Direct Costs vs. Indirect Costs.
What’s the Difference? Why Does it Matter?
The Farmcolony Board of Directors has been grappling recently with how to apply direct and indirect costs of farm operations. What is the difference between direct and indirect costs? Why does it matter?
The main difference between direct vs. indirect cost is that direct costs are costs that can be directly attributed to a specific product, service, or project while indirect costs are shared expenses that support overall business operations that cannot be linked to a single item.
- Direct costs: These are tied to individual activities. For example, if you’re a florist, the roses and tulips purchased for a wedding arrangement are direct costs.
- Indirect costs: Indirect costs, or overhead, are shared expenses supporting overall operations such as rent and utilities that don’t connect to any one task.
Direct costs are easily traced, while indirect costs are allocated.
How are direct and indirect costs determined?
Think of it this way. If the item can be repurposed, it is a shared expense that supports overall operations and is therefore an indirect cost of doing business. The building that currently houses the chickens, for example, is a common space that can be repurposed and used in other ways. The maintenance, operation and repair and improvement of the common areas of the farm are indirect costs of operation that are shared through yearly assessments. Since all lot owners have the right to use the general common elements, they all share the costs of maintaining them.
The cost for chicken feed, however, is attributed solely to chickens, which makes it a direct cost. If there were no chickens, there would be no expense for chicken feed.
Why does this matter?
While the indirect costs of maintenance, operation and repair and improvement of the common areas of the farm are shared through yearly assessments, the direct costs of operation, such as the direct cost of raising chickens for eggs, are reimbursed by those members who are purchasing the eggs “at cost” as specified in the Farmcolony Deed of Declaration.
Article V: General Covenants
Section 6b. Results of Operations. It is the intention of the Declarant that the Farm be and continue as an operating farm for the raising of livestock and produce for the use of the Owners. The results of operations shall be made equally available to all Owners at cost…the term “cost” is defined to include the direct costs of purchasing, feeding, raising, processing and slaughtering…
Technically, “at cost” means the amount of money needed to make or get something at an amount that yields no profit.
In other words, Indirect costs, usually considered overhead, are shared expenses paid through yearly assessments to support overall general operations while direct costs are shared among members who have opted to purchase the product at cost as specified in the Deed. The purchase price for eggs, for example, is set annually to cover the direct cost of the egg operation, making it budget-neutral to the association. According to the Declaration, the definition of “at cost” applies to beef, eggs and produce from the farm.
What happens if direct costs are ignored or incorrectly budgeted?
According to ChatGPT when prompted with this question (April 2025), attributing a direct cost as an indirect cost in a HOA leads to distorted financial reporting, inaccurate budgeting, and potential legal scrutiny. ChatGPT is an advanced AI chatbot developed by OpenAI.
According to ChatGPT, here is what happens when a misclassification occurs:
- Inaccurate Budgeting and Underfunded Reserves
Misleading Financial Health: If a major, specific repair is treated as a general recurring expense the board may underestimate the true cost of maintaining that asset leading to inadequate funding for reserve studies.
Budget shortfalls: Overspending on a direct project that is misclassified as an indirect administrative cost can drain operating funds, forcing the board to cut services or use funds meant for other purposes.
- Legal and Compliance Issues
Fiduciary Breach: HOA board members have a fiduciary duty to manage funds responsibly. Misallocating expenses can be seen as a failure to manage funds effectively.
Violation of Governing Documents/Statues: Many states require detailed financial reporting. Incorrect classification can violate these regulations.
Liability exposure: If homeowners discover that funds were mismanaged, it can lead to lawsuits against the board for breach of fiduciary duty.
- Operational and Financial consequences
Distorted Financial Statements: Misclassification masks the true cost of services causing inaccurate reporting in financial statements
Increased Audit Costs: During an audit, improperly allocating costs can lead to significant audit findings which can be costly and time-consuming to correct.
Loss of Credibility: When homeowners see fluctuating or unexplained numbers in financial reports, it reduces confidence in the board.
- Increases Need for Special Assessments
For any question as to what is a direct or an indirect cost of operation, industry guidelines are available to help clear up any confusion. The Greene County Extension Office is a local resource that can help the farm determine what is or is not a direct or indirect cost, if needed.
Why is this important?
Accurate accounting is important. Understanding the difference between direct and indirect costs isn’t just about bookkeeping. HOAs need to carefully track both direct and indirect costs to ensure responsible budgeting and clear financial records, which are essential for effective business management.