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Direct and Indirect Costs and Their Effect on Pricing your Product

How to Include Direct and Indirect Costs When Pricing your Product

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Part of the process of pricing your product is including the costs of producing that product. Those costs include the direct and indirect costs associated with producing your product.

Direct Costs

Direct costs are costs that can be easily traced to a particular object (also called a cost object), such as a product, the raw materials used to manufacture a product, or the labor associated with the work to produce the product. If your company produces a widget and a production manager is hired to oversee production of that widget, then the production manager's salary is a direct cost. If you own a carpet cleaning business, which is a service organization, and you hire workers just to clean carpets, their wages are direct costs.

Direct costs are often, but not always, variable costs. Variable costs increase as more units of the product are manufactured. As a result, raw materials are variable and direct costs. But, if there is a supervisor overseeing the manufacturing of this particular product, their salary is probably the same regardless of how much of the product is manufactured, so it is a fixed cost.

Direct Materials and Direct Labor

The most common direct costs are direct materials and direct labor. Direct materials are the materials that can be specifically identified with the product. If you are a furniture maker, your direct materials would be the wood that goes into making your furniture along with the nails, varnish, and other products that you apply specifically to making the furniture. But, you wouldn't count the gasoline that the loggers use to drive the trucks to get to the forest to cut down the trees as direct materials.

A method of tracking the direct cost of materials has to be chosen, generally LIFO or FIFO.

Direct materials are all the materials required to produce a product such as raw materials. Direct materials costs are assignable to that particular product, such as the cost of each raw material.

Indirect Costs

Indirect costs are those which affect the entire company, not just one product. They are costs like advertising, depreciation, general supplies for your firm, accounting services, etc. They are services, and costs, for your entire firm, not just one product. Indirect costs are usually called overhead. Overhead is the ongoing cost of operating a business that can't be associated with just one product or service.

Indirect costs can be fixed or variable costs. Often, they are fixed costs with an example being the rent you pay on your building. Sometimes, they are variable. An example would be your electricity or water bill which can change monthly.

Indirect Materials and Indirect Labor

Materials such as tools, cleaning supplies, and office supplies make production of a company's products possible but can't be assigned to just one product. These are classified as indirect materials or the overhead portion of the material your company uses. Indirect materials costs are usually variable because materials are based on the level of production.

Labor costs that make production of a product or products possible but can't be assigned to one particular product are classified as indirect costs. An example of an indirect labor cost would be the salary of a manager as that manager would manage the entire operation and not just one product line. The next issue is whether indirect labor costs are fixed or variable costs. In this case, if the salary is a monthly or annual salary and does not change based on production, it is a fixed cost. If it is based on production, it is a variable cost.

It is important for a business owner to correctly classify direct and indirect costs. One reason is because overhead, your indirect costs, are tax-deductible items. Some of the overhead expenses will be in be included in cost of goods sold, business deductions, inventory, and other categories.

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