Direct costs could be defined as the costs that are exclusively budgeted for specific services or goods. This kind of cost is not split between various activities which are going on in the organization, such as costs which are indirect. Direct costs are the bulk of the larger part of a budget mapped out for a project.
Such costs are taken to be the most crucial outlay in the process of production. In this write-up, I will tell you the meaning of the term Direct Cost, will give different illustrations, as well as give you a formula for working out direct cost.
A cost that is direct is an expenditure that is directly connected to a particular cost item, for instance, a commercial project, a production department or process and so on. A direct cost, by and large, is a set cost; all the same, it adjusts to the modification in the quantity of output produced.
Definition of the term Direct Costs
Majorly, there are two foremost broad classifications of costs that have to do with any business. These are indirect costs and direct costs. An indirect cost is a cost that is not directly linked to a certain project.
In a cost sheet, direct costs are placed at the uppermost position. In addition, they account for eighty percent of the entire budget designated for a task. For instance, costs needed to purchase natural resources are good examples of direct costs.
The natural resources could be used only to carry out the production activities. They cannot be channeled to be utilized in some other way. As a result, the cost for natural resources cannot be split among various activities that are going on in the organization, such as indirect costs.
Illustration
| Natural Resources | Natural Resources also taken as raw materials are placed in the category of direct cost because it is a necessity for the process of production. The expenditure on natural resources is directly connected to the process of production. |
| Cost of labor | The wages paid to those who provide labor which speed along the process of production serve as an example of a direct cost that is linked to the manufacture of a specific good. It is the most prevalent cost acquired by the majority of industries. |
| Cost for machinery | Tools in addition to machinery are important in any given industry, as well as all industries. If there is no machinery, there will be no work done in virtually every industry. For this reason, the expenses of the two are directly linked up to the process of production. While this stands true in situations of industries that manufacture goods, the cost of machinery could as well be linked to the service industry. In the setting of a service industry, even though the key costs are salaries and wages of employees, some chunk of that cost is further expended on machinery. For instance, coffee machines and microwaves are made use of in restaurants. |
| Commission for sales | A commission is paid to a sales representative so as to build up the sales. The expense of that commission paid to the salesperson over the trade of a given good is directly linked to the good and as a result, it is a good example of a direct cost. |
| Consignment in or out | The cost takes to deliver materials to the factory, as well as to send out finished goods is a direct cost connected to the process of production. |
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Dissimilarities between Indirect Cost and Direct Cost
Just like we have said earlier, a direct cost is directly related to the process. These include the expense of raw materials, consumable supplies, and labor. Such items are used simply for the manufacturing of a specific product but are neither here nor there for some other activities in that organization.
On the other hand, an indirect cost is associated with supplies that are utilized for two or more processes, such as office supplies, rent of the building, salaries of office assistants and accountants, internet expenses, electricity and a host of others.
Expenses like this could also be alluded to as overhead costs. Such expenses are not linked to only one process.
The Steps to Estimate Direct Costs
Direct costs take up the major part of a budget. As a result, it is essential, to come to know and evaluate direct costs, in order to diminish these costs and maximize your profits.
The process of evaluating indirect expenses is easy and far less complicated than the process of evaluating direct costs.
Since a direct cost is straight away linked to a singular activity and cannot get used for some other activity. A direct cost earmarked for a project could be evaluated simply by adding up every direct cost associated with the activity.
Right below, I will show you the process of how to evaluate some direct costs, well illustrated with the aid of an instance.
1- Write out every one of the direct expenses that have to do with the process:
In the production process, various direct expenses are involved. It is recommended that you write out an inventory of every likely direct cost, prior to your drawing up a budget. Let us use as an example a company called ABC that is about to commence the process of producing a product called DEF.
There has to be a budget earmarked for the process of production. This budget could be organized by working out every possible kind of direct expense, for instance, the cost of labor, raw materials, cost of consumable provisions, machinery, packaging as well as a sales commission.
2- List out the direct expense for every item:
In this following stage, you have to apportion the prices of the direct cost towards each item. You should not just make up the prices randomly. Each price should be worked out, following the necessity of output from production. Let us give value to expenditure associated with the manufacture of this product DEF, as made up by us.
The natural resources are the most essential aspects of the process of production. It is impossible for the process of production to even commence when natural resources are unavailable. Let us take it that the natural materials needed to produce the good called DEF have a value of $20,000. Let us give each production cost a value.
In this illustration, we are making up the figures. In other respects, these prices would be got after taking a look at past projects, in addition to comparing provisions from various retailers. The total amount earmarked for labor cones to $10,000. The expenditure for the necessary machinery is $50,000. The price of consumable supplies is $8000. The packaging is put at $3000 and a sales commission comes to $10,000.
3- Put together all these direct costs that are related to the process of production.
The total sum of these direct expenses for the process of production would reach by summing up every one of the direct expenses of the process of production.
Prices of natural materials – $20,000
Price of labour -$10,000
Cost for machinery – $50,000
Cost for consumable supplies -$8000
Expense for packaging – $3000
Expenses for sales commission – $10,000
GROSS DIRECT COST = $101,000
The gross direct expenses for carrying out the process of producing product DEF comes to $101,000, plus the entire cost of making product DEF would as well have the indirect expenses. The addition of the indirect costs to the direct costs will help you arrive at the complete amount for production.
This project can yield profit only if the profits generated are more than the entire expense for production.
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