Direct and Indirect Costs

By Cindy Walker

Outline
Definition of direct and indirect costs Benefits of differentiating costs Explanation of the two costs How to find the costs Real world example Exercise Summary Suggested readings

What are direct and indirect costs?

Direct costs are costs that can easily be traced to a specific project or activity. Indirect costs are costs that can not be easily traced to a specific project or activity.

Benefits of differentiating costs

More accurate forecasting Reduced overspending Understanding trade-offs Learning the true cost of projects/activities Pricing

Lets practice!
Determine if the following are direct or indirect costs: 1. 2. 3. 4. 5. 6. 7. 8. Assembly line worker Direct Manager of a paper company Indirect Electricity Indirect Alarm sales rep Direct Chef for a gourmet dinner Indirect Office space Indirect Microscope for a chemist Direct Postage for a FedEx package Direct

Common direct costs

Project materials Project staff

Common indirect costs

Office supplies Utilities Rent Administrative staff

What to remember
When identifying an activity, service, or product as a direct or indirect cost, it is important to remain consistent. Example: If labor is considered a direct cost for one project, it must continue being considered a direct cost.

Finding the direct cost

1. Is the cost incurred from a certain project or activity? 2. Can I easily trace the cost to a specific project or activity? 3. Will the cost disappear once the project or activity is finished?

Finding the indirect cost

1. Case-by-case allocation 2. Indirect cost rate

Case-by-case allocation
Find the actual usage of the indirect cost in question Disadvantage: DIFFICULT!!

Indirect cost rate

Formula:

Total Indirect Costs

Indirect Cost Rate Total Direct Costs

Indirect cost rate (cont.)

To find the indirect costs for Project A: Project As Direct Costs Indirect Cost Rate Project As Indirect Costs

Real world example

Company XYZ has costs totaling $15,000. If Function A has direct costs of $7,000 and Function B has direct costs of $4,000, what are the indirect costs of Function A and Function B?

Real world example (cont.)

$4,000/$11,000 = 0.3636 or 36.36%

Function A: $7,000*0.3636 = $2,545.20 indirect costs Function B: $4,000*0.3636 = $1,454.40 indirect costs

Exercise
Project A has direct costs of $400, Project B has direct costs of $500, and Project C has direct costs of $900. If all of these projects combined has a total cost of $3,000, what is the amount of indirect costs for Project B?
Project Bs Indirect Costs: $333.35

Summary
Direct costs relate specifically to a project while indirect costs relate on a broader scale. Consistently identify an activity as either a direct or indirect cost. Distinguish the type of cost through three questions. Solve for indirect costs through case-by-case allocation or an indirect cost rate.

Suggested readings
Gordon, L. A. and M. P. Loeb. 2001. Distinguishing between direct and indirect costs is crucial for internet companies. Management Accounting Quarterly (Summer): 12-17. Accounting for Dummies by John Tracy SBIR Basics: The Numbers (Accounting, Costs, Rates, Audits, and More) by Lea Strickland http://www.umdnj.edu/rimweb/rim_cfp/indexcfp.htm