Direct and Indirect Costs - Essay Example

DIRECT AND INDIRECT COSTS …………………. College/ ………….. …………. Introduction Availability of accurate and right information about the costs incurred is extremely important to management, especially in today’s complex and changing business contexts, in order to take right decisions and to avoid losses and wastages and thus to increase business efficiency. The management and cost accounting departments would be able to make appropriate appraisal of the productivity and performance of employees and manufacturing activities only effective costing methods are used to analyze costs incurred. Costs are generally classified in to two, namely direct and indirect based on the traceability to the product. When it comes to cost accounting concepts, there are large numbers of different costs and a number of costing methods as well. Often, different costs like marginal cost, fixed cost etc are given greater emphasis in different costing methods like marginal costing, absorption costing etc. This piece of research paper attempts to identify and explain four real world examples of pure direct costs. This paper explains the examples where a direct cost may change to indirect cost or an indirect cost may become direct cost. Direct and Indirect Costs According to the traditional manufacturing system, the costs of producing a product or service can be broken down in to two, namely direct and indirect costs. Direct cost is the cost of a resource or activity that are acquired for or used by a single cost object, whereas indirect cost is the cost of a resource or activity that are not acquired to be used by more than one cost object. In simple words, direct costs are those costs that are fully attributable to a cost object, such as a product, a service or a department. Indirect costs are those costs that cannot directly be attributable to a product, service or department, even though such costs were incurred in producing these goods or services (factbusiness.com, 2010). Both direct and indirect costs can be assigned to cost object, but direct costs can be accurately traced to cost object whereas indirect costs cannot be accurately traced to cost object. Direct costs are accurately traced to cost object because they can be specifically and exclusively traced to a specific cost object (Accounting for management, 2011). Direct cost can be directly associated with changes in production volume. According to this definition, expenses are not parts of direct costs, and more over, since direct labor tends to be present even when production volume varies, there is a strong case that direct labor also cannot be a part of direct cost (Direct Costing, 2011). Direct costs comprise of direct material costs, direct wages or normally termed as direct labor costs and direct expenses. All these costs can be directly identified with a job, batch, product or service. In costs accounting concepts, direct cost is also termed as prime cost. Prime cost/ Direct cost= Direct material+ Direct labor + Direct expenses. Indirect costs are all those material costs, labor costs and expenses that cannot be directly identified with a job, batch, product or service. The three elements of indirect costs, namely indirect materials, indirect labor and indirect expenses are collectively known as Overheads. Out of the three components of the direct costs, both labor and expenses may not be as accurately traceable as materials can be (Peavler, 2011). Cost accountants and management accounting experts often find it difficult to attribute some costs and determining whether a labor cost or expense is direct or indirect is highly critical and difficult to take a decision based on them. At different circumstances, it is difficult to conclude whether a particular labor cost is direct or indirect, similarly whether a particular expense is direct or indirect. But, when it comes to materials, determining whether it is direct or indirect is relatively less critical due to that materials can be easily reflected in the finished goods or final outputs. Real-world examples of pure direct costs 1- Labor cost in a construction work, The labor costs of 80 labors who are working for constructing a 2 storied building for three months can be directly apportioned to that building. Exact numbers or volumes of materials used for the construction of the same building can be attributed directly to the final output, ie, building, and similarly, the total expenses of 80 labors for the whole time they have been working for can also be directly attributed to the building and therefore the labor cost in the construction work is an example of ‘pure direct cost’. Suppose, the building includes around 50 rooms, administrative office, conference hall, car parking area etc. It may be possible to directly attribute raw materials such as Cements, ceiling materials, furniture and bricks to each room, office space, hall, conference hall etc. This can be easily calculated by dividing the total material cost by the space or wall-space of each room or individual cost object. But, how about labor costs? Identifying accurate labor cost for each individual room, conference hall and other areas would be critical and they cannot be easily attributable. It’s because, labors normally work in groups. Attributing labor costs to individual cost object in a building is thus quite difficult and the management may find it very difficult to get an accurate calculation on it. Total labor cost can be easily identified and attributed to the whole building, but labor cost incurred for individual room, hall, car parking area etc cannot easily be attributable and traceable, and therefore they are less likely to be pure direct costs, though they are often treated as direct costs. 2- Salary of a person who works at a manufacturing machine, The salary of a person who works in a machine that manufactures a specific product can be considered to be a real world example for ‘pure direct cost’, Wages normally considered as direct costs (Accounting education, 2010), but it is not always possible to attribute wages to a particular cost object. If only one person works in the machine and that machine produces 100 products a day, it is easy to calculate the direct labor cost for each product, whereas if there are more workers in the same machine and they work as a group in the machine, it may not be very accurate to calculate direct labor cost for the final outputs. The labor cost of factory supervisor or manufacturing manager are normally considered as indirect labor costs. For the cost department, it is quite critical to decide whether the labor cost of factory supervisor is direct or indirect. For instance, when the factory supervisor works for a single section of the project, and the total output from that single section can be calculated, the salary or wages paid to the factory supervisor can be considered as direct labor cost. In some other cases, the factory supervisor’s work may be shared among different sections and his work cannot be easily traceable to any individual output, the cost will be considered as indirect labor cost. Both the above examples show that determining whether a cost is direct or indirect is solely depending on the circumstances. Factory Supervisor is some time an indirect labor cost and some time a direct labor cost. 3- Tool-hiring expenses, The hiring expenses of a tool can be an example of ‘pure direct cost’. For instance, a large manufacturing firm may require some specific tools required for the production and it may hire from outside. The hiring expenses to be paid for the tool can be easily and directly traceable to the products manufactured by the firm. Tool-hiring expense can be considered to be a direct expense only if it can be directly attributed to the cost object. If the firm hires the tool for the overall production process, it is not possible to attribute the tool-hiring expense to any particular cost object, but rather it is shared among all the production processes and is to be considered to be indirect expense. This also shows that an indirect cost becomes direct cost and a direct cost becomes an indirect cost in different circumstances. Tool-hiring expense is indirect cost if the tool is used for the production of various items. The tool hiring cost is therefore shared among many cost objects and is not attributable to any particular one. If the tool has been hired for the production of only one particular item, this can be considered to be an indirect cost as well. 4- A sales promotion program for selling a particular kind of goods, When a firm arranges a sales promotion program in order to promote selling, the expenses incurred for arranging the promotion program can be considered to be a real example of pure direct cost only if it has been incurred for selling a particular kind of goods. Advertising and sale promotion are normally regarded as indirect expenses, because, both these are carried out for the overall marketing benefits of the firm and the expense cannot be easily traceable to any specific cost object. A firm conducts a general sales promotion or advertising program. Both these can benefit the firm as a whole, and the benefits will be shared among all of its different kinds of products. So, these two are very evidently indirect expenses. It is very difficult to attribute the expense of advertising to any particular product or kind of products, but rather, the whole firm has benefited and all of its different products have shared the benefits. So, generally, both advertising and sales promotion are considered as indirect expenses. But, sales promotion and advertising expenses often become direct expenses, if these are conducted only for a very specific or kind of product and the firm as a whole does not benefit but rather only that particular kind of products benefits from conducting advertising and sales promotion. Conclusion All the above four examples have illustrated that there can be different circumstances for different costs, and accordingly the direct cost may become indirect cost and vice versa. The examples detailed above show that a cost is not merely direct or indirect, but they become direct or indirect according to different circumstances. Labor costs in a construction work is purely a direct cost because it can be attributed to the building as a whole, but it can be reckoned as indirect as well as labor cost cannot be accurately attributed to each room or space. This piece of research paper has described the cost accounting concepts of direct and indirect costs and detailed four different examples illustrating various circumstances that a direct cost may become indirect and vice versa. References Accounting education, 2010, Direct Labor cost example, accounting education, retrieved from http://www.svtuition.org/2010/08/direct-labor-cost-examples.html Accounting for management, 2011, Cost Classifications for Assigning Costs to Cost Objects (Direct and Indirect Cost), retrieved from http://www.accountingformanagement.com/Direct_costs_and_indirect_costs.htm Direct costing, 2011, Direct Costing Overview, Accountingtools.com, Retrieved from http://www.accountingtools.com/direct-costing Factbusiness.com, 2010, Cost Classification, Direct and Indirect costs, factbusiness.com, retrieved from http://factbusiness.com/business/cost-classification-direct-and-indirect-costs/ Peavler, R 2011, Direct and Indirect Costs and Their Effect on Pricing your Product, How to Include Direct and Indirect Costs When Pricing your Product, bizfinance.about.com, Retrieved from http://bizfinance.about.com/od/pricingyourproduct/a/Direct-And-Indirect-Costs-And-Their-Effect-On-Pricing-Your-Product.htm Read More