The identification and allocation of costs determine the profitability of the product or the organization. The costs are classified into direct and indirect costs based on the cost’s traceability to the product.
It is called direct cost when the expenditure can be identified and feasibly allocated to a particular product.
Contrary to this, those costs that cannot be tied to a particular cost center or cost object owing to the difficulty in tracing the cost are indirect costs.
The two of these are explained below in a detailed manner:
The costs that can be directly attributed to a particular cost center or cost object of the product or department are called direct costs.
Direct costs are roughly divided into three types:
- Direct Material: The direct material can be directly traceable to a product. It includes raw material expenses. For example, wood bought for making furniture can be directly traceable as direct material and falls under direct cost.
- Direct Labor: This is incurred on workers directly involved in developing a product or with a particular cost center. It includes pay to workers who are directly involved. For eg: Foreman’s pay.
- Direct expenses include all other expenses other than direct material or direct labor that can be linked directly to the production of the product.
The combination of direct material, direct labor, and direct expenses is also called prime cost. The direct cost can be both variable and fixed.
The traditional thinking that direct costs are only variable is the wrong notion. For example, the salary of labor directly employed is fixed and can be traceable to a product.
The costs that cannot be directly traceable to a particular cost center or cost objects like a product or department are called indirect costs. The indirect cost is divided into the following categories:
- Indirect Materials: The materials that cannot be directly identified. For example, metal screws are used in making wooden furniture.
- Indirect labor: Similar to indirect materials, these cannot be traceable or allocated feasibly to a product, for example, security guard personnel of factories.
- Indirect expenses: All indirect costs other than indirect materials or labor are called indirect expenses. It includes interest, tax, cess, etc.
Now, we shall study in-depth the differences between direct costs and indirect costs:
|Basis for Comparison||Direct Cost||Indirect Cost|
|Meaning||The cost apportioned to a particular cost object is called direct cost.||The cost which cannot be directly apportioned to a particular cost object is called indirect cost.|
|The benefit to product(s)||Direct cost only benefits a single product or project.||Indirect cost benefits range of products.|
|Total of costs||The sum of direct material, direct labor, and direct expense is called direct cost. In other words, it is called prime costs.||The sum of indirect materials, indirect labor, and indirect expenses is an indirect cost. In other words, these are called overheads.|
|Traceability||These costs can be directly traceable to a product.||These costs cannot be directly traceable to the product.|
|Classification||Direct costs are divided into direct material, direct labor, and direct expenses||Indirect costs are divided into indirect materials, indirect labor, and indirect expenses.|
|Presentation in the cost sheet||It is computed at the beginning of the cost sheet.||It is determined after computing the direct costs.|
|Nature in General||These are generally variable however it is not necessary to be variable.||These are generally fixed in nature. It is not, however, necessary to be variable always.|