Direct vs. Indirect Expenses: A Lesson In COGS

Do you know that direct and indirect expenses account for over 70% of the overall costs in a typical business? Businesses attract these two expenses in their daily operations to make money.

Both direct and indirect expenses have different impacts on a company’s financial and accounting goals. Direct expenses affect the COGS, which then impacts a company's profits. Indirect expenses impact the running costs of a business, where they're subtracted from the gross profit to realize a net gain.

So, understanding their differences is crucial for businesses because it will help them optimize their books. This guide will discuss direct vs. indirect expenses and how to calculate and allocate them. We'll also offer tips for managing these expenses well.

Direct Expenses

They are expenses that relate directly to goods or service production and delivery. Direct expenses are also a part of COGS because it is a direct expense. The good thing about a direct expense is that you can allocate it to a service, good, or user.

Now, every business runs differently, and it makes direct expenses vary. A good example is a manufacturing company. Direct expenses include salaries, storage rent, raw materials, and more. For a service business, direct expenses may include the cost of materials used to provide the service.

Direct expenses can also vary depending on the production or service delivery level. So, direct expenses are usually variable costs that change with the output volume. However, in some cases, they’re fixed direct expenses, such as wages and rent.

Indirect Expenses

They are the costs a business must pay to run its operations. However, they're not related to making or selling its products or services. They are also called overhead costs or operating expenses. Indirect expenses differ from direct expenses, which are the costs a business has to pay for making or selling its products or services.

Some examples of indirect expenses are:

• Insurance: The money that a business pays to protect itself from different risks, such as fire, theft, liability, and others.

• Depreciation: The money a business loses when its fixed assets become less valuable over time because of use or age.

• Audit and legal fees: The money that a business pays to outside experts to check its financial records or give legal advice.

Indirect expenses rarely change much with the changes in sales or output. It means they stay the same or change a little when the business sells more or fewer products or services. For example, rent and insurance remain the same no matter how many products get sold.

Indirect expenses affect a business's profits and the use of resources. They get subtracted from the gross profit to get the business's net profit. The lower the indirect expenses, the higher the net profit. Indirect expenses are also used to find the overhead rate for each unit of output or sales. The lower the overhead rate, the better the business is.

Direct vs. Indirect Expenses Comparison 

Let's look more closely at the main differences between these two expenses

How to Calculate Direct and Indirect Costs

Calculating direct costs requires a business to know and assess the production expenses. They can use records like receipts or invoices to trace expenses like labor and raw materials. The formula looks like this:

Direct Costs = Labor + Raw Materials + Other Direct Expenses

Calculating indirect costs requires a company to determine and evaluate expenses that don't link directly to output. However, keep in mind that they're needed in daily operations. Companies can use documents like contracts or bills to find the expenses on insurance or utilities. The formula for calculating is:

Indirect Expenses = Total Costs - Total Direct Expenses

How To Allocate Direct and Indirect Expenses

Allocate indirect expenses using a consistent method. For example, you can use a percentage of direct costs, sales revenue, labor hours, or any other factor that reflects how you incur indirect costs. You can then multiply the total indirect cost by the allocation factor to get the allocated indirect cost for each product or service.

There are advantages and disadvantages to different allocation methods. For example, using a percentage of direct costs may be simple and easy to apply. However, it may not reflect the actual consumption of resources by each product or service. 

Using labor hours may be more accurate and fair but require more data collection and calculation. An activity-based costing method may be more precise and realistic but more complex and costly.

Tips for Managing Direct and Indirect Expenses

• Monitor and review your direct and indirect expenses regularly to identify trends, patterns, or anomalies.

• Compare your actual expenses with your budgeted or expected costs to identify variances or deviations.

• Analyze the causes and effects of any significant variances or deviations and take corrective actions if needed.

• Evaluate your allocation method's efficiency and effectiveness and make necessary adjustments.

• Optimize your direct and indirect expenses by reducing waste, improving quality, increasing productivity, and enhancing customer satisfaction.

Final Thoughts

Direct and indirect expenses affect the cost of goods sold and the net profit of a business. Any business must understand how to calculate and allocate direct and indirect costs using various methods and formulas. Using some tips above, you can manage direct and indirect expenses effectively.

Applying these concepts can improve your accounting and financial performance and optimize your profitability and efficiency. You can also comply with accounting standards and tax regulations and avoid errors or disputes.