Direct and Indirect Costs

Direct and Indirect Costs

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Direct and Indirect Costs

Direct costs

An organisation can apportion the costs incurred in the production of
products or services in either a direct or an indirect manner. The
direct costs can be defined as being the amount materials actually
cost plus any other directly linked costs, such as labour.

(for Quirk, materials, electricity, labour employee and management,
machine depreciation)

Production materials, machine or assembly wages

1. Labour and wages – the cost of obtaining, training and retaining
labour is a significantly high cost which must be allocated to each
unit of production. There are many legal obligations as well as social
and welfare considerations, which add to this high costs total.

In order to work out the exact labour and wages costs to be attributed
to each unit of production, an organisation must take a careful study
of the production process and allocate the appropriate expenses. If,
for example, an individual earns £10 per hour and processes 10 units
during that hour, then £1 of direct costs may simply be added to each
unit. Unfortunately, things are not that simple.

There are many other individual costs which an organisation must bear
in the employment of individuals. These may include employer’s
national insurance contributions, pension payments and insurance
policy payments. In most organisations, labour and wage costs account
for the majority of direct costs.

2. Materials – the costs of materials differ according to the sector
in which an organisation operates. As organisation that operates in
the primary sector has comparatively low material costs. At the other
end of the scale, in the tertiary sector, the costs of finished goods
to a retailer for example, will be extremely high. The principal
elements that affect the costs of materials should be included in the
organisation's overall budgetary controls. In addition, an
organisation must also consider the cost of materials in relation to
market demands, as these will inevitably cause periodic fluctuations
in material costs.

Only those materials that are actually used in the production of a
product or service should be considered part of the cost of that
product or service.

Task 2 Page 2

Other consumables used by the organisation are classed as indirect
costs and are considered under separate budgets.

Indirect costs

(for Quirk, rent/rates, sales/ marketing/ insurance/ non-production
depreciation management salaries)

Indirect costs are costs incurred in the running of an organisation
that cannot be easily apportioned to the production process.

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effect, they cover all of the support and management services of the
organisation. These indirect costs may be apportioned in percentage
terms to each unit produced. However, the optimum balance between
direct and indirect costs can be somewhat difficult to ascertain. If
an organisation allows its indirect costs to rise in a
disproportionate manner to its direct costs and production levels,
then we can consider the organisation to be rather ‘top heavy’. It
will suffer loss of both profit and working capital.

The main forms of indirect cost are:

Ø Other wages
Ø Depreciation
Ø Management
Ø Administration
Ø Marketing
Ø General running expenses
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