Direct costs are business costs related to a particular product or service, while indirect costs are business costs related to the wider business.
Take a landscaping company as an example. When they purchase a new lawnmower to help with their work, that's a direct cost because it's directly tied to the service they provide. On the other hand, they may be required to take out employee liability insurance. This insurance is considered an indirect cost because it isn't directly related to the company's main services.
Let's take a closer look at direct costs and indirect costs, with examples, analysis and why it's important to know the difference.
Understanding the difference
“If a cost can 100% be attributed to a particular product or service that you sell, then it’s a direct cost,” says Jane de Vos, a freelance Strategy and Operations Consultant with the Association for Project Management. “The indirect costs are everything else that you need to run your company.”
Both direct and indirect costs may be counted if you need to calculate the total cost of goods sold (COGS).
Why is the direct vs. indirect cost distinction important? Because knowing the difference may help you calculate the profit margin of your business more accurately, as well as provide you with a better overall understanding of costs across your business.
“When you want to find out how much profit you’re making, if you know your direct costs, it’s possible to work out the profit margin for each individual product or service,” explains de Vos. “So, you can work out which product is most profitable – is something actually cheaper to make, and therefore more profitable to sell?”
Direct cost examples
As explained, direct costs are expenses that your business incurs that are directly and entirely related to your product or service. They can range from employee salaries to the price of raw materials to make your product.
At sustainable bedding retailer Ethical Bedding, founder and CEO James Higgins admits he monitors business costs more or less ‘constantly’. “It’s absolutely imperative to know your product costs and running costs because that’s how you know which levers to pull from a cost perspective, and how those costs are linked to revenue and ultimately profit,” he says.
Some of the company’s most important direct costs include materials, web hosting and salaries. “When we look at the overall cost associated with an item like a pillowcase on our website, the materials are only a small part of that direct cost, the biggest part of it is technology and people,” he says.
Direct cost examples can include:
- Raw materials or ingredients
- Component parts
- Freelance labour
- Employee salaries
- Sales commissions
- Web servers and hosting
- Packing and shipping
- Warehouse space
- Equipment such as production line machinery or industrial equipment
- Power and energy (if directly used to create your product)
Indirect cost examples
Indirect costs, also referred to as overhead costs, are those expenses that can’t be attributed to a single product. Instead, they are incurred to support the overall functioning of the business. Indirect costs are essential for an organisation's operations but are not directly tied to the production of goods or services.
Indirect expenses can be more substantial and, at times, difficult to manage. That’s why the American Express® Business Gold Card offers Cardmembers extended payment terms of up to 54 days to help with cash flow management¹. You'll also earn Membership Rewards® points on everyday business purchases, which can be used across travel, retail and dining, or redeemed as a statement credit to reinvest in your business².
Examples of indirect costs can include:
- Corporate head office salaries
- General administrative salaries
- Stationery, general paperwork fees, and printing expenses
- Office equipment
- Rent for office space
- Insurance
- Distribution
- Depreciation and amortisation
- Postage and packaging
Why is it important to know the difference?
Ultimately, understanding the difference between direct and indirect costs helps business leaders to make smarter and more informed strategy decisions, says de Vos. “You have to know what you’re spending your money on, and [where] you can afford to invest," she says. "If you want to launch a new product, understanding both direct and indirect costs is critical to understanding if you can actually afford it.”
In practice, there are compelling benefits to tracking and understanding direct and indirect costs in your business:
Understand product profit margins
Ethical Bedding uses figures from its direct and indirect costs to understand the costs that are directly associated with each product it sells. This figure could be very different for a pillowcase compared to a mattress, for example.
Understanding the costs of each product helps in a range of ways, from setting prices to ensuring that advertising spend is proportionate, says Higgins. “By understanding the costs associated with each item, we know how much to spend getting customers through the door, without making a loss or reducing the overall profit margin.”
Track business expenses over time
It’s important to understand direct and indirect costs, and track them monthly, says de Vos. “Before you invest in a lot of training or new software, I’d look at how your costs are changing over time. If you can see a rise in direct costs, then you might want to make changes to materials or look to increase revenues before making that investment,” she says.
Tracking direct and indirect costs means that if profits fall for a particular quarter, it's easier for business leaders to understand the reason. "Are our direct costs increasing? This suggests an issue with our materials, production, or shipping costs. If indirect costs are increasing, then the issue is likely to be related to spiralling operating costs, and adjustments can be made."
Make decisions on what to sell
Direct costs can provide valuable insight into which products cost the least to make in relation to the profit margin, de Vos adds. This means a stationery company might stop making a pen but make pencils that are cheaper, but offer a higher profit margin, for example.
This information also helps you to understand the likely costs involved in launching new products and services, says de Vos. “If you launch a new product, use direct costs after six or 12 months to see how well that product is performing relative to other products you already sell.”
Identify potential cost savings
Tracking direct and indirect costs and checking these figures on a weekly or monthly basis could save you money. De Vos recently worked with a company that had eight different software subscriptions, most of which were no longer used. “Because people in the business started tracking those costs each month, they were able to see these unnecessary costs and cancel those subscriptions,” she says.
Ultimately, direct vs. indirect costs provide a useful way to understand business performance, says de Vos: “It’s essentially about enabling smarter decision-making because you have a fuller understanding of what’s involved in running your business and selling to your customers.”
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
2. Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
