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Indirect Expenses

Concept Behind Indirect Expenses

The expenses incurred to operate a business as a unit or a part of a business, and therefore cannot be directly attributed with a specific cost object, such as a product, service, or customer are called indirect expenses. These are costs that are being consumed by more than one department or cost object. That is to say, these costs are shared between two entities and can't be allocated completelytoone entity. A cost object is an entity for which costs can be measured separately.

One approach to allocate these expenses is based on usage. For example, office rent is can be allocated based on square footage. If three functions or departmentsare present in the building, the overall rent expense will be attributed to each entity depending on the space in square foot each is occupying.

Some examples of indirect expenses are:

  • Rent
  • Accounting, audit, and legal fees
  • Business permits
  • Office expenses
  • Supervisor salaries
  • Telephone expense
  • Utilities

Utilities are more difficult to allocate. Sometimes, other measures must be used to allocate expenses, for example. The office department uses much less electricity than manufacturing department. This cannot be allocated based on the square footage.

One of the purpose such allocations serve is to allow calculating the profitability of departments, products or entities. If we don't allocate expenses to entities but to the whole company, managers won't be able to strategic decisions.

As opposed to this, direct costs expense that can be directly attributed to a particular cost object. Example of direct expenses are-

  • Direct materials
  • Direct labor
  • Freight
  • Insurance of goods in transit
  • Carriage
  • Wages
  • Custom duty
  • Import duty
  • Octroi duty

One important thing to note here is that indirect expenses can be allocated. For example, Telephone expenses or utilities are indirect expenses that are rarely allocated to anything. However they can be allocated if these are corporate overheads and are being attributed to subsidiaries. Such expenses are assigned as expenses incurred in a period, and therefore these types of indirect expenses are called period costs.

If the indirect expenses are factory overhead, they will be allocated to the units that are being produced in the factory during the particular period that the indirect expenses were incurred.As a result, these will be charged to expense when those products are sold to which they were allocated.

  • Production supervisorsalaries
  • Quality assurance salaries
  • Materials management salaries
  • Factory rent
  • Factory utilities
  • Factory building insurance
  • Fringe benefits
  • Depreciation
  • Equipment setup costs
  • Equipment maintenance
  • Factory supplies
  • Factory small tools charged to expense

Difficulties Encountered In Indirect Expenses

Students tend to ignore indirect costs in budgeting. While developing the budget for a grant proposal, one must include indirect expenses as these can be a significant component of overall expenses. This allows for a more realistic expectation for all stakeholders involved and prevents uncertainty down the line.

Another common problem faced by students while working on expenses is the failure to categorize properly. There is one approach a student can take: When trying to categorize direct and indirect expenses, consider them in terms of attribution. If you can attribute it to production then it's a direct expense. If you cannot attribute it to production it is indirect. May times student will need to rely on their judgment, but mostly, examining them in terms of attribution gives a significantly clear idea for one to categorize expenses easily.

Students must also keep in mind that once they have figured out the indirect expenses, these must be allocated properly. This is important if one wants to benefit from the whole exercise of the categorizing into direct and indirect expenses. Only with proper allocation of indirect expenses can one use the numbers for analysis of profitability and any other metric. The example of electricity and office rent mentioned above is a good example of how students should consider different appropriate ways of allocating indirect expenses.

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