Factors Affecting Direct/Indirect Cost Classifications

Several factors affect whether a cost is classified as direct or indirect:

• THE MATERIALITY OF THE COST IN QUESTION AND THE AVAILABILITY OF INFORMATION-GATHERING TECHNOLOGY. The smaller the amount of a cost—that is, the more immaterial the cost is—the more likely it is to be classified as an indirect cost. Consider a mail-order catalog company such as Lands’ End and one of their customer orders. Given the amount involved, it is economically worthwhile for the company to trace the courier charge for delivering the package to the customer as a direct cost. In contrast, it may not be worthwhile for Lands’ End to trace the cost of the invoice paper included in the package as a direct cost, but rather to classify it as an indirect cost. Why? Although the cost of the paper can be traced to each order, it may not be cost effective to do so. The benefits of knowing that, say, exactly $0.005 worth of paper is included in each order may not exceed the data processing and administrative costs of tracing the cost to each order. Consider, for example, that the cost tracking is done by the sales administrator who earns a salary of $60,000 a year. His or her time is better spent organizing customer information to help with the company’s marketing efforts than tracking the cost of paper. However, improvements in information-gathering technology make it economically worthwhile to consider smaller and smaller amounts of costs as direct costs. Bar codes, for example, allow manufacturing plants to treat certain low-cost materials such as clips and screws, which were previously classified as indirect costs, as direct costs of products. At Dell, component parts such as the computer chip and the solid-state drive contain bar codes that can be scanned at every point in the production process. Bar codes can be read into a manufacturing cost file by waving a “wand” in the same quick and efficient way supermarket checkout clerks enter the price of each item purchased by a customer.
• DESIGN OF OPERATIONS. Classifying a cost as direct is straightforward if a company’s facility (or some part of it) is used exclusively for a specific cost object, such as a specific product or a particular customer. For example, General Chemicals can easily classify the cost of its facility entirely dedicated to manufacturing soda ash (sodium carbonate) as a direct cost of the cost object soda ash.

Be aware that a specific cost may be a direct cost of one cost object but an indirect cost of another cost object. That is, the direct/indirect classification depends on the cost object that one is trying to determine the cost of. For example, the salary of an assembly department supervisor at Tesla is a direct cost if the cost object is the assembly department. However, because the assembly department assembles different models of electric cars, the supervisor’s salary is an indirect cost if the cost object is a specific product such as the Tesla Model 3 sedan. A useful rule to remember is that the broader the cost object definition—the assembly department, rather than the Model 3—the higher the direct cost portion of total costs and the more confident a manager will be about the accuracy of the resulting calculated cost.

One final point. A company can incur a cost—sacrifice a resource—without the cost being recorded in the accounting system. For example, certain retirement health benefits are only recorded in the accounting system after an employee retires although the cost is incurred while the employee is actually providing the service. Environmental costs are another example. Many companies, for example General Electric, have had to incur significant costs at a later date to clean up the environmental damage that was caused by actions taken several years earlier. To force managers to consider these costs when making decisions, some companies such as Novartis, the Swiss pharmaceutical giant, are imputing a cost in their cost accounting system for every ton of greenhouse gases emitted to surrogate for future environmental costs. These costs can be a direct cost of a product if they can be traced to a specific product. More commonly, these costs are associated with operating a manufacturing facility and cannot be traced to a specific product. In this case, they are indirect costs.