8.1.4 Direct And Indirect Costs
When the units of output are not identical we split the costs into two types, direct and indirect. As you
know, direct costs are associated specifically with each unit of output and indirect costs are all the
other costs that cannot be related to or identified with, a particular unit of output. Examples of direct
costs are raw materials and production wages (usually called direct labour ). Examples of indirect
costs are rental of premises and wages of administrative staff. Indirect costs are commonly known
as overheads and we must work out a means of allocating these overheads to the units of output.
Note: The decision as to whether a cost is direct or indirect depends on the cost objective. For
example if the objective is to cost the running of an entire business then all costs are direct costs. If
the objective is to cost a unit of output then the direct costs are as described above.
To calculate the full cost of the units of output we must assign the direct costs directly to these units
and apportion the indirect costs as fairly as possible over all units of output.
.2 How Costs Behave
Different kinds of costs are said to 'behave' in different ways. Fixed costs are, as the name suggests,
fixed and will remain at the same level regardless of the number of units of output. For example, rent
of a building doesn't change with a change in the number of units produced, but variable costs relate
directly to the units of output and are expressed as dollars per unit. Variable costs, such as the cost of
raw materials, increase as the number of units of output increases and vice versa.
While there is a tendency for fixed costs to be indirect and variable costs to be direct this is not always
true. The concepts of direct/indirect and fixed/variable are very different and many operations have
variable overheads (an indirect cost) or direct labour as a fixed cost, particularly over a short period of
If we add together the fixed costs and the variable costs we get full cost. Also if we add together the
direct costs and the indirect costs we will also get full cost. We arrive at the same destination using
different paths. With a single product/service organisation we can simply add the fixed and variable
costs and allocate the total across all units of output, but with a multi product/service organisation we
must allocate the direct costs to the units of output and apportion the indirect costs 'fairly' across the
units of output.
A major issue and a difficult practical problem is how to deal with overhead costs.
.2.1 Allocating Overheads
We can look at overhead costs (or indirect costs) as being incurred while providing a service to
the process that produces the output. In a business with a single line product or service all the
overheads are incurred in providing a service to the output process. In a business with multi-product
or service lines we must decide how much of the service provided by the overheads is used by each
line of product or service output. Once we work out a split of the services provided by the overheads
we can apportion the cost.
So the problem is to find a basis or measure by which the amount of services provided by the
overheads is used by each kind of output. This basis must be observable and in some way
measurable. One way to do this is to share out the overheads equally over the units of output, and we
can do this if the outputs get the identical benefit from the overheads.
In practice, a commonly used method is based on direct labour hours (DLH). The logic is that a
product or service output that requires more direct labour hours is using more of the services from the
overheads. Also many overheads relate to time. For example, the expenses related to rent, lighting,
heating, manager's salaries and other overheads for a week will be close to half the amount for two
weeks and so on. Direct labour hours are easily measured and can be related directly to each job. This
information is already collected to calculate the direct labour cost for each job.
There isn't a single 'correct' way to allocate overheads. By definition overheads don't relate directly to
a job, so the best we can do is find a basis that seems logical or fair. As we want to give useful
information to decision makers any method that gives 'acceptable' results is an acceptable method.
The next reading gives a good example of direct labour hours compared with direct machine hours. It
goes on to discuss segmenting overheads and dealing with them on a departmental basis. It is a key
Atrill, Mclaney, Harvey & Jenner, pages 270-272.
Read these pages again and work through Examples 8.1 and 8.2 and do Activity 8.5
8.3 Activity Based Costing (ABC)
Apportioning (called ' absorbing') overheads on the basis of direct labour hours, or some other
measure, is a very traditional approach and was derived during a time when most production centred
on labour. Businesses had large labour forces and work was labour intensive. Comparatively small
amounts of money were spent on overheads. The market at that time was not particularly
Times have changed. By the 1990's much of the world's production had become capital-intensive, as
there was a swing to machine-based production. The cost of overheads, as compared to direct costs,
increased significantly as machines need power, and more money is spent on machines themselves
leading to larger depreciation amounts. Modern industry also incurs more costs associated with the
welfare of its staff and the community in which it operates. The market is now highly competitive and
barriers to international trade have been lifted or lessened so that the market and competition is
worldwide or 'global'.
Historically, the overhead recovery rate was much less than the direct labour hourly rate paid to the
workers. In recent times the overhead recovery rate has been as much as five and ten times the rate
paid to employees.