# 4 Direct and indirect costs

Cost can be divided into two broad categories: direct costs and indirect costs. This distinction is important and forms the basis of absorption costing. The following definitions are attributed to Horngren et al. (1999).

Direct costs are all costs that can be directly attributed to a cost object and that can be traced to it in an economically feasible (cost-effective) way. A cost object is defined as anything for which a separate measurement of costs is desired.

For instance, in an analysis of sales regions, the salaries, commissions and expenses of sales personnel working exclusively in one territory constitute direct costs of that territory.

Indirect costs are all costs that cannot be directly traced to a cost object in an economically feasible way. Indirect costs are allocated to the cost object using a cost allocation method.

The narrower a cost object is (e.g. a customer or a product line), the greater will be the proportion of costs that are indirect, whereas the more broadly based a cost object is (e.g. a sales territory), the greater will be the proportion of costs that can be traced directly to it. It should be noted, however, that direct costs can be fixed or variable in nature (as can indirect costs), so directness should not be linked in any general way with variable costs alone, whether in a marketing setting or in any other instance.

Horngren et al. (1999, p. 32) give the example of a tennis racket as a cost object. The cost of the carbon fibre used to make the racket is a direct cost because it can be easily traced to the racket. However, the cost of lighting in the factory where the racket is made will be an indirect cost. This is because, although lighting helped in the manufacture of the racket (the workers needed to see), it is not cost-effective to try to determine exactly how much lighting cost was used for a specific racket.

Whether a cost is direct or indirect depends on the cost object. Indirect costs are also known as overheads.

## Activity 4 Direct or indirect costs

Allow around 5 minutes for this activity

The following list shows typical costs for a customised sports car manufacturer. Decide whether the following costs are direct or indirect.

Select the correct answer in each instance.

a. component parts

direct cost
indirect cost

### Answer

a. Component parts are clearly a direct cost of production and are variable – double the output and you double the number of components used. Each component can be directly identified with a unit of output.

b. production labour

direct cost
indirect cost

### Answer

b. Similarly, production labour can be directly traced to particular products. However, it is important to recognise that, while the component parts are directly related to output and their costs are, in fact, variable, this is not necessarily the case with production labour. If the production line stops, the production operatives’ wages still have to be paid. However, this in no way changes the nature of these wages. They are a direct cost incurred making a particular product.

c. depreciation of manufacturing equipment

direct cost
indirect cost

### Answer

c. Depreciation of manufacturing equipment is an indirect production cost. Manufacturing equipment also depreciates, for example, through the passing of time or through obsolescence, as new, better equipment will come on to the market.

As you can see from these examples, it is necessary to remember that we are considering whether costs are direct or indirect relative to a particular product. Hence, component parts and production labour are directly linked to the particular product in contrast to depreciation, which is not so related.

## Activity 5 Direct or indirect costs – Nancy’s jewellery

Allow around 5 minutes for this activity

Nancy runs a design and assembly workshop for jewellery. She employs various craftspeople in her workshop. Classify the following costs as either direct or indirect (assume that the individual item of jewellery is the cost object).

Select the correct answer in each instance.

a) silver used in making necklaces, earrings and bracelets

direct cost
indirect cost

b) cost of electricity for smelting

direct cost
indirect cost

c) salary of workshop supervisor

direct cost
indirect cost

d) labour costs to shape and smelt jewellery

direct cost
indirect cost

OpenLearn - Fundamentals of cost accounting and environmental management accounting
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