IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.
Depreciation expense is a non-cash operating activity which is the result of qualitative 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.
Depreciation is computed using various methods. Popular methods include the straight-line method and accelerated depreciation methods. The amount of depreciation needs to be calculated each year and is debited to Income statement like any other operating expenses.
Depreciation cumulatively rises over time and hits the cost less salvage value in the final year of useful life. The historical value of the asset is reduced by this accumulated depreciation so as to arrive at the written down value of the asset.
Written down value is computed after charging depreciation accumulated over the years to the initial cost i.e. historical cost.
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: This overhead relates to administration cost of running a 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 vs overheads
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.
Although depreciation has to be seen on case to case basis to decide whether it is direct cost or overhead, but a general parlance has been formed to classify it as overhead being part of factory overhead generally.
A Contrarian example would be turbine depreciation in the generation of electricity. This is the case of being directly related but is limited to only electricity or fewer industries.
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. This is as per general parlance in businesses around globally.