COST ACCOUNTING; CONCEPT OF DIRECT AND INDIRECT COST
When you're determining the price of a product, it's obvious that you need to charge more than the total cost of producing it. But production costs go beyond the materials and equipment — you also need to factor in workers' salaries, marketing campaigns, overall company maintenance, and the like. Taken all together, these expenses make up the direct and indirect costs of running your business.
It is easy to classify the basic difference between direct and indirect costs. Direct costs are immediately associated with the production of a product or service, while indirect costs include such things as rent — which may be associated with many products — or they may be several steps back in the production process. Though it is tempting to ignore the nuances of this accounting principle, spending some time correctly allocating your costs can improve your accounting ledger — and your clout with potential investors.
Direct costs
Direct costs are expenses that a company can easily connect to a specific "cost object," which may be a product, department or project. This includes items such as software, equipment, labor and raw materials. If your company develops software and needs specific pregenerated assets such as purchased frameworks or development applications, those are direct costs.
Direct costs are expenses that a company can easily connect to a specific "cost object," which may be a product, department or project. This includes items such as software, equipment, labor and raw materials. If your company develops software and needs specific pregenerated assets such as purchased frameworks or development applications, those are direct costs.
Labor and direct materials, which are used in creating a specific product, constitute the majority of direct costs. For example, to create its product, an appliance maker requires steel, electronic components and other raw materials.
Companies typically track the cost of the finished raw materials as a direct cost. Two popular ways of tracking these costs include last in, first out (LIFO) or first in, first out (FIFO).
While salaries tend to be a fixed cost, direct costs are frequently variable. Variable expenses increase as additional units of a product or service are created, whereas an employee's salary remains constant throughout the year. For example, smartphone hardware is a direct, variable cost because its production depends on the number of units ordered.
Indirect costs
Indirect costs go beyond the costs associated with creating a particular product to include the price of maintaining the entire company. These overhead costs are the ones left over after direct costs have been computed, and are sometimes referred to as the "real" costs of doing business.
Indirect costs go beyond the costs associated with creating a particular product to include the price of maintaining the entire company. These overhead costs are the ones left over after direct costs have been computed, and are sometimes referred to as the "real" costs of doing business.
The materials and supplies needed for the company's day-to-day operations are examples ofindirect costs. These include items such as cleaning supplies, utilities, office equipment rental, desktop computers and cell phones. While these items contribute to the company as a whole, they are not assigned to the creation of any one service.
Indirect labor costs make the production of cost objects possible, but aren't assigned to a specific product. For example, clerical assistants who help maintain the office support the company as a whole instead of just one product line. Thus, their labor can be counted as an indirect cost.
Other common indirect costs include advertising and marketing, communication, "fringe benefits" such as an employee gym, and accounting and payroll services.
Other common indirect costs include advertising and marketing, communication, "fringe benefits" such as an employee gym, and accounting and payroll services.
Much like direct costs, indirect costs can be both fixed and variable. Fixed indirect costs include things like the rent paid for the building in which a company operates. Variable costs include the ever-changing costs of electricity and gas.
Classifying expenses
Organizing business expenses as either direct costs or indirect costs is a matter that goes beyond simple product pricing — it affects your tax payments, too. Overhead expenses such as the utilities needed to power equipment and the inventory needed to manage the office are tax-deductible. In some cases, even the costs of goods sold qualify for deductions. It can be tempting to misclassify direct costs as indirect, but this can get you in a lot of trouble if you're audited by the IRS.
Organizing business expenses as either direct costs or indirect costs is a matter that goes beyond simple product pricing — it affects your tax payments, too. Overhead expenses such as the utilities needed to power equipment and the inventory needed to manage the office are tax-deductible. In some cases, even the costs of goods sold qualify for deductions. It can be tempting to misclassify direct costs as indirect, but this can get you in a lot of trouble if you're audited by the IRS.
The relationship of direct & indirect costs with fixed & variable costs is a very crucial concept to understand for doing a real interpretation of costs in any manufacturing business. At the very outset, it should be clear that all costs can be classified into direct / indirect as well as fixed / variable. In brief, we can say that any cost be categorized under one of these categories viz. direct and variable, direct and fixed, indirect and variable, indirect and fixed.
Before moving towards understanding the above dual cost classification concepts, let us recapitulate the basic definitions of direct, indirect, variable and fixed costs
Direct costs are those costs which are related to the product and amount of expense is easily assignable / traceable to the product. These costs are assigned to the product based on cause and effect relationship.
Indirect costs are those costs which are related to the product but the amount of expense is not traceable in an economically feasible manner. These costs are allocated to the product based on the some reasonable basis.
Total variable cost is that cost which changes in proportion to the change in output like direct material costs. Per unit variable cost remains fixed.
Total fixed cost is that cost which does not change in proportion to the change in output like monthly salary cost of a supervisor. Per unit fixed cost is variable.
Now let us look at those dual cost classifications:
1. Direct and Variable: These are those costs which are related to the product, traceable and whose total cost change in proportion to the change in total output. This is very simple to understand and the best and simple example can be the direct material costs like tones of sand in preparation of tiles.
1. Direct and Variable: These are those costs which are related to the product, traceable and whose total cost change in proportion to the change in total output. This is very simple to understand and the best and simple example can be the direct material costs like tones of sand in preparation of tiles.
2. Direct and Fixed: These are those costs which are related to the product, traceable but whose total cost does not change in proportion to the change in output. It is little difficult to visualize. Example for such a cost can be the salary of supervisor of tile x in the factory where tile x and y are manufactured. Here we know that the cost is incurred because we are manufacturing tile x but this cost will not increase or decrease in tandem with the change in manufacturing output of tiles as its nature is fixed for a period.
3. Indirect and Variable: These are those costs which are not directly related to the product and therefore not traceable but whose total cost changes in proportion to the change in total output. For example, power cost at tiles factory where tile x and tile y is manufactured. Here, we know that the increase in output of any of the tiles – x or y will increase the power cost which makes it variable cost but at the same time the power cost cannot be easily allocated to tile x or tile y. It is very difficult to say how much power cost is incurred for tile x or tile y and hence it is an indirect cost.
4. Indirect and Fixed: These are those costs which are not directly related, traceable to product but whose total cost does not change in proportion to the change in the output. It is again a simple to visualize cost. Example can be salary of the supervisor who looks after the production of both tile x and tile y. Here, we can see that the salary cost is a fixed cost which would not change with the change in output of the tiles. But at the same time, it is difficult to say how much cost of his salary is because of tile x or tile y. Therefore the cost is an indirect cost.
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OVERHEADS
A manufacturing concern incurs different items of costs while converting raw materials into finished outputs. Such costs can be classified on different basis. One such basis is the directness of the costs to the product unit or identifications of costs with a particular product unit.For example, raw materials can be directly identified with the product unit, whereas consumable stores or cotton waste can not be directly identified with any product unit. On this basis, therefore, the cost can be classified into direct costs and indirect costs. Hence, the total cost of a product consists of direct and indirect costs. The direct portion of the total cost is known as prime costs and the indirect portion is called overheads. In fact overheads are the total of all indirect costs incurred in the production of outputs which must be taken into account while ascertaining the total cost of a product or job.
The overheads are the aggregate of all indirect costs such as indirect materials, indirect wages and other indirect expenses. They are also known as 'common costs or on costs. They are called common costs because they are common expenses incurred for different products and departments. Similarly, they are also known as 'on cost' as they are the costs over and above the prime cost or total of all direct costs. Overheads or indirect costs are incurred not just for a particular product unit or cost center, but for a number of cost units or cost centers. Therefore, they cannot be identified with a particular cost center or cost unit. Hence overheads should be appropriately apportioned to a number of cost units or cost centers, while determining the total cost of different products.
A manufacturing concern incurs different items of costs while converting raw materials into finished outputs. Such costs can be classified on different basis. One such basis is the directness of the costs to the product unit or identifications of costs with a particular product unit.For example, raw materials can be directly identified with the product unit, whereas consumable stores or cotton waste can not be directly identified with any product unit. On this basis, therefore, the cost can be classified into direct costs and indirect costs. Hence, the total cost of a product consists of direct and indirect costs. The direct portion of the total cost is known as prime costs and the indirect portion is called overheads. In fact overheads are the total of all indirect costs incurred in the production of outputs which must be taken into account while ascertaining the total cost of a product or job.
The overheads are the aggregate of all indirect costs such as indirect materials, indirect wages and other indirect expenses. They are also known as 'common costs or on costs. They are called common costs because they are common expenses incurred for different products and departments. Similarly, they are also known as 'on cost' as they are the costs over and above the prime cost or total of all direct costs. Overheads or indirect costs are incurred not just for a particular product unit or cost center, but for a number of cost units or cost centers. Therefore, they cannot be identified with a particular cost center or cost unit. Hence overheads should be appropriately apportioned to a number of cost units or cost centers, while determining the total cost of different products.
Classification Of Overheads
Overheads can be classified on different basis. The common basis of classifying overheads are as follows.
Overheads can be classified on different basis. The common basis of classifying overheads are as follows.
1.Classification Of Overheads Based On Function
* Manufacturing Overheads
* Non-manufacturing overheads
* Manufacturing Overheads
* Non-manufacturing overheads
2.Classification Of Overheads Based On Behavior
* Fixed Overheads
*Variable Overheads
* Semi-variable Overheads
* Semi-fixed Overhead
* Fixed Overheads
*Variable Overheads
* Semi-variable Overheads
* Semi-fixed Overhead
3. Classification Of Overheads Based On Elements
* Indirect Materials
* Indirect labor (Wages)
* Indirect Materials
* Indirect labor (Wages)
4. Classification Of Overheads Based On Control
* Controllable Overheads
* Uncontrollable Overheads
* Controllable Overheads
* Uncontrollable Overheads
Credit: BusinessNewsDaily
