Direct costs are expenses that a company can easily associate to a specific item such as a product, department or project. This item could be a software or a piece of equipment or raw materials or it could be even a product (department or project) specific labour.
The direct cost for an item will help you with profitable product pricing. The direct cost will give you an idea of how much you must charge for your products and services. For example, you are charging 20 pounds for a microfiber cloth for wiping household items. You purchased 10 of these items wholesale for 5 pounds each. Without knowing the direct cost you will think your profit is 15 pounds.
You paid 10 pounds for packing and shipping these 20 microfiber cloth items wholesale. This 10 pound is a direct cost. This 10 pound can be associated with the specific microfiber cloth item which makes this cost a direct cost. You spent 5 pounds on marketing this specific microfiber cloth item. Since this 5 pounds can be mapped to this product it becomes another direct cost associated with the specific microfiber cloth item.
Your total direct cost is the sum of wholesale price i.e. 5 pounds + packing and shipping price i.e. 10 pounds + marketing price i.e. 5 pounds. Your direct cost associated with specific microfiber cloth item is 20.
Knowing the direct cost you can understand that your profit per unit sale is less than 15 pounds. You will also know how much more you must increase the selling price to attain the 15 pounds intended profit. Hence, the total direct cost helps to determine perfect pricing your selling items.
Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones, rent and utilities, accounting and payroll services, employee benefit and perk programs, Insurance costs, etc. Anything that cannot be directly mapped to products or services. Indirect cost is also important to determine the final cost of the selling item.
In order to more accurately include the indirect cost in the product pricing algorithm, you must try to understand the relationship this indirect cost has with regards to the product being sold. For example, let us say this wholesale item arrives at the nearby pickup facility along with other items and you pick these items from this facility and transport it to your local warehouse.
Renting this pickup facility costs your 5 pounds per hour. You paid 1 pound per gallon of fuel while picking up and transporting all these items. Now it becomes hard to map this 5 pound and 1 pound specifically to a single item. This is where you need to understand the relationship this indirect cost has with regards to the product being sold.
The easiest way is to take percentage proportion of the indirect cost. Say 10% of the items stored in the storage facility is microfiber cloth, then 10% of total storage facility rental can be mapped to the microfiber cloth. Now your indirect cost can be considered as direct cost which in turn could be used for pricing your product being sold.
When converting indirect cost to direct cost you need to make assumptions. These assumptions must be as close as possible to practicality of its application. If your assumptions deviate away from the reality then you end up in accurately determining the direct cost. Lets say any item under 100 grams are stored for free in your storage facility then 10% of storage facility rental cannot be taken as a valid assumption.
Sometimes indirect costs can get very hard to convert to direct cost. If you cannot accurately take an assumption then it is better not to try and convert indirect cost into a direct cost.
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