How are Direct Costs and Variable Costs Different?
Direct costs and variable costs are similar in nature and are both types of costs involved in production. Direct costs are expenses that can be directly traced to a product, while variable costs vary with the level of production output.
Understanding Direct Costs and Variable Costs
Although direct and variable costs are tied to the production of goods and services, they can have some distinct differences. Variable costs can fall under the category of direct costs, but direct costs don't necessarily need to be variable.
- Direct costs are expenses that can be directly tied to the production of a product and can include direct labor and direct material costs.
- Direct costs can be fixed costs such as the rent for a production plant.
- Variable costs vary with the level of production output and can include raw materials and supplies for the machinery.
- Variable costs can also be indirect costs such as electricity for the production plant since it can't be tied to one specific product.
Direct costs are costs directly tied to a product or service that a company produces. Direct costs can be easily traced to their cost objects. Cost objects can include goods, services, departments, or projects.
Direct costs include:
- Direct labor
- Direct materials
- Manufacturing supplies
- Wages tied to production
Direct costs can also be fixed costs, such as rent payments that are directly tied to a production facility. Also, salaries of mangers or supervisors might also be included in direct costs, particularly if they're tied to a specific project. Typically, direct fixed costs don't vary, meaning they don't fluctuate with the number of units produced.
Variable costs are costs that vary as production of a product or service increases or decreases. Unlike direct costs, variable costs depend on the company’s production volume. When a company’s production output level increases, variable costs increase. Conversely, variable costs fall as the production output level decreases.
For example, the packaging costs associated with a product would be a variable cost since the packaging costs would increase as sales increased. The raw materials used to make the product would also be variable costs since the cost of materials would rise and fall depending on sales volume of the product. The raw materials would also be a variable cost.
In addition to direct materials, other examples of variable costs include
- Although labor is typically a fixed cost, some labor is variable. Piecework labor, which is the labor cost that's tied to the number of pieces produced or worked on by each employee.
- Supplies for the factory or machinery might be variable, including oil for the machines or parts tied to production. These supplies are different than raw materials.
- Billable hours for employees who are paid hourly, such as those needed for the production facility or consulting can be variable costs.
- Commissions for the sales staff are often tied to production or the number of units sold. As they sell more goods, sales commissions increase as a variable cost.
- Merchant credit card fees, if a company accepts credit cards for payment, are typically charged to businesses as a percentage of their sales. However, any fixed fees for the service or the machine are considered fixed costs.
- Shipping or delivery costs are often variable costs directly tied to the volume of sales and production.
However, variable costs do not need to be directly related to the product. In other words, a variable cost can be an indirect cost.
For example, a company produces mobile phones and has several production machines to produce their devices. The factory machinery needs electricity to function. The cost of electricity is an indirect cost since it can't be tied back to the product or the specific machine. However, the cost of electricity is a variable cost since electricity usage increases with the number of products that are produced or manufactured.
In short, if the total cost associated with the cost object changes when the production amount changes, it's likely a variable cost.