What is a 'Direct Cost'
A direct cost is a price that can be completely attributed to the production of specific goods or services. Some costs, such as depreciation or administrative expenses, are more difficult to assign to a specific product and therefore are considered to be indirect costs. A direct cost can be considered a variable cost if it is inconsistent and changes amounts often.
BREAKING DOWN 'Direct Cost'
Direct costs are one of two general branches of product costs in accounting for manufactured goods. The other branch, which contains all non-traceable expenses, are indirect costs. Examples of direct costs include manufacturing supplies and commissions. Rent expense may only be a direct cost if only one cost object relates to the facility being rented.
Because direct costs can be specifically traced to a product, direct costs to not need to be allocated to a product, department or other cost object. Direct costs may be related to labor, materials, fuel or power consumption. Direct costs usually benefit only one cost object. Items that are not direct costs are pooled and allocated based on cost drivers.
Fixed vs. Variable
Direct costs do not need to be fixed in nature, as their unit cost may change over time or depending on the quantity being utilized. An example of the salary of a supervisor that worked on a single project. This cost may be directly attributed to the project and relates to a fixed dollar amount. Materials that were utilized in the product, such as wood or gasoline, may be directly traced but do not contain a fixed dollar amount. This is because the quantity of the supervisor's salary is known, while the unit production levels are variable based upon sales.
Inventory Valuation Measurement
Using direct costs requires strict management of inventory valuation when inventory is purchased at different dollar amounts. For example, the cost of an essential component of an item being manufactured may change over time. As the item is being manufactured, the component piece's price must be directly traced to the item. For example, in the construction of a building, a company may have purchased a window for $500 and another window for $600. If only one window is to be used on the building and the other is to remain in inventory, consistent application of accounting valuation must occur. Companies typically trace these costs using the first in, first out (FIFO) method or the last in, first out (LIFO) method.
Tax Deductions and Grants
Certain business expenses, in some cases even the cost of goods sold, are tax-deductible. However, tax-deductible expenses are typically always indirect. Identifying direct costs may be required for specific programs being funded by grants as the grant may impose restrictions on the indirect cost ratio. Companies may implement an indirect cost ratio target to ensure that a certain portion of costs are directly tied to a product cost.