Direct Costs and Indirect Costs

Learning Objective 2 Distinguish between direct costs and indirect costs

costs that are traced to the cost object
costs that are allocated to the cost object

Costs are classified as direct costs or indirect costs. Management accountants use a variety of methods to assign these costs to cost objects.

Direct costs of a cost object are directly related to the particular cost object and can easily and unambiguously be traced to it. For example, the cost of steel or tires is a direct cost of Tesla Model 3s. The cost of steel or tires can easily be traced to or identified with the Tesla Model 3. As workers on the Tesla Model 3 production line request materials from the warehouse, the material requisition document identifies the cost of the materials supplied to the Model 3. Similarly, individual workers record on their time sheets the hours and minutes they spend working on the Model 3. The cost of this labor can also easily be traced to the Model 3 and is another example of a direct cost. The term cost tracing is used to describe the assignment of direct costs to a particular cost object.
Indirect costs of a cost object are also related to the particular cost object, but they cannot easily and unambiguously be traced to it. For example, the salaries of plant administrators (including the plant manager) who oversee manufacturing of the different car models produced at the Fremont plant are an indirect cost of the Model 3s. Plant administration costs are related to the cost object (Model 3s) because plant administration is necessary for managing the production of these vehicles. Plant administration costs are indirect costs because plant administrators also oversee the production of other products, such as the Model X. Unlike steel or tires, there is no specific request made by supervisors of the Model 3 production line for plant administration services, and plant administration costs can therefore not easily and unambiguously be traced to the Model 3 line. The term cost allocation is used to describe the process of assigning indirect costs to a particular cost object.

Cost assignment is a general term that encompasses both (1) tracing direct costs to a cost object and (2) allocating indirect costs to a cost object. Exhibit 2-2 depicts direct costs and indirect costs and both forms of cost assignment—cost tracing and cost allocation—using the Tesla Model 3 as an example.

Flow chart shows the two types of cost such as direct and indirect and two forms of cost assignment such as cost tracing and cost allocation by using the cost object BMW X6 as an example.

The two types of cost are:

Direct Costs
- Example: Cost of steel and tires for the Tesla Model 3
Indirect Costs
- Example: Depreciation cost of the Tesla Factory in Fremont where Tesla makes the Model 3 and other models of electric cars

The two forms of cost assignment are:

Cost Tracing
- It is done based on material requisition document.
Cost Allocation
- It has no requisition document involved.

The direct cost type leads to the cost object using cost tracing assignment and the indirect cost type leads to the cost object using cost allocation assignment. The cost object example is Tesla Model 3.

Cost Allocation Challenges

Managers want to assign costs accurately to cost objects because inaccurate product costs will mislead managers about the profitability of different products. This could result, for example, in managers unknowingly promoting less-profitable products instead of more-profitable products.

Managers are much more confident about the accuracy of the direct costs of cost objects, such as the cost of steel and tires of the Model 3, because these costs can easily be traced to the cost object. Indirect costs are a different story. Some indirect costs can be assigned to cost objects reasonably accurately. Others are more difficult.

Consider the depreciation cost of the Tesla Factory. This cost is an indirect cost of the Model 3—there is no separate depreciation cost for the area of the plant where the Model 3 is made. Nonetheless, Tesla allocates to the Model 3 a part of the depreciation cost of the building—for example, on the basis of a percentage estimate of the building’s floor space occupied by the production of the Model 3 relative to the total floor space used to produce all models of cars. This approach measures the building resources used by each car model reasonably and accurately. The more floor space a car model occupies, the greater the depreciation costs assigned to it. Accurately allocating other indirect costs, such as plant administration, to the Model 3, however, is more difficult. For example, should these costs be allocated on the basis of the number of employees working on each car model or the number of cars produced of each model? Measuring the share of plant administration used by each car model is not clear-cut.