Direct vs Indirect Expenses Explained (With Examples)

If you’ve ever tried to figure out your taxes and found yourself staring at a pile of receipts wondering “does this one go here or there?” — you’re not alone. The distinction between direct and indirect expenses trips up a lot of product businesses, especially in those first few years.

But here’s the thing: getting this wrong doesn’t just cause confusion at tax time. It can mean you’re overclaiming some expenses, underclaiming others, or, perhaps most painfully, badly underpricing your products because you’re not accounting for costs correctly.

What are direct expenses for a product business?

Direct expenses are the costs that go directly into making your products: the raw materials and supplies consumed in your manufacturing process.

If you make what you sell, you’re not just a retailer. You’re also a manufacturer. That’s an important distinction because it changes how your expenses need to be classified and reported to the IRS.

Think of direct expenses this way: if you removed that cost from your process, you literally couldn’t make the product. The yarn a knitwear business uses. The wax and fragrance oils a candle producer melts together. The silver wire a jewellery manufacturer forms into rings. These are your direct expenses — they’re inseparable from the thing you’re producing.

Examples of direct expenses by product type:

You’ll notice these are all consumable: they’re used up completely when you include them in your manufacturing process. A bar of soap uses up lye and oils. A candle uses up wax and fragrance. Those materials cease to exist in their original form; they become something new that you sell.

Direct expenses are not claimed as regular expenses

Here’s where it gets important, and this is where a lot of product businesses get tripped up.

Direct expenses are not claimed as a straightforward business expense on your tax return. Instead, they’re treated as an inventory asset first, and only converted to a claimable expense when you actually sell the finished product.

This is a fundamental concept in inventory accounting: you’re not claiming the cost of materials when you buy them, you’re claiming them when you sell what you made with them. The technical term for this claimable amount is your Cost of Goods Sold (COGS).

If you bought $500 worth of soap-making materials in January and only sold products made from half of them by December, you can only claim $250 in direct expenses for that year. The other $250 remains as inventory on your books.

This is one reason claiming your materials as regular expenses is a really bad idea, as it distorts both your tax position and your actual profitability.

What are indirect expenses?

Indirect expenses are all the costs that support your business operations but aren’t physically incorporated into the products you make.

These are sometimes called “overhead”: the costs of running a business that happen regardless of how many products you produce. Even on a day when you don’t make a single item, your internet bill still comes in, your business insurance still applies, and your phone is still being used for customer enquiries.

Common indirect expenses for product businesses:

• Workspace costs: Rent, a portion of home utilities if you have a dedicated workspace, storage fees
• Equipment: Mixers, scales, looms, kilns, printers, the tools of your trade (these are often depreciated over time rather than fully expensed in one year)
• Technology: Ecommerce platform fees, inventory software subscriptions, website hosting, payment processing fees
• Marketing: Photography equipment, advertising costs, trade show booth fees, packaging design
• Professional services: Accountant fees, business insurance, bank charges
• Office supplies: Paper, postage, printer ink, consumables that support the business but don’t go into products

The key distinction: these costs are indirectly related to production. You couldn’t run your business without them, but they don’t physically become part of what you sell.

Why does this distinction matter at tax time?

The direct/indirect split determines which part of your Schedule C these expenses appear in, and when you can actually claim them.

Indirect expenses are claimed in the financial period they’re incurred. If you pay $600 for annual website hosting in January, you can claim that $600 as an expense for that tax year. Straightforward.

Direct expenses (as COGS) are claimed in the period when the products they went into are sold — which might be a different year entirely. This is the timing difference that catches many product businesses off guard.

On a Schedule C form, this looks like:

• Part III (Cost of Goods Sold): This is where your direct expenses eventually land, after being converted from inventory asset to Cost of Goods Sold. Part III works out the COGS figure across lines 35 to 42, and the total on line 42 carries up to line 4 in Part I, where it’s deducted from your revenue to give your gross profit.
• Part II (Expenses): This is where your indirect expenses sit: all those overhead costs that support the business.

Understanding this structure matters for two reasons. First, it affects your tax accuracy. Second, and just as importantly, it affects how you understand your own profitability. If you’re blending direct and indirect costs together in a spreadsheet without distinguishing them, your product pricing is almost certainly off.

For a deeper dive into the COGS side of things, our step-by-step COGS guide covers the full calculation in detail.

How do direct expenses become COGS?

The journey from “purchased materials” to “claimable expense” involves a few steps that follow the physical reality of your inventory.

When you buy materials, they enter your books as an inventory asset. You’ve spent money, but you haven’t yet incurred an expense in the accounting sense; you’ve exchanged cash for stock.

When you use those materials to make a product (this is the manufacturing stage), your raw material inventory decreases and your finished goods inventory increases.

When you sell the finished product, that’s when the cost converts to COGS and becomes a real expense on your books.

Let’s walk through a concrete example:

You make soy candles. In March, you buy:

• 5 kg of soy wax @ $12/kg = $60
• 100ml of fragrance oil @ $0.40/ml = $40
• 50 wicks @ $0.20 each = $10

Total materials purchased: $110

You make 25 candles in March and sell 18 of them by year end. The remaining 7 are still in your finished goods inventory.

Your COGS for those 25 candles = $110 (materials) ÷ 25 (units made) × 18 (units sold) = $79.20

The remaining $30.80 (representing 7 unsold candles) stays as inventory on your balance sheet. You’ll claim it as COGS when those candles sell, which might be next year.

This is why your pricing absolutely must account for your true material costs. Pricing without knowing your COGS isn’t pricing. It’s guessing.

What counts as a “mixed” expense?

Some costs sit in a grey zone. Packaging is a classic example.

A soap producer who uses plain kraft paper bags might consider those an indirect (packaging/supply) expense. But if you’re vacuum-sealing your soaps in branded shrink wrap that’s integral to the product presentation and preservation, it could reasonably be considered a direct cost.

The IRS guidance here is about whether the cost is “directly allocable” to your product. If you can trace a specific cost to a specific unit of product, it’s likely direct.

When in doubt, talk to your accountant, especially around higher-value items like specialised packaging, labels, or tooling that’s specific to certain product lines.

Equipment is another nuanced area. Your stand mixer for a soap business is an indirect cost: it’s a business asset that you’ll depreciate over time. But if you buy a mould specifically to produce a single product and that mould wears out after a certain number of uses, some of that cost could arguably be allocated directly to the products made.

Common mistakes product businesses make

Claiming materials as regular expenses

This is the most common one. It’s tempting to just log every supply purchase as a business expense and move on. But this creates a mismatch between when you spend money and when you sell products, meaning your reported profit (and tax) can be very wrong in any given year.

The right approach is to track materials as inventory first, then convert them to COGS when products sell. It’s more work upfront, but it gives you accurate numbers. For more on this, see why claiming your materials as expenses is a bad idea.

Mixing up indirect costs into COGS

The other direction is less common but equally problematic. If you’re including your marketplace fees, marketing costs, or shipping packaging as part of your “cost to make” each product, you’re inflating your COGS and potentially understating your indirect expenses.

COGS should reflect only what it costs to physically produce each unit: materials and, if applicable, direct labour for manufacturing.

Not tracking inventory at year end

Your COGS calculation depends on knowing your beginning and ending inventory values. If you can’t tell the IRS (or your accountant) what inventory you had at the start and end of the year, your COGS will be an estimate at best. Invest in a simple inventory system; even a basic spreadsheet is better than nothing, but dedicated inventory software makes this significantly easier.

How to track direct vs indirect expenses in your business

The practical answer depends on your current setup.

If you’re still on spreadsheets: Create separate tracking sheets for your material purchases (direct) and your overhead/operational expenses (indirect). When you make and sell products, calculate your COGS from the materials used. This works but requires discipline, and it gets unwieldy quickly as you add more products or materials to your range.

If you’re using accounting software like QuickBooks: Set up your chart of accounts to separate inventory purchases from regular expenses. QuickBooks Self-Employed, while popular with freelancers, isn’t well-suited to manufacturing because it doesn’t handle inventory asset tracking properly. QuickBooks Online handles this better, though it’s overkill for many sole proprietors. Our guide to QuickBooks for small manufacturers covers where it works and where it falls short.

If you’re using dedicated manufacturing software: Tools like Stocksmith handle the direct/indirect split automatically. You log your material purchases as inventory, build recipes for each product, and the system calculates your COGS as products sell. Your indirect expenses (subscriptions, fees, utilities) are tracked separately. At tax time, you pull a report rather than reconstructing everything from scratch.

The method matters less than the consistency. Pick a system and stick to it from the start of each financial year. Rebuilding your records at tax time is significantly harder, and more error-prone, than keeping them current.

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