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Direct Costs

Direct Cost Colgate 1

What is Direct Cost?

Direct Cost Definition – Direct Costs are costs that can be identified easily as per the expenditure on cost object.

For example, if we pick how much expenditure a business has had on purchasing the raw materials inventory, we will be able to directly point out. Direct cost is a cost that can be easily identified as per the cost objects.

Let’s understand now direct cost in detail.

What is cost object in Direct Costs?

  • Cost object is a particular unit for which cost can be identified. The most common form of cost object is company’s products/services. It is the output of the company.
  • Other than that, we can also identify process, production line, department as costs objects since they can be identified as cost units.
  • Cost objects can be outside the company as well. For example, a cost unit can be accumulated costs for suppliers or customers.
  • In direct costs, we identify the costs for each cost object. In indirect cost, the cost for cost objects can’t be identified. In essence, the ability to identify the costs for cost objects truly creates the difference between direct and indirect costs.

Direct Cost Example #1

Let us look at direct cost example to identify costs in the cost sheet.

Example: ABC Factory has the following information and from the below-furnished information, you need to calculate per unit cost of sales.

  • Raw Materials – Opening Stock: $100,000; Closing Stock: $70,000.
  • Purchases during the period: $225,000.
  • Direct labour – $120,000
  • Works overheads – $35,000
  • Administration overheads – $26,000
  • Selling & distribution overheads – $38,000
  • Finished units – 200,000.

Find out the cost of sales per unit.

In this direct cost example, every input is given. We just need to put the figures in the right place.

Statement of Cost of ABC Factory

Particulars Amount (In US $)
Raw Materials – Opening Stock 100,000
Add: Purchases during the period 225,000
Less: Raw Materials – Closing Stock (70,000)
Cost of material consumed 255,000
Add: Direct Labour 120,000
Prime Cost 375,000
Add: Works overheads 35,000
Works Cost 410,000
Add: Administration overheads 26,000
Cost of Production 436,000
Add: Selling & Distribution overheads 38,000
Total Cost of Sales 474,000
Finished Units 200,000 units
Cost of Sales per unit $2.37 per unit
  • In the above direct cost example, we will look at a prime cost which is the aggregate of direct costs.
  • If you look at each component of prime cost, you will see that each one is a direct cost. Here we used direct material and direct labor which can easily be attributed to finished products. And that’s why they are called direct costs.
  • But if you look down, you would see that after prime costs, all are overheads. Overheads mean they are expended for providing multiple benefits. That means they are not easily attributable. That’s why they are indirect costs.

Direct Cost vs Variable Cost

Direct costs are often called variable costs. But how true it is?

If we look at a business, we will see that the business has two types of costs for producing goods or services and they are not in regards to cost objects. These two kinds of costs are called – fixed costs and variable costs.

  • Fixed costs don’t change until a certain point of production. For example, if you pay rent for a factory, no matter how less or how much you produce, it won’t matter. You still have to pay the same amount. To illustrate this further, we can say that if you pay $4000 as factory per month, it wouldn’t change whether you produce one unit or 10,000 units. That’s why fixed costs always vary per unit.
  • On the other hand, variable costs are costs that are charged per unit. For example, you pay electricity charges for business consumption. And it’s totally dependent on how much you consume as a business. If you consume fewer units, you will pay less; and if you consume more units, you will pay more.

Now, let’s look at direct costs. We know that there’s an element of attribution in the direct costs which we can see in the variable costs too since the variable cost will only increase or decrease as per the units consumed/produced.

So, we can label direct costs as variable costs.

Direct Costs Example #2

Let’s say that Company Q has two departments. The first department A consumed 1000 units of electricity for the month of August and the second department B consumed 1200 units. Electricity Board normally charges $1 per unit. How much departments A and B would cost?

For two departments, Company Q would pay –

  • Department A = (1000 * $1) = $1000.
  • Department B = (1200 * $1) = $1200.

That means here we can see that the cost of each department (cost object) can be identified and at the same time, the cost is variable because the cost would increase/decrease as per the units consumed (variable cost).

Recommended Articles

This has been a guide to Direct Costs definition and its meaning? Here we take direct cost examples along with the concept of cost objects as direct costs and indirect costs.  You may learn more about accounting from the following recommended articles –

  • Cost Accounting vs Management Accounting Differences
  • Contribution Margin Formula
  • Costing vs Absorption Costing
  • What is Cost Accounting

The post Direct Costs appeared first on Learn Investment Banking: Financial Modeling Training Courses Online.



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