Direct vs Indirect Cost

Photo by Sasun Bughdaryan on Unsplash

I will focus on how analyzing direct vs indirect costs can help you make better decisions and be more operationally profitable. Therefore, I will skip the IRS/tax definition and focus on the operational utility of direct and indirect costs. To knock out the definitions at the top:

Direct costs are costs that relate directly to the production of a good or service.

Indirect costs are not directly related to production.

For example, the raw material purchased and built directly into your final sellable good is a direct cost, while the monthly factory rental bill that must be paid to keep from being locked out would be an indirect cost. Both costs are necessary for business success; they simply differ in how they relate to the product or service sold.

Why is this relevant?

Direct costs affect the product or service sold at a UNIT level, meaning to gain insight into monthly comparative performance, you would look at the direct cost’s percentage of sales as the priority, in addition to total direct cost dollars spent. While indirect costs affect the product or service sold at a BUSINESS level, meaning to gain the comparative insight you would look first at month over month indirect cost dollars spent, in addition to the percentage of sales. 

An illustration:

woman in white long sleeve shirt using black laptop computer

Let’s say the raw material costs for your widget are identical from last month to this month on the latest Profit and Loss Statement (P&L). Great job on being consistent month over month; however, this “dollars spent” measure alone does not solely determine whether you succeeded or failed to control raw materials cost. If your sales are twice as high as last month, then you’ve succeeded in cutting your raw materials cost of sales as a percentage in half (great job!). If your sales are half as high as last month, then you’ve failed to maintain cost of sales percentage, and in fact, the cost percentage of sales has doubled (not so good).

In this case, the direct cost of raw material dollars spent is much less important than the cost of the raw materials as a percentage of sales. Put another way, direct cost percentage of sales is a much more relevant and useful KPI compared to direct cost dollars spent. Conversely, let’s say your widget factory rent cost as a percentage of sales is identical from last month to this month. This would seem like a positive to have a consistent cost as a percentage of sales percentage. However, this measure is much less important than the total dollars spent for the month compared to past months. This is because the rent is an indirect business-level cost that is largely decoupled from the number of unit-level widgets produced.

Regardless of how many widgets you sell, the most important measure of rent is how many dollars are spent on that cost. So if the total rent cost is higher compared to the previous month, then this is the best metric to address why and see if there are options to decrease the cost (sub-lease a section of the factory, talk with the landlord to reduce the rent).

In summary:

Direct costs viewed as a percentage of sales will best help assess unit-level profitability, while indirect costs viewed as total dollars spent will best help assess business-level profitability.  At Strata Cloud, we can help identify and separate both cost types, to be most valuable to you and your specific business needs, with the goal of helping you become more profitable.

We value accounting freedom achieved through exceptional customer service and extraordinary financial insights. Check out the services we offer to help you make better business decisions and learn more about our talented team.

By Kyle Smith, CPA