Getting this distinction right affects your margin calculations, your pricing, and how accurately you understand product-level profitability.
Direct costs
Costs directly traceable to producing a specific product or delivering a specific service — raw materials, production labor, packaging for that specific item. These scale directly with how much you produce or sell.
Overhead (indirect) costs
Costs that support the business as a whole but aren’t tied to any single product — rent, administrative salaries, general insurance, software used across the business. These continue whether you sell one unit or a thousand.
Where the line gets blurry
The same expense category can be direct or indirect depending on context — rent for a dedicated production facility might be a direct cost, while rent for a general office is overhead. Classify based on whether the cost is tied to a specific product’s creation, not just the expense category name.
Why the distinction matters
Gross margin calculations should subtract direct costs only; overhead gets accounted for separately, further down the income statement. Mixing the two together muddies both your per-product margin numbers and your overall profitability picture.