January 29, 2022

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Elements of costs: Direct and Indirect costs

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In the previous lesson, the elements of cost were summarised. However, during the course of the lesson, the focus was on material costs, labor costs, and expenses. These costs can be broken down into direct and indirect costs as explained below.

What are Direct costs?

Direct costs are costs readily traceable to a particular product or service. Such cost is related to that product or service. With or without any stress a person can identify the cost to the product.

For example, in a bakery, flour, butter, sugar, machine operator and fuel for the machines used are readily noticeable to relate to the production of bread. Therefore, these items are direct costs.

Types of direct costs

Direct material costs: These are articles of materials you can trace in the production of a particular product or service. In the bakery example, flour, butter, and sugar are direct material costs.

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Direct labor costs: These are wages paid to workers involved in the production of a product or the rendering of services. Such a laborer or employee’s job can be traced directly to either the manufacturing of the product or the rendering of the service.

The machine operator in the example above is directly involved in the production of bread. Hence, he can be referred to as direct labor.

Note that most direct laborers’ jobs are paid as wages and not salaries.

Direct expenses: These are expenses readily traceable to the manufacturing of a product or the rendering of services. The fuel for the machines used directly to manufacture bread in a bakery is deemed to be direct expenses.

What are the indirect costs?

This is directly opposite to direct costs. Indirect costs are costs that are not readily traceable to a particular product or service. Tracing such costs is difficult and the efforts are not worthwhile.

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In the above example of a bakery, indirect costs of the bread include seasoning which will be used in the production of another kind of bread, salaries to salesmen, fuel for delivery van and electricity bills are indirect costs.

Types of indirect costs

Indirect material costs: Indirect material costs are cost not readily traceable to a specific product or service. The seasoning used for all the kinds of bread produced by a bakery is indirect material cost. This is so because it cannot be traced to the production of a kind of bread produced.

The cost is usually aggregated and allotted to each kind of bread based on an agreed formula by the firm’s management.

Indirect Labour costs: These are salaries paid to employees whose jobs are not related to the production of the product or services. The salaries of the manager and sales representatives can not be traced in any way to the production of bread in a bakery.

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Indirect expenses: Indirect expenses are the expenses that are not traceable to the production of the product or service. Electricity bills and fuel for delivery van are indirect expenses.

The elements of costs are classified generally as material cost, labor cost, and expenses. However, to further explain how it can be traced in the production of a specific item or rendering of a service, this cost is separated into direct and indirect costs. In the next lesson, we will see how these elements of costs can be separated further in terms of prime costs, overheads, administrative and distribution costs.

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