The essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. These costs are usually only classified as direct or indirect costs if they are for production activities, not for administrative activities (which are considered period costs).
The concept is critical when determining the cost of a specific product or activity, since direct costs are always used to compile the cost of something, while indirect costs may not be assigned to such a cost analysis. It can be too difficult to derive a cost-effective methodology for the assignment of indirect costs; the result is that many of these costs are considered part of corporate or production overhead, which will exist even if a specific product is not created or an activity does not occur.
Examples of direct costs are direct labor, direct materials, commissions, piece rate wages, and manufacturing supplies. Examples of indirect costs are production supervision salaries, quality control costs, insurance, and depreciation.
Direct costs tend to be variable costs, while indirect costs are more likely to be either fixed costs or period costs.