What are Indirect Costs – Definition Explained

Indirect costs are costs used by multiple activities, and which cannot, therefore, be assigned to specific cost objects. Examples of cost objects are products, services, geographical regions, distribution channels, and customers. Instead, indirect costs are needed to operate the business as a whole.

Indirect Costs Explained

What are Indirect Costs

Indirect costs are costs that are not directly accountable to a cost object (such as a particular project, facility, function, or product). Indirect cost may be either fixed or variable. Indirect costs include administration, personnel, and security costs.

These are those costs that are not directly related to production. Some indirect costs may be overhead. But some overhead costs can be directly attributed to a project and are direct costs.

There are two types of indirect costs. One is the fixed indirect cost which contains activities or costs that are fixed for a particular project or company like transportation of labor to the working site, building temporary roads, etc.

The other is recurring indirect costs which contain activities that repeat for a particular company like maintenance of records or payment of salaries.

Indirect Costs Explained

Indirect costs include costs which are frequently referred to as overhead expenses (for example, rent and utilities) and general and administrative expenses (for example, officers’ salaries, accounting department costs, and personnel department costs).

Commercial (for-profit) organizations usually treat “fringe benefits” as indirect costs. These fringe benefits are applied to direct salaries charged to projects either through a fringe benefit rate or as part of an overhead/indirect cost rate.

Therefore, fringe benefits treated as indirect costs should not be included as a direct cost in the “Personnel” category of the budget form of the grant application or on a contract proposal.

The indirect cost base or bases (that is, the denominator(s) of the fraction producing a rate) should be selected so as to permit an equitable distribution of indirect costs to the benefiting cost objectives.

Generally, indirect cost rate structures for commercial organizations follow a single, two-rate (for example, fringe and overhead rates), or three-rate (for example, fringe, overhead, and General and Administrative expense rates) system. A single rate structure is illustrated below.

Indirect Costs definition

Example

Looking at it another way, indirect costs are those costs that are not classified as direct. Direct costs can be identified specifically with particular cost objectives such as a grant, contract, project, function, or activity. Direct costs generally include:

  • Salaries are wages (including vacations, holidays, sick leave, and other excused absences of employees working specifically on objectives of a grant or contract – i.e, direct labor costs).
  • Other employee fringe benefits allocable on direct labor employees.
  • Consultant services contracted to accomplish specific grant/contract objectives.
  • Travel of (direct labor) employees.
  • Materials, supplies and equipment purchased directly for use on a specific grant or contract.
  • Communication costs such as long distance telephone calls or telegrams identifiable with a specific award or activity.

Costs usually charged directly

  • Salary/wages
  • Consultants
  • Materials
  • Tools
  • Rent
  • Transport
  • Labour
  • Direct materials
  • PPC
  • Any kind of subcontract which is attributable to direct works but the specific company does not possess the required skill

Costs either charged directly or allocated indirectly

  • Director’s salary (this is usually an indirect cost)
  • Electricity (mostly if it needs allocation it is always indirect)

Note that if electricity is not used as the primary source for production then electricity cost will be treated as a utility and is always indirect. For example, if electricity is required to run the boiler which in turn generates steam, then electricity needs to be allocated directly.

Costs usually allocated indirectly

  • Indirect costs related to transport
  • Administration cost
  • Selling & distribution cost
  • Office cost
  • Security cost
  • Shipping and Postage
  • Utilities and rent

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