Direct and Indirect Expenses

Expenses may be defined as “the costs of services provided to an undertaking and the notional costs of the use of owned assets”.

Direct expenses are those expenses which are directly chargeable, easily identifiable, traceable and attributable to the individual units or jobs in an economically feasible manner. Expenses which can be identified with a territory, a customer or product can be considered as direct expenses.

“Direct expenses are defined as “Expenses relating to the manufacture of a product or rendering a service which can be identified or linked with a cost object other than direct materials and direct employee cost.”[Cost Accounting Standard 10]

There is no hard and fast rule regarding classification of expenses into direct and indirect. Direct expenses are specific charges directly attributable while the indirect expenses are apportioned on suitable basis. Some items by nature are direct but treated as indirect because the amounts chargeable are either of small or negligible value i.e. which does not meet the test of materiality. It is difficult and costly to analyse them and hence treated as indirect expenses, e.g. nuts, screws, thread, glue, etc.

Direct expenses are directly attributed to cost unit/cost center. Types of Direct Expenses are as under:

• Royalties if it is charged as a rate per unit.
• Hire charges of plant if used for a specific job.
• Sub-contract or outside work, if jobs are sent out for special processing.
• Salesman’s commission if it is based on the value of units sold.
• Freight, if the goods are handled by an outside carrier whose charges can be related to individual units.
• Travelling, hotel and other incidental expenses incurred on a particular product / contract.
• Cost of making a design, drawing for a specific job.
• Cost of any special process not forming part of the normal manufacture like water proofing for canvas cloth.
• Amortised cost of mould & patterns
• Amount paid for power and fuel whose charges can be related to individual units.
• Software services specially for a product

Direct expenses are chargeable expenses and are debited to Direct Expenses Account in financial books.

∗ The term ‘direct expenses’ has been excluded from prime cost as per latest CIMA terminology, i.e. according to CIMA, prime cost is “the total cost of direct material and direct labour”.

Accounts are prepared in columnar form so that the analysis can be made and the expenses can be related to the specific job/contract.

In cost accounting records, the direct expenses account is credited and the concerned account is debited. The cost department should verify from the accounts department that the expenses are properly booked. These expenses should not be mixed up with overheads.

Items under this head are few. They form a small part of the total cost. Such costs are controlled by fixing standards. The actual should be compared with the standard. The causes of variations, if any, should be ascertained and necessary corrective action should be taken.

Indirect expenses are expenses other than direct expenses. These refer to those expenses which cannot be directly, conveniently and wholly allocated to cost centers or cost units. E.g. factory rent & insurance, power, general repairs etc.

Indirect costs are “those which are incurred for common or joint objectives and therefore cannot be identified readily and specifically with a particular cost unit/cost centre.

A few examples of such expenses are as follows:

• Rent, rates and insurance of factory and office.
• Depreciation, repairs and maintenance of plants, machinery, furniture, building etc.
• Power, fuel, lighting, heating of factory and office.
• Advertising, legal charges, audit fees, bad debts, etc.

The following types of items are not included in cost of production or sales:

(a) Matters of pure finance including interest paid and received, dividend received on investments, rent received, profit or loss on sale of investments or company’s property, transfer fees received etc.

(b) Appropriation of profits including income-tax paid, dividends paid, transfer to sinking fund, general reserve, excessive depreciation, goodwill or other fictitious assets written off, etc.

Expenses that are usually incurred should be included in costs even if a particular firm is not required to pay for such expenses. Rent for own premises is an example. If a firm occupies its own buildings, it does not pay any rent for this, but for costing purposes, an appropriate amount of rent should be included in costs.

Indirect expenses may or may not be allocated. For example, office administrative costs are indirect expenses, but are rarely allocated to anything, unless it is corporate overhead and is being allocated to subsidiaries. These types of indirect expenses are charged to expense in the period incurred. Indirect expenses that are factory overhead will be allocated to those units produced in the factory during the same period that the indirect expenses were incurred, and so will eventually be charged to expense when the products to which they were allocated are sold.