Direct Costs vs Indirect Costs: What’s the Difference?

When determining the price of your products/services, you need to make it low enough that you’re not pricing yourself out of business, but you also want to make sure it’s high enough that you make a profit. The obvious way to do that is to add up all the costs involved in making the product/service, then increase the price from there enough that you can make a profit.

But determining the cost of a product/service isn’t as easy as simply adding up the costs involved in making it, because businesses have what we refer to as direct costs and indirect costs.

The direct costs are the costs you incur when creating your product/service. By adding these up, you can determine exactly how much it costs you to create each item. If you want to make more, you simply multiply the direct costs by the number of items you want to create.

But being in business comes with costs of its own, and if you want to stay in business, you need to make sure those costs are covered in addition to your direct costs.

Let’s start by taking a look at some of the most common direct costs of creating a product/service:

Direct Costs

The direct cost of creating a product/service includes the cost of the:

• Materials needed to make the product.
• Labor needed to make the product or provide the service .
• Packaging needed to wrap up each item before it can be sold.
• Manufacturing supplies – these are materials that get consumed in the process of making the product, but do not go into the product itself.

A lot of people make the mistake of adding up their direct costs and basing their pricing off those costs without taking into account their indirect costs. That can quickly lead your company into the red because every business has indirect costs, or what is sometimes referred to as “overhead.”

Indirect Costs

The costs associated with simply keeping your doors open as a business varies from company to company, but some of the most common indirect costs include:

• Rent and utilities – This includes rent or a mortgage on your office space, your brick-and-mortar store(s) if applicable, and your manufacturing space if applicable. If you work out of your home, you can also apply a portion of your rent and utilities to your business costs, assuming you have a space in your home that is dedicated to your business and is not used for any other purpose.
• Office supplies – This includes all the supplies you need to run your business that are not directly involved in creating the product/service. This can include anything from pens and paper to a computer, a printer, ink and paper for the printer, etc. It also includes software, such as your bookkeeping software or any other software you need to run your business, but that is not directly related to the process of making your product/service.
• Insurance – Every business needs business insurance. The kind and amount of insurance you’ll need will depend on your business, but the cost of insurance is an indirect cost of having your own company.
• Marketing and advertising – You can’t sell anything if no one knows you’re selling it, which means you need to assign a portion of your budget to marketing and advertising. It is not directly related to the cost of creating a product/service, but it is a vital cost you need to pay if you want to keep your doors open.
• Salaries of support staff – any staff you need to hire to keep your doors open, but who are not directly involved in the making your product/service, is support staff and they need to be paid in addition to the people making your product or providing your service. Some examples of support staff include sales representatives, clerks, receptionists, administrative assistants, bookkeepers, and marketers.
• Depreciation – Finally, if you invest in any expensive materials for your business that you use for a long period of time, you need to take into account the depreciation of those materials. This most often means any equipment you need to make your product or provide your service, or a company vehicle you need to deliver your products or get your staff on-site to provide your services. 

Keeping track of things like direct costs vs indirect costs and what it means for your business’ bottom line is one of the benefits of having a Bookkeeping Doctor. By asking the right questions and incorporating all the relevant information, I can help you pinpoint the ideal price for your product, in addition to doing the day-to-day back-office work of making sure all your costs get listed in your bookkeeping software of choice, alongside your sales so you can get an idea of the financial health of your business. If you think you could benefit from having a Bookkeeping Doctor helping you with your back office, let’s talk.