The identification and allocation of costs determine the profitability of the product or the organization as a whole.
The costs are classified basically into direct and indirect costs based on the cost’s traceability to the product.
When the expenditure can be identified and allocated to a particular product in a feasible way, it is called direct cost.
Contrary to this, those costs which cannot be tied to a particular cost center or cost object owing to the difficulty in tracing the cost, such costs are called 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 be it product or department is called direct cost. 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 and is direct material and falls under direct cost.
- Direct Labor: This is incurred on workers who are directly involved in developing a product or with a particular cost center. It includes pays to workers who are directly involved. For eg: Foreman’s pay.
- Direct expenses: It includes all other expenses 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 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 used in making wooden furniture.
- Indirect labor: Similar to indirect materials, these cannot be traceable or allocated in a feasible manner to a product. For example Security guard personnel of factories.
- Indirect expenses: All indirect costs other than indirect materials or indirect labor are called indirect expenses. It includes interest, tax, and cess, etc.
Now, we shall study in-depth about the differences between direct costs and indirect costs:
|Basis for Comparison||Direct Cost||Indirect Cost|
|Meaning||The cost which is 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 the 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 in nature however it is not necessary to be variable.||These are generally fixed in nature. It is not, however, necessary to be variable always.|