Difference between direct and indirect costs

In every production process of goods or services and in the operation of any company, expenses are generated that represent the costs to be paid to be able to produce and function as an economic entity. The categorization of these costs in relation to the item being presented is based on the nature of the direct and indirect costs and how to apply them in order to calculate the total cost of a certain product.

Before delving into direct and indirect costs, it is convenient to make a few brief clarifications about Management Accounting and especially Cost Accounting.

Cost analysis

In the first line I will comment that Management Accounting arises from the need for sufficient and personalized information about costs general involved in the product to be produced and sold, which serves the management when making some decisions of a nature financial. Then, in this way, said accounting unlike the financial accounting that prepares the Annual Accounts based on the General Plan Accountant, will be responsible for encompassing budget control, Cost Analysis and cost accounting, with the objective of calculating the general production and operating costs of the company, streamline the planning and control process and serve as support in making decisions.

Notwithstanding the above, it should be noted that Financial Accounting and Management Accounting complement each other, serving as mutual support in some administrative scenarios.

Let's move on now to talk about what are direct and indirect costs and how are they classified and they differ. We start from the idea the need to establish the cost of a certain product, in order to set the sale price. The cost is the sum of the total expenses incurred to obtain a good or service.

The expenses that give rise to a cost are:

• Those that are part of the normal activity of the company.
• Those that are linked to productive activity.
• Those that are unavoidable for the development of productive activity.

In order to obtain the cost of a specific product or service, the first thing that is done is the classification of costs, it is here that the criteria and conceptualizations of the mentioned direct and indirect costs.

What are direct costs?

They are those costs that are associated with the product clearly, without making any kind of distribution. They serve to establish control mechanisms that make known exactly the amount of cost that the product or service deserves. They are known as production costs.

Examples of direct costs:

• Direct Raw Materials: They are the material resources that are incorporated into the production process to be totally or partially transformed to achieve the Final Product. For example, flour for making bread, fabric for clothing, gold for rings, wood for furniture, etc.
• Direct Materials: They are all those transformed goods that serve the final product without constituting part of it, but if they are marketed jointly. For example, packaging, wrapping, labels, packing boxes, accessories, spare parts, etc.
• Direct Labor: It is the labor force used to transform the raw material into the final product. For example, workers' salaries, social benefits, contributions to social security, bonuses for overtime and productive bonuses to encourage high productivity.

What are indirect costs?

They are those costs that are implicit in the production process but are not directly incorporated into the final product. These. They are common in several products, so some distribution criteria must be established. They are known as manufacturing expenses.

Examples of indirect costs:

• Indirect Production Costs: These are essential costs for production such as the cost of supply and manufacturing.
• Indirect Labor: Salaries of production managers, plant manager and supervisors, benefits, social security, overtime payments, night bonuses, high productivity bonuses, the same.
• Indirect Materials: These are Inputs that are not directly quantified in the elaborated product, nor are they part of it, but without these, Production would not be possible. For example, supplies such as lubricants, oils, cleaning supplies, work tools and equipment, maintenance materials, etc.
• Physical elements: Inputs for the operation of the plant, necessary for production. For example, electrical energy, water, refrigerants, etc.
• General Indirect Costs: They are costs of the productive period, they are not necessary for production. Example: promotion, administration, patent and financial costs. they are valued at the end and must not be greater than 10% of the direct cost.

Characteristics that must have a cost to be considered direct

• It must be physically incorporated into the finished product or participate directly in its preparation.
• They are proportional to the product.
• It is the sum of the costs of material, labor and equipment used.
• They affect in their entirety on each activity.
• Its degree of incidence is expressed as a percentage of the total value of the property.

Characteristics that must have a cost to be considered indirect

• They do not apply to a specific game.
• They participate in the production process, but are not physically incorporated into the finished product.
• They are linked to the productive period and the finished product.
• They have a partial impact on activities and a direct impact on the cost of the finished product.
• They are difficult to assign, measure and quantify.

Importance of having a cost structure

It is necessary and important for management to know the profitability of each line or productive unit, for this, the allocation of all costs must be made. An applied cost constitutes a budget that is used by management in determining the company's capital, allocation and use of available resources, determination of comparable goals over time, planning and coordinating activities for each Department.

It is also vital to have full knowledge of each of the costs generated by production and operation. general company, in order to avoid incurring unnecessary costs and misuse of company resources. business. In this way to achieve economic profitability and business success.