While preparing a budget for a business adventure or a new project, it is important to have the knowledge of different types of business expenses/costs that might occur. There can be two types of costs, such as direct costs and indirect cost.
Both costs have the meaning as implied by their names such as direct costs are easily traceable in the production process whereas, indirect costs which might be necessary for the production process but can’t be traced directly.
In this article, you will learn about the definition and meaning of indirect costs with the help of a few examples.
Definition of Indirect Costs
An indirect cost is a cost which is not directly related to a single activity in the production process. It is mutually used by one or more business processes; therefore, it is difficult to identify it with a specific department, product, or process.
Indirect costs can be both fixed and variable in nature.
Indirect costs are the expenses associated with the production of a particular product or the cost incurred in maintaining the entire business. These are the costs which are not visible as direct costs and are also known as real costs for running a business.
These are the costs which remained separated once the direct costs are considered. For example, the cost of stationery used daily and the cost of tea and coffee served to the employees to keep them awake and energized during the working hours.
These types of costs are not directly associated with a particular project or production of a particular project. But they make a large portion of the expense of the entire business.
It is difficult to associate indirect costs with a single cost objective, but it is possible to associate indirect costs with more than one final cost objectives. Therefore, indirect costs cannot be treated as direct costs and cannot be deducted from a single work.
A fair portion of indirect costs will be bored with each project. The portion of indirect cost bore by each project can be determined using indirect costs ratio. The indirect cost ratio is the ratio between indirect cost pool and direct cost base.
Indirect Cost Ratio= Indirect Cost Pool/Direct Cost Base
Generally, indirect costs consist of general and administrative expenses (such as Personnel department costs, salaries of employees, and accounting department costs, etc.) and overhead expenses (such as rent of the building, utility expenses, etc.).
Most of the times, managers force his subordinates to cut down such costs so that the overall cost on the business can also be reduced. It is easy to identify, manage, and charge indirect costs as compared to larger organizations.
To manage and minimize the indirect costs, it is important to identify which indirect costs are necessary for the business and which indirect costs can be avoided.
Difference between direct and indirect costs
Direct and indirect costs are tow type of costs which are incurred in the business.
Direct costs are the costs which are directly associated with a department, or the production process of a business and direct cost is not divided between two or more departments or projects.
On the other hand, indirect costs are difficult to assign to a single department or business project. Therefore, it is divided using indirect cost ratio between all the departments and business projects.
Because direct costs can be identified easily and associated with a department of the business project, it is easy to minimize it, and on the contrary, it is always difficult to find out where indirect costs can be minimized.
List of Indirect Costs
|Rent of the property||A building is required to run the business operations. All types of business operations are run in a single building.|
|Administrative Salaries||Salaries of employees performing all administrative duties are also a kind of indirect costs.|
|Accounting and legal Expenses||Accounting and legal expenses are unavoidable in business and these expenses are not directly associated with a particular project or department.|
|Telephone and Internet Expenses||Connectivity is essential for every business to run successfully. Telephone and internet are one of the most basic necessities for work to be done. Again, these expenses cannot be associated with one project of department as they are needed and used by all departments equally.|
|Vacation, Holidays, and sick leave||Employees working in an organization are given a few perks. These are necessary to retain the employees and to keep them happy. However, these expenses are best example of indirect costs endured by the businesses.|
How to calculate Indirect Cost?
As we have learned that indirect costs are not directly associated with a particular department or business project like direct costs, they are difficult to associate director.
So, the question arises about how to calculate these costs to determine their right association. Therefore, a formula is designed about which we will learn shortly in the article ahead.
Indirect costs such as telephone and internet expenses, rent of the building, insurance expense of employees cannot be associated with any single department or project.
Therefore, to calculate indirect costs divide the sum of indirect expenses with the total revenue generated by each department or projector unit. In this way, you will get the rate of indirect cost.
Let us understand step by step process to calculate indirect costs
1. Prepare a list of all indirect expenses occurring
In the first step, you are required to determine the list of all indirect costs and expenses associated with them. The list should include expenses such as rent of the building, courier expenses, administrative expenses, accounting, and legal expenses, etc.
Expenses such as expenses for raw material, production costs, delivery costs, etc. are direct expenses; therefore, these should not be included in the indirect costs list.
2. Sum all the indirect costs
Add all the indirect costs for a particular time period. You can calculate indirect costs over a month or over a year.
You can choose the time period to calculate indirect costs according to the nature of business and revenue generated by your business.
3. Compare Indirect costs to revenue generated
In this step, calculate the proportion of indirect costs associated with revenue generated in one month (or period of your choice). Divide the monthly total indirect costs with the total revenue generated in one month. The percentage can also be calculated by multiplying the value with 100.
Indirect cost rate = Total indirect expenses/Total revenue generated (monthly/half yearly/ annually)
Indirect Cost Rate (Percentage) = Total Indirect Expenses/ Total revenue generated (Monthly/ half yearly/ annually)*100