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.

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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.

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.
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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