Direct Costs

Direct costs refer to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.

Direct costs are output costs and operational costs. They contrast with indirect costs. Indirect costs are not concerned with the production or purchase of merchandise. Indirect costs are attributed to the running and managing of a business entity.

• Direct cost comprises all manufacturing expenses incurred in producing final goods or services. Alternatively, it could be the procurement of goods for wholesale reselling.
• It includes various overheads like direct labor, direct material, manufacturing supplies, freight, and fuel or power consumption.
• Direct cost is used to determine the per-unit cost of production. The aggregate of direct expenses is called prime costs.

Direct cost refers to any expense that is directly associated with a company’s production facility. These expenses vary, depending on quantity, but certain fixed costs like factory rent can also be considered direct expenses.

Costs objects about direct expense are output costs and operational costs. Cost objects determine the exact product cost and selling price.

The output cost object determines the per-unit cost of production of each product or service. Overall production cost is distributed among departments, projects, and processes—operation cost objects. Thus, we can say that the company’s direct expenses can be allocated to each unit of the cost object.

Direct expense is essential for budgeting, decision making, selling price estimation, and profit evaluation. A firm’s direct expenses determine the cost of goods sold (COGS). When companies attain economies of scale, they successfully reduce COGS. Alternatively, direct expenses can be reduced by finding suppliers who provide higher discounts. Also, manufacturers try to eliminate inefficiencies in production processes.

The different types of direct costs are as follows:

1. Direct Labour: Wages paid to factory workers directly involved in the production of goods or services add to the direct expenses accrued by a business. Such expenses vary—increase or decrease depending on production quantity. 
2. Direct Material: Raw material is a variable cost. It is either used in the production process or purchased for reselling purposes.
3. Manufacturing Supplies: These refer to various consumables used in a factory—even registers, pens, paper, and other stationery goods.
4. Transportation: Whenever goods are moved in or out of a factory, the freight paid by the company is considered a direct expense.
5. Consumption of Power, Fuel, and Utilities: The various sources of fuel and power used for running the machinery and equipment are direct expenses—diesel, gasoline, natural gas, electricity, or coal.
6. Factory Rent: Factory rent is a fixed and direct expense.

In accounting, the total direct cost or prime cost is computed with the help of the following formula:

Here,

Let us assume ABC Manufacturing furnishes the following cost information:

• Raw materials – Opening stock: $100,000;
• Closing stock: $70,000;
• Purchases: $225,000
• Direct labor – $120,000
• Work Overhead – $35,000
• Administration overhead – $26,000
• Selling & distribution overhead – $38,000
• Finished units – 200,000

Now, based on the given data, calculate the overall direct expense and cost of sales per unit.

Solution:

The Cost Statement of ABC Manufacturing is as follows:

Cost of Sales Per Unit = Total Cost of Sales/Finished Units

Cost of Sales Per Unit = 474000/200000 = $2.37

Interpretation:

• Each component of prime costs is a direct cost. It included explicit material and direct labor—easily attributed to finished products.
• The overheads mentioned after prime costs are indirect and do not contribute to the production of goods—work overhead, administrative overhead, and distribution overhead.

This article has been a guide to what are Direct Costs. Here we explain the concept with examples, formulas, types, and its interpretation. You may learn more about accounting from the following articles –

• Direct Cost vs Indirect Cost
• Calculate Depreciated Cost
• Cost Per Unit Definition
• Raw Material Inventory Examples