What are Indirect Costs?
The indirect costs are usually those expenses of a business that are used by multiple activities and as such can’t be directly assigned to a specific cost object like manufacturing of a product, service delivery etc. Rather, they are required to operate the business as a whole. Further, it is important to recognize the costs so that it can be omitted from short term pricing decisions where the management intends to fix prices in such a way that the variable costs of production are met. An indirect can be either a fixed cost or a variable cost by nature. Examples of fixed nature of indirect costs are building temporary roads, transportation of labor to the working site etc., while examples of variable nature of indirect costs are payment of salaries, maintenance of records etc.
How to Calculate Indirect Costs
The indirect cost for any company can be computed by using the following three simple steps:
Step 1: Firstly, it is to be determined which input costs are indirect by nature for the manufacturing of a product or service delivery. Next, add up all these costs together to arrive at the total manufacturing overhead.
Step 2: Next, calculate all the administrative costs and general costs which can’t be directly allocated to the manufacturing of the product or service delivery. Now, add all these costs together to arrive at the total administrative overhead.
Step 3: Finally, add together the total manufacturing overhead and the total administrative overhead that will eventually give the total indirect cost of the production.
Let us consider a factory named XYZ Ltd that has the following information and from the below-furnished information, the total indirect cost of production has to be calculated.
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- Raw material cost: $300,000
- Labour wages: $150,000
- Depreciation – $5,000
- Repairs and maintenance – $50,000
- Office electricity expense – $10,000
- Salaries – $100,000
- Factory supplies – $3,000
- Accounting expense – $10,000
- Audit expense – $5,000
- Legal expense – $3,000
Now, the Total Indirect Manufacturing Overhead is calculated as below
- Total Indirect Manufacturing Overhead = Depreciation + Repairs and Maintenance + Office Electricity Expense + Salaries + Factory supplies
- Total Indirect Manufacturing Overhead = $5,000 + $50,000 + $10,000 + $100,000 + $3,000
- Total Indirect Manufacturing Overhead = $168,000
Again, the Total Indirect Administrative Overhead is calculated as below
- Total Indirect Administrative Overhead = Accounting Expense + Audit Expense + Legal Expense
- Total Indirect Administrative Overhead = $10,000 + $5,000 + $3,000
- Total Indirect Administrative Overhead = $18,000
Now, few of the expenses mentioned above is not included in the calculation of Total cost because they are direct cost by nature. Those excluded set of costs in the above cases comprise of raw material cost and labour wages.
Finally, the Total Indirect Cost can be calculated as below,
- Total Indirect Cost = Total Indirect Manufacturing Overhead + Total Indirect Administrative Overhead
- Total Indirect Cost = $168,000 + $18,000
- Total Indirect Cost = $186,000
Relevance and Uses of Indirect Costs
It can help the companies to make significant pricing decisions. Usually, an accountant will add all the overhead costs together and then allocate them out on the basis of per unit cost to compute the company’s overhead per product. This eventually helps a company to make sure that they are still making a profit on each unit, even after incorporating all the overhead costs. Ultimately, this becomes the foundation for the product pricing strategy prior to setting the desired profit margin. In the case of manufacturing companies, indirect material costs include items which are utilized for the production of the end product which again is not part of the finished goods inventory. Such items can be glue, plastic wrap, staples and tapes that are needed in a production process. Although indirect material costs may vary widely based on the nature of operations, it is important that these costs are included in the calculation of the overhead costs. The senior management should be cognizant of the true cost of production, taking into account all types of input costs required in the manufacturing process. Otherwise, the financial reporting and the subsequent analysis may end up to be inaccurate.
Another kind of indirect costs that make the production of a product possible but can’t be allocated to one particular product are classified as indirect labor costs. For instance, the salary of a production manager who manages the entire production process and not just one product line or the salary of an employee who manages the administrative offices of the company. Further, other examples of labor costs are the salaries and fees paid to the accountants, legal advisors, supervisors, and other support services personnel that make production possible. It is very important that senior management is knowledgeable about the administrative cost of running a company. However, such indirect can become too large and then impact the profit margins adversely, which results in downsizing or labor reallocation. It is of utmost importance to carefully evaluate indirect labor costs and analyze its impact on overhead costs to keep the businesses operating efficiently and effectively.
This has been a guide to Indirect Costs. Here we discussed the concept with examples, relevance and uses. You may also look at the following articles to learn more –
- Accrual Accounting vs Cash Accounting
- Accounting and Financial Management
- Distinguish Between Direct cost vs Indirect Cost
- Absolute Advantage vs Comparative Advantage
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