alt="Bullet"/> Distinguishing between direct and indirect costs
This chapter provides the rules of the road for cost accounting. Use these basic terms and ideas to understand more complex topics later in the book. If you read another chapter and start to get lost, head back here and take a look at these concepts again.
Understanding the Big Four Terms
Direct costs, indirect costs, fixed costs, and variable costs are the four most important cost accounting terms … and these four terms can be confusing. The following sections outline a process for understanding the differences among these words. If you follow this process, you should be able to keep these important terms straight in your mind. Ready? Let’s go!
Comparing direct and indirect costs
Direct costs are costs you can trace (or tie) to your product or service. Indirect costs can’t be traced directly to the product or service. Instead, indirect costs are allocated. (Indirect costs are also referred to as overhead costs.)
Material and labor costs are good examples of direct costs. Say you manufacture cotton gloves. You buy cotton, yarn, and leather to make the gloves. You can trace the materials directly to the gloves; for example, you can take a glove apart and see the materials that were used to create it. Cotton, yarn, and leather are considered direct material costs, because they can be directly tied to one unit of product.
You pay workers to cut, sew, and dye the materials. Because you can trace the hourly labor cost directly to the gloves, these costs are direct labor costs. You can review each employee time sheet and determine how many hours each employee worked, and how many gloves he or she moved through production.
Indirect costs can’t be traced directly to a product or service. So instead, they have to be allocated. You typically allocate costs by assigning a cost per unit. The per-unit rate attaches all the indirect costs to your products. The term overhead is also used to describe indirect costs.
Allocating indirect costs
To allocate overhead, you need to compute a rate or amount of cost per product. Assume you lease the building where you manufacture the cotton gloves. Obviously, the reason you’re leasing the building is to make gloves.
You can’t trace the cost of the lease to any particular pair of gloves. The cost belongs to all the gloves, yet the cost does need to be included in the cost of a single unit of your product. That way, you can determine the price and profit for one unit (one glove).
One way to allocate overhead is to base it on some level of activity. As you see later in Chapter 5, activities in your business cause you to incur costs. Assume you run a machine for 1,000 hours a year and pay $2,000 for the repair and maintenance on the machine. You could allocate the repair cost to each hour of machine time as $2,000 ÷ 1,000 hours, or $2 per machine hour.
Deciding on direct versus indirect costs
As a business owner, you need to analyze all your costs and decide which ones are direct and which ones are indirect. One way to do that is to visualize your product. Look at that pair of gloves one more time. You can certainly picture the materials (cotton, yarn, and leather) used in a pair of gloves. Also, you can visualize a worker cutting the cotton and sewing it together.
That exercise should convince you that material and labor are direct costs. You can imagine those costs “traveling along” with the gloves as they are produced, packaged, and shipped to a customer. Okay, direct costs. Got it.
Working with direct costs in cost planning is preferable because direct costs are known. In the previous example, you defined material and labor costs as direct, because you can attach the costs directly to the product. If the costs are known, your planning is more precise. Actual costs are likely close to your planned amounts. Because indirect costs are based on estimates, your budgeted costs are less precise.
Next, you review your checkbook to find other costs. You find checks for vehicle insurance for a truck. Consider what you just read in the previous section. Insurance costs can’t be traced directly to the gloves, so you need to decide on an activity level to allocate the costs.
The truck’s insurance cost can be allocated based on the number of miles you drive the truck. Assume you compute an insurance allocation of $0.10 per mile. You now need to get the cost allocated to your product.
Instead of allocating the cost to individual pairs of gloves, you allocate costs to each shipment of gloves. When a customer orders gloves, they are packed up and shipped, using the truck. Based on the number of miles driven to a client, you can allocate the truck insurance cost.
Mulling over fixed and variable costs
Total fixed costs don’t change when your level of production or sales changes. On the other hand, total variable costs do change with the level of production or sales.
Kicking around fixed costs
Consider a lease payment for a piece of equipment. Whether your production increases or decreases, the check you write for the lease stays the same. The cost is fixed in your lease agreement.
Say the lease payment is $500 per month, and that you manufacture office desks. You can’t directly trace the lease payment to the product you produce — the cost is indirect. So you allocate the lease payment cost to each desk you produce. In March you produce 1,000 desks. The equipment lease is $500 ÷ 1,000 desks, or $0.50 per desk.
