What is a direct cost?

A direct cost is an expense tied to making the goods or delivering the services your business sells. The more you make and sell, the more of these costs you’ll usually have.

The Corporate Finance Institute’s definition of direct cost describes it as a cost traceable to a cost object, such as a product or project. For most small businesses, direct costs are the same thing as cost of goods sold (COGS).

Think of a batik shirt. The fabric, dye, buttons and the tailor’s time are all direct costs, because each one goes into the shirt itself.

Examples of direct costs

Direct costs look different in every industry, but they always follow the product or service out the door. Here’s how they show up in five common types of small business.

Retail

A retailer’s biggest direct cost is usually the stock it buys to resell. Anything spent getting that stock ready for sale can count too.

Stock bought from suppliers
Import duty paid on that stock
Delivery charges to bring stock into your shop
Bags and labels that go out with each sale

Manufacturing

Manufacturers turn raw materials into finished goods, so their direct costs sit on the factory floor. A furniture maker in Johor, for example, would track these costs for each batch of chairs.

Timber, fabric and other raw materials
Screws, hinges and bought-in components
Wages for staff on the production line
Lease and electricity for a factory used only for production

Service businesses

Service businesses sell time and skill, so their direct costs are mostly people. A design agency, for instance, can trace these costs to one client project.

Wages for the hours your team spends on client work
Fees paid to freelancers hired for the project
Software or stock images bought for that client
Travel to the client’s site

Construction

Builders and contractors track direct costs job by job, which is the heart of job costing. Each site gets its own list of costs.

Cement, sand, steel bars and tiles for the site
Wages for workers on that site
Subcontractor fees for electrical or plumbing work
Machinery hired for that job

Food and beverage

Cafés and hawker stalls have direct costs that rise with every plate served. A nasi lemak stall, for example, would count these.

Rice, santan, chicken and other ingredients
Wages for kitchen staff
Takeaway containers and paper wrappers
Cooking gas used in the kitchen

The 3 main types of direct cost

Every direct cost fits into one of three groups. Sorting your costs this way shows you where the money goes in each product.

Direct materials, such as the flour in a loaf of bread or the timber in a table
Direct labour, such as the wages of the baker or the carpenter who makes the item
Direct expenses, such as subcontractor fees or equipment hired for one specific job

Add the three together and you get prime cost. It’s the full cost of making a product before any overheads are added. That makes it a useful starting point for pricing.

Direct costs vs indirect costs

Each cost is either direct or indirect, so you only need one test to sort them. Ask yourself: “Can I trace this cost to a specific product or job?” If the answer is yes, it’s direct.

Indirect costs, often called overheads, keep the business running in the background. They stay much the same whether you sell one item or a thousand.

Utilities for your office
Business insurance
General admin, such as accounting and office supplies
Marketing and sales costs

Some costs can land on either side, depending on how your business works. Staff and premises are common examples, and so are workshop costs, freight and warehousing.

The deciding factor is the cost object you’re measuring. AccountingTools’ guide to direct costs gives the example of a supervisor’s salary: direct for one project, but indirect when it supports the whole company.

Choose a definition that suits your business and apply it the same way every time. Consistent treatment keeps your reports comparable month by month.

How to calculate direct costs

The basic formula is quantity multiplied by price for each cost, then added together. Follow these steps to work it out for anything you sell.

Choose what you’re costing, such as one batch of products or one client job.
List every cost you can trace to it, using the three types of direct cost.
Multiply the quantity of each cost by its price.
Add the totals together to get your total direct cost.
Divide the total by the number of units made to get your direct cost per unit.

Here’s how it works for a small bakery in Kuala Lumpur that bakes 500 loaves in a week. Its direct costs for that week are:

RM900 for flour, yeast and salt
RM300 for butter and eggs
RM200 for paper bags and labels
RM600 for baker wages, based on 40 hours at RM15 an hour

The bakery’s total direct cost for the week is RM2,000. Divided by 500 loaves, that’s RM4 per loaf. This weekly total also feeds into the bakery’s cost of sales for the period.

Why direct costs matter for your business

Every sale you make brings its own set of direct costs with it. Knowing those costs helps you price well and plan ahead.

Your direct cost per unit is your pricing floor. The bakery above needs to charge more than RM4 a loaf to cover its direct costs, before it pays any overheads.

Direct costs also drive gross profit, which is revenue minus COGS. If the bakery sells all 500 loaves at RM9 each, revenue is RM4,500 and gross profit is RM2,500. Tracking this over time shows you how your gross profit margin is moving.

Finally, direct costs help you plan cash flow. A kuih maker preparing for Hari Raya orders has to buy ingredients and pay extra staff weeks before customers pay. The same applies to a big sales push: check that you can afford the extra stock and labour that more demand brings.

Track your direct costs with Xero

When you know your direct costs, you can price with confidence and plan ahead for busy seasons. Xero makes that easier by keeping your spending organised in one place.

Automated bank feeds and document uploads bring your expenses straight into Xero, where you can code direct costs separately from overheads. Easy-to-read reports then show your gross profit, so you can spot which products earn the most. Try Xero today and get one month free to start tracking your direct costs.

FAQs on direct costs

These quick answers cover common questions small business owners ask about direct costs.

Is labour a direct cost?

Labour is a direct cost when you can link the hours to a specific product or job, such as a chef cooking meals. Staff who support the whole business, like a receptionist, are indirect.

What is another name for direct costs?

Direct costs are often called cost of sales or cost of goods sold (COGS). When you add direct materials, direct labour and direct expenses together, the total is called prime cost.

Are direct costs fixed or variable?

Direct costs can be either. Materials usually rise with output, while the lease on a factory that makes only one product line is a direct cost that stays the same each month.

What’s the difference between direct costs and COGS?

Direct costs cover everything you spend making products, while COGS counts only the products you sold in the period. Under IAS 2 Inventories, unsold stock is held as inventory at purchase cost plus conversion costs, like direct labour.

Is rent a direct cost?

Rent for your office or shopfront is usually an indirect cost. Rent for a workshop used only to make what you sell can be direct, if you treat it consistently.

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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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