Direct costs Vs indirect costs

Sometimes, direct costs are treated as indirect because tracing costs directly to the cost object is not cost effective. For example, the nails used to manufacture a particular desk can be identified specifically with the desk, but, because the cost is likely to be insignificant, the expense of tracing such items does not justify the possible benefits from calculating more accurate product costs.

The distinction between direct and indirect costs also depends on the cost object

A cost can be treated as direct for one cost object but indirect in respect of another. if the cost object is the cost of using different distribution channels, then the rental of warehouses and the salaries of storekeepers will be regarded as direct for each distribution channel. Also consider a supervisor's salary in a maintenance department of a manufacturing company. if the cost object is the maintenance department, then the salary is a direct cost. However, if the cost object is the product, both the warehouse rental and the salaries of the storekeepers and the supervisor will be an indirect cost because these costs cannot be specifically identified with the product.

 

Assigning direct costs to cost objects

 

Direct costs can be traced easily and accurately to a cost object. For example, where products are the cost object,

Direct costs in cost assignment

Direct costs

direct materials and labour used can be physically identified with the different products that an organization produces. Therefore it is a simple process to establish an information technology system that records the quantity and cost of direct labour and material resources used to produce specific products.

 

Assigning indirect costs to cost objects

 

In contrast, indirect costs cannot be traced to cost objects. Instead, an estimate must be made of the resources consumed by cost objects using cost allocation. A cost allocation is the process of assigning costs when a direct measure does not exist for the quantity of resources consumed by a particular cost object Cost allocations involve the use of surrogate rather than direct measures. 

Example

 

For example, consider an activity such as receiving incoming materials. Assuming that the cost of receiving materials is strongly influenced by the number of receipts then costs can be allocated to products (i.e. the cost object) based on the number of material receipts each product requires.

Prices raw materials in cost accounrting

If 20% of the total number of receipts for a period were required for a particular product then 20% of the total costs of receiving incoming materials would be allocated to that product.

Assuming that the product was discontinued, and not replaced, we would expect action to be taken to reduce the resources required for receiving materials by 20%.

in the above illustration the surrogate allocation measure is assumed to be a significant determinant of the cost of receiving incoming materials. You should note that only direct costs can be accurately assigned to cost objects.

The more direct costs that can be traced to a cost object, the more accurate is the cost assignment.