Direct vs Indirect Costs Difference + Examples

indirect cost

Indirect cost pools must be distributed to benefitted cost objectives on bases that will produce an equitable result in consideration of relative benefits derived (2 CFR § 200.1). Examples of variable costs may include direct labor costs, direct material cost, and bonuses and sales commissions. For businesses selling products, variable costs might include direct materials, commissions, and piece-rate wages. For service providers, variable expenses are composed of wages, bonuses, and travel costs. For project-based businesses, costs such as wages and other project expenses are dependent on the number of hours invested in each of the projects.

If it’s impossible or too time-consuming to quantify the exact amount, these costs are untraceable and are indirect costs. Indirect labor cost is the sum of all salaries or wages attributed to employees who perform work that is directly related to producing a product or service. For a video-streaming service, data storage could be considered a direct cost because the product is literally storing videos to be shared online.

Direct cost definition:

Determining direct costs to a product also helps you in allocating resources. However, small businesses face scarcities in resources due to different limitations—such as financial capabilities, difficulty in accessing materials, and other external factors. The indirect labor cost generally includes Fixed Indirect Labor Cost and Variable Indirect Labor Cost.

If you want to determine your indirect cost rate, you need to use cost allocation. Cost allocation is the process of distributing your indirect costs among specific departments or projects. Common or indirect costs differ from direct costs, which are expenses specifically related to a particular project or activity and can be directly traced to that project.

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Indirect costs are general business and administration expenses that aren’t directly linked to making products or delivering services. Administration costs include general administrative expenses that are not specific to the project but serve the entire organization. Examples include general administration and general expenses such as the director’s office, legal, accounting, and administrative personnel. Indirect costs extend beyond the expenses you incur when creating a product; they include the costs involved with maintaining and running a company.

  • The General and Administrative (G&A) costs pool consists of those expenses related to the overall running and management of the company.
  • What is considered an indirect cost for one company might be considered a direct cost for another.
  • Finally, if you ever apply for and receive a grant, there are several rules around the types of indirect costs and the maximum amount you can claim.
  • In more complicated government and defense contractors, some indirect costs are collected in intermediate pools and then allocated further to the final indirect pools.
  • You should prepare a project budget in coordination with your organization’s Institutional Grant Administrator (IGA) and/or Office of Sponsored Projects.
  • Understanding the distinction between direct costs and indirect costs is necessary to properly keep track of a company’s expenses, as well as for pricing products appropriately.
  • Activity-based cost allocation (ABC) is a method of assigning overhead and indirect costs such as salaries and utilities to products and services.

An indirect cost rate is simply a device for determining fairly and expeditiously the proportion of general (non-direct) expenses that each project will bear. It is the ratio between the total indirect costs of an applicant and some equitable direct cost base. After the accounting period is completed, contractors can calculate actual incurred indirect cost rates. These final rates are then submitted to government or agency for final agreement before final contract payments are made. You can allocate indirect costs to determine how much you are spending on expenses compared to your sales.

Understanding Cost Structures

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indirect cost

Your organization may also selectively apply the de minimis rate in cases in which it does not have an applicable rate. For example, research rates are not applicable to the scholarly research that NEH funds, except in rare circumstances. In cases in which an organization has only negotiated a research rate (see below for an explanation of rate types), the organization may apply the de minimis rate.

Effective management of financial resources is vital for the sustainability and growth of any organization. FP&A managers play a pivotal role in making all that happen by their critical support of the major corporate decisions of the CFO, CEO, and Board. Seth Catalli is chief revenue officer of Palo Alto, California-based Globality, which provides technology designed to help companies optimize how they spend their money. The final product becomes less competitive because it may cost more to produce than the price being offered for sale. There is significant opportunity to increase savings and build value through process optimization, monitoring, and streamlining total spend—rather than prioritizing direct spend management alone. With the right tools, companies who want to control their indirect spend can find savings and build value.

The base period for allocating indirect costs is the cost accounting time period during which such costs are incurred and accumulated for allocation to work performed in that period. The indirect cost rate is calculated by dividing a pool of expenses (numerator) by an allocation base (denominator) such as total labor cost. The allocation base selected can be something other than a monetary cost such as machine hours or facility square footage. The expense pool represents indirect costs accumulated by logical groupings, and distributed on the basis of benefits accruing to the several different cost objectives. This means that the existence of the base and the employment of the base activities creates the pool of expenses over a period of time. To facilitate equitable distribution of indirect expenses to the cost objectives served, your organization may need to establish a number of pools of indirect costs.