Understanding Direct and Indirect Costs in Business Accounting

The direct costs and indirect costs are a common type of costs incurred by each company. What does it include? Costs that are often incurred in business are usually measured in units of money. Everything in business can not be separated from the cost.

Cost is one of the most crucial and important elements in business. Matters related to costs must be recorded in the report to be accounted for.

For business owners you should be aware that tracking costs is an important part of the budgeting process. Some of you may not understand the difference between direct and indirect costs.

Not only can properly categorizing expenses affect a company’s cash flow, it can also have a significant impact on federal tax payments. Understanding and tracking direct and indirect costs is an important part of keeping your business in compliance. For more details on direct and indirect costs, see the explanation below.

Identifying Direct and Indirect Costs

 Knowing Direct and Indirect Costs in Business Accounting

Companies classify direct or indirect costs based on whether they are used to produce goods or services. Here’s the explanation.

1. Direct Cost

The direct costs is the cost associated with producing the goods and can be traced back to a specific object.

Usually, direct costs are under the control of the department manager and are constant for each unit of production.

The direct costs ( direct costs ) are costs that can be charged directly to cost objects or products.

Employee salaries are included in the direct costs of producing a product, and include the raw materials needed to produce certain goods.

In some contexts, direct costs include employee benefits and programs, equipment, travel, and consulting services.

The following is an explanation of several types of direct costs.

a. Material Cost

Material costs are costs that include the purchase of materials and materials calculated by unit price analysis.

Things that must be taken into account in material costs are leftover materials, loco or franco prices, best prices, and payment methods to suppliers.

b. Labor Wage Cost

The cost of labor wages is the payment of workers’ wages which is calculated against unit items and usually has a standard unit price.

In calculating the cost of workers’ wages, it is necessary to pay attention to things such as the difference between daily or wholesale, work capacity, where the workers come from, as well as taking into account the applicable labor laws.

c. Equipment Cost

The cost of equipment is the cost of equipment to carry out construction work.

To calculate this cost, several things need to be considered, such as; costs of entering and leaving the warehouse, operating labor costs, and operating costs if the equipment is rented, depreciation, repairs, maintenance, and mobilization costs if the equipment is not rented.

2. Indirect Cost

Usually direct costs are easy to determine, but indirect costs are often much easier. Indirect costs ( indirect costs ) are costs that can not be connected and charged directly to the unit produced.

Generally, indirect costs include electricity and utilities, distribution and sales, building maintenance, and other office-related costs.

This makes indirect costs considered as business costs. The following explains some types of indirect costs.

a. Unforeseen expenses

Unexpected costs are costs that are prepared for events that may or may not occur.

For example, if there is a flood at the project site, of course there will be special costs to overcome it.

Contingency costs are usually estimated to be between 0.5 and 5% of the total project cost. Below are the things that are included in the incidental cost.

  • Subjective uncertainty, where there is a subjective interpretation of something such as the use of certain materials that can be interpreted differently by workers.
  • There is an error, for example, an incomplete working drawing or the contractor making a mistake in his work.
  • Objective uncertainty, namely there is uncertainty whether or not a job is necessary because it is determined by objects beyond human capabilities. For example, the installation of sheet piles for foundations determined by the high and low water table.
  • Efficiency variations, meaning the presence or absence of efficiency from resources such as materials, labor, and equipment.

b. Overhead Cost

i.e. additional costs that are not directly related to the process of running the project but must still be included in the budget so that the project runs well.

Overheard costs are grouped into 2 types of costs, namely;

  • Field overhead, related to field personnel costs, warehouse, field office, lighting, transportation, building permits, quality control costs, and others.
  • Office overhead, related to office rental costs and facilities, employee salaries, business licenses, bank references, and others.

c. Profit

namely all the results obtained from the implementation of a project. This advantage is not the same as a salary because the profit includes effort, expertise, plus the presence of business risk factors .

In some cases, it is quite difficult to classify costs as direct or indirect.

For example, purchasing raw materials for the production of certain goods is a direct cost. Meanwhile, if the purchase of raw materials in large quantities and goes to other business areas, this is considered an indirect cost.

The Importance of Tracking Direct and Indirect Costs

As a business owner you may be tempted to overlook this task, as it takes time to track costs.

However, if you fail to allocate direct and indirect costs, it will certainly have a negative impact on your company’s budget.

This can affect your ability to properly price the product.

The fact is that the price of a product is determined by several factors, including production costs, worker salaries, marketing campaigns and other expenses.

In the long term, this failure could affect a business’ ability to meet fiscal obligations and remain productive.

Incorrect expense tracking can affect your business’ position with clients and creditors. By implementing cost tracking in your business, you know what costs you need to bill your customers and pay internally.

Inaccurate tracking can lead to clients receiving incorrect invoices, which can damage your business reputation in the long run.

Furthermore, tracking costs is especially important for companies that receive government grants or other types of funding.

Many government grant programs stipulate that funds be allocated to a certain amount of direct and indirect costs.

However, violating this policy can jeopardize business funding. Ultimately, cost tracking can affect a company’s cash flow by increasing or decreasing its tax burden.

By learning how to properly track direct and indirect costs, you can help your business stand the test of time.

Manage Corporate Finances with Accounting Software

Also, what you need to do to make your business better, you need accurate financial reports. It can help you have various financial reports with accurate and fast results.

In addition, the accounting application also provides reports in the form of graphs that make it easier for you to analyze business finances in a short time.

That is an explanation of direct costs and indirect costs which are generally incurred by every company.

Hopefully the information above is useful. Follow Actively Share social media for more information about business, finance, and accounting.


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