Direct and Indirect Costing Definition

Direct and Indirect Costing Definition | Examples | Formula 2022

Direct and Indirect Costing Definition | Examples | Formula 2022:-

Direct costs are costs that can be identified easily as per the expenditure on cost objects. For example, if we pick how much expenditure a business has had on purchasing the raw goods inventory, we will be able to directly point out.

In the case of indirect costs, the challenge is that we can’t identify the costs as per the cost object. For example, if we try to understand how much rent is given for the sitting of the machinery in a place, we won’t be able to do it because the rent is paid for the entire space, not for a particular place.

What is Direct Costing?

Direct costs are expenses a company has that is directly related to the activities of a project or a department. Analyzing direct costs is an important activity because it helps managers understand if projects are profitable, if expenses are out of line for one department versus another, and if managing a project directly is more cost-effective than outsourcing it.

Being able to analyze the costs of each internal group is important, especially when budget cuts are necessary or when searching for ways to trim costs. By looking at each group, management can look for expenses that could be cut while having the least negative effect on company performance.

Types of Direct Costs

There are two basic ways that direct costs are used:

  • The first is in calculating the production costs of a product. The cost of goods sold (COGS) is the amount of all of the supplies used for creating a product, the labor costs from employees working on a product, the space required to create the product, packaging costs, utilities used in production, and equipment use. All of these amounts are added together to calculate what it costs to create a product. Understanding the cost of a product is vital in creating a sales price that is profitable and ensuring the product is making money, not losing money.

 

  • The second way that direct costs are used is in calculating the operating expenses of a department or division of a company. Direct costs that a department may sustain include payroll for department employees, office or workspace for the members of the team, training expenses, travel and entertainment costs incurred by a department, and any other expenses that are specifically associated with each department.

Examples of Direct Costs

Direct costs are costs related to a particular cost object. A cost object is an item for which costs are compiled, such as a product, sales region, person, or customer.

  • Direct materials
  • Sales commissions
  • Freight
  • Consumable supplies

There are very few direct costs since most costs are associated with overhead – that is, they cannot be precisely matched to a cost object.

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What is Indirect Costing?

An indirect cost is any cost not directly identified with a single, final cost objective, but identified with two or more final cost objectives or an intermediate cost objective. It is not subject to treatment as a direct cost. After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to the several cost objectives. An indirect cost shall not be allocated to a final cost objective if other costs incurred for the same purpose in like circumstances have been included as a direct cost of that or any other final cost objective.

Examples of Indirect Costs

  • Office expenses

  • Accounting and legal expenses

  • Administrative salaries

  • Rent

  • Telephone expenses

  • Security expenses

  • Utilities.

Difference Between Direct Cost and Indirect Cost

The key differences between these costs are as follows –

  • Direct cost is incurred on specific projects, units, departments, and objectives. Indirect cost, on the other hand, is incurred to provide multiple benefits to the business at large.
  • The direct cost can be identified easily as per the cost object. Indirect costs can’t be identified easily.
  • As you have seen, the aggregate of direct costs is called the prime costs in the cost sheet. The sum of indirect costs, on the other hand, is called the overheads in the cost sheet.
  • Direct cost is also labeled as the variable cost since it changes as per the unit consumed/produced. Indirect cost, on the other hand, is labeled as the fixed cost since it doesn’t change with the unit consumed/produced.

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