Direct Cost

Definition of Direct Cost

Direct cost refers to the cost that is attributable directly to the production of the core goods and the services, i.e., direct cost is the costs that can be economically identified to a cost object or are incurred for a specific cost object and include raw material cost, direct labour and other direct materials incurred explicitly for the production of goods & services.

Explanation

It includes all the costs incurred by the organization for the manufacturing goods & services sold to the customers in the normal course of business. It majorly consists of the cost of raw materials, the cost of labor working in a factory that is engaged in the conversion of raw materials into finished goods, and all the other expenses that can be easily identifiable as an expense that is incurred for the production, such as power & fuel cost incurred for running machinery in a factory, freight charges, etc. but does not include cost such as advertisement cost, the salary cost of office staff, etc. because they are not directly allocated to the production of goods & services. Direct costs are generally variable costs, i.e., it changes with the level of production, but factory rent, etc. which is also a part of direct costs, is an exception that is fixed in nature. Therefore, it should be minimal to generate more profits. Some strategies that can help cut direct costs are negotiating with the vendor, purchasing the raw materials in bulk quantities to avail discounts, etc.

Examples of Direct Cost

Suppose there is a company whose name is Clothes Inc. that is involved in the production of garments. The company incurs the following expenses in the year 2018-19.

Particulars Start Your Free Investment Banking Course Download Corporate Valuation, Investment Banking, Accounting, CFA Calculator & others	Amount ($)
Raw fabric Purchased for producing garments	150,000
Wages paid to factory staff	60,000
Cloth purchased for office use	10,000
Power & fuel for the factory	3,000
Rent for factory	50,000
Rent for an office building	20,000
Electricity expense for office	4,000
Printing & Stationery purchased	1,000

From the above transactions, we need to calculate total direct costs.

Solution:

Calculation of total direct costs

Particulars	Amount ($)
Raw fabric Purchased for producing garments	150,000
Wages paid to factory staff	60,000
Rent for factory	50,000
Power & fuel for the factory	3,000
Total Direct Cost	263,000

Analysis of the above example:

• In the above question, Wages paid to factory staff are given to the labor involved in the production of garments, and the power& fuel is used to run machinery. Hence both wages and power & fuel are part of direct costs.
• The fabric purchased for raw material production is only included in the direct costs, not the cloth amounting to $1,000, which is purchased explicitly for office use and not for production purposes. Similarly, only the rent of a factory is part of the direct costs as it is attributable to production but not the rent of an office building which is a part of the indirect cost.
• Even the electricity expenses and printing & stationery expenses are incurred for the office. Hence they both are also not included in direct costs.

Importance of Direct Cost

The main and the most critical cost incurred in every organization is the direct cost, which is ancillary to the central business. For running any business, direct costs are essential. As for business furniture, purchasing wood is necessary, and the cost of purchase of wood is the direct cost without which the business has no existence. These costs are easily identifiable to the cost objects, unlike the indirect cost. The direct costs figure is required to calculate the profitability of the business. These costs are essential to knowing the business’s financial performance, and the business entities should try to reduce the direct costs to increase profit levels.

Benefits

Some of the benefits are mentioned below:

1. For calculating the gross profit (Sales – Cost of goods sold) of the business, the total direct cost is required as the total direct cost is the part of the cost of goods sold that is deducted from the total sales revenue to know the amount of gross profit of the business.
2. Direct costs are generally variable as it increases with the increase in production and vice versa. Therefore these costs are only incurred when there is production and not when the production is stopped.
3. Direct costs are essential to carry out the business’s necessary operations as it involves purchasing raw materials and other costs required to convert raw materials into finished goods. Then the sale of such finished goods is the primary source of earnings for the business.

Disadvantages

Some of the disadvantages are mentioned below:

1. Some of the costs are not easily identifiable as the direct cost, i.e., that cost can have attributes of both direct as well as indirect costs. Then in such a case bifurcating the cost into direct and indirect costs is time-consuming.
2. In the service industry, an employee’s salary is the direct cost. Still, in the manufacturing industry, the salary of the office staff is indirect, which concludes that the direct costs depend upon the nature of the business and are different for every company. Therefore, the accountant should be intelligent enough to categorize the expenses as direct and indirect.

Conclusion

Direct costs are the costs directly attributed to the cost object, i.e., these costs are directly traceable to the production of a specific product or service that is ancillary to the business. The same cost may be direct for one industry, and indirect for another, such as the cost incurred on purchasing furniture by a company that trades in furniture is a direct cost. Still, the cost incurred on purchasing furniture by a company in trading footwear is an indirect expense. Therefore the bifurcation of direct to indirect expenses must be done wisely.

Recommended Articles

This is a guide to Direct Cost. Here we also discuss the definition and examples of direct costs, benefits, and disadvantages. You may also have a look at the following articles to learn more –

1. Incurred Cost
2. Period Costs
3. Fixed Cost
4. Mixed Cost