In finance, direct costs are those costs that are associated with a specific project, department, or activity. Sometimes referred to as hard costs, expenses of this type are found with just about every type of business activity, beginning with research and development, moving through sales and marketing campaigns, and into the production of different types of goods and services. A direct cost is often some type of fixed expense, but there are some situations where a variable expense may also fall into this category.
The key to understanding what does and does not constitute direct costs is to identify costs that apply only to a specific project, and have nothing to do with any other activity that is taking place concurrently. In order to be a true hard cost, the expense must be for resources that benefit that one project. For example, if the project is to construct a telephone, the costs for the handset casing, internal circuit boards, and the wiring would all fall into the category of direct costs. In addition, the wages paid in exchange for the labor to build the telephone would also be a direct cost.
In situations where expenses do not go to benefit a specific task or project, the cost would be considered indirect. Utilities, such as electricity, used to operate a facility that houses several different product lines or other activities would not be considered direct costs, since those utilities benefit more than one specific project. Expenses of this type would be shared among the different projects, rather than be tied directly to any one activity.
Not every business operation will evaluate direct costs in exactly the same way. Depending on the structure of the company, something that is considered a hard cost in one business culture may be classified as an indirect cost in a different culture. As long as the internal guidelines for determining what is and is not a direct cost remain consistent, it is still possible to properly determine the historical cost or the cost of goods sold with a high degree of accuracy. That same consistency makes it possible to compare the absorption costing from one period to the next, and determine if there has been an increase in direct costs associated with a particular function or project.
Identifying direct costs associated with a specific project or operation is very important. Unless the costs associated with the project are recognized and accounted for, it is impossible to determine the total expense involved in carrying out the project. Without knowing the total expense, determining the rate of return for the project is extremely difficult to manage.
