How Are Direct Costs and Variable Costs Different?

Direct Costs vs. Variable Costs: An Overview

There are many inputs related to the production of goods and services, not to mention the associated production costs. These expenses can be divided into different categories. Direct costs and variable costs are two types of costs associated with the production of goods and services. Although they are similar in this respect, they have some distinct differences. Direct costs are expenses that can be directly traced to a product while variable costs change based on the level of production output.

Key Takeaways

• Direct costs are expenses that can be directly tied to the production of a product and can include direct labor and direct material costs.
• Direct costs can be fixed costs such as the rent for a production plant.
• Variable costs vary with the level of production output and can include raw materials and supplies for the machinery.
• Variable costs can also be indirect costs, such as electricity for the production plant since it can’t be tied to one specific product.

Direct Costs

A direct cost is a cost that is directly tied to the production of a good or service. Direct costs, which can also be referred to as specific costs, can be easily traced to their cost objects. Put simply, any costs or expenses that are directly related to the creation of goods and services are considered direct costs.

Cost objects can include goods, services, departments, or projects. Some of the most common types of direct costs include wages (tied to production), direct labor, and direct materials.

Direct costs can be but aren’t always fixed. This means they are the same in the frequency of use and price regardless of production levels. Some of the most common types of fixed cost include the rent for a production facility or the salaries of managers and supervisors.

In some cases, direct costs may also be variable. As such, the amount used and the price at which they’re purchased can change based on the production level of goods and services. We explore variable costs in more detail in the next section.

Note

Direct costs don’t necessarily need to be variable. Variable costs, on the other hand, often fall under the category of direct costs.

Variable Costs

Variable costs are expenses that vary as production increases or decreases. These costs depend on the company’s production volume. When a company’s production output level increases, variable costs increase. Conversely, variable costs fall as the production output level decreases.

Unlike direct costs, variable costs don’t have to be directly related to the product. In other words, a variable cost can be an indirect cost. For example, a company that produces smartphones with several production machines needs electricity to function. The cost of electricity is considered an indirect cost since it can’t be tied to the product or the specific machine. The cost of electricity, though, is variable since electricity usage increases as production levels rise.

In short, if the total cost associated with the cost object changes when the production amount changes, it’s likely a variable cost.

Examples of Direct Costs and Variable Costs

Let’s take a look at some of the most common examples of direct and variable costs.

Direct Cost Examples

As noted above, wages related to the production of goods and services, direct labor, and direct materials are considered direct costs. The rent that a company pays for facilities along with management salaries are also considered direct costs.

Here are some other common direct costs that companies must pay:

• Manufacturing supplies
• Equipment rental and purchase
• Fuel and transportation
• Insurance
• Marketing costs

Variable Cost Examples

The packaging costs associated with a product would be a variable cost since the packaging costs would increase as sales increased. The raw materials used to make the product would also be variable costs since the cost of materials would rise and fall depending on the sales volume of the product.

Other examples of variable costs include:

• Some labor like piecework, which is the cost tied to the number of pieces produced or worked on by each employee
• Certain supplies, including oil for the machines or parts tied to production
• Hourly employees, such as those needed for the production facility or consulting
• Sales staff commissions—when they sell more goods, their commissions increase
• Merchant credit card fees
• The cost of shipping or delivery

What Are Indirect Costs?

Indirect costs are any expenses that companies incur that aren’t directly related to the production of goods and services. Some examples of indirect costs include indirect labor like wages for security and operational management, software costs, and administrative salaries.

What’s the Difference Between Fixed and Variable Costs?

Fixed and variable costs are two common types of costs incurred by companies. They can be direct or indirect, meaning they may or may not be related to the production of goods and services.

Fixed costs tend to remain the same regardless of whether production increases or decreases. Examples of fixed costs include rent and management salaries. Variable costs, on the other hand, fluctuate with production levels, so when production increases, variable costs follow suit. Conversely, if production drops, so too do variable costs. Some examples of variable costs include raw materials and hourly wages.

How Are Production Costs Determined?

Production costs must be directly related to the development and manufacturing of goods and services. As such, they are related to the generation of company revenue. Keep in mind that production costs can be direct and indirect. Production costs include raw materials, labor, and equipment costs among others.

The Bottom Line

There are different kinds of costs associated with the production of goods and services. These include direct and variable costs. Direct costs are directly related to production while variable costs fluctuate with production levels. Keep in mind that variable costs can be direct but not all direct costs have to be variable.