DIRECT vs. INDIRECT COSTS EXPLAINED

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Many organizations use erroneous formulas or the wrong approaches when classifying which costs are direct and which are indirect (overhead/fixed). This creates a significant managerial problem because the results derived from any financial analysis are usually flawed and ultimately, lead to bad decisions.

Example:
The cost of travel in many organizations is classified as overhead when in reality they are direct costs. If a Marketing Associate travels across state to sell a company’s products, then the travel cost should be considered as a selling cost, which is a direct cost. Therefore, the cost of travel should be included in the Cost of Goods Sold column in order to establish the total cost of the products. This little mistake leads many organizations to conclude that the Total Cost of their products is cheaper than in reality. As a result, any Cost-Plus Pricing structure will be flawed because they will be based on the wrong foundation.

Insight:
The wrong allocation of overhead cost may also lead to the wrong staff makeup. For example, a manager may determine that the overhead percentage is too high and non-sustainable because there are too many employees on salaries. With this conclusion, this manager may terminate many necessary employees by wrongly classifying staff members—Instead of Direct Labor, they will be in the salaried column.

Solution:
In order to separate effectively the direct cost from overhead, you must follow the following two rules:

Rule 1: Direct Costs are easy to calculate:
If you have trouble allocating a cost to a specific unit in the organization, then it is probably an overhead cost. Overhead Costs usually span over months and may come from many directions. Direct Costs are easy to identify. They usually include direct materials and direct labor cost. When outlining Direct Costs, complex financial computations or complex allocation processes aren’t necessary.

Rule 2: Overhead Costs are non-negotiable:
Overhead costs are non-negotiable because they serve as the lifeline of the business. Without them, the business cannot survive. If you could eliminate a cost, then it is probably a direct cost. An organization may not survive without incurring the cost of rent and utilities for example. Overhead cost affects the immediate survival of a business. Other costs such as office supplies are in the grey area. Even though they are not directly attributable to the direct production of a product, they still constitute an essential part in the delivery of products and services. Some managers will split and allocate the cost half-and-half between direct and indirect to satisfy this ambiguity. Whichever is the strategy, it must be established with only two non-negotiable choices: survival vs. non-survival. Or, Overhead Cost vs. Direct Cost.