What are Indirect Costs?
Indirect costs or indirect expenses, are costs which cannot be traced directly to a particular cost object. The cost object is usually a product in the manufacturing industry, but can be any object to which the business is seeking to assign costs to such as a department, activity, project, customer, or geographic area. In schools, for example, the cost object might be students or a subject department, in the healthcare industry, the cost object might be a patient or medical department.
Allocation of Indirect Costs
If appropriate, indirect costs need to be allocated to the cost object using some predefined basis. For example a business with say four departments to which it assigns direct costs, might allocate a quarter of the indirect costs to each department, or as an alternative it might allocate the indirect costs in proportion to the direct costs assigned to a particular department.
Example of Indirect Costs
In a manufacturing business the materials and labor used to manufacture a product can be directly traced to the product (the cost object) and are therefore direct costs, on the other hand insurance and professional fees might not be attributable to the product directly and are therefore classified as indirect costs.
An example of indirect costs in healthcare industry might be the cost of utilities such has gas, electricity, and water which are for the benefit of the whole operation and not one department and cannot be traced to a cost object, such as the emergency department. On the other hand the cost of emergency room medical supplies would be classified as a direct cost, these costs are for the sole benefit of the emergency department and can be traced.
It can be seen that the decision as to whether a cost is indirect or direct depends on the definition of the cost object and therefore the type of business and the industry in which the business operates.
By differentiating between direct and indirect cost it is possible for a business to create budgets for a cost object (such as a department) and give responsibility for that budget to a manager. The manager will be held responsible for the direct costs (such as departmental wages) which they can control, but will have no responsibility for the indirect costs (such as insurance cover) over which they have little or no control.
For further information see the Wikipedia Indirect Cost definition.
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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.