Direct and Indirect Costs and Fixed and Variable Costs
I’m sure you’ve heard about fixed costs and variable costs, and you probably have a good understanding of these. But how well do you know direct costs and indirect costs? Did you that the grouping of direct/indirect costs differs from that of fixed/variable costs, even though items can fit into both groupings?
Fixed Costs vs. Variable Costs
Fixed costs: Necessary costs required for a business to exist, even if it produces nothing. These costs do not vary with changes in the volume of sales. They stay fixed, or constant. If the company sells zero products during the month, the fixed costs remain the same. And if the company sells thousands of items during the month, again, the fixed costs remain the same. Common examples of fixed costs include rent/mortgage/lease, insurance, taxes, salaries, legal fees, advertising, etc
Variable costs: These are costs which do change in direct proportion to the volume of sales. A company with zero units sold technically has zero variable costs. When the company sells thousands of units, the total variable costs increases proportionately. Some examples of variable costs include materials to make the item being sold (ingredients if selling food or parts if selling an item), accompanying supplies to the item (restaurant using paper napkins or paper plates, or an online retailer’s shipping costs), labor (overtime pay, part-time workers, contract workers)
Semi-variable costs: A special category of costs that includes both a fixed and a variable portion to it. There is a fixed portion that must be paid regardless of business volume, and also a variable portion that does change when sales volume changes. For example, a company’s utility bills would be semi-variable costs. Utilities have a flat standard rate just for having the service to the building, which is the fixed piece. During busy times, the utilities may be used more, such as more customers flushing the toilets, which is the variable piece of the water bill
Direct Costs vs. Indirect Costs
Direct costs: Expenses directly connected to a specific cost object. A cost object could be a product, service, project, or department. For example, an employee working on a project. The project is the cost object, and the employee’s labor on the project is the direct cost. Another example would be a company producing a product. The product is the cost object, and all of the parts to make the product plus the employees’ salaries are the direct costs
Indirect costs: These are referred to as the “real costs” of a business and would be the expenses, materials, and supplies for day-to-day operations. Indirect costs are not directly connected to a specific cost object. For example, utilities, rent/mortgage/lease, cleaning supplies, office supplies, insurance, fringe benefits, and the salaries for administrative personnel would all be indirect costs. None of these are required costs of producing an item, yet all of them are necessary for the business to operate
Group [Fixed/Variable/Semi-variable Costs] vs. Group [Direct/Indirect Costs]
Take a look at the examples in each of the categories. You see some items listed variable costs as well as direct costs, and you see some variable costs also listed in the indirect costs list. So we can assume that all direct costs are variable costs and that all indirect costs are fixed costs, right? Not quite. I would change the “all” to “most” or “many”.
Many direct costs are variable costs, but some have a fixed portion. And most indirect costs are fixed costs, but some might be variable or semi-variable costs.
Confusing, right? Well, let’s look at an example.
We have a company that produces birdhouses. Let’s start with the most obvious of costs, the materials that go into making the birdhouses. These materials would be direct costs, since they are directly related to a cost object (birdhouse). With making a bird house, there will be wood, screws, paint, glue, and maybe some mini shingles for the roof. I think we can all agree that each of these direct costs would also be variable costs, right? If we sell 100 birdhouses, our costs for wood, screws, paint, etc., would be directly proportionate to the volume sold of 100. If we sold 1,000, then these costs would increase accordingly.
But what about the power drill, the glue gun, the wood planer, the electric table saw? These accompanying tools would also be direct costs since they are necessary to make the item. However, these are not variable costs. These tools are fixed costs. We need to buy the tools once. They will be able to help manufacture one house to one thousand houses and beyond. The price of these tools does not change with the volume of sales. This is the example that illustrates that not all direct costs are variable costs.
How about the indirect costs of the company? We will spend money on shipping supplies, office supplies (printer paper, ink, toner, pencils, etc.), the building lease, advertising in magazines and on television, and the salaries of the supervisor and administrative staff. None of these costs are directly connected with making the birdhouses, but they are all essential for the business to operate, which makes them indirect costs. The fact that these costs do not proportionately change with a change in sales volume makes them fixed costs.
The company’s electricity bill will be another indirect cost. This utility is a semi-variable cost. There’s a portion paid each month to provide electricity to the building, and another portion that varies based on how much electricity is used. Much of this electricity is used to light the offices of the manager and the accountant, to power the fans for circulating air throughout the building, to power the staff refrigerator. None of these uses of electricity have anything to do with producing the item. However, we can argue that a small portion of the electricity bill will have a direct component to it, and this is the portion that will be powering the drills and saws and lighting the production floor. The more we produce, the more electricity that’s needed, which is a variable cost. While it would be quite difficult to quantify the amount of energy used for the direct needs of the product (and pretty insignificant when comparing this to the total usage), utilities would just be grouped into an indirect cost. This is an example of how some portions of indirect costs can have a variable cost component to them.