The essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. These costs are usually only classified as direct or indirect costs if they are for production activities, not for administrative activities (which are considered period costs).
Direct Cost is a price that can be completely attributed to the production of specific goods or services. Direct costs refer to materials, labor and expenses related to the production of a product. Other costs, such as depreciation or administrative expenses, are more difficult to assign to a specific product, and therefore are considered indirect costs.
Indirect cost is a cost that is not directly traceable to a cost object. Rather, the cost is common to several objects and requires an allocation.
For example, the depreciation of the factory building is an indirect cost of manufacturing products. The reason is that the annual cost of the factory building is not directly traceable to a specific unit of product manufactured during the year. The depreciation will be included in manufacturing overhead which is allocated to the units of product manufactured during the year.
The concept is critical when determining the cost of a specific product or activity, since direct costs are always used to compile the cost of something, while indirect costs may not be assigned to such a cost analysis. It can be too difficult to derive a cost-effective methodology for the assignment of indirect costs; the result is that many of these costs are considered part of corporate or production overhead, which will exist even if a specific product is not created or an activity does not occur.
Direct costs tend to be variable costs, while indirect costs are more likely to be either fixed costs or period costs.