- Differentiate between direct and indirect costs
Direct costs are those that are directly attributable or traceable to the manufacture of a product or performance of a service, while an indirect cost cannot be directly attributable or traceable to a product or service.
There are some items that are difficult to determine how much goes into each product. Let’s say we have two products that we build in our manufacturing plant and one plant manager.
Widget 1: plastic is the main component
Widget 2: steel is the main component
A plant manager who manages the entire factory.
Allocating the cost of the plastic and steel is pretty simple! Since there is no plastic in widget 2 and no steel in widget 1, those two products are clearly attributable or traceable to one product right? But how do we allocate the plant manager’s salary when we are figuring out how much it costs us to produce each widget? We can’t! Unless we had him track every minute of his day to one product or the other, which doesn’t sound very effective from a time management standpoint.
Let’s look at another example from a service business.
A CPA firm employs a bookkeeper and a receptionist. The bookkeeper works on a variety of tasks during the day, but tracks her time by client. The direct cost that can be attributed or traced directly to one client, would be the time spent by the bookkeeper on that client’s work. The receptionist on the other hand, is not directly involved with client work, but answers the phones, files and makes appointments. His time would be an indirect cost. Other possible indirect costs in this service business would include computer software, printer ink and pens. None of these can be directly traced to one client.
Direct costs go directly into a product or service, and indirect costs cannot be directly linked to one product or service. We will go into much more detail about different classifications of direct and indirect costs in future modules, but just make sure to remember how we determine direct vs. indirect costs!