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).
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 overhead 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.
Using Direct Costs and Indirect Costs in Pricing
At a minimum, direct costs should always be included in the derivation of a product’s price, since the established price must always equal or exceed its direct cost; otherwise, every sale will generate a loss. Pricing based just on direct costs makes the most sense in situations where there is an opportunity to sell a few extra units on a one-time sale with excess production capacity. Indirect costs should also be included in the derivation of a product’s price when setting long-term rates, where product sales must cover both direct and indirect costs.
Examples of Direct Costs and Indirect Costs
Examples of direct costs are direct labor, direct materials, commissions, piece rate wages, and manufacturing supplies. Examples of indirect costs are production supervision salaries, quality control costs, insurance, and depreciation.
November 15, 2018
This two-part series of articles has been abridged and adapted from the chapter “Analysis of Cost Behavior,” by Elizabeth A. Eccher, Jeffrey H. Kinrich, and James H. Rosberg, in the book Lost Profits Damages: Principles, Methods, and Applications, edited by Everett P. Harry III and Jeffrey H. Kinrich (Valuation Products and Services, 2017). In many lawsuits, a plaintiff may recover damages for lost profits. For a given time period, profit equals the
difference between sales revenues and the costs or expenses required to generate those revenues. When revenues are (wrongfully) diminished, costs are often reduced as well. Therefore, computing lost profits requires computing not only lost sales revenues, but also the resulting avoided costs that would have been required to generate those sales (also referred to as saved expenses or incremental costs). Think of it as a simple equation: Lost Profits = Lost Revenues – Avoided
Costs Although proper calculation of avoided costs is thus essential to calculating lost profits, it is not as straightforward as it may seem, and it often becomes a point of contention between damages experts. The higher the costs that can be attributed to a sale, the lower the profit from that sale. This can lead to disagreements between a defendant’s expert and a plaintiff’s regarding both the nature of the costs associated with lost sales and the amount of those costs.
In what follows, we lay out the basic concepts behind avoided costs and offer analytical guidelines as to their proper calculation.
Fundamental Cost Concepts
We begin with costs themselves, which are measures of resources used or foregone to achieve a particular objective. A cost object is something that a cost measures—it could be a physical object, a service, or an activity.
An example of a physical product that is a cost object is a bicycle. Costs associated with manufacturing and selling the bicycle would arise from acquisition or production of the bicycle’s components, labor used to assemble the components into a bicycle, distribution of the bicycle to retailers, and so on.
An example of a service that is a cost object is the customization of a database software package. Here, the relevant costs could include those associated with sales and marketing, developers’ time to do the required development work, and ongoing development to maintain and update the program.
An understanding of the different ways to classify costs is essential for an accurate calculation of avoided costs. We describe some of the basic distinctions below.
Variable, Fixed, and Semi-variable Costs
The first important dimension to consider is whether costs are variable or fixed. Variable costs vary with respect to changes in the underlying activity or volume/quantity. In the bicycle example, if each bicycle requires two pedals, and the company purchases each pedal for $3, the pedal cost is a variable cost of $6 per bicycle. This cost is variable because the total cost varies in constant proportion to the number of bicycles produced.
Fixed costs, by contrast, do not change in response to changes in the volume of activity over a specified time period or range of volume. Consider rent for factory space under a lease that requires a monthly payment of $2,000. Although the company’s production volume may fluctuate from one month to another, the rent remains a constant fixed cost of $2,000 per month.
Fixed costs, however, may not always remain fixed. A lease may expire, causing the rent to increase or decrease. Over a long enough period of time and a large enough change in volume, nearly every cost becomes variable. Thus, fixed costs are typically fixed for a limited period (e.g., the monthly rent can increase or decrease after the lease expires), and only over a relevant range of activity (e.g., a large change in production volume may require a change in production facilities or equipment).
Therefore, in assessing whether a cost is fixed, a critical consideration is “fixed with respect to a particular period and a relevant range of activity.” Costs that are fixed over a certain range but change outside that range are sometimes referred to as step costs.
Finally, the term semi-variable costs refers to those costs that have both a fixed and a variable component, for example a telephone service contract that charges an “access” cost of $10 per month that includes 300 minutes of connection time plus a usage cost of $0.05 for each minute beyond 300.
Direct and Indirect Costs
Another important distinction is between direct and indirect costs. Direct costs are those that can be traced in an economically feasible or cost-effective way to a particular cost object, whereas indirect costs cannot. Typically, companies record indirect costs in cost pools and then make allocations from these pools to calculate the full cost of a product or service.
Continuing with our bicycle example, the direct costs for the product include the pedals and other components that are purchased from outside vendors. The cost of each pedal is directly traceable to the cost object (the bicycle). By contrast, consider a production supervisor whose job entails oversight of a number of projects, one of which involves bicycles. The supervisor’s salary is an indirect cost that cannot be traced directly to the cost object (the bicycle) in a straightforward way. Such indirect costs have become a greater proportion of total product costs in recent years, making their analysis and estimation increasingly important.
Analysis of Cost Behavior
Why are these distinctions important? Why should they matter for the project of determining lost profits?
The answer is that, as a general rule, fixed costs should not be deducted from lost sales during the lost profits calculation. In a simplified case, only variable costs that change according to the volume of lost sales should be taken into account. Similarly, indirect costs that cannot be traced to the lost sales of a particular cost object should be excluded from the avoided costs calculation; only direct costs and those indirect costs that can be traced to lost sales of a particular cost object should be included as saved expenses. This is because, in many cases, traceable costs tend to behave as variable costs, whereas untraceable costs tend to behave as fixed costs.
To take a rather basic example, think of our bicycle manufacturer, which claims it has lost sales of a specific number of bicycles due to a competitor’s allegedly illegal actions. If the company does not purchase the pedals that would have gone into the manufacture of those bicycles, the cost of those pedals is a direct (traceable to the cost object of the bicycle) variable (with the number of bicycles that were not sold) cost, and hence an avoidable cost. By contrast, the rent on production space, which would have to be paid regardless of the disruption, is a fixed cost that is not avoidable. A portion of a production supervisor’s salary that cannot be traced to bicycle production in a straightforward way is an indirect cost that also may not be relevant for the saved expenses calculation.
Although this may sound straightforward, these distinctions are rarely so clear-cut when it comes to multifaceted, real-world businesses. In particular, the line between fixed and variable costs may prove especially complex in certain cases. Consider a business that has suffered a disruption and wants to argue that it would have significantly ramped up its production volume (and hence its profits) but for the disruption.
In this scenario, certain costs that would have been considered as fixed in the existing circumstances should be considered as variable in the “but for” world; examples could include increased rent for a larger factory space, or additional labor costs to meet the new production demands. These costs should now be considered step costs because the alteration in range has made a portion of the costs variable instead of fixed; this portion should now be considered as part of the avoided costs calculation.
The broader point is that the calculation of avoided costs is a complex task that requires a set of sophisticated tools in order to produce a plausible assessment in litigation.
Analyzing Avoided Costs: A Step-by-Step Methodology
As we have seen, a key cost question in a lost-profits analysis is: What incremental costs would the plaintiff have incurred to realize the additional sales revenues but for the unjust disruption to the business? The following steps are helpful in making this calculation:
- identify the cost objects (i.e., the products or services) comprising the lost sales;
- identify the resources involved in producing the product or service;
- identify the resources involved in selling and delivering the product or service;
- identify the cost data that are available for analysis;
- develop hypotheses about cost behaviors using the data and knowledge gathered from the steps above,;
- test these hypotheses; and
- develop conclusions, subject them to “sanity” checks, and revise conclusions as necessary.
We discuss and illustrate each step in Part Two of this series.
Elizabeth A. Eccher
A specialist in accounting, financial analysis,
and valuation, Dr. Eccher has served as an expert in commercial disputes involving the proper application of accounting principles. Her consulting experience includes interpretation and application of financial accounting standards and terminology, damages estimation for lost sales, cost analyses, business valuations, and financial analyses for transfer pricing. Dr. Eccher’s work has spanned such industries as computer software, biotechnology, automotive, financial services, agriculture, retail,
and utilities. Examples of her consulting work include calculating lost profits in breach of contract and unfair competition cases in the high-speed rail, software, and pharmaceuticals industries; analyzing complex transactions in tax litigation; and evaluating the materiality of financial statement disclosures in the financial services industry. Before joining Analysis Group, Dr. Eccher taught financial and managerial accounting at the Sloan School of Management, Massachusetts Institute of
Technology. Her research has been published in leading academic accounting journals.
Jeffrey H. Kinrich
Mr. Kinrich consults on cases involving financial and economic analysis, accounting, business valuation, statistics, and mathematical modeling. He has often testified on damages, valuation, and accounting issues in federal and state courts
and other dispute resolution forums. Over his 35-year career, Mr. Kinrich has directed numerous large-scale analyses involving a broad range of litigation areas. A certified public accountant, he specializes in damage quantification and valuation in the areas of commercial litigation and intellectual property. He also has significant experience in many other areas of the law, including breach of contract, construction, fraud, antitrust, business interruption, marital dissolution, dealership
disputes, and tax litigation. Mr. Kinrich has authored a number of publications on damages-related topics, and recently co-edited the book entitled Lost Profits Damages: Principles, Methods, and Applications. Before joining Analysis Group, he was with PricewaterhouseCoopers for 20 years.
James H. Rosberg
Dr. Rosberg specializes in
directing complex, data-driven analysis on projects requiring the application of financial and economic theory to address issues in both litigation and strategic contexts. He has substantial experience in securities, antitrust, and corporate governance litigation, particularly as it relates to Foreign Corrupt Practices Act (FCPA) cases. His recent case work has involved supporting leading experts in several major securities cases, ranging from investment suitability matters to disputes
surrounding mortgage-backed securities, as well as consulting on a number of high-profile antitrust cases. Dr. Rosberg has specific expertise in conducting cost accounting analysis for antitrust litigation and investigations, in which he analyzes companies’ variable costs and the use of managerial accounting data in pass-through analyses. He has also collaborated with experts in a wide variety of corporate governance cases, including matters involving the appropriateness and impact of board
decisions, whether boards have followed acceptable processes in their decision making, and whether corporate officers acted reasonably in specific circumstances. In addition, he has supported experts preparing testimony on the question of whether certain state owned enterprises constituted government instrumentalities as defined under the FCPA. Prior to joining Analysis Group, Dr. Rosberg was a consultant at The Parthenon Group and taught at Dartmouth and Boston College.