Costs may be classified as direct costs or indirect costs. The purpose of this classification is to assign costs to cost objects. Cost object means anything about which cost information is collected and used. Some examples of cost objects are products, departments, customers, plant, a territory, a product line and research and development activities of the business etc.
A brief explanation of direct costs and indirect costs are given below:
A cost that is easily traceable to a particular cost object is known as direct cost. The use of the term “direct cost” is not limited to direct materials and direct labor; every cost that can be easily and conveniently traced to a particular product, customer, branch, plant or any other cost object is a direct cost for that object. For example, if Bata Shoes Company wants to assign costs to all of its branches located in Pakistan, the salary of the manager of Islamabad Branch would be a direct cost for that branch.
A cost that is not easily traceable to a particular cost object is called indirect cost. For example, a clothing factory produces different varieties of cloths. The salary of the manager would be an indirect cost because it is caused by all the varieties and is not easily traceable to a particular variety. The Rafhan Maize Products company produces a large number of products by processing tones of corn every year. The salary of the factory manager is an indirect cost for these products because it is incurred for all the products that are produced in the factory. Any individual product cannot be held responsible for this cost.
The costs that are caused by a number of cost objects but cannot be traced to a particular cost object is known as common cost. In our examples, the salaries of the managers of clothing factory and Rafhan maize products are common costs.
When we say direct or indirect cost, we mean that it is direct or indirect with respect to a particular cost object. A cost may be direct for one cost object but indirect for another. For example, National Food Products Co. has a number of branches in Pakistan and each of them sells a variety of food products. The salary of the manager of Karachi Branch would be an indirect cost of a particular food product but direct cost for the Karachi Branch as a whole.