⬟ What Are Direct Costs and Indirect Costs :
Direct costs are costs directly incurred in producing a specific product or delivering a specific service. They increase when production or delivery volume increases. Direct costs belong in cost of goods sold (COGS) and sit above the gross margin line. Examples of direct costs: raw materials and components, packaging materials, direct labour wages of workers who physically make the product or deliver the service, utilities directly tied to the production process, and outbound freight to deliver the product to the customer. Indirect costs support the business as a whole but are not tied to a specific unit of product or service delivery. They remain constant whether or not a particular product is made. Indirect costs are overheads and sit below the gross margin line. Examples of indirect costs: rent for office or showroom, management and administration salaries, marketing spend, accounting fees, insurance, general utilities not tied to production, and business travel for sales or management. The practical test: if the business produced one more unit, would this cost increase? If yes, it is direct. If the cost remains the same regardless, it is indirect.
A small MSME garments manufacturer in Tirupur, Tamil Nadu produces cotton T-shirts. Monthly revenue: Rs. 8.4 lakh. Incorrectly classified: Revenue minus fabric cost only = Rs. 3.36 lakh gross profit (40% margin). Tailor wages Rs. 1.2 lakh, thread and accessories Rs. 18,000, and sewing machine electricity Rs. 14,000 are sitting below the gross margin line as operating expenses. Correctly classified: COGS includes fabric, tailor wages, thread, and production electricity (Rs. 6.52 lakh). Gross profit: Rs. 1.88 lakh (22.4% margin). Operating overheads (rent, owner salary, accounting): Rs. 80,000. Net profit: Rs. 1.08 lakh. Net profit is nearly the same because total costs have not changed. But the gross margin has moved from a misleading 40% to the accurate 22.4%, and the COGS now correctly reflects the full cost of making each T-shirt.
⬟ Why Correct Cost Classification Directly Affects Pricing and Profitability Decisions :
Correct direct and indirect cost classification delivers three specific benefits. The first is an accurate gross margin as the correct basis for pricing. When direct costs are fully captured in COGS, the gross margin reflects what the business actually earns on each unit after paying the full cost of making or delivering it. This is the number to use when evaluating a negotiated order price, a new product launch, or a specific customer's profitability. The second is accurate product-level cost knowledge. When all direct costs are correctly captured, the total cost of making each product is known. This is the floor below which the business cannot price profitably. Without correct classification, the apparent cost floor is lower than the real one and the business may accept pricing that looks profitable but is actually loss-making. The third is better overhead visibility. When indirect costs are correctly separated, the total overhead burden is visible as a distinct number, and the owner can track whether overhead as a percentage of revenue is rising or falling.
A small MSME printing services company in Chennai, Tamil Nadu calculated gross margin as revenue minus paper and ink. The CA identified three additional direct costs: press operator wages, electricity consumed by printing machines, and courier cost for delivering print jobs. When moved to COGS, gross margin fell from 48% to 29%. The owner had used the 48% figure to evaluate purchasing a second printing machine. At 48%, the payback was 2.1 years. At 29%, it was 3.6 years, above the owner's investment threshold. The machine purchase was deferred. A small MSME chemical distributor in Surat, Gujarat treated all vehicle costs as overhead. The CA separated delivery vehicle costs tied to customer deliveries (direct) from management vehicle costs (indirect). The revised gross margin fell from 18% to 11.4%. Small-order customers requiring separate delivery trips were found to be unprofitable. Delivery surcharges were introduced for orders below Rs. 15,000.
For small MSME owners, correct cost classification is the first and most fundamental step in understanding true profitability. Without it, every margin calculation and pricing decision is based on a wrong number. For chartered accountants preparing MSME accounts, the cost classification review should be done at the initial accounting setup stage, not discovered years later when incorrect margin data has accumulated. For lenders reviewing MSME loan applications, a P&L with correctly classified direct costs and accurate gross margin signals higher financial management competence.
⬟ How Most Small MSMEs Currently Classify Costs :
Most small MSMEs classify costs in the order they are invoiced rather than by their economic nature. Raw material purchases are captured as COGS because the purchase invoice is directly associated with production. But direct labour wages appear below the gross margin line alongside all other salary costs, because payroll is processed as a single entry covering both production workers and administrative staff. The result is a gross margin in most small MSME P&Ls that is overstated. The owner sees a margin higher than the real one and makes pricing and product decisions on that basis.
⬟ How Cost Classification Practices Are Evolving for Small MSMEs :
Modern accounting software including Tally Prime and QuickBooks supports bill of materials and manufacturing journal entries that automatically include direct labour and overhead in the cost of finished goods. When used correctly, the cost of each unit includes all direct material, labour, and overhead components. GST-linked accounting has improved cost data accuracy at the line item level for many MSMEs, creating a natural basis for better direct cost tracking. CA firms increasingly provide clients with a standard chart of accounts that separates direct and indirect costs into correct P&L sections from the beginning, reducing the misclassification problem that accumulates when accounting is set up without a structured cost classification framework.
⬟ How to Classify Costs Correctly in a Typical Small MSME :
The starting point is the direct cost test for each P&L line: does this cost exist because a unit of product is being made or a service is being delivered, and does it increase with production or delivery volume? For a manufacturing MSME, typical direct costs are: raw materials and components, packaging materials, direct labour wages of production floor workers (not managers), production consumables, utilities directly tied to the production process, and outbound delivery freight. For a trading MSME, typical direct costs are: the purchase price of goods sold, inbound freight to the warehouse, and outbound freight to the customer. For a service MSME, typical direct costs are: wages and contractor fees of staff who directly deliver the service, materials consumed in service delivery, and third-party costs incurred specifically for a client engagement. Administration staff wages, management salaries, office rent, accounting fees, insurance, and general marketing are indirect costs for all three business types and belong below the gross margin line.
● Step-by-Step Process
List all cost lines from the last twelve months of P&L. Apply the direct cost test to each: does this cost exist because a specific unit of product is made or a service is delivered? For salary lines: split payroll between workers or staff whose time is directly in production or service delivery (direct labour, goes to COGS) and all others (indirect, stays in operating expenses). For utility bills: estimate the proportion used in production versus office. The production proportion is a direct cost. The office proportion is indirect. For freight and logistics: separate delivery costs incurred to fulfil customer orders (direct) from management and sales travel (indirect). For packaging: materials that are part of the product as sold are direct costs. Storage-only packing materials are indirect. Recalculate gross margin with the corrected COGS. Compare against the prior figure. A significant difference indicates pricing or product decisions made on the prior figure should be reviewed.
● Tools & Resources
In Tally Prime, the COGS section can include ledger groups for direct labour, direct utilities, and direct packaging in addition to raw material purchases. The CA can reconfigure the chart of accounts to place these correctly in one to two hours. In QuickBooks and Zoho Books, the income statement allows multiple cost categories in COGS beyond purchase cost. A standard direct-vs-indirect classification table for the specific business type, prepared by the CA as a reference document, helps the accounting team code new cost lines correctly going forward.
● Common Mistakes
Including only raw material purchase cost in COGS while leaving all other production costs below the gross margin line is the most common error in small MSME manufacturing. The gross margin appears higher than it should, and the overhead appears higher than it should, simultaneously, because the direct costs are sitting in the wrong section of the P&L. Every pricing and product decision made on this basis is built on wrong numbers. Treating all wages as a single below-the-line cost is the second mistake. A business with two production workers and three administrative staff may have all five salaries in one overhead line. Splitting payroll by function is the correction: production workers go to COGS, administration staff stay in operating expenses. Using a rough percentage to split shared utilities rather than a reasonable estimate based on actual use is the third mistake. A 50/50 split of an electricity bill between production and office may significantly understate the production component in a manufacturing business where machines run for eight to ten hours per day.
● Challenges and Limitations
Some costs are genuinely mixed and require judgment to split. A supervisor who works on the production floor and in the office, a vehicle used for deliveries and management travel, or utilities in a building where production and storage share space cannot be cleanly allocated. The approach is to estimate the split using the best available information: time records, kilometre logs, or metered sub-circuits. A reasonable estimate consistently applied is far better than treating the entire cost as indirect because the split is inconvenient. For small MSMEs with a simple chart of accounts recording all costs in five or six broad ledger groups, the accounting system may not support the line item separation that accurate classification requires. Improving the chart of accounts structure is the prerequisite for any reclassification exercise.
● Examples & Scenarios
A small MSME bakery in Hyderabad, Telangana treated all staff wages as a single operating expense. The CA reviewed the payroll: two bakers (direct labour), one delivery driver (direct, for customer order deliveries), one cashier and one manager (indirect). After moving baker wages (Rs. 42,000 per month) and the delivery driver's salary (Rs. 18,000 per month) to COGS, gross margin fell from 54% to 38%. The owner had been planning to launch two new product lines assuming 54% gross margin to absorb launch costs. At 38%, only one launch was financially viable. Correct classification prevented an undercosted product launch. A small MSME IT services company in Pune, Maharashtra treated all staff salaries as operating expenses. Three engineers spent 80% of their time on billable client work. The direct labour component (80% x combined salary Rs. 3.9 lakh = Rs. 3.12 lakh per month) was a direct cost. After reclassifying it to COGS, gross margin fell from 68% to 44%. The 44% was still healthy, but the 68% had been used to justify accepting a large fixed-price project now seen as underpriced at the corrected margin.
● Best Practices
Review the cost classification of every P&L line item with the CA once a year at the time of the annual accounts. The business changes: new cost lines appear, existing costs change their nature, and the classification that was correct two years ago may no longer be appropriate. Use the revised gross margin, after correct classification, as the basis for all pricing reviews. The floor price for any product or service should be based on the total direct cost per unit, not just the raw material cost. After a reclassification exercise, document the decisions in a one-page reference for the accounting team, showing how each cost category should be coded. This prevents misclassification from reappearing as new cost lines are added.
⬟ Disclaimer :
This content is intended for informational and educational purposes only and does not constitute professional accounting, financial, or tax advice. Cost classification practices described in this article are general guidance based on common accounting principles and MSME practices in India. Specific cost classification decisions depend on the nature of the business, industry practice, and accounting standards applicable to the business. MSME owners should consult a qualified chartered accountant for guidance specific to their business's cost structure and accounting requirements.
