Direct and Indirect CostsBy Cindy Walker

Outline• Definition of direct and indirect costs• Benefits of differentiating costs• Explanation of the two costs• How to find the costs• Real world example• Exercise• Summary• Suggested readings

What are direct and indirect costs?

• Direct costs are costs that can easily be traced to a specific project or activity.

• Indirect costs are costs that can not be easily traced to a specific project or activity.

Benefits of differentiating costs• More accurate forecasting• Reduced overspending• Understanding trade-offs• Learning the true cost of projects/activities• Pricing

Let’s practice!Determine if the following are direct or indirect costs:

1. Assembly line worker2. Manager of a paper company3. Electricity 4. Alarm sales rep5. Chef for a gourmet dinner6. Office space7. Microscope for a chemist8. Postage for a FedEx package

Direct

Indirect

Indirect

Direct

Indirect

Indirect

Direct

Direct

Common direct costs

• Project materials • Project staff

Common indirect costs

• Office supplies• Utilities• Rent• Administrative staff

What to remember

• When identifying an activity, service, or product as a direct or indirect cost, it is important to remain consistent.

• Example: If labor is considered a direct cost for one project, it must continue being considered a direct cost.

Finding the direct cost

1. Is the cost incurred from a certain project or activity?

2. Can I easily trace the cost to a specific project or activity?

3. Will the cost disappear once the project or activity is finished?

Finding the indirect cost

1. Case-by-case allocation

2. Indirect cost rate

Case-by-case allocation

• Find the actual usage of the indirect cost in question

• Disadvantage: DIFFICULT!!

Indirect cost rateFormula:

Total Indirect Costs

Indirect Cost Rate

Total Direct Costs

Indirect cost rate (cont.)• To find the indirect costs for Project A:

Project A’s Indirect Project A’sDirect Costs Cost Rate Indirect Costs

Real world example

• Company XYZ has costs totaling $15,000. If Function A has direct costs of $7,000 and Function B has direct costs of $4,000, what are the indirect costs of Function A and Function B?

Real world example (cont.)

• $4,000/$11,000 = 0.3636 or 36.36%

• Function A: $7,000*0.3636 = $2,545.20 indirect costs

• Function B: $4,000*0.3636 = $1,454.40 indirect costs

Exercise

• Project A has direct costs of $400, Project B has direct costs of $500, and Project C has direct costs of $900. If all of these projects combined has a total cost of $3,000, what is the amount of indirect costs for Project B?

Project B’s Indirect Costs: $333.35

Summary

• Direct costs relate specifically to a project while indirect costs relate on a broader scale.

• Consistently identify an activity as either a direct or indirect cost.

• Distinguish the type of cost through three questions. • Solve for indirect costs through case-by-case

allocation or an indirect cost rate.

Suggested readings• Gordon, L. A. and M. P. Loeb. 2001. Distinguishing

between direct and indirect costs is crucial for internet companies. Management Accounting Quarterly (Summer): 12-17.

• Accounting for Dummies by John Tracy• SBIR Basics: The Numbers (Accounting, Costs,

Rates, Audits, and More) by Lea Strickland• http://www.umdnj.edu/rimweb/rim_cfp/indexcfp.htm