Segregating Costs: Direct vs. Indirect Costs

THOMAS BUTTROSS: One of several topics to cover when talking about basic cost concepts is the segregation of costs into direct and indirect costs. The learning objective is to understand and be able to use cost categories, which are segregations of costs that underlie managerial accounting. Be aware that these cost categories are fundamental and are used throughout the study of cost and managerial accounting.

One way to segregate costs is direct versus indirect costs, which is covered here. Another way is fixed versus variable cost, which is covered separately. A third way is the segregation of costs in financial accounting for financial reporting purposes by functional categories, such as separating rent expense from utilities expense from interest expense, which is not covered in managerial accounting.

An important point is that there are different segregations of the same cost for different purposes. Note that these categories are not mutually exclusive. For example, a direct cost can be fixed or variable, and an indirect cost can be fixed or variable.

These methods used to segregate costs apply to all kinds of organizations, as well as to individuals such as you. Any organization that incurs costs, whether it is in manufacturing, merchandising, service, not-for-profit, or government can segregate its costs. All organizations are likely to have some costs that are direct and some costs that are indirect with respect to a particular cost object.

Direct costs are costs that can be traced to one cost object and are material enough to be worthy of tracing. An indirect cost is a cost that cannot be traced to one cost object, meaning it belongs to more than one cost object. Or it belongs to one cost object, but it is not material enough to be worth tracing.

One way to understand direct versus indirect costs is to go through some examples. As you can see here, you have to first define the cost object. If we were talking about a product cost object, direct materials can be directly traced to the product. Each car has around 2,000 pounds of steel, a windshield, seats, and other various components. The direct labor can also be traced to the particular product. As they go down the assembly line, each car uses, say, 11 hours of direct labor.

Indirect costs would include most of the manufacturing overhead. For example, take the plant depreciation. You have to have a plant to build your product, but the plant depreciation cannot be traced to the particular units of product built. So it has to be allocated among the units. The same would be true of the utility bill for the plant, the janitorial services for sweeping the plant, and most of the other costs of operating the plant.

Now consider an accounting department cost object. The salaries of the accountants can be directly traced to the accounting department. The depreciation of computers and office equipment used solely by accountants can be traced to the accounting department.

However, what about the cost of human resources? After all, human resources personnel handle the hiring and termination of accountants, as well as take care of the accountants' employee benefits while employed. The cost of human resources, which also handles the non-accounting departments of the company, would have to be allocated among the various departments that benefit from the use of human resources.

What about the cost of the payroll department? The payroll department pays all the employees. And the cost of running the payroll department would have to be allocated among all the departments benefiting.

Finally, let's take customer. A customer cost object here, numbered as customer 21. We can trace the cost of goods sold to customer 21. That is, we know what merchandise was sold to customer 21. We can trace the shipping to customer 21, assuming we used an outside shipper. That is, we know how much we paid the shipper to take merchandise to customer 21.

The sales commission on sales to customer 21 are also direct. If we sold one million to customer 21 and paid 5% in commissions, the 50,000 sales commissions is clearly traceable to customer 21. Now what if the sales department individuals besides commissions get a salary?

Assume sales staff were paid 2,000 a month, and they called on various customers. So the person who called on customer 21 also called on 30 other customers during the year. We would have to allocate the base salary of the sales individual to the various customers who benefited. And most of the sales department overhead, like the depreciation of the equipment, used by the sales department, would also be indirect and require allocation.

Returning to the shipping example, it would not be direct if the company used its own internal delivery trucks that delivered something to customer 21, and then continued down the highway and delivered something to customer 22. Then delivery expense would be an indirect cost.

The cost object is a key. That is you have to define the cost object before you can determine whether a cost is direct or indirect because you have to ask yourself, direct or indirect with respect to what. The cost that is direct with respect to one cost object can actually be indirect with respect to a different cost object. So you can't just memorize the handling of a particular cost. For example, it is incorrect to make a statement like, "The depreciation of the plant is always indirect."

Let's take a product example, the salary of the plant manager. If the cost object is the plant, then the salary of the plant manager is directly traceable to the cost object. If the cost object is one of several products made in the plant, and the plant manager oversees the entire plant, the plant manager is indirect with respect to the individual products. And the salary would have to be allocated among them, if you choose to allocate the salary. What if the plant makes only one product? If the plant makes only one product, the salary of the plant manager would be directly traceable to that product.

Now, take a service example, the salary of an accountant. If the cost object is the accounting department, that is you're trying to keep track of the cost of running your accounting department, the salary of an accountant is directly traceable. If you're trying to determine the cost of having a human resources department, human resources does need the accounts to keep the financial records involving human resource salaries and other human resource department costs, you cannot trace the accountant's salary to the human resources department. A certain amount of the accountant's salary could be allocated to running the human resources department.

Put another way. If you close down, that is outsource human resources, at least in theory, there would be a little less accounting to do. And as you outsource departments, you might be able to reduce the number of accounts you need. Again, do not just memorize. Review the particular situation. If you have an accountant whose only job is to keep records for human resources, that accountant's salary would be directly traceable to the human resources department.

Here's an opportunity for you to make sure you understand direct versus indirect costs. Classify each of the following costs with respect to a purchasing department cost object. That is, you want to determine the cost of running the purchasing department.

The purchasing department has its own building. Is depreciation on the building direct or indirect? Pause the recorded presentation until you have a solution. If you say direct, you are correct. Because purchasing has the entire building, all of the depreciation is directly traceable to purchasing.

Purchasing has several purchasing agents. Is the salary of a purchasing agent direct or indirect? Pause the recorded presentation, until you have a solution. If you say direct, you are correct. Because a purchasing agent works full time in the purchasing department, the agent's salary is directly traceable to purchasing.

What about office building utilities, where purchasing uses approximately 10% of the building space? Pause the presentation, until you have a solution. If you said indirect, you are correct. In this case, the utilities benefit the entire building, which includes other departments.

You might say because purchasing is 10% of the space, they surely used 10% of the utilities, so you can trace it. Well, you don't know how much purchasing really uses. Maybe the people in the other 90% of the building like it cooler, and turn their air conditioning down more. Or maybe the purchasing people work later than everyone else and, therefore, have their lights on more and use more than 10% of the electricity.

In all likelihood, one would allocate to purchasing 10% of the utility bill, based on the square footage used by purchasing. While allocating based on square footage is a normal way to allocate utilities, never forget that it is still an allocation. This is the end of the discussion of direct versus indirect cost.