What is an Indirect Cost? Definition

A direct cost is a cost that is directly traceable to the production of goods and services…. More detailed definitions can be found in accounting textbooks or from an accounting professional. Understanding your costs will help you effectively price your products for optimal sales.

In construction, the costs of materials, labor, equipment, etc., and all directly involved efforts or expenses for the cost object are direct costs. Because these activities are easily traced to projects, their costs are usually charged to projects on an item-by-item basis. In theory, costs like heat, light, accounting and personnel might be charged directly if little meters could record minutes in a cross-cutting manner. Therefore, cost allocation plans or indirect cost rates are used to distribute those costs to benefiting revenue sources.

Indirect vs direct costs

Indirect costs incurred in manufacturing operations are known as manufacturing overhead, while indirect costs incurred in the general and administrative area are known as administrative overhead. One are the fixed indirect costs, which are unchanged for a particular project or company, like transportation of labor to the working site, building temporary roads, etc. The other are recurring indirect costs, which repeat for a particular company, like maintenance of records or the payment of salaries. In cases of government grants or other forms of external funding, identifying direct and indirect costs becomes extra important.

Most cost estimates are broken down into direct costs and indirect costs. A cost which can’t be directly traced to a particular department, activity or product within a company. Since they can’t be attributed to one area, these costs may be pooled and split between different departments. Examples can include utility bills, office rental payments and security costs. An indirect cost is money a business spends even when it’s not selling goods or delivering services.

• Indirect costs incurred in manufacturing operations are known as manufacturing overhead, while indirect costs incurred in the general and administrative area are known as administrative overhead.
• Often, such as when applying for funding under a grant, indirect costs are specified as a fixed percentage, this percentage having been negotiated in advance.
• Most cost estimates are broken down into direct costs and indirect costs.
• These fringe benefits are applied to direct salaries charged to projects either through a fringe benefit rate or as part of an overhead/indirect cost rate.

Additional guidance follows on how to obtain an approved indirect cost rate. You may see these costs mentioned in company reports, or even discussed by your own employer. Other examples of indirect costs can include telephone bills, legal costs, accounting expenses and IT charges. When a company accepts government funds, the funding agency may also have several strict mandates in place regarding the maximum indirect cost rate and which expenses qualify as indirect costs. Often, funding for a specific project will largely support direct costs.

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Direct costs are expenses that a company can easily connect to a specific “cost object,” which may be a product, department or project. It can also include labor, assuming the labor is specific to the product, department or project. Indirect costs are general business and administration expenses that aren’t directly linked to making products or delivering services.

Indirect costs are costs used by multiple activities, and which cannot therefore be assigned to specific cost objects. Examples of cost objects are products, services, geographical regions, distribution channels, and customers. Instead, indirect costs are needed to operate the business as a whole. It is useful to identify indirect costs, so that they can be excluded from short-term pricing decisions where management wants to set prices just above the variable costs of products. Indirect costs do not vary substantially within certain production volumes or other indicators of activities, and so are considered to be fixed costs. Examples of indirect costs are accounting and legal expenses, administrative salaries, office expenses, rent, security expenses, telephone expenses, and utilities.

What you need to know about indirect costs.

Note that if electricity is not used as primary source for production then electricity cost will be treated as utility and is always indirect. For example, if electricity is required to run the boiler which in turn generates steam, then electricity needs to be allocated directly. The same cost can be labeled as indirect in one industry and direct in another. For example, fuel cost in a telecom is usually allocated as an indirect cost, while for an airliner it is a direct cost.

• An indirect cost shall not be allocated to a final cost objective if other costs incurred for the same purpose in like circumstances have been included as a direct cost of that or any other final cost objective.
• Examples of cost objects are products, services, geographical regions, distribution channels, and customers.
• Labor costs, for example, can be indirect, as in the case of maintenance personnel and executive officers; or they can be direct, as in the case of project staff members.
• For example, to create a product, an appliance-maker requires steel, electronic components and other raw materials.

Grant rules are often strict about what constitutes a direct or an indirect cost and may allocate a specific amount of funding to each classification. The materials and supplies needed for a company’s day-to-day operations – such as computers, electricity and rent – are examples of indirect costs. While these items contribute to the company as a whole, they are not assigned to the creation of any one service. Direct costs represent the money that goes into creating and delivering products or services to customers. Indirect costs are all the other background expenses involved with running the business.

What is an indirect cost rate?

Understanding the difference between direct costs and indirect costs is a critical aspect of proper accounting. Tracking each type of cost separately can help small businesses understand their cash flow, price their items properly and attain the maximum allowable tax deductions. If you need assistance with breaking down your business’s expenses, contact a professional accountant or choose accounting software that can support your business.

Certain government agencies might allow you to explain why indirect costs should be funded, too, but the decision to grant funding is at their discretion. It’s important to know the difference between the types of costs because it gives you a greater understanding of your product or service, thus leading to more competitive pricing. In addition, when tracking direct and indirect costs, you will have a better grasp on your accounting and be better equipped to plan for the future. For-profit businesses also generally treat “fringe benefits,” including paid time off and the use of a company car, as indirect costs. An indirect cost rate is simply a device for determining fairly and expeditiously the proportion of general (non-direct) expenses that each project will bear.

These fringe benefits are applied to direct salaries charged to projects either through a fringe benefit rate or as part of an overhead/indirect cost rate. Therefore, fringe benefits treated as indirect costs should not be included as a direct cost in the “Personnel” category of the budget form of the grant application or on a contract proposal. In simpler terms, indirect costs are those costs not readily identified with a specific project or organizational activity but incurred for the joint benefit of both projects and other activities. Indirect costs are usually grouped into common pools and charged to benefiting objectives through an allocation process/indirect cost rate.

Consult your accountant or bookkeeper to see which costs qualify. It is possible to justify the handling of almost any kind of cost as either direct or indirect. Labor costs, for example, can be indirect, as in the case of maintenance personnel and executive officers; or they can be direct, as in the case of project staff members. Similarly, materials such as miscellaneous supplies purchased in bulk—pencils, pens, paper—are typically handled as indirect costs, while materials required for specific projects are charged as direct costs. Indirect costs include supplies, utilities, office equipment rental, desktop computers and cell phones.

Additionally, certain costs are tax-deductible, so properly tracking both direct and indirect costs can help you maximize deductions. Finally, if you ever apply for and receive a grant, there are several rules around the types of indirect costs and the maximum amount you can claim. Indirect costs are costs that are not directly accountable to a cost object (such as a particular project, facility, function or product). Like direct costs, indirect costs may be either fixed or variable.

While it’s relatively simple to pick apart all the direct costs that go into delivering products or services, indirect costs can sometimes be hidden. It’s important to identify them, understand them, and have a plan for funding them. You will need a sales and pricing strategy that can pay for everything. Often, such as when applying for funding under a grant, indirect costs are specified as a fixed percentage, this percentage having been negotiated in advance. This is the case, for example, in federally-funded research in the United States.

Indirect costs include administration, personnel and security costs. These are those costs which are not directly related to production. Some indirect costs may be overhead, but other overhead costs can be directly attributed to a project and are direct costs.

Indirect costs extend beyond the expenses you incur when creating a product; they include the costs involved with maintaining and running a company. These overhead costs are the ones left over after direct costs have been computed. Consider investing in top accounting software to track direct costs and record your expenses. Smartphone hardware, for example, is a direct, variable cost because its production depends on the number of units ordered. A notable exception is direct labor costs, which usually remain constant throughout the year. Typically, an employee’s wages do not increase or decrease in direct relation to the number of products produced.

What are the differences between direct and indirect costs?

It is the ratio between the total indirect costs of an applicant and some equitable direct cost base. Rather than applying to a particular department, indirect costs are generated by the wider business. A good example is heating costs, which often take the form of a single bill and can’t always be accurately traced to a single department. Heating bills may therefore be split between different departments, depending on the amount of space they occupy. As the name suggests, indirect costs are the opposite of direct costs, which are expenses that can be completely attributed to a specific department or business activity.