost too. This is true if these two expenses are solely for the product.
Picture the same tee-shirt company. Consider the cost of labor for the factory workers, the machines used to create the tee-shirts, and the cotton that made the tee-shirt. Each of these expenses is all considered direct costs. However, the electricity used to power the machine would be an indirect cost.
Spending will contribute to the direct cost if the entire amount spent is necessary for the production of the ‘cost product.’ It is important to keep track of the direct costs related to your business. There are two methods commonly used to track these costs. They are FIFO, first in-first out, or LIFO, last in-first out.
IMPORTANT DIFFERENCES TO NOTE
We need to review the differences between these two kinds of costs. But first, let’s examine what the costs actually mean. Direct costs and indirect costs are accounting terms. Use these terms to distinguish between company expenses.
Knowing how to separate and track these two expenses boosts your company’s success. We will explain why in the next section.
In general, direct costs are the costs of creating a product or providing a service. These costs relate to the production, improvement, and release of a product. In comparison, indirect costs are the expenses that keep your business operating. Any expense considered indirect relates to the office, management, and company maintenance.
It will require both direct and indirect expenses to keep your business afloat. Noting the differences between these two costs will assist you in building your company’s success. Though both of these costs are crucial, they serve different purposes. Direct expenses fund the project, while indirect expenses fund the company.
WHY DOES IT MATTER
All this information is great, but why does it matter? Understanding the differences between these two costs is the key to precise accounting. Direct costs are pretty easy to keep track of even though they vary with the amount of production. Indirect costs are a little more difficult to track, but the expenses are usually fixed.
Treating these expenses as two separate costs will impact your potential funding. Government agencies base their funding on costs, more specifically the direct costs. Some agencies are willing to work with you. They may give you an opportunity to explain why you need funding for an indirect cost.
Even these companies may not be willing to fund the cost. If they do, they will likely regulate how much of the funding you can spend on indirect costs.
It can be difficult to understand the difference between these two separate costs. Managing finances is often one of the most difficult tasks that come with owning a business. If the process still seems hard, consider reaching out to an accountant. An accountant should be able to answer most of your questions. Accountants spend a great deal of time on work-related to direct and indirect costs. They will be able to help you with any other financial issues too.
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Thought leaders & celebrities share their tactics for success on the Lisnic podcast by Lisa Teh & Nick Bell