What is Direct Cost of Sales?
Direct cost of sales, more commonly known as cost of goods sold (COGS), is the amount of cash that a company invests in the production of a good or service it sells.
Direct cost of sales doesn’t include rent, facility costs, or administrative expenses. On the other hand, they do include the following:
- Direct labor costs
- Utilities costs directly related to production
- Shipping costs
- Processing costs
- Commissions paid to sales personnel
- Advertising costs
Calculating Direct Cost of Sales
Direct cost of sales isn’t particularly hard to calculate. Every company’s income statement includes a COGS account, where sold inventory is listed. Inventory listed at the beginning of the year is what remains with the company from the previous year. Throughout the year, as new inventory is produced and services are rendered, the costs are added.
When the billing year ends, any unsold inventory is deducted from the inventory at the beginning of the year, plus the additional goods produced and services rendered. Once subtracted, the company gets its direct cost of sales for the year.
Labor and direct materials used to produce any product are direct costs of sales. For example, a woman is hired to work on the production of wooden craft boxes. She receives an hourly wage. The amount that she is paid for every hour she works is a direct cost of sales. The wood and metal hinges that make up the box are also direct costs of sales.
Direct costs are almost always variable because they are going to increase when more goods are produced. The primary exception to the rule is labor. Most employee wages are fixed and will not change over the course of the year. However, if employees work overtime to meet production needs, then the direct labor costs increase.
Direct Costs vs. Indirect Costs
From an accounting and budgeting standpoint, having accurately classified expenses is crucial. Direct and indirect costs, on the surface, seem pretty self-explanatory. However, there is a certain amount of nuance between the two.
Indirect costs are usually necessary for the production and distribution of a good or service, but they can’t be linked back directly to said good or service. They are a sort of prerequisite for a good or service to make it to production. On the other hand, direct costs are specific to a particular good and/or service that the company offers.
Having a firm understanding of the difference between direct and indirect costs is important because it shapes how a company attaches prices to the goods and services it offers. Knowing the actual costs of production enables the company to efficiently and competitively price its products.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: