Difference between direct and indirect expenses

Definitions and meanings

Direct expenses

Direct expenses are those expenses that are incurred directly in the manufacturing process of a certain product. These costs are directly proportional to the changes in production level of the business.

Indirect expenses

Indirect expenses are those expenses that cannot be associated directly with the production process of a company but are necessary to incur in order to run the business activities effectively. These costs do not change with the changing activity level of a business.

Example:

For example, Joy’s Motors Ltd. is a car manufacturing company. The company incurs various types of costs in a certain financial year like direct materials (auto parts, auto engines etc.), direct labor (skilled and unskilled labor including assembly and manufacturing workers), factory rent, salaries of production supervisors, bills& utilities etc. These costs can be separated as direct and indirect expenses. Those expenses which Joy’s Motors Ltd. incur to directly manufacture the cars will be referred as direct expenses like direct material and direct labor. Those expenses that are not related to the direct production process of Joy’s Motors Ltd. but are necessary to run the production process of the company smoothly will be known as indirect expenses, like the rent of the factory, salaries paid to the production supervisors and bills & utilities.

Difference between direct and indirect expenses:

The difference between direct and indirect expenses is given below:

Objective of expense:

The primary objective to incur direct costs is to manufacture a product or products. These costs are directly attributed to the cost units of a business because they have a direct correlation to the changing activity levels of the business. On the other hand, such expenses which are necessary to run the business operations effectively and simultaneously to continue the production process of a business are known as indirect expenses.

Nature:

Direct costs are usually variable costs because these costs normally vary with the related activity level of the organization. In this way the more the production of a product, the more the direct costs are incurred and vice versa. Indirect costs are normally fixed costs (costs which remain fixed), step-fixed costs (costs which remain fixed for a certain level of an activity after which they step up and remain fixed for another specific level of activity) or semi-fixed costs (costs that have elements of both variable costs and fixed costs). This is because these costs are incurred for a specific period of time rather than for a specific unit of cost or object and therefore do not directly vary with the changing production level of the business.

Cost allocation:

The cost units of a business are the reason business spends all its expenses. These cost units will eventually be designated a price on which business will sell them as its finished products. However, for the reliable estimation of costs attached to these costs units, a business needs to trace all the costs incurred which are both direct expenses and indirect expenses. This practice is much easier for direct expenses, because these expenses are spent directly in the production process and thus are easily identifiable. One the other hand, the charging of indirect expenses to the individual costs units or cost centers becomes complicated, because these costs are period costs and are incurred irrespective of the production level or capacity of the business. Businesses use different costing techniques like, absorption costing, activity-based costing etc. to reasonably apportion these costs amongst its cost units.

Direct expenses versus indirect expenses – tabular comparison

A tabular comparison of direct and indirect expenses is given below:

Conclusion – direct expenses vs indirect expenses:

For a manufacturing business, both direct and indirect expenses are necessary. Direct expenses or costs are required to manufacture or produce the cost units of the company, but indirect expenses are important to run the business without any hurdles. A business cannot be run without incurring indirect expenses. Service sector organizations have a higher proportion of indirect expenses and minimal to nil direct costs. However, reliable estimation of costs is vital for every business to calculate its profits or losses because although there is a segregation between direct and indirect costs a business will ultimately have to allocate and/or apportion all its costs to its cost units.