What are indirect costs? Impacts, how to identify

One of the bottlenecks in corporate financial management is the calculation of indirect costs of production or service provision.

This data is essential for the appropriate pricing of items produced and services performed in companies. In addition, it influences the closing of the annual budget, a fundamental definition to avoid wasting resources.

In comparison to many direct fixed expenses, identification and computation are less accurate. This does not imply, however, that there are no means to include them into the company’s financial statements.

This article explains what indirect costs are, how they vary from direct costs, how to calculate them, and gives examples of indirect costs in businesses to assist you with the process.

Keep going and enjoy reading!

What are indirect costs?

Indirect expenses are those that are incurred throughout the production process but are not directly connected to the product’s manufacture or the company’s service delivery. As a result, determining the value per unit generated at the moment of pricing is more challenging.

The difficulty in measuring values ​​to use in calculations is one of the main characteristics of indirect costs.

Two simple examples of this category are monthly water and electricity costs. Both are fixed and variable expenses, but it is not possible to quickly calculate how much of these resources is spent to produce a unit of the product or provide a service.

Except when the company has meters on each machine to know the electrical consumption of operational equipment, the value of indirect costs is obtained through apportionments, a proportional calculation that generates an approximate value.

In this way, financial management can predict costs and balance spending in sectors that have indirect costs to prevent the budget from being compromised.

Direct VS indirect costs

The difference is that direct costs are easy to measure and define their value, as they are directly related to the final product, such as raw materials and labor. Indirect costs, on the other hand, are not related to the product/service, making it more difficult to attribute their value to the company’s expenses .

Despite the difficulty, it is important that the finance team strives to organize direct and indirect costs to improve the accuracy of calculating operating expenses .

Understanding the nature of these charges and how they affect the company’s cash flow is crucial, even if the list of indirect expenses only includes an estimated amount.

This is due to the fact that in the absence of data on this particular account, there is a higher likelihood of budget waste because it is unknown how the funds are being used.

How to identify indirect costs?

A useful method for determining an organization’s indirect costs is to enumerate the costs that are and are not associated with the production of the good or the rendering of the service.

Division and organization can be facilitated with the support of business management software or a data spreadsheet. The larger the volume of data, the more advantageous it is to implement an automated and integrated data system in the company (here’s a tip!).

To help with identification, consider the following points:

• Use of indirect materials : they are not part of the product, but are used in the manufacturing process, such as sandpaper for finishing, cleaning materials, etc.
• Indirect team : this is the workforce that does not work in production, but its function ensures correct execution, such as salaries and charges for supervisors, assistants, among others.
• Other indirect costs : these are other unidentifiable costs, such as cleaning materials, brooms, telephone and internet services, workplace safety measures, etc.

Indirect cost examples and calculation

To calculate indirect costs, the most commonly used costing method is apportionment . In other words, the proportional division of expenses in the period analyzed and according to what was produced.

The allocation can be based on three factors: equal shares, quantity of products, production time .

As an example, let’s consider a bakery that makes three different types of bread. The factory spends R$3,500 per month on electricity bills.

Equal parts

The apportionment of the indirect cost of electricity for pricing the bakery’s bread, dividing it into equal parts, would be:

3,500 ÷ 3 = R$ 1,166 for each product.

Quantity of products manufactured

The calculation method based on the quantity of products manufactured is less arbitrary and allows for a more appropriate distribution of costs. As an example, consider the following volumes:

Bread 1: 30 units

Bread 2: 150 units

Bread 3: 300 units

Total: 480 units

3,500 ÷ 480 = R$ 7.29 per unit

Bread 1: 30 units x 7.29 = R$ 218.70

Bread 2: 150 units x 7.29 = R$ 1,093.50

Bread 3: 300 units x 7.29 = R$ 2,187

Production time

Production time is also a costing method that can be applied to allocate indirect costs in a company. In this case, the period of use of the machines involved in the manufacture of the products is associated with the electricity bill.

Continuing with the bakery example, consider the values ​​below related to the time to produce each type of bread and the energy costs in each production cycle.

This third calculation is even less subjective and gives results closer to reality, even though it is an approximation calculation method.

To obtain exact values, the bakery could install meters on the machines used to obtain the exact electricity costs for each manufacturing cycle.

However, this would move the expense into the direct cost category, since the precise value of the resource would be obtained.

Is electricity a direct or indirect cost?

Generally, electricity is considered an indirect cost for companies, since the value is used throughout the structure, requiring calculation using the apportionment method.

However, if the company performs personalized measurements of the equipment involved in production, this can be classified as a direct cost.