Definition – Direct Cost
The cost which is directly attributable/traceable/chargeable to a specific product or service is called direct cost.
definition – Indirect Cost
The cost which cannot be directly attributable/traceable/chargeable to a specific product or service is called indirect cost.
Calculation of unit cost
A business needs to calculate the cost of its unit to set a selling price. A trading business can easily calculate the cost of a unit as it has to include only the purchase cost and transportation cost in the cost unit. On the other hand, a manufacturing business finds it difficult to calculate the unit cost because there are a large number of expenses from the purchase of raw material to the completion of the ultimate finished product.
For example, a manufacturing business pays for the material purchase, transportation cost to the factory, wages and salaries cost, rent of factory, light and heat, etc. So, it requires a systematic approach to formulate the cost per unit. For this purpose, a manufacturing business splits the total production cost into direct and indirect costs.
Production cost is split into three categories. These are:
- Direct and Indirect Material Cost
- Direct and Indirect Labour Cost
- Direct and Indirect Expenses
The direct cost (direct material, direct labour and direct expense) of a business is collectively called prime cost.
The indirect costs (indirect material, indirect labour and indirect expenses) of a business are collectively called production overheads.
Flowchart – Direct Cost vs Indirect Cost
Let us explain each type of direct and indirect cost of a business in detail.
Direct Materials Cost vs Indirect Materials Cost
Material cost can be split into direct material cost and indirect material cost. If the material cost can be directly traceable to a specific product, it is the direct material cost, otherwise, it is regarded as an indirect material cost.
Let us take an example of a publishing house which is publishing books. In a particular period, they have published 50 books. Two types of materials are used in the production of books, Paper and Glue. If we are asked to calculate the cost of paper per book, we can easily determine it by counting the number of pages used in the book and multiplying it by the cost per paper. So, the cost of paper is a direct material cost as it can be directly traceable to each book.
However, if we are asked to calculate the cost of glue per book, we cannot conveniently calculate it as we do not know the exact amount of glue used in a book. But if we know that the purchase cost of a pack of glue was $100 and we used it in the production of 50 books, we can distribute this cost over 50 books giving a glue cost of $2 per book. This is an example of indirect cost as we cannot directly trace this to a particular book.
Direct Labour Cost vs Indirect Labour Cost
Labour cost is also divided into direct labour cost and indirect labour cost. If the cost of labour is directly traceable to a specific product, it is a direct labour cost, otherwise, it is regarded as an indirect labour cost.
Let us take an example of a furniture manufacturing business which is manufacturing wooden chairs. In a particular period, the business has manufactured 50 chairs. A carpenter is directly involved in the production process and is being paid $50 per chair. This $50 per chair can be regarded as a direct labour cost because the carpenter is directly involved in the production process and his cost can be directly traceable to a specific product (chair).
However, there is a loader whose job is to load/unload the wood or chairs. If we want to calculate the labour cost of the loader per chair, we cannot determine it as the loader is not directly involved in the production process. We know that the loader is being paid $500 weekly. We can calculate the loader cost per unit by dividing his weekly wage by the number of chairs produced in a week. Therefore, wages paid to the loader are an indirect labour cost as they cannot be directly traced to a specific product.
Direct Expenses and Indirect Expenses
All expenses of a business (that do not relate to material and labour) are divided into two types, direct expenses and indirect expenses. Direct expenses are those which can be directly traced to a specific product.
For example, a business hired a machine for the manufacturing of a specific unit. So, the rental cost of the machine can be directly traced to that product.
On the other hand, indirect expenses are those which cannot be charged directly to a specific product. Some examples include rent of a factory, insurance of plant, depreciation of machine, electricity cost, fuel cost, repairs and maintenance cost, the salary of production manager, etc. All of these expenses cannot be identifiable to a specific cost unit. For example, a business incurred costs like the rent of the factory, insurance cost, electricity cost etc. for the production of 1,000 units of a product. How can a business know how much rent, insurance, electricity cost etc. relates to one specific unit directly? Thus, to include the cost of indirect expenses in a production unit, a business takes the total cost and spreads it over the production units to estimate an average cost per unit.
Production overheads
All indirect production costs are called production overheads. When a manufacturing business needs to determine cost per unit, it splits the cost into two categories i.e., direct and indirect costs. As we have already explained direct costs are those costs which can be conveniently charged to a specific unit. On the contrary, indirect costs cannot be conveniently charged to a specific unit. Business takes the average of indirect costs by dividing them into the number of units produced in a particular period. Therefore, all such costs are added under the umbrella of production overheads. The total production overheads cost is then divided into the number of units. This overhead cost per unit is added to prime cost to reach at the total production cost per unit.