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Direct Cost: Definition, Formula & Examples

Direct Cost: Definition, Formula & Examples
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  • 0:04 What Are Direct Costs?
  • 0:42 Types of Direct Costs
  • 1:42 Examples of Direct Costs
  • 3:14 Calculating Direct Costs
  • 3:50 Lesson Summary
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Lesson Transcript
Instructor: Tara Schofield
This lesson explains direct costs. Included in the lesson is how they are calculated. You'll also have the chance to examine examples of direct costs.

What Are Direct Costs?

Direct costs are expenses a company has that are directly related to the activities of a project or a department. Analyzing direct costs is an important activity because it helps managers understand if projects are profitable, if expenses are out of line for one department versus another, and if managing a project directly is more cost effective than outsourcing it.

Being able to analyze the costs of each internal group is important, especially when budget cuts are necessary or when searching for ways to trim costs. By looking at each group, management can look for expenses that could be cut while having the least negative effect on company performance.

Types of Direct Costs

There are two basic ways that direct costs are used.

The first is in calculating the production costs of a product. The cost of goods sold (COGS) is the amount of all of the supplies used for creating a product, the labor costs from employees working on a product, the space needed to create the product, packaging costs, utilities used in production, and equipment use. All of these expenses are added together to calculate what it costs to create a product. Understanding the cost of a product is vital in creating a sales price that is profitable and ensuring the product is making money, not losing money.

The second way that direct costs are used is in calculating the operating expenses of a department or division of a company. Direct costs that a department may incur include payroll for department employees, office or work space for the members of the team, training expenses, travel and entertainment costs incurred by a department, and any other expenses that are specifically associated with each department.

Examples of Direct Costs

Let's look at a couple of examples to help us understand direct costs better.

In the first example, you are a shipping manager for a large business. Your responsibility is to break down the shipping costs to ensure the expenses are charged to the right department. As you begin organizing the shipping costs, you realize you have mail and packages that must be shipped for several company divisions: administrative, accounting, marketing, sales, and operations. As the manager, it is your responsibility to break down the costs further.

By posting the cost of shipping to each department, the operating expenses for each division is correctly reported. If the shipping costs were lumped as one amount to one general account, there would be no way to know how much shipping and mailing each department did and what amount of the total shipping expenses they are each responsible for.

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