Direct costs

What it means

Direct costs are costs that can be clearly and directly attributed to a specific product, job or service. Typical examples are materials used, the wages of people who worked on the job, subcontracting and other costs incurred solely for that output.

Their opposite is overheads, which relate to several outputs or to running the whole company, such as rent, office energy or management, and are allocated to outputs using a key. This distinction is the basis of costing prices and profitability.

Direct costs are often, but not always, variable too. Materials for a product rise with the number of units, but the wage of a permanent employee working on a job may be fixed even though we assign it directly to the job.

How it works in practice

For job-order production or projects we set up the records so that direct costs are posted straight to the job or cost centre: material issue notes, timesheets and subcontractor invoices. Otherwise costs get mixed together and the profitability of individual jobs cannot be seen.

From direct costs and a share of overheads we build a costing that we compare with the selling price. The difference between price and direct costs shows the job’s contribution to overheads and profit. When deciding whether to accept a job, this figure is often more important than the fully loaded result.

For goods the company produces itself, direct costs form the basis for valuing inventory at production cost. The company may include part of production overheads in the valuation, but not administrative overheads or selling costs.

What to watch out for

If direct costs are posted generally, without assignment to a job, costing is later done by guesswork. It is then easy for jobs that look profitable to turn out loss-making. We therefore recommend assigning costs when the document is posted, not after the fact.

Shifting overheads into direct costs just to make a job look better or worse distorts the picture. We therefore set out in an internal policy what counts as direct and what as overhead, and apply it consistently.