What is the difference between direct and indirect costs?

Direct costs can be distinctly identified and traced directly to a specific project, product, or service. This includes expenses such as materials and labor that are directly involved in the manufacturing or completion of that specific item or project. For example, if a company produces furniture, the wood used for making a specific chair would be considered a direct cost because it can be directly attributed to that chair's production.

On the other hand, indirect costs, often referred to as overhead, are expenses that are not directly traceable to a single project or product but are necessary for the overall functioning of the business. These include costs such as utilities, administrative salaries, and rent. These expenses support multiple projects and cannot be attributed to any single one outright.

This understanding is crucial for budgeting, cost analysis, and financial reporting, as it allows businesses to assess the true cost structure of their projects and allocate resources more effectively. Recognizing the distinction between these types of costs helps in pricing decisions, profitability analysis, and performance evaluations.