Indirect ExpensesTypes, Examples, and How to Calculate them
Indirect expenses refer to the expenses a business incurs as part of its operations that cannot be directly associated with a cost object.
Indirect expenses are incurred in order to operate either the business or a particular segment and thus cannot be tied to a specific cost object such as a good, service, or customer.
Common examples of these expenses include business permits, accounting fees, office expenses, rent, and utilities.
- Indirect expenses are costs that cannot be directly allocated to any cost object and are instead necessary for the operation of the business or a particular business segment.
- Indirect expenses may be either fixed or variable.
- Attention must be paid to identifying a given expense as direct or indirect because the same cost may be direct in one industry and indirect in another.
- Identification of indirect costs can improve pricing decisions by ensuring that these costs are not included in the variable costs associated with a particular product.
- In contrast to indirect expenses, direct expenses can be allocated to a particular cost object, such as a particular product.
Understanding Indirect Expenses
Indirect expenses are costs that extend beyond those directly associated with producing a good or service.
These expenses are incurred in order to maintain and run a business and thus cannot be allocated to a particular cost object such as a good, service, or customer.
Cost objects are accounting items that are used for separately tracking costs.
In contrast to indirect expenses are direct expenses.
Direct expenses are costs that are directly incurred in relation to a particular cost object.
These include costs such as direct labor and direct materials, which can be traced to a particular good or service.
Conversely, indirect expenses offer benefits to multiple cost objects making them difficult or impossible to allocate to a particular project.
Some of the most common examples of indirect costs are office supplies used in running a company’s day-to-day operations.
These may be essential for operating the company, but they are not directly related to the production of a given good or service.
As a result, when accounting for indirect expenses, they may or may not be allocated.
Instead of allocating indirect expenses, they can be considered period costs and expenses in the period in which they are incurred.
Common Examples of Indirect Expenses
There are many examples of costs that are predominantly indirect.
However, whether a given cost is direct or indirect will vary between industries and must be evaluated individually.
Some of the costs that are most commonly indirect include:
- Employee Salaries
- Utilities and Telephone Costs
- Administrative Expenses
- Office Supplies
- Shipping Costs
- Advertising Expenses
- Legal, Audit, and Accounting Fees
Types of Indirect Costs
For convenience, indirect costs can be divided into three general categories, including overhead costs, general and administrative costs, and selling and distribution costs.
- Overhead Costs: Overhead costs are expenses incurred in support of a specific function, such as factory maintenance or material handling. These costs are still indirect because they are shared between several manufacturing jobs.
- General and Administrative Costs: These costs are incurred in performing administrative functions that support the entire company. Common examples include office rent utilities, office supplies, and costs associated with human resources departments.
- Selling and Distribution Costs: Selling expenses are the costs associated with the operations of the sales department. Distribution expenses include all of the costs associated with a product from its completion to the time it reaches its final destination. Common examples include salaries and commissions paid to sales personnel and advertisement expenses.
Example of Calculating Indirect Expenses
In order to better understand indirect expenses, consider the expenses incurred by the ABC Widget Manufacturing Company.
- Depreciation of Plant and Machinery: $20,000
- Direct Materials: $100,000
- Direct Labor: $200,000
- Rent and Insurance: $10,000
- Taxes: $5,000
- Utilities: $15,000
- Sales Expenses: $25,000
- Salaries Paid: $45,000
With the exception of the direct materials and labor expenses, all of these costs are indirect expenses.
Total indirect expenses can simply be found by adding these costs together.
$20,000 + $10,000 + $5,000 + $15,000 + $25,000 + $45,000 = $120,000
Similarly, direct expenses for the ABC Widget Manufacturing company were $300,000
($100,000 + $200,000).
What Are the Differences Between Direct and Indirect Costs
In order to distinguish between direct and indirect costs, it is necessary to determine what costs are related to a particular product.
Direct costs are those that are involved in the creation, development, and release of a given product or service.
In order to classify a cost as an indirect expense, it should not be tied to a specific product.
Typically, general business expenses that are necessary for maintaining a business, such as taxes or utilities, are indirect expenses.
In contrast, expenses that are incurred in producing a good or service, including direct labor and materials, are direct expenses.
Advantages and Disadvantages of Indirect Expenses
Advantages of Indirect Expenses
- Reduced Tax Liability: A thorough understanding of indirect expenses can help to identify tax-deductible indirect costs, which can reduce tax liability.
- Improved Product Pricing: Identifying indirect expenses can help to better understand what costs are associated with a particular product. This can help to better price specific products and ensure competitive pricing.
Disadvantages of Indirect Expenses
- Likelihood of Pricing Out: Identifying and managing indirect expenses can be challenging for any company. Failure to do so can result in high prices, which can leave a company unable to compete with others in its industry. This may result in such a company being forced out of a given industry or left bankrupt.
- Recurring: Many indirect expenses are recurring by their very nature. This means that these expenses will continue to occur regardless of whether the company is currently earning revenue.
Indirect expenses are costs that offer benefits to multiple cost objects.
Common examples such as legal fees, insurance, utilities, salaries, depreciation, and taxes allow a business to operate but cannot be tied to any one business activity.
Instead, they indirectly benefit the entire company or a particular segment.
As a result, they are referred to as indirect expenses.
Three common categories of indirect expenses include overhead, general and administrative costs, and selling and distribution costs.
An understanding of these expenses is crucial to reducing expenses, minimizing tax liabilities, and optimizing product pricing.
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University of Louisiana "Direct Costs vs. Indirect Costs" Page 1 . November 3, 2022