Costs that the costing system directly traces to the cost object are direct costs and that are not directly traced to the cost object are called indirect costs.
Resources that are common to more than one cost object are necessarily classified as indirect costs. These costs are aggregated under an account number (e.g. repair and maintenance of building) and then are assigned to cost objects on some equitable basis.
Certain costs that could be traced to the cost object by establishing an elaborate cost accounting system are often treated as indirect costs because the benefits of tracing those costs to the cost object are not commensurate with the cost of operating such an elaborate cost accounting system. E.g., glue in bookbinding operation is usually not traced to the particular batch of book for which the glue is used.
The cost of glue is classified as indirect cost. The cost of glue consumed during a period is aggregated under an appropriate account head and then it is assigned to different batches of book on an equitable basis.
A cost may be direct to a particular cost object, but may be indirect to another one. E.g., depreciation of a machine is directly traced to the workstation where the machine is installed to determine the cost of operating the workstation, but it cannot be traced to different jobs which have received the service of the machine and, therefore, the same is assigned to them on some equitable basis.
Proper documentation is necessary to trace costs to cost objects. E.g., in order to trace cost of employees (who are not dedicated to a particular software project) to software projects, employees should maintain proper records of time spent on different projects to book the employee cost directly to different projects which received employee services during a particular period.
Similarly, if material costs are to be traced directly to a job or a batch of production or to a project, material issue vouchers, which authorize the storekeeper to issue materials, should mention the job/batch/project number. Proper documentation increases the cost of operating the cost accounting system, but leads to better control; and tracing costs directly to cost objects improves the accuracy of cost determination.
Therefore, firms, in general, consider the following factors in deciding whether an item of cost should be classified as an indirect cost:
(a) Materiality of the Cost:
If an item of cost is not material, it is classified as indirect cost. However, if the cost, as a proportion of the total cost, shows an increasing trend, it is advisable to classify the cost as ‘direct cost’.
(b) Availability of an Appropriate Basis for Absorption:
If the demand on a resource can be measured fairly accurately by using a factor as ‘proxy’, the firm may decide to apportion or recover the cost to objects (e.g. products or projects) by using the factor as a basis for assigning the cost.
(c) The Cost of Gathering Information:
Firms prefer to trace as many cost items as possible to cost units or other cost objects. This provides an insight into the factors that create demand on different resources. E.g., a firm that traces cost of after-sales services to customers has a better understanding of the behaviour of the cost as compared to that of a firm which assigns those costs to customers on some equitable basis.
The former can ascertain customer profitability more accurately. However, in deciding whether a particular cost should be traced to the cost object, enterprises consider the cost of gathering data. The cost of gathering data differs between enterprises. For example, an enterprise using an ‘enterprise resource planning’ (ERP) package does not incur additional cost for gathering cost data.
Unless otherwise mentioned, we shall use the terms direct costs and indirect costs with reference to a unit of production, which may be a job, a batch, a process, or a unit of service provided.