Understanding the concept of direct and indirect cost is very important from the viewpoint of assignment of various costs to a product or products (the cost objects). Most important terms for understanding and correct classification of the costs into direct and indirect is traceability. Cost traceability is nothing but a clear cause and effect relationship between the incurred costs and the cost object. Let us look at a detailed explanation with example.
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Direct costs are those costs which are incurred for producing a particular product and amount of expense is easily assignable to the product.
Example: The cost of the processor in a laptop manufacturing facility, producing two models X and Y, is a direct cost for the laptop. Why? It is explained by two things. One is the direct relation of the processor with the laptop. Every laptop uses one processor. Second is the traceability of the cost of the processor. Since one processor is used in a laptop, the cost of that processor can be completely assigned to the laptop. So, two checks are important for classifying any costs as a direct cost viz. relatedness and traceability.
Indirect costs are those costs which are related to the product but are not traceable in an economically feasible manner.
Example: Salary of a supervisor of the laptop manufacturing utility for producing X and Y model. Why? It is simple. The supervisor supervises X model of laptop and Y too. But, it is very difficult to say that how much cost should be assigned to X and Y and finding out that may not be economically feasible. Here, we can see the relatedness is there since the manufacturing of X laptop requires the supervision of the supervisor but the traceability is not there as it is very difficult to trace how much supervision is on which model of laptop. The cause and effect relation between the product say Model X and the supervision cost is not direct and clear.
Direct costs are assigned to product based the relationship between the costs and the cost object whereas indirect costs are allocated based on some logical base.
For finding exact costing of a product, it is always desirable to have most part of costs as direct costs. But such a scenario is not practically possible. There are two main factors which affect the classification of costs into direct and indirect.
If a particular cost is big in value, the cost incurred for tracing that cost may be affordable by the management. There is another reason for the higher amount of efforts put in for tracing the cost is that the impact on the final product cost would be very big if this big cost is assigned to products wrongly. So smaller the amount of cost, lower is its traceability.
Information Gathering Technology
The technology employed for tracing the costs is also very important because it becomes easy to trace costs with the help of improved technology. The big organization focuses a lot on the information and reporting systems. Therefore, they are able to trace even the smaller costs.