What Is An Indirect Cost?
Indirect cost is any cost that the firms cannot count for a particular business activity, project, service, or objective. Instead, this expense incurred helps achieve more than one business objective at a time, and hence it cannot be directly linked to any one particular cost object.
An indirect cost differs from a direct costDirect CostDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects., which is directly associated with production and is identified with a particular cost object of a business. The indirect expenses are fixed and not variable. Some examples of such costs are – salaries, rent, legal expenses, etc.
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- Indirect cost cannot be directly attributed to the expenditure made for producing goods and products. These are common or general expenses that affect the overall functioning of the business. It is a fixed cost that can’t be easily identified with one particular cost object.
- Some examples of such costs are office expenses, salary paid to administration, sales promotion expenses, security and supervision expenses, etc.
- Indirect costs are considered fixed as they do not change with the increase or decrease in the number of products to be manufactured.
- Calculating the indirect cost rate helps companies figure out how much they have spent covering the indirect expenses.
Indirect Cost Explained
Indirect cost is the money that firms use to build resources that are not concerned with serving one but multiple purposes simultaneously. It not only facilitates production but also impacts the overall business and operations. For example, if a firm takes a production unit on rent, it does not utilize it to make one particular product only. Instead, the firm uses this rented premise for everything from production to packaging and dispatching the items. Thus, the rent paid for the purpose becomes an indirect expenditure.
It differs from its direct counterpart, which involves money concerned with production. Plus, the amount spent increases with the increase in the volume of products manufactured. For example, the raw materials used for manufacturing ten units would be less than 20 units. Hence, the cost incurredCost IncurredIncurred Cost refers to an expense that a Company needs to pay in exchange for the usage of a service, product, or asset. This might include direct, indirect, production, operating, & distribution charges incurred for business operations. would be more for the 20 units. Therefore, the amount for buying raw materials with respect to the required quantity of products becomes the direct cost.
The indirect expenses, however, are not affected by the number of items to be manufactured or produced. This means, if the number of units to be produced in a rented premise increases, it won’t increase the rent amount to be paid. Thus, the indirect costs become fixed costs of the firms.
This is how the firms identify the indirect and direct costs for maintaining accurate accounts.
Indirect Costs Video Explanation
The indirect cost definition helps derive the following formula or equation to calculate the percentage of money that firms spend for covering indirect expenses:
Let us consider the following indirect cost examples to understand the concept better:
#1 – Conceptual Example
Let’s say, Company M pays a fixed rent of $5000 every month for a factory. However, if the company produces thousands of products within the factory, it would be impossible to identify each unit and attribute a portion of rent expenses. Moreover, no matter how much the factory produces, the rent doesn’t change, making it a fixed cost.
#2 – Calculation Example
Company C pays rent worth $2,000 for a production unit, $5,000 as salary to the workers and employees working in the firm, and has machinery worth $1,000 to manufacture goods. The total monthly sales record for the company is $40,000. In this case, the company can easily calculate the indirect cost rate using the abovementioned formula.
This shows that Company C spends 20% of its monthly sales on covering its indirect expenses.
Indirect Costs vs Overheads
Though the terms seem synonymous, there is a slight difference between them. Let us explore the minor differences:
- While indirect expense is a narrower term that includes a few types of such costs, overhead costs define these expenses on a broader horizon.
- Overheads are the costs without which the firms cannot run. However, the indirect costs may or may not be required, but they affect the business’s overall functioning.
- Indirect expenses are normally linked to the costs revolving around the production of the products, while overheads include costs associated with every aspect of a business.
Frequently Asked Questions (FAQs)
These are defined in the same way as described for the other fields, including a grant. These are the expenses that are not identifiable with any one particular cost object of an entity. For example, if a machine is taken on rent for manufacturing multiple products, the expense cannot be segmented for each product separately. This is what makes these common costs affect the overall business finances rather than impacting the production procedures alone.
Indirect and overhead costs are two different terms signifying the similar expenses that a company incurs. The indirect or overhead costs include all general expenditures a firm incurs to carry out multiple business functions. However, overhead costs are broader terms than indirect expenses.
These costs can easily be labeled as fixed costs. The fixed costs remain the same even if there is a change in the number of units produced. So, for example, if a piece of machinery can produce 100,000 finished products and a business pays paid $200,000 to buy it – it won’t matter how many units it produces using that machinery; the machinery cost would remain the same.
The same applies to indirect expenses. For example, if one takes a car on lease and pays a lump sum every month, they can use it as much as possible. The lessor will not see how much the resource would be used and how many times. This is because the servicing and maintenance become the lessee’s liability.
This has been a guide to what is an Indirect Cost. Here we explain its formula, calculation, examples, and differences with overhead costs. You may also learn more about accounting from the following articles –