Small businesses owner never think about how they want to track their costs. So their bookkeeper, their accounting software or a COA they downloaded from some website makes this decision for them. Software subscriptions gets thrown in cost of goods sold, production manager’s salary ends up in admin, and shipping costs go where ever the previous invoice was entered. It all adds up, so nobody cares.
Maybe the numbers add up, but the narrative they create lies. The allocation of costs between direct and indirect dictates gross margin, which in turn dictates pricing, defines which products are profitable, and puts your business in perspective with your competitors. Incorrect allocation of costs can make business raise prices that should have been increased, or continue producing goods that eat away at profit with every sale.
Direct costs can be directly connected to production of a particular product, service or project. Whereas indirect costs are required to keep the business running, but cannot be attributed to a particular sale. Seems easy enough, but small businesses struggle with proper cost allocation every day.
The misclassification I find most often in small business books is software and admin costs sitting in cost of goods sold. An agency puts its project management tool, accounting software, and office manager's salary into COGS because they felt like costs of doing the work.
Gross margin looks low, so the owner assumes delivery is inefficient and pushes the team harder, when the real delivery margin is fine. The opposite happens too, with subcontractors or client-specific travel coded as overhead, which makes projects look more profitable than they are. Clean up the classification before making any pricing decision.
Abhinav Gupta, CPA, CA, MBA · LinkedInWhat is a Direct Cost?
A direct cost can be specifically and exclusively traced to the production of a specific product or the delivery of a specific service. Direct costs change in proportion to production volume, make more units, incur more direct costs.
Examples of Direct Costs
| Business Type | Direct Cost Examples |
|---|---|
| Manufacturing | Raw materials, direct labour (assembly line workers), packaging, factory utilities directly tied to production |
| Restaurant | Food and beverage ingredients, kitchen labour, disposable packaging |
| Software / SaaS | Cloud hosting costs per customer, third-party API costs per transaction |
| Consulting / Professional Services | Billable staff hours, project-specific travel, subcontractor fees |
| Retail (e-commerce) | Product purchase cost (COGS), shipping per order, payment processing fees |
What is an Indirect Cost?
An indirect cost supports the overall business but cannot be directly attributed to a specific product or service. Indirect costs are often fixed or semi-fixed, they continue even when production is zero.
Examples of Indirect Costs
| Category | Examples |
|---|---|
| Administrative overheads | CEO/CFO/HR/admin salaries, office rent, utilities, office supplies |
| Sales and marketing | Advertising campaigns, CRM software, sales team salaries (not project-specific) |
| Technology / IT | General software licences, IT support, server costs not tied to specific customers |
| Finance costs | Accounting fees, bank charges, audit fees, insurance |
| Depreciation | Depreciation of general office equipment, vehicles not used in production |
Worked Example: Direct vs Indirect Cost Allocation
A marketing agency completes a client project:
| Item | Amount | Category |
|---|---|---|
| Project revenue | $50,000 | , |
| Designer hours (80 hrs × $75/hr) | $6,000 | Direct |
| Copywriter hours (40 hrs × $60/hr) | $2,400 | Direct |
| Freelance photographer (project-specific) | $1,500 | Direct |
| Total Direct Costs (COGS) | $9,900 | Direct |
| Gross Profit | $40,100 | = Revenue − Direct Costs |
| Gross Margin | 80.2% | = Gross Profit / Revenue |
| Monthly office rent (allocated to this project) | $3,000 | Indirect |
| Marketing software licences (monthly share) | $500 | Indirect |
| Admin salaries (allocated share) | $2,000 | Indirect |
| Total Indirect Costs | $5,500 | Indirect |
| Operating Profit | $34,600 | = Gross Profit − Indirect Costs |
The gross margin of 80.2% reflects only direct project costs. Once indirect overhead is allocated, operating profit drops to $34,600, still healthy, but the overhead load is visible.
Why Does the Classification Matter?
- Pricing: You must cover at minimum all direct costs plus a contribution margin that covers indirect costs and generates profit. If direct costs alone are priced correctly but indirect costs are ignored, the business is underpriced.
- Gross margin analysis: Gross profit only reflects direct costs. Two businesses with identical revenue can have very different gross margins if their direct cost structures differ.
- Cost control: Direct costs scale with revenue, they can be managed by pricing and volume. Indirect costs are overhead, they can only be controlled by renegotiating contracts, restructuring, or achieving economies of scale.
- Tax treatment: Some indirect costs are capitalisable (e.g., factory overhead for inventory under absorption costing); others are period expenses. Misclassification affects taxable income.
Getting the Classification Right
Start with a written rule: a cost is direct if it exists because of a specific product, service, or project, and indirect otherwise. Set up COGS accounts that match that rule, then review your chart of accounts for costs sitting in the wrong place. The most common problems are software, admin salaries, shipping, subcontractors, and payment fees.
For staff who split time between client work and internal work, use timesheets or a reasonable percentage to divide their cost between direct and indirect. Apply the same method every month, so gross margin trends reflect real changes instead of changes in how costs were coded.
How Profitjets Can Help Manage Direct and Indirect Costs
Correct cost classification is foundational to accurate financial reporting. Profitjets reviews your chart of accounts and expense categorisation to ensure gross margin reflects only true direct costs giving you an honest view of production efficiency and pricing power
Approximately 30% of new Profitjets clients have direct and indirect costs that need some reclassification at onboarding, with the cleanup often changing reported gross margin by 3 to 8 percentage points.”.
Book a free consultation and we will set the costing up properly.
FAQs
Is rent a direct or indirect cost?
Usually indirect. Office rent supports the whole business, not a specific product or project. Rent on a factory or production space is often treated as part of production overhead in COGS. Rent on space leased for a single contract or job can sometimes be treated as a direct cost of that job.
Are employee salaries direct or indirect costs?
It depends on what the employee does. Staff who make products or deliver client work are generally direct costs. Management, admin, HR, sales, and marketing staff are generally indirect. Employees who do both can have their cost split based on time spent.
Are shipping and payment processing fees direct costs?
Often, especially in ecommerce. Shipping to customers and fees charged on each sale can be traced to individual orders, so many businesses include them in COGS. What matters most is choosing a treatment and applying it consistently.
Can a cost be direct in one business and indirect in another?
Yes. Software is a direct cost for a SaaS company if it's used to deliver the product to customers, but indirect for an agency using it to run the office. Classification depends on how the cost relates to what each business sells.
Do indirect costs matter if they don't affect gross margin?
Very much. Indirect costs still have to be covered before the business makes a profit. A business with a strong gross margin can still lose money if overhead is too high. Track both gross margin and operating margin.
Written by
Abhinav Gupta, CPA, CA, MBA
Abhinav works with business owners across the US on industry-specific bookkeeping, from dental practices and restaurants to construction and e-commerce. He writes about what each trade's books actually need. Connect on LinkedIn
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