A direct cost is totally traceable to the production of a specific item, such as a product or service. For example, the cost of the materials used to create a product is a direct cost. There are very few direct costs. The cost of any consumable supplies directly used to manufacture a product can be considered a direct cost. However, production labor is frequently not a direct cost, because employees usually are not sent home if there is one less incremental item being produced; instead, they are paid for the duration of their work shifts, irrespective of the volume of production.
Other costs that are not direct costs include rent, production salaries, maintenance costs, insurance, depreciation, interest, and all types of utilities. Thus, when in doubt, assume that a cost is an indirect cost, rather than a direct cost.
For example, the materials used to produce an automobile are a direct cost, whereas the electrical cost of the metal stamping machine used to convert sheet metal into body panels for the automobile is not, because the machine must still (presumably) be powered up throughout the working day, irrespective of any changes in production volume.
Direct cost analysis can also be used outside the production department. For example, subtract the direct cost of goods sold to individual customers from the revenues generated by them, which yields the amount customers are contributing toward the company’s coverage of overhead costs and profit. Based on this information, management may decide that some customers are unprofitable, and should be dropped.
However, there are a number of situations in which direct costing should not be used, and in which it will lead to incorrect behavior. Its single largest problem is that it completely ignores all indirect costs, which make up the bulk of all costs incurred by today’s companies. This is a real problem when dealing with long-term costing and pricing decisions, since direct costing will likely yield results that do not achieve long-term profitability. For example, a direct costing system may calculate a minimum product price of $10.00 for a widget that is indeed higher than all direct costs, but which is lower than the additional overhead costs that are associated with the product line. If the company uses the $10.00 price for well into the future, then the company will experience losses because overhead costs are not being covered by the price.
Using just direct costs to derive the value of inventory is not allowed under generally accepted accounting principles and international financial reporting standards, on the grounds that it does not provide a comprehensive view of every cost being incurred to create a product.
Direct Cost Examples
The preceding discussion should clarify that the typical business has very few direct costs. The most common ones are: