What is Indirect Cost? (Definition, Explanation, Types, and example)

Definition:

Indirect costs are those expenses that are incurred in common for different projects, products, or business activities and cannot be easily divided for individual projects, products, or activities. We also could say all the costs that could not be allocated to direct costs are indirect costs.

Indirect costs are also recorded in the company’s income statement like direct cost which is normally in the cost of goods sold while indirect costs are normally recorded in the general and administrative expenses.

Explanation:

From the definition, we can say that indirect costs can’t be directly proportionated to the cost object. These expenses are general and not associated with a specific product or activity.

Indirect costs are infeasible to allocate to each unit of product or service since these costs are used in multiple manufacturing activities and can’t be assigned to a single unit.

For example, a hospital can’t trace the utility bill back to a specific service or cost object because it will be used by all the hospital departments, hence it will be charged as a whole rather than charged to a specific department.

These costs are however attributed to each unit of accounting even after facing inherent difficulties through the following methods:

  • Fixed Cost Classification
  • Proportional Allocation
  • Activity-based Cost Allocation
  • Cost Rate Calculation

The nature of indirect costs is sometimes variable and sometimes fixed. Indirect variable cost is not directly related or traceable to each unit of the product but it varies as per the output, for e.g. electricity bill in the manufacturing industry.

Similarly, indirect fixed cost is not traceable or directly related to each unit of product and neither does it vary as per the output, for e.g. guard salary.

Indirect costs are also referred to as overheads, administrative costs, or facility costs. All these terminologies are synonymous and mostly used in the replacement of one another.

Indirect costs may be different for different industries. It is also possible that one type of cost within the same organization may be considered as a direct cost for one product while at the same time may be considered an indirect cost for another department or product.

Related article  Cost of Goods Sold for a Rental Property

Usually, management has very little control over indirect costs as compared to direct costs which can be minimized by efficient management.

Benefits of Costs Classification:

The classification of total costs into direct and indirect costs allows management to take important decisions to survive and grow in the era of cut-throat competition, by adopting different cost strategies.

This classification allows businesses to decide the price for any product or project using the broken down and classified information.

Common Types of Indirect Costs:

Common types of indirect costs are:

  • Salary & Wages & Fringe Benefits: Salaries of clerical and administrative staff, directors, and the manager who are not directly associated with the project or manufacturing or products are considered indirect costs.
  • Office supplies and other administrative supplies: Expenses of pens, pencils, cartage, staples, toner, and any other supplies which belong to the head office and are not directly related to the object cost are commonly considered indirect costs.
  • Travel Expenses: All those travel expenses which are not directly related to the product activity are commonly considered indirect expenses. In manufacturing concerns traveling of selling personnel maybe consider indirect costs for the product.
  • Premises Rent: Rent of premises for head office staff or factory staff is commonly considered an indirect cost.
  • Depreciation of Equipment: The depreciation costs charged are commonly considered indirect costs it is not directly associated with the project or units manufactured. The depreciation charge is allocated on a proportional base to each unit, making it an indirect cost.
  • Utility Expense: Utility expenses that may be used for the manufacturing of different products at the same time but cannot be associated with a specific product or service are commonly considered indirect costs.
Related article  Accounting for Finished Goods: Definition, Journal Entries and More

Journal Entries:

How do the indirect costs record in the company financial statements?

As we describe the types of indirect costs above, they are commonly general administrative expenses. Therefore, the double entries of indirect costs or indirect expenses in the income statement are the same as other expenses.

The entries are:

Dr Indirect Expenses (Cost)

Cr Cash/bank

For example, if the indirect cost is related to travel expenses in the amount of $1,000, then the entries are:

Dr Indirect Expenses (Cost) $1,000

Cr Cash/bank $1,000

What is indirect cost construction? 

Indirect construction costs are not directly associated with a specific construction activity but are necessary for the project’s overall completion. 

These expenses are usually not included in the direct costs of construction, but they still impact the project’s final cost.

Examples of indirect costs in construction may include:

  1. Overhead costs include administrative and support staff salaries, office rent, and utilities.
  2. Equipment maintenance and repair costs, including those for construction equipment and vehicles.
  3. Insurance, bonding, and other legal fees associated with the project.
  4. Safety costs such as safety inspections, safety equipment, and safety training.
  5. Temporary facilities and equipment, such as trailers, scaffolding, and cranes.

For example, if a construction company is building a new office building, the direct costs would include materials, labor, and equipment costs associated with the actual construction of the building. 

Indirect costs include expenses such as the salaries of the project manager and administrative staff, renting office space to manage the project, and insurance and legal fees.

Indirect costs are important to consider when estimating the total cost of a construction project. Accurately accounting for indirect costs helps to ensure that the project remains financially viable and profitable for the construction company.

What is a reasonable indirect cost rate?

A reasonable indirect cost rate can vary depending on a variety of factors, such as the type of construction project, the location, and the size of the construction company. 

Related article  Prime Costs: Definition, Formula, Explanation, and Example

Generally, a reasonable indirect cost rate falls within the range of 10% to 20% of the total direct costs of a project.

However, it is important to note that what is considered a reasonable indirect cost rate may vary based on the specific circumstances of a project. 

For example, a smaller construction company may have a higher indirect cost rate due to lower economies of scale, while a larger company may have a lower indirect cost rate due to greater efficiencies and cost-sharing opportunities.

In addition, certain types of construction projects may have higher or lower indirect cost rates depending on the specific requirements of the project.

For example, a project that involves significant safety or environmental concerns may require a higher level of indirect costs to ensure compliance with regulations.

Ultimately, determining a reasonable indirect cost rate requires careful analysis of the specific circumstances of a project and the construction company involved.

A qualified accountant or financial advisor can help a construction company calculate an appropriate indirect cost rate for their specific situation.

Are indirect costs also known as common costs?

Yes, indirect costs are also known as common costs. Both terms refer to expenses that are not directly associated with a specific construction activity or project but are necessary for the project’s overall completion. 

These expenses are shared across multiple projects or activities and are not directly traceable to a specific cost object or activity.

Common or indirect costs differ from direct costs, which are expenses specifically related to a particular project or activity and can be directly traced to that project. Direct costs include materials, labor, and equipment for a particular project.

Indirect or common costs include expenses such as rent, salaries of support staff, and utilities, which are shared across multiple projects or activities. These costs cannot be directly attributed to a specific project or activity, but they are still necessary for the overall completion of the work.