| In management accounting, it is important to classify | | | | important role in determining the traceability of costs. |
| costs. Accountants might categorize these in several | | | | Some costs are so immaterial or negligible that it is |
| ways-including direct and indirect costs. Direct costs | | | | not feasible to trace them, even if they are fully |
| (DC) are those that are fully attributable to a | | | | traceable. |
| product, service or department. Indirect costs (IC) | | | | For example, assume that you are producing 20 |
| are those that cannot be attributed directly to a | | | | chairs for a custom order. Some of the expenses |
| product service or department, even though the | | | | associated with producing the chairs for the order |
| costs were incurred in producing the good or service. | | | | would be classified as follows:a) Wood used in the 20 |
| Whether costs are direct or indirect, accountants | | | | chairs: Direct material costb) Overtime required by |
| attribute them to three categories-materials, labour | | | | the customer for workers on the order: Direct labour |
| and expenses. As such, there are direct and indirect | | | | costc) Rent for equipment used specifically for the |
| materials; direct and indirect labour; and direct and | | | | custom order: Direct expensesd) Staples used to fix |
| indirect expenses. ICs are also known as overheads. | | | | the fabric to the chair: Indirect material coste) Wages |
| Total production cost represents the sum of prime | | | | for the foreman who oversees all custom orders: |
| cost (all direct costs) and production overheads (ICs | | | | Indirect labour costf) Electricity used when making |
| associated with production). | | | | the 20 chairs: Indirect expense |
| Production overheads are all indirect costs (wages, | | | | In the example, staples are a negligible cost, although |
| expenses and materials) that are associated with the | | | | you could trace them fully if you wish. However, it is |
| order, product or service. In addition, overheads | | | | impractical to trace the cost of the few staples used |
| apply to other functions as well, such as | | | | per chair, making it an IC. If the wages for the |
| administration, distribution and selling. Even if you | | | | foreman were specifically attributed to the custom |
| relate overheads to other functions, it still refers to | | | | order, then that would have been a direct cost. |
| wages, expenses and materials that are ICs. | | | | However, that foreman oversees all custom orders, |
| Distilling direct and indirect costs can be somewhat | | | | so his wages can only be apportioned to the 20 |
| tricky to the beginner. The key words for a direct | | | | chairs-i.e. not fully traced to the chair production. The |
| cost is that it must be "fully traceable" to the | | | | example identified aspects of prime costs and |
| product, service or department. This suggests an | | | | production overheads. Other overheads may be |
| objective measure of costs. Materiality also plays an | | | | incurred in selling, distribution and administration yet. |