Updated July 29, 2023
Definition of Indirect Costs
The indirect costs are usually those expenses of a business that are used for multiple activities and 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.
Furthermore, recognizing the costs is crucial to exclude them from short-term pricing decisions where the management aims to set prices based on variable production costs. Indirect costs can be either fixed or variable costs. Examples of the fixed nature of indirect costs are building temporary roads, labor transportation to the working site, etc. In contrast, examples of the 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 determine which input costs are indirect by nature for manufacturing a product or service delivery. Next, combine all these costs to arrive at the total manufacturing overhead.
- Step 2: Next, calculate all the administrative and general costs that can’t be directly allocated to manufacturing the product or service delivery. Add all these costs together to arrive at the total administrative overhead.
- Step 3: Finally, add together the total manufacturing overhead and administrative overhead that will eventually give the total indirect cost of the production.
Example
Given below is the example mentioned:
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.
- Raw material cost: $300,000
- Labor 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 = $5,000 + $50,000 + $10,000 + $100,000 + $3,000
- Total Indirect Manufacturing Overhead = $168,000
Again, the Total Indirect Administrative Overhead is calculated below.
- Total Indirect Administrative Overhead = $10,000 + $5,000 + $3,000
- Total Indirect Administrative Overhead = $18,000
A few of the abovementioned expenses are not included in the Total cost calculation because they are direct costs. Those excluded costs in the above cases comprise raw material costs and labor wages.
Finally, the Total Indirect Cost can be calculated as below,
- Total Indirect Cost = $168,000 + $18,000
- Total Indirect Cost = $186,000
Relevance and Uses of Indirect Costs
- It can help companies to make significant pricing decisions. Usually, an accountant will add all the overhead costs and then allocate them based on the per-unit cost to compute the company’s overhead per product. This eventually helps a company ensure 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 before setting the desired profit margin. In the case of manufacturing companies, indirect material costs include items utilized for the production of the end product, which again is not part of the finished goods inventory. Such items can be glue, plastic wraps, staples, and tapes needed in production. Even though indirect material costs may vary widely depending on the nature of operations, it is crucial to include them when calculating overhead costs. Senior management should know the actual production cost, considering all input costs necessary in the manufacturing process. Otherwise, the financial reporting and the subsequent analysis may be inaccurate.
- Another kind of indirect cost that makes the production of a product possible but can’t be allocated to one particular product is classified as indirect labor costs. For instance, the salary of a production manager who manages the entire production process, not just one product line, or the salary of an employee who manages the company’s administrative offices. Additionally, salaries and fees paid to accountants, legal advisors, supervisors, and other support services personnel who contribute to making production possible are examples of labor costs. Senior management must be knowledgeable about the administrative cost of running a company. However, such indirect can become too large and impact the profit margins adversely, resulting in downsizing or labor reallocation. It is important to carefully evaluate indirect labor costs and analyze their impact on overhead costs to keep businesses operating efficiently and effectively.
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