What is a direct cost?

A direct cost is an expense you can trace straight to something you sell, such as a product or a client job. If you stopped making that product, the cost would disappear with it.

Accountants call the thing you’re costing a “cost object”, which might be one item or a whole project. If you can link the cost to it without estimating, it’s direct.

Picture a warung selling nasi goreng. The rice and eggs in each plate are direct costs. The shop rent is indirect, because it stays the same whether you sell 10 plates or 200.

Examples of direct costs

Direct costs look different depending on what you sell. These examples show typical direct costs in four types of Indonesian small business.

Manufacturing businesses

A furniture workshop in Jepara turns raw timber into finished pieces, so most of its direct costs sit on the workshop floor. Typical direct costs include:

teak and other timber used in each piece
hinges, screws, glue and finishing oils
wages for the carpenters who build the furniture
packaging for each finished order

Retail businesses

A clothing boutique or online store buys finished goods and resells them. Its direct costs include:

stock bought from suppliers or wholesalers
shopping bags and packaging for each order
marketplace commission charged on each sale
payment gateway fees on each transaction

Service businesses

A digital marketing agency sells time and expertise, so labour is usually its biggest direct cost. Direct costs for a client project might include:

salaries for the hours staff spend on that client’s work
fees for freelancers hired for the project
ad spend bought on the client’s behalf
software or stock images bought for that client only

Construction and project-based businesses

A renovation contractor in Surabaya can link almost every cost to a specific site. Its direct costs include:

building materials such as cement and tiles
wages for builders working on site
subcontractor fees for electrical or plumbing work
equipment hire for that job

When each job has its own budget, tracking costs by project shows you which jobs earn the most.

How to calculate direct costs

You calculate direct costs by adding up everything you spent to produce a specific order or job. Many businesses group those costs using the prime cost formula.

Prime cost formula

Prime cost is the total of your direct costs for a product or job. The formula is: prime cost = direct materials + direct labour + direct expenses.

Direct expenses are any other costs you can trace to the job, such as subcontractor fees or equipment hire.

Steps to calculate direct costs

Follow these steps to work out the direct cost of an order or a product line.

Choose what you’re costing, such as one customer order or a month’s production
Add up the materials used for it, using supplier invoices or stock records
Add the labour cost for the time staff spent making or delivering it
Add any other expenses you can trace to it, like subcontractors or equipment hire
Total the amounts, then divide by the number of units if you want a cost per unit

Worked example in rupiah

Say the Jepara workshop takes an order for 20 teak dining chairs. Timber and finishing materials cost Rp 34,000,000, carpenters’ wages come to Rp 12,000,000, and an upholstery subcontractor charges Rp 4,000,000.

That gives a prime cost of Rp 50,000,000, or Rp 2,500,000 per chair. If the workshop sells each chair for Rp 4,000,000, revenue is Rp 80,000,000 and gross profit on the order is Rp 30,000,000.

Direct costs vs indirect costs

Every cost falls into one category: direct or indirect. What decides it is whether you can trace the cost to the specific thing you’re costing.

Indirect costs keep the whole business running, like office rent, insurance, accounting fees and marketing. Here’s how the two types compare:

Direct costs link to a specific product or job, while indirect costs support the business as a whole
Direct costs usually move with sales, while many indirect costs stay steady month to month
Direct costs sit above gross profit on your profit and loss report, while indirect costs sit below it
Direct costs guide your price per unit, while indirect costs guide your overall budget

The category can shift when the cost object changes. A project manager’s salary is direct when they work on one client project, but indirect when they oversee every project at once.

Direct costs vs overheads

Overheads are the ongoing costs of running your business, such as rent, utilities, admin salaries and software subscriptions. All overheads are indirect costs, so they sit outside your direct costs even though you need them to operate.

Staff and premises can land on either side. A factory used only for one product line may count as a direct cost, while a shared office is overhead.

Fixed and variable direct costs

Most direct costs are variable, which means they rise and fall with the amount you produce or sell. Make twice as many chairs and you’ll buy roughly twice as much timber.

Some direct costs are fixed, though. A machine leased only to make one product costs the same each month whatever your output, yet it’s still traceable to that product.

Knowing which direct costs are fixed shows you how much profit each extra sale adds once those fixed amounts are covered.

Direct costs, COGS and cost of sales

For most small businesses, direct costs and cost of goods sold (COGS) are the same figure. COGS is the term product businesses use, while cost of sales (COS) is the broader term that also suits service businesses.

You can check what counts towards COGS for your business, then work through a cost of sales calculation step by step.

Timing is the main difference. Direct costs for stock you haven’t sold yet stay in inventory, then move into COGS when the sale happens. Your profit and loss report subtracts COGS from revenue to show gross profit.

Why direct costs matter for your business

Direct costs show what each sale really costs, which shapes your prices and your cash needs.

Pricing comes first. If a chair costs Rp 2,500,000 to make, selling it for Rp 2,600,000 leaves little gross profit to cover rent and wages. Starting from direct costs helps you set prices that cover your costs and still leave a healthy margin.

Cash planning follows, because direct costs rise before the sales money arrives. A retailer preparing for Lebaran buys extra stock weeks ahead, so planning your cash flow early keeps shelves full. A big sales push needs the same planning.

Businesses treat some costs differently, such as workshop rent or warehousing. Choose a definition that suits your business, then apply it the same way every month so your gross profit figures stay comparable.

Track direct costs with Xero

Clear direct costs lead to better prices and a truer picture of profit. With Xero, you can code each supplier bill to cost of sales and see gross profit in your financial reports whenever you need it.

FAQs on direct costs

These answers cover common questions about classifying and managing direct costs.

Is depreciation a direct or indirect cost?

Depreciation is usually indirect, because equipment wears out across many products rather than one sale. Some manufacturers treat depreciation on dedicated production machinery as direct, so pick one treatment and keep it the same each period.

Is labour always a direct cost?

Labour is direct only for the time people spend making or delivering what you sell. When an employee splits their day between client work and admin, timesheets let you record each portion correctly.

Are delivery costs direct costs?

Freight to bring in stock or ship a specific customer order links to that sale, so many businesses count it as direct. General courier costs, like sending documents to your accountant, are indirect.

How do direct costs affect gross profit margin?

Gross profit margin is gross profit divided by revenue, shown as a percentage. In the chair example, Rp 30,000,000 gross profit on Rp 80,000,000 revenue gives a 37.5% margin, and rising direct costs shrink it until you adjust prices.

How often should you review your direct costs?

Review them at least monthly, and again whenever a supplier changes its prices. Regular checks help you spot shrinking margins early and adjust prices while profit is still on track.

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Disclaimer

This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.

What is a direct cost?

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