Depreciation is a non-cash operating activity resulting from wear and tear in the use of assets. Still, it has been quantified by using 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 the income statement like any other operating expense. Depreciation expenses cumulatively rise over time and 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 contribute to the product’s value-added. 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 are connected to a specific cost object, a product, department, or project. Direct costs can include production materials as raw materials, paint for finishing the product, and labor skill in finishing the product. Labor and direct materials used in creating a specific product constitute the majority of direct costs.
For example, to make furniture, the direct costs are 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 basis as the use can differ and sometimes link to production units. 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’s 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 that 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.