Indirect cost is one that affects the production process of one or more products that a company sells, and that cannot be measured and assigned directly to one of the production stages or to a specific product, but rather a coherent imputation criterion must be assumed.
In other words, an indirect cost affects several products and to assign this cost to each product it is necessary to ask the following question: How could I distribute this cost among the units that I produce? When you produce a car you know that it is necessary to put 4 wheels on it, but… do you know how much electricity you need to produce each car? This is the main difference with direct cost, since direct costs can be very clearly associated with the final product and without the need to establish an allocation criterion.
Indirect cost is a category of cost classified according to its relation to production.
Indirect cost types
Mainly we can differentiate the following types of indirect costs:
- Indirect production cost: These are the costs linked to the production process of those factors that contribute to obtaining the final product, with the exception of direct costs (raw material or labor). For example, indirect production costs could be the amortization of machines, maintenance, supervisory personnel, quality control, leases or electricity, among others. As we can see, these costs are linked to the production process but do not directly affect it and, furthermore, they generally cannot be distributed without the need to establish an allocation criterion.
- General indirect costs: These are the costs considered as not necessary for the manufacture of products, if not that they belong to functional areas used for the correct development of the business activity. These are usually mainly business or administration costs.
Indirect cost allocation criteria
As we have already mentioned, the main characteristic of indirect costs is the need to establish a coherent distribution criterion.
There are various imputation criteria, the most common being the following:
- Produced unit : As its name suggests, it consists of distributing indirect costs based on the units produced.
- Sales price : In this case, indirect costs are allocated based on the sale price of the product for the units sold, that is, based on the weight of the product in the total sales volume.
- Work unit : Distribution of costs by the hours of each machine or the kilos of material used in each product, for example.
Indirect cost example
In order to synthesize what is described above and apply it to a real example, below we will see an example of both types of indirect costs and the possible criteria that the management of a company could follow to distribute them among all the products:
- Factory rental . The most common way would be to distribute it according to the units produced.
- Supplies (electricity). It could be distributed based on the manufacturing hours used with each machine for the different manufacturing lines.
- Indirect labor. According to the time taken for production.
- Transport. Their distribution could be made based on the units sold for the sale price of each one.
- Amortization of machinery. In the case of having several machines, their distribution could be made between the hours worked in each machine and in turn between the amount of products manufactured in each of them. In the case of having only one machine, the allocation could be made directly by the number of units produced.