Depreciation is a non-cash operating activity which is the result of wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.
The amount of depreciation needs to be calculated each year and is debited to Income statement like any other operating expenses. Depreciation expenses cumulatively rise over time and hit the cost less salvage value in the final year of useful life.
Overhead costs are residual costs after direct labor, direct expenses, and direct materials. Overhead costs are basically indirect costs. These cannot be directly traced back to the product and indirectly contributes to the value-added to the product. There are two types of overhead.
- Manufacturing overhead termed as factory overhead: These costs relate to the factory where production is taking place. Manufacturing overhead includes expenses as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, cost of security guard personnel.
- Non-manufacturing overhead termed as administrative overhead: These overheads relates to administration cost of the running factory. These are basically office expenses that get added to the product in the cost sheet. Non-manufacturing costs include expenses related to maintenance, printing and stationery, depreciation of non-manufacturing equipment like vehicles to sell and distribute the products.
Direct costs are easily traceable to a product and be connected to a specific cost object, which may be a product, department or project.
Direct costs can include materials of production as raw materials, paint for finishing product, and cost of labor skill in finishing the product. Labor and direct materials, which are used in creating a specific product, constitute the majority of direct costs.
For example, to make furniture, the direct costs are the cost of wood, the labor skill to make furniture and the paint works to complete it.
Direct costs vs indirect costs
Direct costs are easily traceable to the product. For example, a factory worker makes the product, so, direct labor is labor costs. Wood in the making of furniture attributes to direct material costs.
As can be seen, direct costs can be easily identified to product but not overheads. Overheads are indirectly related to the production and manufacturing of products.
Depreciation has to be decided on one to one basis as the use can differ and can link sometimes to units of production. Take an example of a logging machine where depreciation is computed according to the number of plants it cuts in the financial year.
This is however not a general case in business. Most of the business’ assets are not linked to units of production. For example, the milk tarnishing machines are just assets not linked to the production of milk. There is a rigid depreciation method here which is fixed.
The important thing is that in both the case, the input of assets cannot be visibly seen in the feature of the product.
Hence, depreciation expense is considered an indirect cost, since it is included in factory overhead and then allocated to the units manufactured during a reporting period
Direct Overhead can be defined as costs that are incurred during the production process, regardless of the output that the company produces. In other words, this is the cost that the company has to pay, regardless of the level of output they operate.
Unlike costs like Direct Material, which are variable and directly proportionate to the quantity that the company produces, it can be seen that this is the cost that cannot be termed as directly proportionate to the output produced. Therefore, it says fixed at a certain level of output.
Direct Overheads can be regarded as a manufacturing overhead, which is directly incurred during the production process, but cannot be specifically identified to a certain job.
This means that without this particular cost, the manufacturing or the production process could not have taken place, but, it cannot be identified to a certain product.
As seen earlier, it can be seen that indirect factory-related expenses, that are incurred during the production process.
Examples include electricity that is used in the production process or the depreciation that is charged on the machinery and other relevant equipment. Direct Overhead Costs are a subcategory of manufacturing overhead, and it can be seen that this particular cost is directly associated with the manufacturing process.
Without incurring this cost, the manufacturing process would not have taken place. For example, the manufacturing process cannot take place without electric cost. However, the process can still take place without the admin supervisor.
As per Accounting Laws, it can be seen that direct manufacturing direct overheads are applied to the product to arrive at a certain product cost. This product cost can then be calculated by adding other cost components, which include direct material, direct labor, and indirect overheads. The cost allocation is mostly done using cost drivers.
Direct Overhead must also be included in the
work-in-process inventory, and finished goods inventory in the manufacturing
account, as well as Cost of Sales in its Income Statement.
The overall process to record and calculate Direct Overheads is done by applying a rate of application to the costs, and then calculating the difference to see for under application for over-application.
Under applied or over applied fixed costs then need to be adjusted to record and show the actual amount of overhead that is incurred over the course of time.
Direct Overhead, therefore, can be best defined as a manufacturing overhead, which is incurred during the production process, regardless of the fact that this does not vary with the level of output, yet it can be seen that this particular cost is an extremely important component in the overall production process.
Direct Overheads and Direct Costs can be explained using the concept of direct material and indirect material.
The only difference between indirect material, and direct material, is the fact that direct material can be regarded as an upfront product cost, which can be traceable to an individual product, whereas indirect material cannot be traced to an individual product.
Indirect Labor Costs can be defined as costs that cannot be directly traced to an individual product. These are the costs that are incurred across the course of time, regardless of the output that the company is operating.
These are overheads that the company incurs, and therefore, they can be referred to as fixed costs. Given the fact that they are not attributable to any given product, they are therefore spread across products using an allocation basis, in case of a manufacturing concern.
In the cases where the main operations of the company relate to trading, it can be seen that these overheads are simply placed as other costs that are associated with the production process.
between Direct and Indirect Labor Costs
Direct Labor Costs are costs that are incurred during the manufacturing process, and therefore, these costs can also be directly traceable and attributable to a given product.
They are non-variable in nature. On the other hand, as far as Indirect Labor Costs are concerned, they are mainly fixed, regardless of output level the company is operating at. Therefore, these have to be spread evenly across products in the case where the company is a manufacturing concern and produces a single product.
An example of Indirect Labor Cost can be the salaries and wages for the labour force that is hired as administrators. Similarly, auditors, accountants, and human resource professionals all belong to the ancillary functions of the company.
Therefore, they cannot be associated with a particular product, as a result of which they are treated as indirect labour costs.
The accounting treatment of indirect labour costs is similar to the accounting treatment of direct labour, excluding one main difference.
The main difference is in the positioning and classification of this particular costing. In the case of direct labour costs, they are associated with Prime Costs and specific product costs.
On the other hand, indirect labour is mainly treated as an overhead expense, and in the case where they cannot be related or attributed to a single product, they are mainly treated as overheads in the income statement.
As far as relevant journal entries are concerned, indirect labour is an expense. By the nature of the account, it is debited, when the expense is incurred. On the contrary, credit entry involves making adjustments for payments (or accruals) that are made as a result of this expense. This is further illustrated below:
Debit – Indirect Labor Expenses
Credit – Payroll Payment Payable / Cash
Therefore, to summarize the points made earlier, it can be seen that indirect cost is mainly the cost that is associated with the running of the organization in a smooth manner.
As a matter of fact, it can be seen that regardless of the fact that it is a payroll cost, and ‘indirectly’ relates to the manufacturing process, yet it cannot be attributed to a single unit of product, as a result of which it is treated as an overhead.
Raw materials are the resources that are utilized by
the company to produce its goods and services for purposes of resale. Raw
Materials can broadly be categorized into two categories, which are direct
materials and indirect materials. As far as direct materials are concerned,
they are used within the final product. Without direct materials, the final
product which the company produces cannot be produced or subsequently sold. On
the other hand, it can be seen that indirect materials are mainly utilized across
the production process, but they are not directly involved with the production
process. In other words, they do not constitute as a major ingredient of the
Examples of direct raw materials constitute of cloth,
which is required to manufacture a certain suit. Indirect raw materials, in
this case can be the lubricant that is required to ensure smooth functioning of
the sewing machine.
Entry and Accounting Treatment
Raw Materials are recorded on the Balance Sheet as a
Current Asset. When raw materials are being recorded, a debit entry is
processed in the raw material inventory account (to record increasing assets).
Subsequently, to record the purchase of this inventory, a credit is made to the
accounts payable account, to account for increasing credit balances that the
company has to be make over the course of time.
When raw materials are used within the production
process, the accounting treatment varies according to the nature of the raw
materials that are utilized. In case of direct materials, the work in process
inventory account is debited to record that the inventory is currently being
utilized for production processes. Subsequently, the raw materials inventory
account is credited, to reflect that the inventory is no longer in stock.
However, this treatment is mostly carried out when the production process is
long, and spreads across a certain time frame. Subsequently, the production
process is completed, the work in process account is credited, and finished
goods inventory is debited.
On the other hand, it can be seen that if the
production process is short and brief, then the work in process step is
eliminated. Once the goods are sold, the cost of raw materials are then
recorded in the cost of goods sold account.
In the case of indirect raw materials, the overhead
account is debited, and raw materials inventory asset is credited. After the
end of the accounting period, the balance of overhead account is then allocated
to cost of goods sold and ending inventory.
To conclude, it can be seen that raw materials are
mainly inputs and materials that are required for the production process. As a
matter of fact, it can be seen that these inputs are required for the core
activity of the business, where goods and services are mainly produced for the
purpose of resale. Depending on their classification as direct or indirect raw
materials, they are subsequently treated to reflect their utilization in the
books. However, purchase of raw materials is different from purchase of other
goods and services, predominantly because of the reason that they are purchased
with the objective of being processed and manufactured for resale (in case of
direct raw materials).
Direct Labor Costs can be defined as payroll costs
that are incurred to manufacture a certain product. These are the costs that
can directly be traceable and attributable to a certain product. In other
words, direct labor can also be referred to as the wages that are paid to
employees and the payroll who work directly on a manufacture products and bring
them to a sellable condition. However, it can be seen that this is something
that is directly traceable and associated with the production process, and the
manufacturing that is carried out within the company. In this regard, this is
the outlining difference between direct and indirect labor costs.
Direct Labor Costs are mostly associated with products
that exist in a job costing environment. This is mainly relevant to situations
where the workers are expected to record the time spent on various working
jobs. Mostly, these costs are mainly concerned with the production process, and
therefore, they are variable in nature. Varying from industry to industry, they
are treated on a product basis (in a manufacturing concern), or a client basis
(in the service sector).
between Direct and Indirect Labor Costs
Labor Costs are categorized as direct and indirect labor
costs. The main difference between direct and indirect labor costs is the
underlying fact that direct labor can be directly attributed to a certain
product. On the other hand, it can be seen that indirect labor cannot be
directly attributed to any given product. In the same manner, direct labor is
expense that is incurred on payroll to manufacture the given goods and/or
services. On the other hand, indirect labor expense is incurred regardless of
the manufacturing status of the company.
An example of Direct Labor would be the wages and
salaries paid to workers who are working on the production line to create and
assemble a given product.
The Direct Labor Cost is classified as product cost,
inventory cost, prime cost or a conversion cost (in case of manufacturing
overhead allocation). Direct Labor Costs are added to the Work-in-Progress
Inventory, at the end of the relevant financial year. The journal entry that is
required to record this particular transaction is as follows:
Debit – Direct Labor Expense
Credit – Payroll Payable / Cash
This is because Direct Labor costs are expenses in
nature, and therefore, they are supposed to be treated as such. When they
increase, they are debited, and the relevant credit entry depends on whether
the payment has been made to these employees or not.
To summarize the points made above, it can be seen that Direct Labor Costs are costs that are directly associated with the manufacturing process. These are the costs that are easily be traced or identified to a certain product, and therefore, this can also be referred to as a product cost. The main rationale behind this distinction is to ensure that product costing can be made possible so that relevant margins can subsequently be created.
Manufacturing Overhead can be termed as a fixed cost that is incurred as a result of normal operations of the business. As a matter of fact, it can be seen that this cost is incurred as a result of the production and manufacturing process that is carried out as a normal course of the business.
Broadly speaking, it can further be seen that manufacturing overheads can be defined as fixed costs that are associated with the production process but cannot be individually identified to a certain product.
As far as direct manufacturing overheads are concerned, they can be defined as the manufacturing overheads that are directly incurred as a result of the manufacturing process.
On the other hand, indirect manufacturing overheads are incurred within the production facility, but they are not directly related to the manufacturing process. The common element between both types of overheads is the fact that they are not directly traceable to an individual product.
Therefore, the main difference between manufacturing overheads and indirect overhead costs is the fact that manufacturing overhead costs are directly associated with producing certain products that are being offered. On the other hand, indirect costs are cost are costs that the business incurs, regardless of the manufacturing process.
As far as Manufacturing Overheads are concerned, it can be seen that there are numerous different types of direct manufacturing overheads that are directly relevant to the production process.
For example, machinery maintenance and depreciation cost can be treated as a manufacturing direct overhead.
However, since it cannot be directly associated with a specific product, it has to be applied to a product using a certain cost driver. In the same manner, other manufacturing overheads include product inspection costs, quality supervisor salaries, factory management team, and safety and environment costs.
According to accounting principles, manufacturing overheads need to be included in the Work in Process inventory, as well as finished goods inventory on a manufacturers’ balance sheet.
This is predominantly because of the reason that this is something that is related to the manufacturing process, and therefore, this should be reflected in the product costing.
In order to treat, and subsequently record manufacturing overheads, there is a need to select the allocation base, which links overhead cost to the cost object.
The main rationale here is to spread the overall cost across the number of items produced, to spread them evenly, or more accurately. This can be done using any significant cost driver like direct materials used, or direct labor hours.
To conclude, it can be seen that manufacturing overheads are regarding as fixed costs that are incurred across the course of time, but cannot be individually traced to a specific particular product.
In this regard, it becomes rudimentary to ensure that specific cost drivers are utilized to spread the overheads across the number of items that are produced across a given production cycle. The main rationale behind deciding cost drivers changes from cost to cost.
For example, machinery repair and maintenance is going to be divided using the number of labor hours utilized.