In order to understand and manage direct costs and indirect costs in real terms, accountants and small-scale enterprises (SMEs) need to be able to measure these two categories by allocating financial items in both categories. This is not always easy as there are different ways in which they can be estimated, using either a comparison or a cross-reference method as shown below.
You’ve probably heard of the terms “direct costs,” “indirect costs,” and “gross profit” before, but do you really know what they mean? If not, this guide is for you! That’s because “Direct Costs” and “Indirect Costs” can be a bit tricky to understand. But don’t worry—this quick guide will help you understand what “Direct Costs” and “Indirect Costs” are, how they work together, and how to use them in your accounting systems. It’s also important for accountants and small-scale enterprises (SMEs) to understand this so they can properly produce their financial reports.
What Is Direct Costing and Indirect Costing?
Direct costing and indirect costing are two methods of calculating the cost of manufacturing a finished product or service. A direct costing model allocates all production costs to their most appropriate category, while an indirect costing method projects all costs (including material and labour) directly related to a finished product or service.
The cost of goods sold is known as the direct cost. This is the cost of production of such goods as raw material, labour, and machinery. The indirect cost is made up of various other expenses including overheads such as rent, interest payments, insurance premiums and depreciation etc. Indirect costs are only calculated when calculating gross Profit, revenue and profit after tax.
Indirect costs are not allocated to the cost of goods produced, but are instead allocated to a particular product or service. Examples of indirect costs include rent, depreciation, insurance and interest payments. Indirect costing is usually used to determine the profitability of individual products or services in order to allocate resources accordingly.
Direct costing is used when you want to determine the costs of making a product or providing a service. It’s often used in conjunction with other types of cost accounting, such as activity-based costing, which helps you understand where your resources are being spent and how much they cost.
Direct costing can be applied at the following levels:
- When there are only one or two products in your business
- When you have limited data on the costs of each activity.
Direct costing is most commonly used in calculating the cost of goods sold. This is because it is easy to determine how much of each product or service goes into producing another, and therefore how much should be allocated as a cost.
Example: If a company makes a shirt for $10 and sells it for $20, then the cost of goods sold would be $10.
What is a Contribution Margin?
Contribution margin is the difference between revenue and cost of goods sold. It is one of the most important financial metrics for businesses to monitor because it tells you how much money you can make from each sale. Contribution margin is calculated by subtracting cost of goods sold from revenue:
Example: If a company sells widgets for $10 and their materials cost $5, then their contribution margin would be $5.
Contribution margin is a measure of how much money you make on each product or service. It is the amount of revenue left over after all expenses have been taken into account, and it can be calculated as follows:
Contribution margin = Sales – Cost of Goods Sold Contribution
How to Calculate Direct and Indirect Costs
There are two types of costs that you need to consider when calculating your contribution margin: direct costs and indirect costs. Direct costs are the expenses associated with providing a product or service—for example, the cost of materials used to make a widget. Indirect costs are those expenses not directly related to providing a product or service—for example, the cost of office rent.
Direct costs are expenses that can be directly associated with the production of goods or services. For example, if a store sells t-shirts at $15 each and spends $3 on materials for each shirt, then their direct costs would be $3 per shirt. Indirect costs are those that cannot be easily traced back to a particular product or service. For example, a company might spend $100 per month on electricity bills but have no way of knowing how much of that money is going toward powering their warehouse versus office space.
Which Costing Method is Best Suited for Your Business?
You can use either method to determine your costs, but it’s important to understand how each will impact your business. Direct costing is more accurate, but indirect costing might be easier for small businesses or startups that don’t have the resources to track expenses down to the penny.
You can use either method to determine your costs, but it’s important to understand how each will impact your business.
You’ll want to consider the following questions when choosing between direct and indirect costing:
- How accurate do you need your data and budgeting to be?
If you are a startup or small business that doesn’t have a lot of resources available, indirect costing might be more practical for you.
- Are there any legal or regulatory requirements that require you to use a particular method?
If so, you will need to follow these guidelines.
- Is it important for your business to be able to track costs down to the penny?
If so, direct costing might be more practical for you.
- Do you need to keep track of your costs down to the penny?
If so, direct costing might be a better option for your business.
- How much time do you have to track your costs?
If your business is growing quickly and you need accurate data as soon as possible, direct costing might be more suitable.
- What type of business do you have?
If your product has very few variables and doesn’t require a lot of overhead expenses (such as wages or utilities), indirect costing might work better for you.
In Conclusion, direct costing allows you to easily calculate the cost of your products or services, while indirect costing is a more complex method that factors in all costs associated with your business. As an accountant or business owner, you need to decide which costing method will best suit your company.