Direct Costs: Definition
Direct costs are costs that can be conveniently and economically identified with some cost objectives, or which can be associated with specific segments under consideration.
Indirect Costs: Definition
Indirect costs are costs that cannot be conveniently and economically identified with cost objectives and must be allocated—on some equitable basis—to the cost objectives or segments under consideration.
Explanation and Examples
Every cost for a firm must be assigned to a cost objective, which may be a production department, a division of the firm, or a unit of production. The key difference underpinning these two terms—direct and indirect costs—is their traceability.
- A manufacturing cost that is traceable to a specific product, activity, or department is known as a direct cost. Direct costs are fully traceable to a cost objective.
- For example, a department manager’s salary is easily traceable to their department, and so it is considered a direct cost for that department.
- An indirect cost is a manufacturing cost that is not traceable to a specific product or cost objective, and which must be assigned using some allocation method.
- For example, overhead costs in manufacturing are not directly identifiable with any particular product or service. Therefore, they are considered indirect costs with respect to that product or service.
A critical piece of information for managers is the ratio of direct to indirect costs in the total cost. If most incurred costs are direct and traceable, then the manager is in a better position to understand and control these costs.
By contrast, the manager will not have control over the portion of indirect costs.