A direct cost is an expense directly related to the production of a particular product or service. For instance, the cost of raw materials used for the creation of a product fall under this classification. The cost of administrative work in the company that produces the item, on the other hand, is not considered direct cost.
Direct costs can be further divided into three specific areas, namely, direct labor, direct materials, and direct expenses. Direct expenses are comprised of all expenses not classified as direct materials or labor.
Direct costs may fall under variable costs. However, this is not always the case. For example, to produce a cake, a baker needs to use a variety of ingredients. If the price of flour goes down or if the baker finds a less expensive supplier of ingredients, then the direct cost is also reduced. On the other hand, some franchise agreements require franchisees to purchase ingredients from an authorized supplier. In such a situation, the ingredients are sold at a flat rate and the direct cost is not as variable as in the first example.
In other situations, however, determining which costs fall under direct cost is harder. This are dependent on the type of project, as well as the culture of the particular business. A company needs to be consistent in categorizing the types of costs it incurs in order to come up with a relevant and reliable comparison of one business cycle with another.
Direct costs may also be referred to as hard costs. All other costs that do not fall under this classification are considered indirect costs.