What is Indirect Cost?
Indirect cost is the cost that cannot be directly attributed to the production as these costs are incurred in general costs and can be fixed or variable in nature like the office expenses, salary paid to administration, sales promotion expense, security and supervision expense, etc.
It is a cost that can’t be easily identified for each cost objectCost ObjectA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. read more. For example, let’s say that the firm is buying machinery for producing toys for children in consideration of $50,000. Now, a firm decides to produce 1000 units in one month and 5000 units in the next month. Would it be possible to identify how much production cost of each unit is since the cost of machinery remains the same no matter how fewer or more the firm produces?
The answer is no because it isn’t easy to identify the cost of each unit produced.
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Indirect Cost Example
Let’s say that Company G hires an on-site supervisor for its plants. And the company decides to pay him $50,000 per year. His job would be to visit the plants on a regular basis and supervise whether the work is done properly or not. At the end of the month, he will find the discrepancies in the plants and provide recommendations to deal with them through a report.
- In this case, if we look at the cost incurredThe Cost 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. read more for the plants by the company, it would be the indirect cost because it’s impossible to tell how much time and effort the supervisor would invest in each plant.
- At the same time, if we look at the salary of the supervisor as a whole, it is the direct costDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more of the company; because the salary of the supervisor can easily be identified.
If we go deep, we would see the same scenario in the cases of fixed costs and variables costs as well.
We can take an example to illustrate this.
Let’s say that Company M pays a fixed rent of $5000 every month for a factory on rent. 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 into it. Moreover, no matter how much the factory produces, the rent doesn’t change.
Company M also rents 3 more factories at $4000, $6000, and $8000. And every month, Company M pays the rent for each factory. Since the payment each month doesn’t change, they can be called variable costs as well because the company will pay more if it rents for multiple months and less if it takes rent for a few months.
Indirect Cost vs. Fixed Costs
Fixed costs are the costs that don’t change with the number of units produced. For example, if a piece of machinery can produce 100,000 finished products and you have paid $200,000 to buy it – it won’t matter how many units you produce using that machinery; the cost of machinery would remain the same.
This is similar to indirect costs. For example, if you take a car on leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more and you pay a lump sum every month, then you can use it as much as you can. The lessorThe LessorA lessor is an individual or entity that leases out an asset such as land, house or machinery to another person or organization for a certain period.read more will not see how much you would use it (and how many times) since as a lessee, you are servicing and maintaining it, and also you are paying for it.
So, indirect costs can easily be labeled as indirect fixed costs.
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