The essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. These costs are usually only classified as direct or indirect costs if they are for production activities, not for administrative activities (which are considered period costs).
The concept is critical when determining the cost of a specific product or activity, since direct costs are always used to compile the cost of something, while indirect costs may not be assigned to such a cost analysis. It can be too difficult to derive a cost-effective methodology for the assignment of indirect costs; the result is that many of these costs are considered part of corporate overhead or production overhead, which will exist even if a specific product is not created or an activity does not occur.
Direct costs tend to be variable costs, while indirect costs are more likely to be either fixed costs or period costs.
Using Direct Costs and Indirect Costs in Pricing
At a minimum, direct costs should always be included in the derivation of a product’s price, since the established price must always equal or exceed its direct cost; otherwise, every sale will generate a loss. Pricing based just on direct costs makes the most sense in situations where there is an opportunity to sell a few extra units on a one-time sale with excess production capacity. Indirect costs should also be included in the derivation of a product’s price when setting long-term rates, where product sales must cover both direct and indirect costs.
Examples of Direct Costs and Indirect Costs
Examples of direct costs are direct labor, direct materials, commissions, piece rate wages, and manufacturing supplies. Examples of indirect costs are production supervision salaries, quality control costs, insurance, and depreciation.
CHAPTER 2
AN INTRODUCTION TO COST TERMS AND PURPOSES
2-1Define cost object and give three examples.
A cost objectis anything for which a separate measurement of costs is desired. Examples include
a product, a service, a project, a customer, a brand category, an activity, and a department.
2-2Define direct costs and indirect costs.
Direct costs of a cost object are related to the particular cost object and can be traced to that cost
object in an economically feasible (cost-effective) way.
Indirect costs of a cost object are related to the particular cost object but cannot be traced
to that cost object in an economically feasible (cost-effective) way.
Cost assignment is a general term that encompasses the assignment of both direct costs
and indirect costs to a cost object. Direct costs are traced to a cost object, while indirect costs are
allocated to a cost object.
2-3Why do managers consider direct costs to be more accurate than indirect costs?
Managers believe that direct costs that are traced to a particular cost object are more accurately
assigned to that cost object than are indirect allocated costs. When costs are allocated, managers
are less certain whether the cost allocation base accurately measures the resources demanded by
a cost object. Managers prefer to use more accurate costs in their decisions.
2-4Name three factors that will affect the classification of a cost as direct or indirect.
Factors affecting the classification of a cost as direct or indirect include
the materiality of the cost in question
available information-gathering technology
design of operations
2-5Define variable cost and fixed cost. Give an example of each.
A variable cost changes in total in proportion to changes in the related level of total activity or
volume. An example is sales commission paid as a percentage of each sales revenue dollar.
A fixed cost remains unchanged in total for a given time period, despite wide changes in
the related level of total activity or volume. An example is the leasing cost of a machine that is
unchanged for a given time period (such as a year) regardless of the number of units of product
produced on the machine.
2-6What is a cost driver? Give one example.
A cost driver is a variable, such as the level of activity or volume that causally affects total costs
over a given time span. A change in the cost driver results in a change in the level of total costs.
For example, the number of vehicles assembled is a driver of the costs of steering wheels on a
motor-vehicle assembly line.
2-7What is the relevant range? What role does the relevant-range concept play in explaining
2-1