Categorizing your business costs into direct expenses and indirect expenses is essential for tax purposes. But how do you know which is which? Let’s take a simplified look at the differences between the two and how to determine which category your expenses fall under.
Note: Under the Internal Revenue Service (IRS) 2025 Schedule C instructions, a small business taxpayer with average annual gross receipts of $31 million or less for the prior three tax years may not be required to account for inventory in the traditional way if it uses a permitted method that clearly reflects income.
What are direct expenses?
Direct expenses are costs linked to producing a specific good or service. These business expenses can be directly linked to a cost object (any item for which you measure expenses) and have a clear, identifiable connection to your business operations.
For example, imagine you open an Etsy shop selling homemade goods such as candles. In this instance, the cost of supplies such as containers, wax, a hot plate, wicks, or fragrances would be considered direct expenses. This is because these expenses can be directly attributed to the production of a specific product.
Cost of goods sold
Direct expenses are sometimes associated with the cost of goods sold (COGS), though the two terms aren’t interchangeable. COGS generally applies to businesses that produce, purchase, or sell goods, and is often used to help inform pricing.
What are indirect expenses?
In contrast, indirect expenses are not directly associated with a particular product or service. Indirect expenses are also sometimes referred to as overhead costs. These expenses are still necessary for your business to function successfully, but they often support multiple business operations rather than a single specific activity.
Costs, such as electricity, packaging, or license fees, are often treated as indirect expenses, but classification depends on whether the cost can be directly traced to a specific product or job.
What are some examples of direct costs?
Some common examples of direct expenses include the following:
Direct materials
Labor costs (such as wages for production staff)
Materials and supplies used to produce goods
Transportation costs
Other production costs directly tied to producing a product or delivering a service
Direct expenses are often variable because they tend to rise or fall with production volume, but some direct expenses may be considered fixed costs, depending on the business and the cost object being measured.
What are some examples of indirect costs?
The following are often considered to be indirect expenses necessary for running and maintaining your company:
Office supplies/office equipment and other related expenses
Rent
Business technology and software
Marketing expenses
Administrative costs (including salaries for administrative staff)
Business insurance and permits
Accounting and legal fees
Indirect expenses may be fixed, variable, or mixed. They support the business overall rather than being easily traced to a single product or service, and some indirect costs may need to be allocated under applicable tax or accounting rules.
How do I distinguish between direct and indirect expenses?
When determining whether a cost is a direct or indirect expense, ask yourself the following:
1. How is the cost associated with my business?
If the expense is directly linked to a specific good or service, it should be classified as a direct expense. If the cost supports your overall business operation but not a particular product, it’s an indirect expense.
2. What impact does the expense have on my profitability?
True to their name, direct expenses directly affect the cost of producing goods or delivering services, thereby affecting your profitability and cash flow. On the other hand, indirect expenses may not be easily traced to one specific product or service, but they still affect profitability and, in some cases, require allocation to products, jobs, or inventory.
The bottom line
Just remember that the key difference between direct expenses and indirect expenses is how they relate to the production or delivery of a specific good or service. If assigning a cost to a product, service, or business activity is easy, it’s likely a direct expense. If it supports the business more broadly, it’s generally an indirect expense.
This article is for informational purposes only and not legal or financial advice.
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