Direct and Indirect Costs

• Lesson
• Exercise
• Answer

The allocation and identification of direct and indirect costs contributes to more accurate profit calculations. Not only is the clarification of costs important to business owners, it may be of particular interest to some prime contractors who may actually impose a specific accounting methodology in order to meet its own policy requirements. If your project is funded in full or in part by taxpayer financing, expect to meet specific guidelines for determining overhead.

Overhead Rate         =   Indirect Costs / Direct Costs

Methods may vary according to circumstances. As mentioned some prime contractors or even government entities may dictate the overhead calculation method according to their needs.

Direct Costs

These are costs that directly contribute to the development of a product or provision of a service. Examples include the following:

• Salary
• Wages
• Materials

N.B. Direct costs cannot be allocated to overhead.

Indirect Costs

Indirect Costs are those that are difficult to assign to a particular cost object, for example typical indirect costs might include the following:

• Heat
• Light
• Taxes
• Benefits

Cost allocation assigns an indirect cost to one or more cost objects according to a formula. Industries where the accurate identification of direct and indirect cost is particularly important include the following:

• Manufacturers
• Service firms
• Merchandisers
• Manufacturers
• Not for profit firms
• Joint venture projects
• Education

Indirect Cost Calculation

Overhead costs are calculated as a ratio – it is the percentage of a firms indirect cost, in relation to its direct costs.