Based on traceability, costs can be classified into direct and indirect costs.
Now let's look at direct and indirect costs.
Direct costs
Direct costs are those costs that can be traced and attributed directly to a specific cost unit or cost centre.
They are those costs which can be directly identified with a job, batch, product or service.
A direct cost is a cost that can be traced in full to the product, service, or department that is being costed.
An example of direct cost is the cost of the engine in the car because the costs can be directly traced to a specific car.
Direct costs are generally classified into three categories: direct material costs, direct labour costs, and direct expenses.
A. Direct material costs: These are the cost of materials that are used in making and selling a product or providing a service.
Direct materials consist of all those materials that can be identified and traced with a specific product or service.
For example, the wood that is used the manufacture a table can easily be identified as part of the product and thus can be classified as direct materials.
Other examples of direct material costs include the cost of raw materials used in production, the cost of plants and assemblies that are incorporated into finished goods, etc
B. Direct labour costs: These are the specific costs of the workforce used to make a product or provide a service.
Direct costs include wages, salaries, and other forms of compensation paid to employees who are directly involved in the production process
Generally speaking, all labour costs that can be specifically traced to or identified with a particular product are considered direct labour costs.
Direct labour costs are calculated by measuring the time taken for a job, or for direct production work.
C. Direct expenses: These are expenses that have been incurred in full as a direct consequence of making a product, providing a service, or running a department.
These expenses are specifically incurred for a particular product, service, or batch.
Examples of direct expenses include royalties paid per unit for a copyright design and plant charges for a particular job or batch.
Note: The summation of all direct costs is sometimes referred to as prime costs.
Therefore, prime consists of direct labour costs plus direct material costs plus any direct expenses.
Indirect costs
Indirect costs are expenses that are incurred in the process of producing a product, providing a service, or running a department, but which cannot be directly attributed to a specific product or service
Generally speaking, all material, labour and expenses costs which cannot be identified as direct costs are termed indirect costs.
Indirect costs are also known as overheads and can be divided into three categories: indirect materials, indirect labour, and indirect expenses.
Typical examples of indirect costs are supervisory wages, cleaning materials, building insurance, etc.
A. Indirect material cost: These are materials costs that cannot be easily identified with any one product because they are used for the benefit of all products rather than for any one specific product.
They are costs of materials that are necessary for the production of a product, but cannot be directly attributed to a specific product or service
Examples of indirect materials include lubricating oil, stationery, consumable materials, maintenance materials, and spare parts for machinery.
B. Indirect labour costs: This consists of the wages of all employees who do not work on the product itself but who assist in manufacturing operations.
All wages and salaries paid to workers who are not directly related to the production of goods and services are considered indirect labour costs.
Examples of indirect labour costs include factory supervisor wages and storemen wages.
C. Indirect expenses: Any costs which cannot be traceable to a product or services, which are neither labour costs or material costs, are called indirect expenses.
Examples of indirect expenses include rent and rates for the factory, depreciation of machinery, building insurance, and cleaning materials.