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Categorizing your business costs into direct expenses and indirect expenses is essential for tax purposes. But how do you know which is which? Let’s take a simplified look at the differences between the two and how to determine which category your expenses fall under.
What are direct expenses?
Direct expenses are costs linked to producing a specific good or service. Direct costs are also referred to as the cost of goods sold. These business expenses can be directly connected to a cost object (any item that you measure expenses for) and have a clear and identifiable connection to your business operations.
For example, imagine you open an Etsy shop selling homemade goods such as candles. In this instance, the cost of supplies such as containers, wax, a hot plate, wicks, or fragrances would be considered direct expenses. This is because these expenses can be directly attributed to making a specific product.
What are indirect expenses?
In contrast, indirect expenses are not directly associated with a particular product or service. Indirect expenses are also sometimes referred to as overhead costs. These expenses are still necessary for your business to function successfully, but they often support multiple business operations instead of one specific business activity.
Let’s continue using the candle shop example above. In this case, the cost of electricity to heat the wax, office supplies for shipping, or business license fees could all be considered indirect expenses. These costs are essential to the operation of your business but are not directly tied to a specific product like the candles.
What are some examples of direct costs?
Some common examples of direct expenses include the following:
- Manufacturing supplies and equipment
- Direct materials
- Labor costs (such as wages for production staff)
- Transportation costs
- Other production costs
Direct expenses are typically variable costs, as these costs increase or decrease depending on the volume of goods or services produced.
What are some examples of indirect costs?
The following are often considered to be indirect expenses necessary for running and maintaining your company:
- Office expenses
- Business technology and software
- Marketing expenses
- Administrative costs (including salaries for administrative staff)
- Business insurance and permits
- Accounting and legal fees
Indirect expenses are typically fixed costs, as they remain the same regardless of if goods or services are produced or not.
How do I distinguish between direct and indirect expenses?
When determining whether a cost is a direct or indirect expense, ask yourself the following:
1. How is the cost associated with my business?
If the expense is directly linked to a specific good or service, it should be classified as a direct expense. If the cost supports your overall business operation but not a particular product, it’s an indirect expense.
2. What impact does the expense have on my profitability?
True to their name, direct expenses directly impact the cost of producing goods or services, thus impacting your profitability. On the other hand, indirect expenses don’t directly affect the cost of producing goods or services, but they are still necessary for running your business.
Just remember that the key difference between direct expenses and indirect expenses is how they relate to the production or delivery of a specific good or service. If assigning a cost to a specific object or business activity is easy, it’s likely a direct expense, while indirect expenses are more general.