Definition: Indirect costs are expenses that cannot be traced back to a single cost object or cost source. During the manufacturing process, items like products, departments, and customers create costs. These are considered cost objects because the original manufacturing costs stem from them.
What Does Indirect Cost Mean?
Managerial accountants look at cost objects in order to understand the over cost of manufacturing a product. Each expense is allocated to its applicable cost object. For instance, a tire manufacturer might trace rubber raw materials back to the tire. The tire is the cost object and the raw materials are considered a direct cost because they can be traced back to a cost object.
Indirect costs cannot be traced back to a cost object. These expenses are general costs like factory utilities. The tire manufacturer can’t trace the electric bill back to a specific cost object or product because the electricity is used to make all the products produced by the manufacturer.
The same is true with rent and administrative expenses. The building rent benefits all the company operations equally. The rent cannot be traced back to a single product or cost object. Administrative expenses are equally untraceable.
Indirect costs are usually allocated to cost objects based on a pro rata basis. For instance, factory overhead can be allocated to each product produced by the total number of products or based on the total number of hours it took to manufacture each product. This way the indirect costs are apportioned to the cost objects in a meaningful way.