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Direct costs can include expenses like pay for employees who provide goods or services and any money needed to purchase and maintain specialized equipment. — Getty Images/aldomurillo

In financial accounting and taxes, attributing expenses to the correct category isn’t just a tip or guideline; it’s a requirement when filing IRS forms, requesting grant funds, or reporting to investors. The difference between direct vs. indirect costs comes down to exclusivity in use but isn’t always cut and dried.

This guide provides definitions and examples of direct and indirect expenses while explaining what distinguishes them and why they matter.

What is a direct cost?

Direct costs are expenses with clear ties to a specific cost object, like a product, service, project, or department. For example, direct costs include food ingredients at a restaurant or printing services for a project. Direct costs can be variable or fixed, but most fluctuate according to sales or production. To meet the direct cost definition, the expense should connect to core production or department operations and wouldn’t exist if the activity didn’t exist.

Direct cost examples for small businesses

Depending on your industry, you may have assets and expenses directly related to producing goods or services.

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Consider these examples of direct costs:

  • Dedicated salaries, wages, or fees (direct labor) to create goods or services, including paying assembly line workers or hiring a freelance graphic designer for a specific client project.
  • Direct materials are included in the cost of goods sold (COGS), such as restaurant food ingredients and to-go packaging, wholesale price of resale items, or construction building materials.
  • Specialized tools or equipment like a custom manufacturing mold for a new product line, a skid steer rental for a construction project, or maintenance-related fees.

What is an indirect cost?

Indirect costs are expenses that apply to multiple activities as part of daily operations. These overhead or operating costs include fixed and variable expenses, such as rent and utilities. It’s challenging to allocate indirect costs to a specific product, service, or project. However, you can use a cost allocation process with accounting software or an enterprise resource system to distribute expenses.

Correctly classifying direct and indirect costs assists with financial planning, taxes, and funding.

Indirect cost examples for small business owners

Depending on their use, you can categorize indirect expenses under CapEX, OpEX, and COGS.

Here are a few examples of indirect costs:

  • General labor, management, and administrative wages include salaries or hourly pay for employees who support business operations, like accountants, janitors, and cashiers.
  • Rent or mortgage payments include retail spaces selling several product lines or leased restaurant buildings.
  • Depreciation for the wear and tear of general machinery or business trucks that aren’t tied to specific projects or production.
  • Insurance and benefits include fringe benefits and company-wide general small business insurance coverage.

Why it’s important to know the difference between direct and indirect costs

Correctly classifying direct and indirect costs assists with financial planning, taxes, and funding. To sum up the differences, direct costs are exclusive use expenses, whereas indirect costs apply to the whole company.

Direct vs. indirect costs for tax purposes

Understanding the difference between direct and indirect costs is essential for accurate tax filing and can help you find tax deductions. The IRS requires businesses to separate the costs of goods sold from operating expenses and to enter the amounts on different lines and sections. These must be classified correctly to calculate gross profit and net income.

Product or service pricing: indirect vs. direct costs

Knowing how to allocate indirect and direct expenses can help you price services or products competitively and profitably. For instance, direct costs like COGS show the obvious expenses. But you can dig deeper to see the actual labor per product using an activity-based costing system to allocate indirect overhead expenses.

Direct and indirect costs in accounting and financial reporting

Distinguishing between direct and indirect costs is critical for tracking cash flow and creating profit and loss statements. Accurately recording transactions can help you estimate the next quarter’s overhead costs and improve profit margin calculations.

Funding: direct vs. indirect expenses

Small business grants and programs may disperse funds according to indirect and direct cost rates. To meet the guidelines, you should understand how to identify and allocate these expenses appropriately when applying for business grants.

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