In relation to specific cost object, the cost that can be traced back to same cost object is considered as direct cost. Simply put if we can identify a cost to a specific cost object then it is a direct cost.
Indirect costs are such costs that are either not traceable or it is just not economically beneficial to trace such costs back to cost object.
Cost object is anything of interest for which determination of cost is necessary and can be an activity, product, responsibility center (cost center), person or department.
While determining the cost, if one can easily associate a cost to certain product or cost center then it is a direct cost and it should be as easy as knowing to what product or department a certain cost belongs. For example:
- a machine that works solely for packing department have its depreciation as direct cost in relation to packing department.
- Royalty paid for a product on monthly basis is also a direct cost as it specifically belongs to one product.
- One team of skilled labour that worked 10 hours on one product and 12 hours on another is still a direct cost as we can easily calculate how much is incurred for each product on the basis of hours.
On the other hand, if a cost cannot be associated to certain product or department specifically or if its difficult to easily determine how much cost relates to specific product or department then it is considered an indirect cost. For example:
- Heating and lighting expense of one building with several departments thus making it difficult to determine how much out of total cost belongs to which department.
- Supervisor monitoring the labour working on two production lines. It is difficult to estimate how much time supervisor spent monitoring particular production line.
- Quality control department inspecting the finished goods from several departments, one product each day of the week.