What is a Direct Cost?
A direct cost means a direct price associated with the production of goods. For example, a direct cost relates to the cost of an object, a service or product, or a specific department.
Expenses or costs are divided as follows:
I) Direct Costs
II) Indirect Costs
In any organization, direct costs are often variable costs, which fluctuate with production levels, such as inventory. Any associated cost with production is a part of the direct cost. Examples include-
- Direct labor
- Direct usage of materials
- Manufacturing supplies
- Production staff wages
- Freight or fuel or power consumption
However, indirect costs are more difficult to assign to a specific product. Examples of indirect expenses include depreciation and administrative expenses.
Direct Cost vs. Indirect Costs
Let’s understand this through an example. When assessing any cost items, direct costs are relatively straightforward. For example, we know that any automobile company produces cars or trucks. The steel and bolts required to make a car or truck will be known as "direct costs." However, the electricity utilized at the manufacturing plant will be an indirect expense. While we can connect the cost of electricity to the system, it cannot be linked directly to a particular car or truck. It is, therefore, labeled as an indirect cost.
Types of Direct Costs
There are six different types of direct costs, which are as below:
- Direct Labor: Factory workers are directly paid wages to produce goods or services that add to the direct expenses accrued by a business. Such costs vary—increasing or decreasing depending on production quantity.
- Direct Material: Raw materials used for production or resale purposes are a variable cost.
- Manufacturing Supplies: Apart from the primary function of manufacturing goods, costs are also incurred by consuming pens, paper, stationery items, and registers in the factory.
- Transportation: The delivery of goods inside or outside a factory is a part of transportation. The freight charges paid by the company are considered a direct expense.
- Consumption of Power, Fuel, and Utilities: Various sources of fuel and power used for operating machinery and equipment are direct expenses—diesel, gasoline, natural gas, electricity, or coal.
- Factory Rent: Factory rent is considered a fixed and permanent direct expense.
Direct Cost Formula
In accounts, the total direct cost is computed with the help of the following formula:
Direct Costs = Direct Material Consumed + Direct Labor + Manufacturing Supplies + Fuel or Power Consumption + Other Direct Costs
Direct Material Consumed = Opening Stock of Raw Materials + Purchases - Closing Stock of Raw Materials
Benefits of using Direct Cost Methods
Using the direct costing method has the advantage that it provides practical information to the management for decision-making about the product and its pricing.
Direct costs are relatively easier to control through efficient management than indirect or overhead costs.
Given below are the distinct advantages of using direct costing methods:
- Plan Master Budget: It helps make a master budget for the year as direct costing provides a variable per unit cost.
- Analyze the Breakeven Point: Variable costs allow you to analyze your business's cost-volume relationship or break-even point. Breakeven refers to the sales metrics at which there is no profit and loss for the company.
- Decide the Price: Once the direct and indirect costs are measured and determined, it becomes easy for management to decide on a reasonable price for their product.
- Administrative Control: It gives more control to the administration over organization operations, as direct costing pinpoints the responsibility according to organizational lines.