assignment of indirect costs

Direct Manufacturing Costs for Products Alpha and Beta

In one fiscal year, the firm manufactures and sells the following:

• Product Alpha: 1,800,000 units at $3.00 each
• Product Beta: 2,100,000 units at $2.00 each.

 The revenues and direct costs for these sales appear in Exhibit 2.

Indirect Manufacturing Cost Totals for Products Alpha and Beta

The so-called indirect or overhead costs for manufacturing products Alpha and Beta are the total costs for support activities (overhead). Exhibit 3, below, shows the indirect cost totals for the period's production. 

Allocating Indirect Costs for the Cost Pool Example Calculations

T he simple cost allocation method appearing here uses only the indirect cost total from the Exhibit 3 bottom line. Here, the total indirect cost line is the cost pool for allocation later to individual product units. A more complex example could, of course, use single items (for example, Purchasing materials) as cost pools and then allocate each pool's costs by its own rules.

For this example, however, putting all indirect costs into a single cost pool is appropriate because allocation percentages will derive from a single direct cost item. That direct cost item is known as a cost base .

Selecting a Cost Base for Allocation

In traditional cost accounting, firms usually allocate the indirect cost total ( cost pool ), based on proportional usage of a designated resource they can measure directly (the cost base ). This approach is production volume based (PVB) cost allocation.

PVB allocation, however, can allocate the total indirect cos to each product based on factors such as the:

• Production machine time for a product unit.
• Direct labor time for a product unit.
• Manufacturing floor space each product uses.

Other factors may also serve this purpose. For this example, however, the firm selects direct labor costs as the cost base for allocation. 

Using Direct Labor as a Basis for Allocation

Note that the indirect cost total from Exhibit 3 above is $1,422,500. And, the direct labor total (line 6 from Exhibit 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product's own direct labor cost:

 Indirect labor cost / direct labor cost         = $1,422,500 / $1,500,000          = 0.948         = 94.8%

Direct labor costs for both products appear in line 6 of Exhibit 2. As a result, the indirect cost allocations are as follows:

• Product Alpha:       Direct labor costs = $450,00.       Indirect cost allocation = 94.8% of $450,000                                                 = $426,750.
• Product Beta:       Direct labor costs = $1,050,000.        Indirect cost allocation = 94.8% of $1,050,000                                                 = $995,750.

Allocating Indirect Costs to Product Units

Exhibit 4 shows how this allocation leads to indirect cost estimates per unit. Also, the Exhibit also shows the resulting gross profit and gross margin for each product unit.

Conclusions: Product Volume Based Allocation Example

• Firstly, the estimated Indirect cost per unit is the same for both products, $0.47 (Exhibit 4, line 14). This equality must be the case because" indirect costs" for both products apply the same allocation rate ( 94.8%) to the same direct labor costs ($0.50 / unit).
• Secondly, on a per unit basis, this costing method finds Product Alpha more profitable than product Beta. The Gross margin rate of 42.5% for Alpha compares with a Gross margin of 26.3% for Beta.

Note that this same example appears in the article " Activity Based Costing ." That article compares costing results under Activity Based costing to traditional costing results like those above. As a result, ABC finds different indirect costs and therefore different margins and profits for products Alpha and Beta.

Activity Based Costing Turns Indirect Costs Into Direct Costs Why Do Firms Turn to Activity Based Costing?

C ost accountants are well aware that allocated (or apportioned) costing methods can be problematic. The primary problem is that they do not always reflect actual resource usage accurately. This problem is a particular concern when it is essential to know precisely the "true cost" of, say, manufacturing Product Alpha compared to the "true cost" of product Beta.

Accurate knowledge of these costs can be essential for the following:

• Accurate financial accounting reports.
• Effective product lifecycle management.
• Effective product portfolio management.

Nevertheless, there may be little assurance that cost allocation rules like those above accurately reflect real differences in product costs. 

Some Turn to Activity Based Costing

As a result, some organizations turn from allocation costing to Activity Based costing (ABC) . ABC assumes the following:

• Product production should be analyzed first from the activities that go into it (for example, manufacturing machine set up and machinery maintenance).
• Then, the analyst measures the resources that go into each activity. Resources may include, for example, skilled labor hours, unskilled labor hours, electricity, fuel, replacement parts, and others.

Accountants then determine the total cost for each activity by the very measurable "costs" of the resources it uses.

ABC then finds the cost of producing each product by referring to the product's usage of each activity. As a result, Activity Based costing essentially converts many of the indirect costs from traditional costing into direct costs.

• The advantage to ABC is that it provides more accurate, direct measurement of some cost objects than does traditional cost allocation.
• The disadvantage to ABC is that it is "accounting intensive," that is, it requires substantially more hours of analysis and accounting time than traditional methods.

For a complete introduction to ABC, see the article Activity Based Costing.

What is Cost Structure?

Fixed vs. variable costs, fixed costs, variable costs, direct vs. indirect costs, direct costs, indirect costs, cost allocation, example of cost allocation, the importance of cost structures and cost allocation, additional resources, cost structure.

The different types of cost structures incurred by a business

Cost structure refers to the various types of expenses a business incurs and is typically composed of  fixed and variable costs . Costs may also be divided into direct and indirect costs. Fixed costs are costs that remain unchanged regardless of the amount of output a company produces, while variable costs change with production volume.

Direct costs are costs that can be attributed to a specific product or service, and they do not need to be allocated to the specific cost object. Indirect costs are costs that cannot be easily associated with a specific product or activity because they are involved in multiple activities.

Operating a business must incur some kind of costs, whether it is a retail business or a service provider. Cost structures differ between retailers and service providers, thus the expense accounts appearing on a  financial statement  depend on the cost objects, such as a product, service, project, customer or business activity. Even within a company, cost structure may vary between product lines, divisions or business units, due to the distinct types of activities they perform.

Key Highlights

• Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs, or direct and indirect costs.
• Fixed costs are incurred regularly and are unlikely to fluctuate over time. Variable costs are expenses that vary with production output.
• Direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct costs are usually variable costs, with the possible exception of labor costs. Indirect costs are costs that are not directly related to a specific cost object. Indirect costs may be fixed or variable.
• Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers.

Fixed costs are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs are overhead costs such as rent, interest expense, property taxes, and  depreciation  of fixed assets. One special example of a fixed cost is direct labor cost. While direct labor cost tends to vary according to the number of hours an employee works, it still tends to be relatively stable and, thus, may be counted as a fixed cost, although it is more commonly classified as a variable cost where hourly workers are concerned.

Variable costs are expenses that vary with production output. Examples of variable costs may include direct labor costs,  direct material cost , and bonuses and sales commissions. Variable costs tend to be more diverse than fixed costs. For businesses selling products, variable costs might include direct materials, commissions, and piece-rate wages. For service providers, variable expenses are composed of wages, bonuses, and travel costs. For project-based businesses, costs such as wages and other project expenses are dependent on the number of hours invested in each of the projects.

As alluded to earlier, direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct material is an example of a direct cost.

Direct costs are almost always variable because they are going to increase when more goods are produced. As discussed earlier, an exception to this is labor. Employee wages may be fixed and unlikely to change over the course of a year. However, if the employees are hourly and not on a fixed salary then the direct labor costs can increase if more products are manufactured.

Indirect costs are costs that are not directly related to a specific cost object like a function, product or department. They are costs that are needed for the sake of the company’s operations and health. Some other examples of indirect costs include overhead , security costs, administration costs, etc. The costs are first identified, pooled, and then allocated to specific cost objects within the organization.

Indirect costs may be either fixed or variable costs. An example of a fixed cost is the salary of a project supervisor assigned to a specific project. An example of a variable indirect cost would be utilities expense. This expense may fluctuate depending on production (for example, there would be an increase in utility expense if a manufacturing plant is running at a higher capacity utilization ).

Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers. Knowing the actual costs of production enables the company to price its products efficiently and competitively.

Cost allocation is the process of identifying costs incurred, and then accumulating and assigning them to the right cost objects (e.g. product lines, service lines, projects, departments, business units, customers, etc.) on some measurable basis. Cost allocation is used to distribute costs among different cost objects in order to calculate the profitability of different product lines.

A cost pool is a grouping of individual costs, from which cost allocations are made later. Overhead cost, maintenance cost and other fixed costs are typical examples of cost pools. A company usually uses a single cost-allocation basis, such as labor hours or machine hours, to allocate costs from cost pools to designated cost objects.

A company with a cost pool of manufacturing overhead uses direct labor hours as its cost allocation basis. The company first accumulates its overhead expenses over a period of time (for example, a year) and then divides the total overhead cost by the total number of labor hours to find out the overhead cost “per labor hour” (the overhead allocation rate ). Finally, the company multiplies the hourly cost by the number of labor hours spent to manufacture a product to determine the overhead cost for that specific product line.

To maximize  profits , businesses must find every possible way to minimize costs. While some fixed costs are vital to keeping the business running, a  financial analyst  should always review the financial statements to identify possible excessive expenses that do not provide any additional value to core business activities.

When an analyst understands the overall cost structure of a company, they can identify feasible cost-reduction methods without affecting the quality of products sold or service provided to customers. The financial analyst should also keep a close eye on the cost trend to ensure stable cash flows and no sudden cost spikes occurring.

Cost allocation is an important process for a business because if costs are misallocated, then the business might make wrong decisions, such as over/underpricing a product, or invest unnecessary resources in non-profitable products. The role of a financial analyst is to make sure costs are correctly attributed to the designated cost objects and that appropriate cost allocation bases are chosen.

Cost allocation allows an analyst to calculate the per-unit costs for different product lines, business units, or departments, and, thus, to find out the per-unit profits. With this information, a financial analyst can provide insights on improving the profitability of certain products, replacing the least profitable products, or implementing various strategies to reduce costs.

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Cost Allocation – Meaning, Importance, Process and More

Cost Allocation or cost assignment is the process of identifying and assigning costs to the various cost objects. These cost objects could be those for which the company needs to find out the cost separately. A few examples of cost objects can be a product, customer, project, department, and so on.

The need for cost allocation arises because some costs are not directly attributable to the particular cost object. In other words, these costs are incurred for various objects, and then the sum is split and allocated to multiple cost objects. These costs are generally indirect. Since these costs are not directly traceable, an accountant uses their due diligence to allocate these costs in the best possible way. It results in an allocation that could be partially arbitrary, and thus, many refer cost allocation exercise as the spreading  of a cost.

Examples of Cost Allocation

• Cost Allocation – Importance

Cost Allocation Method

Define costs, identify cost objects, basis of allocation, accumulate costs into cost pool.

For example, a company’s CEO uses his car for personal and official purposes. So, if the CEO decides to allocate costs, then they will divide the cost (fuel, maintenance, etc.) for business and personal use based on usage.

The following examples will help us understand the cost allocation concept better:

• A company has a building in which there are various departments. One can allocate depreciation costs to the department on the basis square ft area of each department. This cost will then be further assigned to the products on which the department works.
• An accountant can attribute electricity that a production facility consumes to different departments. Then the accountant can assign the department’s electricity cost to the products that the department works on.
• An employee works on three products for a month. To attribute their salary to three products, an accountant can use the number of hours the employee gave to each product.

Cost Allocation – Importance

The following points reflect the importance of allocating costs:

• Allocating cost is essential for financial reporting, i.e., to correctly assign the cost among the cost objects.
• It allows the company to calculate the true profitability of the department or function. This profitability could serve as the basis for making further decisions for that department or service.
• If cost allocation is correct, it allows the business to identify and understand the costs at each stage and their impact on the profit or loss. On the other hand, if the allocation is incorrect, the company may end up making wrong or inconsistent decisions concerning the distribution of resources amongst various cost objects.
• The concept is also useful for finding the transfer prices when there is a transaction between subsidiaries.
• It helps a company make better economic decisions, such as whether or not to accept a new order.
• One can also use the concept to evaluate the performance of the staff.
• It helps in better explaining to the customers the costs that went into the pricing of a product or service.
• Allocation cost helps a company know where the money is going and how much. It will assist the company in using the resources effectively. Pool costs, if not allocated, may give an unbalanced view of the cost of various objects.

As such, there is no specific method to allocate costs. So, an accountant needs to use his or her due diligence to assign a cost to the cost object. Of course, they are considering the practice adopted in a similar industry. For instance, the accountant may decide to allocate expenses based on headcount, area, weightage, and so on.

Also Read: Cost Object – Meaning, Advantages, Types and More

Irrespective of the method an accountant uses, their objective should be to allocate the cost as fairly as possible. Or to allocate cost in a way that is in line with the nature of the cost object. Or to lower the arbitrariness in awarding costs.

Several efforts are underway to better cost allocation techniques. For instance, the overhead allocation for manufacturers, which was on plant-wide rates, is now based on departmental standards. Also, accountants use machine hours instead of direct labor hours for allocation.

Moreover, some accountants are also implementing activity-based costing to better the allocation. So, there can be several ways to allocate costs. But, whatever form the company selects, it is essential to document the reasons backing that method, and that need to be followed consistently for several periods.

A company can ensure documentation by developing allocation formulas or tables. Moreover, if a company wants, it can also pass supporting journal entries to transfer costs to the cost objects or do it via the chargeback module in the ERP system.

Also Read: Cost Hierarchy – Meaning, Levels and Example

Nowadays, cost allocation systems are available to assist in cost allocation. Such systems track the entity that produces the goods or services and the body that consumes those goods or services. The system also identifies the basis to distribute the cost.

The process to Allocate cost

As said above, there are no specific methods for allocating costs. Similarly, there is no particular process for it, as well. However, the process we are detailing is one of the most popular, and many companies use it for allocating costs. Following is the process:

Before allocating the cost, a company must define the various types of costs. Generally, there are three types of costs – direct, indirect, and overhead. Direct costs are those that one can easily attribute to a product or service, such as wages to factory workers or raw material for the specific product.

Indirect costs are ones that a company needs to incur for its operations, such as administration costs. Primarily, these are the costs that a company needs to allocate as it is difficult to attribute them directly to a product or service or any other cost object.

Another type of cost is an overhead cost , which is also an indirect cost. These costs are incurred for the production and selling of goods or services. Such costs do not vary based on production or sales. A company needs to pay them even if it is not producing or selling anything. Research and development costs, rent, etc., are good examples of such a cost.

The company or the accountant must know the cost objects for which they need to allocate the cost. It is crucial as we can’t assign costs to something on which we have no information. A cost object could be the product, customer, region, department, etc.

Along with the cost object , the company must also determine the basis on which it would allocate the cost. This basis could be the number of hours, area, headcount, and more. For example, if headcount is the basis of allocation for insurance costs and a company has 500 employees, then the department with 100 employees will account for 20% of the insurance cost. Experts recommend choosing a cost allocation base that is a crucial cost driver as well.

A cost driver is a variable whose increase or decrease leads to an increase or decrease in the cost as well. For instance, the number of purchase orders could be a cost driver for the cost of the purchasing department.

An accountant may create many categories to pool costs, which are to be allocated subsequently. It is the account head where the costs should be accumulated before assigning them to the cost objects. Cost pools can be insurance, fuel consumption, electricity, rent, depreciation, etc. The selection of the cost pool primarily depends on the use of the cost allocation base.

Continue reading – Costing Terms .

RELATED POSTS

• Cost Structure
• Types of Costs and their Classification
• Cost Accounting and Management Accounting
• Types of Cost Accounting
• Cost Accumulation: Meaning, Types, and More
• Types of Costing

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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What Is an Indirect Cost?

To turn a profit in your business, you need to make sure your products or services bring in more money than what you put into them. But if your business expenses are greater than your revenues, you won’t stay afloat. Learn about indirect cost and how to calculate and reduce it.

What is indirect cost?

Indirect expenses, or overhead costs , are expenses that apply to more than one business activity. You cannot apply an indirect cost directly to the production of a specific good or service. Instead, they are costs that go into running your business as a whole. If you want to determine the portion of your indirect costs that go towards producing certain items, you must distribute the costs.

Your indirect expenses can be either fixed costs or variable costs .

Fixed costs are expenses that are the same regardless of how many goods or services you produce. An example of a fixed indirect cost would be rent.

On the other hand, variable costs are expenses that change depending on how many goods or services you produce. An example of a variable indirect cost includes equipment maintenance.

For more examples of indirect costs, see the list below.

Indirect cost examples

Every business has indirect costs. Here are just some of the indirect expenses you might have:

• Professional fees
• Administrative expenses
• Office supplies
• Employee salaries
• Advertising
• Equipment maintenance

The above expenses are considered indirect if they cannot be applied toward a single product or service. Office supplies, for example, are indirect if they are not direct materials to create products.

Let’s look at rent. You need to pay rent to keep your business building. But, the money you pay towards rent does not go towards producing a specific product. Instead, rent payments make it possible to produce all your products and run your business.

What is the difference between indirect and direct costs?

Indirect expenses aren’t the only costs you will have at your business. You will also have direct costs, which are expenses you can assign to the production of a specific product or service.

Unlike indirect costs, you do not divide direct costs among different departments or projects. You must know your business’s direct and indirect costs when pricing products and updating your accounting books so your records are accurate. And, you need to separate costs to claim tax deductions.

Examples of direct expenses include manufacturing materials, direct materials, and direct labor.

Identifying your indirect expenses might be a little tricky. What is considered an indirect cost for one company might be considered a direct cost for another. And, one employee’s salary might be an indirect cost while another’s is a direct cost. For example, an employee on an assembly line receives wages that are considered direct costs. But an employee who works as a secretary in the same company would receive wages that are considered indirect expenses.

Indirect cost rate calculation

If you want to determine your indirect cost rate, you need to use cost allocation. Cost allocation is the process of distributing your indirect costs among specific departments or projects.

You can use the indirect rate calculation to price your products. You want your offerings to generate enough money to cover your expenses. By considering your indirect and direct expenses, you can determine a reasonable cost for your products or services so you don’t underprice.

Another reason to use the indirect cost rate formula is so you can decide whether your expenses are too much. If your indirect costs are too high, you can find ways to reduce your expenses.

You can allocate indirect costs by taking your total indirect expenses and dividing them by some sort of allocation measure, like direct labor expenses, direct machine costs, or direct material costs.

Here is the indirect cost formula, or overhead rate:

Indirect Rate = Indirect Costs / Allocation Measure

The formula gives you a ratio. Let’s say that you want to find your overhead rate using your direct labor expenses.

Your total indirect costs are $10,000 and your direct labor expenses are $5,000. Your formula would look like:

Indirect Rate = $10,000 / $5,000

In this example, your indirect rate is 2:1, meaning you spend $2 of overhead per $1 of direct labor expenses. The lower your indirect rate, the better.

How to reduce indirect expenses

Knowing how to reduce expenses in business is essential if you need to increase your profits. You can reduce your indirect expenses using the following strategies.

Compare vendors to make sure you are getting the best deal. Expenses like office supplies can vary from provider to provider, so see if there are others who are less expensive.

If you want to reduce indirect expenses like utilities, cut your bills down by conserving energy. You can power down equipment when you aren’t using it, purchase energy-conserving equipment, or switch utility providers.

You can reduce other indirect costs, like advertising, by engaging customers through social media or using other inexpensive marketing ideas.

There are many ways you can reduce your indirect expenses. Consider how valuable the expense is to operating your business and come up with ways to slash the price.

Use Patriot’s online accounting software to track all of your business expenses. Our software is made for the non-accountant, so you can update your books on your own. Try it for free today!

This article is updated from its original publication date of March 13, 2018.

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• Cost Classifications
• Relevant Cost of Material
• Manufacturing Overhead Costs
• Conversion Costs
• Quality Costs
• Revenue Expenditure
• Product Cost vs Period Cost
• Direct Costs and Indirect Costs
• Prime Costs and Conversion Costs
• Relevant vs Irrelevant Costs
• Avoidable and Unavoidable Costs
• Cost Allocation
• Joint Products
• Accounting for Joint Costs
• Service Department Cost Allocation
• Repeated Distribution Method
• Simultaneous Equation Method
• Specific Order of Closing Method
• Direct Allocation Method

Cost allocation is the process by which the indirect costs are distributed among different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

Typical cost allocation mechanism involves:

• Identifying the object to which the costs have to be assigned,
• Accumulating the costs in different pools,
• Identifying the most appropriate basis/method for allocating the cost.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

• Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
• Number of purchase orders can be a good cost driver for cost of purchasing department,
• Number of invoices sent can be a good cost driver for cost of billing department,
• Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

Cost allocation base

Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

Related Topics

• Cost Behavior

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What are Indirect Costs of a Cost Object?

Home › Accounting › Cost Accounting › What are Indirect Costs of a Cost Object?

Definition:  For a cost object, an indirect cost are those costs that cannot be linked to a specific object, job, customer, or process directly. In other words, they are costs that do not increase in direct proportion with increasing cost objects.

• What Does Indirect Costs of a Cost Object Mean?

Summary Definition

What is the definition of indirect cost of an object?  In an organization, a cost object is anything for which a cost can be allocated. Examples of  cost objects  include but are not limited to clients, functional departments, goods that are produced, and services rendered by the business. When determining how costs in a business will be assigned,  direct costs  are easy to assign because they have a direct relationship to the cost object. For indirect costs of a cost object, however, it must be determined how these costs will be split up since they are not directly tied to the cost object.

Indirect costs  are assigned to a cost object using different methods. These include  activity-based costing , proportional allocation, and cost rate allocation. Most of these methods include looking at an indirect cost pool and determining how much of the pool should go to each cost object.

Let’s look at an example.

Mr. Scout is the  CFO  of a mid-sized law firm in Florida. His has many clients, and while it is simple to determine the allocation of some costs, the indirect costs are more challenging for him to assign. Which of the following costs are considered indirect costs?

• Attorney labor hours
• Secretary’s salary
• Rent of the building
• Travel expenses
• Internet expense

Attorney labor hours, travel expense, and postage are likely directly charged to the cost object (the client). However, the secretary’s salary, rent, and internet expense do not increase directly with the cost object and are therefore indirect costs for the cost object.

Define Indirect Costs of a Cost Object:  This means the expenses that cannot be traced back to a production process.

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Overhead Allocation: Assigning Indirect Costs to Cost Objects

Jttaccounting - july 1, 2023.

Overhead allocation is a crucial process in cost accounting that involves assigning indirect costs to cost objects. Indirect costs, such as rent, utilities, and administrative expenses, cannot be easily traced to specific products or services. By using appropriate allocation methods, businesses can distribute these costs to cost objects, such as products, departments, or projects. In this blog post, we will explore the concept of overhead allocation, discuss various allocation methods, and highlight its significance in cost management.

• Understanding Overhead Allocation: a. Definition: Overhead allocation refers to the process of assigning indirect costs to cost objects in a systematic and reasonable manner.

b. Indirect Costs: Indirect costs are expenses that are not directly linked to a specific product, service, or department but contribute to the overall operations of the organization.

• Importance of Overhead Allocation: a. Accurate Cost Determination: Overhead allocation ensures that indirect costs are appropriately attributed to cost objects, allowing for a more accurate determination of the total cost associated with producing a product or delivering a service.

b. Pricing Decisions: Proper overhead allocation helps in setting competitive prices by incorporating the full cost of production, including indirect costs, into the pricing strategy.

c. Resource Allocation: Overhead allocation enables businesses to allocate resources efficiently by considering the true cost of various cost objects.

• Methods of Overhead Allocation: a. Direct Labor Hours: Overhead costs are allocated based on the number of direct labor hours incurred for each cost object. This method assumes that overhead costs are related to labor activity.

b. Machine Hours: Overhead costs are allocated based on the number of machine hours used by each cost object. This method is suitable when machinery is a significant contributor to indirect costs.

c. Percentage of Direct Costs: Overhead costs are allocated based on a percentage of the direct costs incurred for each cost object. This method assumes a proportional relationship between indirect costs and direct costs.

d. Activity-Based Costing (ABC): ABC allocates overhead costs based on the activities that drive those costs. It identifies cost drivers and assigns overhead costs to cost objects based on their consumption of those drivers.

• Factors Influencing Overhead Allocation: a. Cost Variability: Some overhead costs may vary with changes in production levels or other factors. Businesses must consider this variability when selecting an allocation method.

b. Cost Pool Accuracy: Accurate cost pools are essential for effective overhead allocation. Cost pools should be structured to reflect the nature and behavior of the costs being allocated.

• Challenges and Considerations: a. Cost Drivers: Identifying appropriate cost drivers for overhead allocation can be challenging, as some costs may not have a direct causal relationship with specific activities.

b. Complexity and Accuracy: Overhead allocation requires careful analysis and consideration to ensure accuracy and avoid distortions in cost allocation.

• Modern Approaches to Overhead Allocation: a. Advanced Cost Management Systems: Technology-driven cost management systems, such as enterprise resource planning (ERP) software, provide sophisticated overhead allocation capabilities, allowing for more accurate and efficient allocation processes.

b. Real-Time Tracking: Automation and real-time data collection enable businesses to track and allocate overhead costs more accurately, leading to improved decision-making.

Conclusion: Overhead allocation is a critical aspect of cost accounting that ensures indirect costs are appropriately assigned to cost objects. By employing suitable allocation methods, businesses can accurately determine the total cost of producing goods or delivering services, make informed pricing decisions, and allocate resources effectively. It is important for organizations to carefully consider the nature of their costs and select the most appropriate allocation method to achieve accurate cost representation and optimal cost management.

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What Are Some Ways to Allocate Indirect Cost?

Cost allocation is significantly more straightforward when allocation involves direct rather than indirect costs. The object of cost allocation is to assign costs to one or more specific cost objects or objectives, something that can't be done with costs such as utility expenses, wages for office administration personnel and business insurance. Despite inherent difficulties, however, there are ways to accurately allocate indirect costs.

Fixed Cost Classification

Fixed cost classification is the simplest way to allocate indirect costs. This method works with costs such as depreciation and labor that can be classified as fixed. Fixed costs are allocated as a fixed charge to a specific business asset or department within the business. For example, depreciation expenses for a trash compactor are allocated to the machine, wages for employees in the receiving department are allocated to the department manager and office supplies expense are allocated according to the department ordering the supplies.

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Why do companies have predetermined overhead rates, reasons to allocate costs, what is included in figuring out the predetermined overhead rate for manufacturing, how to calculate the total manufacturing price per unit, functional based cost accounting basics, proportional allocation.

Proportional indirect cost allocation assigns a percentage of an indirect cost to all or several departments within the business. Percentages can be determined each month for each indirect cost but most often are assigned and reviewed annually. The amount each department is charged depends on the type of cost. For example, a heating bill might be allocated according to the number of square feet each department occupies, while a telephone bill -- minus long distance charges that can be traced to a specific department -- might be allocated evenly between every department.

Activity-Based Cost Allocation

Activity-based indirect cost allocation is more time-consuming but is also a more accurate method for allocating indirect costs. It first requires managers to identify and record each business activity a department performs. Activities then are categorized as incurring direct or indirect costs. At the end of reporting period, such as at month's end, records are reviewed, indirect cost rates are calculated and the appropriate indirect costs are allocated.

Cost Rate Calculations

Indirect cost rate calculations can be determined by dividing an indirect cost by a cost object, such as sales revenues or square footage. Indirect cost rates for proportional allocation also can be calculated using an overhead cost calculation. An overall overhead cost rate can be calculated by dividing individual or total indirect costs by the direct costs each department incurs.

Assume, for example, that total indirect costs are $3,000. The printing department has direct costs totaling $4,000, and the mail room has direct costs totaling $2,000 for a combined total of 6,000. Divide $3,000 by $6,000 to get an overhead rate of 50 percent. Then, multiply direct costs for each department to get the total indirect costs to be allocated to each department. In this case, $2,000 of indirect costs are be allocated to the print shop, and $1,000 is allocated to the mail room.

• U.S. Department of Education: Indirect Cost Overview
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• Internal Accounting Engineering: Allocation of Indirect Cost
• Inc.: How Do I Calculate My Overhead Rate?

Based in Green Bay, Wisc., Jackie Lohrey has been writing professionally since 2009. In addition to writing web content and training manuals for small business clients and nonprofit organizations, including ERA Realtors and the Bay Area Humane Society, Lohrey also works as a finance data analyst for a global business outsourcing company.

Everything you need to know about direct and indirect costs [explained by a Certified Accountant]

Explanation: What Are Direct and Indirect Costs?

Definition: what are direct costs.

For example, retailers spend money buying products wholesale and manufacturers spend money on raw materials and labor.

All other costs are considered to be indirect costs.

Definition: What are Indirect Costs?

Indirect costs are also referred to as:

• Operating expenses
• SG&A , which stands for other selling, general and administrative expenses.
• Overheads , such as manufacturing overhead for costs incurred in during manufacturing process; or administrative overhead for costs incurred in the general administrative operations of a business.

For example, it may not be possible or financially feasible to precisely determine how the activities of company directors benefit a particular product, service or project.

Similarly, a company may not be able to easily assign a utility bill (e.g., electricity, water, waste collection) to a particular cost object (e.g., department) because the utilities were used by the whole building.

Top 20 Examples: What Are Examples of Direct and Indirect Costs?

Top 8 direct costs examples.

The most common examples of direct costs include the following expenditures, assuming they are specific to a cost object , such as a product, service, department or project.

• Direct labor (e.g., hourly or piece rate wages of production line workers)
• Direct materials (e.g., raw materials like steel, wood, glass, rubber)
• Ingredients
• Manufacturing supplies
• Direct utility consumption (e.g., fuel, electricity, gas, water)
• Data center space
• Product transportation
• Commissions (e.g., sales commissions or patent royalty payments)

Top 12 Indirect Costs Examples

The most common examples of indirect costs include the following expenditures, assuming they are not specific to a cost object, such as a product, service, department or project.

• Production supervision salaries
• Corporate head-office administrative overhead expenses and salaries
• Marketing , advertising and selling expenses and salaries
• Accounting , payroll and legal expenses and salaries
• Office supplies and equipment
• Office hardware, software and other technology
• Rent , utilities , security
• Maintenance , repairs and cleaning
• Quality control and inspection
• Distribution , transportation, shipping and postage
• Depreciation and amortization

Direct vs. Indirect Costs

Combined , direct and indirect costs represent all of the expenses incurred to run a company’s day-to-day business operations.

The key difference between direct and indirect costs is in how closely they relate to business output :

• Direct costs go directly into producing products and services, such as materials and labor.
• Indirect costs are general expenses that keep a business operating, like marketing and administration.

In an example of a car manufacturer, the materials like steel, plastic or glass used in the car production line are classified as direct costs.

Indirect costs would be the utilities, administrative and marketing expenses and salaries involved in running of the overall business that cannot be easily assigned to a specific car production unit.

Tip: How to Distinguish Direct Costs from Indirect Costs?

In practice, it is possible to justify the classification of almost any expense as both direct and indirect.

To make the matter even more complicated, direct and indirect expense categories can vary among different industries and even within the same business.

Continuing with the example of a car manufacturer, the factory staff could be categorized as direct labor if they are working on a production line of one car model, whereas a supervisor overseeing multiple production lines and processes would likely be in the indirect labor category.

So, how do you tell them apart? Here’s the trick :

The rule of thumb for distinguishing direct and indirect costs is to ask two questions :

• 1. If I sold no products or services in a specific time period, would I still incur this expense for that time period?
• Yes >> indirect cost
• No >> direct cost
• 2. Can I directly associate a cost with the sale of a specific product or service?
• Yes >> direct cost
• No >> indirect cost

Top 7 Differences Between Direct and Indirect Costs

Looking more closely, there are 7 main differences between direct costs and indirect costs:

Keep reading to find out more about each of these differences >>>

Are Direct Costs Variable & Indirect Costs Fixed?

Indirect costs are sometimes referred to as fixed costs, which is not necessarily an accurate classification. Let’s debunk this myth right now >>>

Both direct and indirect costs can be fixed and variable, depending on how likely or regularly the cost is to change as business output grows:

Fixed Costs

For example:

• Manufacturing: The same amount of rent for a factory building needs to be paid throughout the year independently of whether the facility produces 1 unit or 10,000 units.  
• SaaS: Salary of an IT administrator that manages the cloud storage of customers’ data remains unchanged each month (up to a certain point when the company might need more than one administrator).

Variable Costs

• Manufacturing: The total cost of production materials (e.g., wood, glass or steel) increases or decreases in relation to the number of products manufactured. It is more costly to produce 1 unit than 10,000 units.
• SaaS: The total server costs increase as the company needs to buy more server space to satisfy growing customer demand.

Although most direct costs tend to be variable, there are exceptions to the rule and some direct costs may be considered fixed.

Let’s take a look at the example of labor costs, which is an expense that is notoriously difficult to label >>>

Labor Example: Is Labor Direct or Indirect Cost?

• Direct labor cost refers to the work directly related to a product or service being produced, delivered and sold, such as workers on a manufacturing assembly line.
• Indirect labor cost relates to roles that facilitate the ability of a business to make sales, but do not actually directly deliver the product or service, including management, administration and marketing staff.

Formula: How to Calculate Direct and Indirect Costs?

Direct cost calculation formula.

The direct cost formula is as follows:

Indirect Cost Calculation Formula

The indirect cost formula is as follows:

Which is equal to:

Accounting: What Are Direct & Indirect Costs in Financial Statements?

• How do you treat direct & indirect expenses for accounting purposes?
• Where do you show direct & indirect costs in a company's financial statements?

Keep reading to find out! >>>

Measurement & Valuation: How to allocate direct and indirect expenses?

Direct costs = attribution.

Direct costs need to be properly tracked , measured and valued so they can be correctly attributed directly to a specific cost object, such as a product, service or business unit.

For example , if the price of an essential component used in the production of goods fluctuates over time, the value of a cost item can be assigned based on which item was added to inventory first (method known as FIFO or first-in-first-out) or last (LIFO or last-in-first-out). Accordingly, the unit cost of production would be measured using the newest or oldest inventory items.

Although indirect expenses tend to be more difficult to allocate because their connection to a specific cost object is not always readily apparent, every business needs a reliable way to identify, quantify, assign and control them to achieve optimal financial health. This is especially true for entities with high ratio of indirect to direct costs.

Indirect Costs = Allocation

Indirect costs first need to be added together into a cost pool and then allocated out to cost objects pro rata in a fair and proportionate way, typically by dividing up the total shared pool of expenses based on cost drivers, such as usage, revenue generated or physical dimensions.

For example , factory overhead costs can be apportioned to each unit produced by the total number of products manufactured, or based on the number of hours it took to manufacture each product. This helps a company to calculate the overhead cost per unit so that prices can be set accordingly to ensure a profit is made on each product even after incorporating all indirect expenses.

In practice, there are several costing methods used to allocate indirect costs, such as activity-based costing (ABC) or fixed cost classification. Each method has its own pros and cons, for example in terms of impact on pricing, financial reporting and taxation.

Presentation: How are direct and indirect costs reported on an income statement?

Direct and indirect costs are reported under two separate line items on an income statement:

• Direct expenses and allocated indirect expenses are reported as costs of goods sold to calculate gross profit.
• Unallocated indirect expenses are reported as operating expenses to calculate operating profit.

This is  an example of how direct and indirect costs appear on a company’s income statement.

Let’s take a look at Cost of Goods Sold, Operating Expenses and Profit Margins in more detail >>>

Cost of Goods Sold (COGS)

Variations of the cost of goods sold line item in an income statement include:

• Cost of goods sold (COGS) – used in manufacturing to represent the exact cost incurred to produce goods
• Cost of sales (COS) – used in retail or wholesale to represent the cost of goods purchased for resale from suppliers
• Cost of revenue (COR) – used in the service industry to represent the costs associated with delivering services

Compared to direct costs, COGS/COS/COR is a broader term that encompasses all the cost related to production of an item, including not only the direct cost of materials and labor, but also any allocated overhead expenses.

Any finished goods that remain unsold are kept on a balance sheet as an asset . For that reason, a company may decide to classify certain costs as operating expenses instead of COGS. For example, a business may incur some direct labor costs even if it does not sell a single product/service.

Operating Expenses and SG&A

Profit margins.

Cost of goods sold (= direct costs + allocated indirect costs) is subtracted from sales revenue to calculate gross profit and gross profit margin; with the operating expenses (= unallocated indirect costs) then being subtracted from gross profit to arrive at operating profit and operating profit margin.

Profit margins serve as a good measure of how efficient and profitable a company is at providing its products and services.

The profit margins should be healthy enough to comfortably accommodate both direct and indirect expenses–and generate a net profit .

Analysis: Are High or Low Direct & Indirect Costs Better?

Hence, mastering cost management is an important part of running and growing a business.

Importance: Top 5 Benefits of Cost Management

Understanding the true total cost of producing goods and services enables a business to make sound decisions , particularly in the areas of pricing, budgeting, operational efficiency, and taxation.

1. Profitability

A business that accurately classifies and consistently tracks both indirect and direct expenditures can set its pricing to make sure that its customers pay more than it costs to offer the products or services (e.g, break-even point plus profit margin), with the aim to turn a profit while remaining competitive.

2. Efficiency

Continuous monitoring of direct and indirect expenses provides valuable insights into the efficiency of business operations to identify areas for improvement and cost optimization.

3. Budgeting

Correct allocation of direct and indirect costs leads to more accurate and transparent budgeting, forecasting and cash flow planning, as well as reporting for management and financial purposes.

4. Taxation

Proper cost classification will also come in handy when it is time to file a business tax return as some direct and indirect expenses may be tax deductible.

When an entity accepts a grant, such as government funding, the funding guidelines typically stipulate what qualifies as a direct versus indirect cost, along with any threshold amounts for each cost type.

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Indirect Costs

Updated July 29, 2023

Definition of Indirect Costs

The indirect costs are usually those expenses of a business that are used for multiple activities and can’t be directly assigned to a specific cost object like manufacturing of a product, service delivery, etc. Rather, they are required to operate the business as a whole.

Furthermore, recognizing the costs is crucial to exclude them from short-term pricing decisions where the management aims to set prices based on variable production costs. Indirect costs can be either fixed or variable costs. Examples of the fixed nature of indirect costs are building temporary roads, labor transportation to the working site, etc. In contrast, examples of the variable nature of indirect costs are payment of salaries, maintenance of records, etc.

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How to Calculate Indirect Costs?

The indirect cost for any company can be computed by using the following three simple steps:

• Step 1:  Firstly, it is to determine which input costs are indirect by nature for manufacturing a product or service delivery. Next, combine all these costs to arrive at the total manufacturing overhead .
• Step 2:  Next, calculate all the administrative and general costs that can’t be directly allocated to manufacturing the product or service delivery. Add all these costs together to arrive at the total administrative overhead.
• Step 3:  Finally, add together the total manufacturing overhead and administrative overhead that will eventually give the total indirect cost of the production.

Given below is the example mentioned:

Let us consider a factory named XYZ Ltd that has the following information, and from the below-furnished information, the total indirect cost of production has to be calculated.

• Raw material cost: $300,000
• Labor wages: $150,000
• Depreciation – $5,000
• Repairs and maintenance – $50,000
• Office electricity expense – $10,000
• Salaries – $100,000
• Factory supplies – $3,000
• Accounting expense – $10,000
• Audit expense – $5,000
• Legal expense – $3,000

Now, the Total Indirect Manufacturing Overhead is calculated as below.

• Total Indirect Manufacturing Overhead = $5,000 + $50,000 + $10,000 + $100,000 + $3,000
• Total Indirect Manufacturing Overhead = $168,000

Again, the Total Indirect Administrative Overhead is calculated below.

• Total Indirect Administrative Overhead = $10,000 + $5,000 + $3,000
• Total Indirect Administrative Overhead = $18,000

A few of the abovementioned expenses are not included in the Total cost calculation because they are direct costs. Those excluded costs in the above cases comprise raw material costs and labor wages.

Finally, the Total Indirect Cost can be calculated as below,

• Total Indirect Cost = $168,000 + $18,000
• Total Indirect Cost = $186,000

Relevance and Uses of Indirect Costs

• It can help companies to make significant pricing decisions. Usually, an accountant will add all the overhead costs and then allocate them based on the per-unit cost to compute the company’s overhead per product. This eventually helps a company ensure they are still making a profit on each unit, even after incorporating all the overhead costs.
• Ultimately, this becomes the foundation for the product pricing strategy before setting the desired profit margin. In the case of manufacturing companies, indirect material costs include items utilized for the production of the end product, which again is not part of the finished goods inventory. Such items can be glue, plastic wraps, staples, and tapes needed in production. Even though indirect material costs may vary widely depending on the nature of operations, it is crucial to include them when calculating overhead costs. Senior management should know the actual production cost, considering all input costs necessary in the manufacturing process. Otherwise, the financial reporting and the subsequent analysis may be inaccurate.
• Another kind of indirect cost that makes the production of a product possible but can’t be allocated to one particular product is classified as indirect labor costs. For instance, the salary of a production manager who manages the entire production process, not just one product line, or the salary of an employee who manages the company’s administrative offices. Additionally, salaries and fees paid to accountants, legal advisors, supervisors, and other support services personnel who contribute to making production possible are examples of labor costs. Senior management must be knowledgeable about the administrative cost of running a company. However, such indirect can become too large and impact the profit margins adversely, resulting in downsizing or labor reallocation. It is important to carefully evaluate indirect labor costs and analyze their impact on overhead costs to keep businesses operating efficiently and effectively.

Recommended Articles

This has been a guide to Indirect Costs. Here we discussed the concept with examples, relevance, and uses. You may also look at the following articles to learn more –

• Accrual Accounting vs Cash Accounting
• Accounting and Financial Management
• Direct cost vs Indirect Cost
• Manufacturing Overhead

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What Is Activity-Based Costing (ABC)?

How activity-based costing (abc) works, requirements for activity-based costing (abc), benefits of activity-based costing (abc), what are the five levels of activity in abc costing, what does activity-based costing seek to identify, how do you calculate abc costing, the bottom line.

• Corporate Finance

Activity-Based Costing (ABC): Method and Advantages Defined with Example

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This cost accounting method recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs—such as management and office staff salaries—are difficult to assign to a product.

Key Takeaways

• Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. 
• This system of cost accounting is based on "activities"; an activity is any event, unit of work, or task with a specific goal.
• All activities are cost drivers: Purchase orders and machine setups are examples of activities. 
• The cost driver rate, which is the cost pool total divided by the cost driver total, is used to calculate the amount of overhead and indirect costs related to a particular activity. 
• ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

Investopedia / Theresa Chiechi

Activity-based costing (ABC) is mostly used in the manufacturing industry. It enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. 

The formula for activity-based costing is the cost pool total divided by the cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. 

The ABC calculation is as follows:  

• Identify all the activities required to create the product. 
• Divide the activities into cost pools, which include all the individual costs related to an activity. Calculate the total overhead of each cost pool.
• Assign each cost pool activity cost drivers, such as hours or units.
• Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.
• Multiply the cost driver rate by the number of cost drivers. 

As an activity-based costing example, consider Company ABC, which has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked; in this example, this is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. 

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal—such as setting up machines for production, designing products, distributing finished goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involve counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours, to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity , unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. 

Second, it creates new bases for assigning overhead costs to items, so costs are allocated based on the activities that generate costs, instead of on volume measures—such as machine hours or direct labor costs. 

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation , utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

There are five levels of activity in ABC costing: unit-level activities, batch-level activities, product-level activities, customer-level activities, and organization-sustaining activities. Unit-level activities are performed each time a unit is produced. (For example, providing power for a piece of equipment is a unit-level cost.) Batch-level activities are performed each time a batch is processed, regardless of the number of units in the batch. Coordinating shipments to customers is an example of a batch-level activity.

Product-level activities are related to specific products; product-level activities must be carried out regardless of how many units of product are made and sold. (For example, designing a product is a product-level activity.) Customer-level activities relate to specific customers. An example of a customer-level activity is general technical product support. The final level of activity, organization-sustaining activity, refers to activities that must be completed regardless of the products being produced, how many batches are run, or how many units are made.

The goal of ABC costing is to optimize business activities and processes to enhance efficiency and reduce costs. It seeks to identify the highest cost drivers: the activities and processes that consume the most of a company's resources.

ABC costing is calculated by finding the total cost pool and dividing it by the cost driver. The cost pool is an aggregate of all the costs associated with performing a particular business task, such as making a particular product. Cost drivers are labor hours, machine hours, and customer contacts.

Activity-based costing (ABC) is a costing method that directly ties all overhead and indirect costs to specific products and services.

Activity-based costing recognizes the relationships between costs, overhead activities (all events, tasks, or units of work with a specific purpose), and manufactured products. The goal of activity-based costing is to understand a company's true costs and reduce inefficiencies by identifying the highest cost drivers: the activities and processes that consume most of a company's resources.

Chartered Global Management Accountant. " Activity-Based Costing (ABC) ."

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Appendix IV to Part 200—Indirect (F&A) Costs Identification and Assignment, and Rate Determination for Nonprofit Organizations

Cross reference.

1 . Indirect costs are those that have been incurred for common or joint objectives and cannot be readily identified with a particular final cost objective. Direct cost of minor amounts may be treated as indirect costs under the conditions described in § 200.413(d) . After direct costs have been determined and assigned directly to awards or other work as appropriate, indirect costs are those remaining to be allocated to benefitting cost objectives. A cost may not be allocated to a Federal award as an indirect cost if any other cost incurred for the same purpose, in like circumstances, has been assigned to a Federal award as a direct cost.

2 . “Major nonprofit organizations” are defined in paragraph (a) of § 200.414 . See indirect cost rate reporting requirements in sections B.2.e and B.3.g of this Appendix.

B. Allocation of Indirect Costs and Determination of Indirect Cost Rates

a . If a nonprofit organization has only one major function, or where all its major functions benefit from its indirect costs to approximately the same degree, the allocation of indirect costs and the computation of an indirect cost rate may be accomplished through simplified allocation procedures, as described in section B.2 of this Appendix.

b . If an organization has several major functions which benefit from its indirect costs in varying degrees, allocation of indirect costs may require the accumulation of such costs into separate cost groupings which then are allocated individually to benefitting functions by means of a base which best measures the relative degree of benefit. The indirect costs allocated to each function are then distributed to individual Federal awards and other activities included in that function by means of an indirect cost rate(s).

c . The determination of what constitutes an organization's major functions will depend on its purpose in being; the types of services it renders to the public, its clients, and its members; and the amount of effort it devotes to such activities as fundraising, public information and membership activities.

d . Specific methods for allocating indirect costs and computing indirect cost rates along with the conditions under which each method should be used are described in section B.2 through B.5 of this Appendix.

e . The base period for the allocation of indirect costs is the period in which such costs are incurred and accumulated for allocation to work performed in that period. The base period normally should coincide with the organization's fiscal year but, in any event, must be so selected as to avoid inequities in the allocation of the costs.

2. Simplified Allocation Method

a . Where an organization's major functions benefit from its indirect costs to approximately the same degree, the allocation of indirect costs may be accomplished by

( i ) separating the organization's total costs for the base period as either direct or indirect, and

( ii ) dividing the total allowable indirect costs (net of applicable credits) by an equitable distribution base. The result of this process is an indirect cost rate which is used to distribute indirect costs to individual Federal awards. The rate should be expressed as the percentage which the total amount of allowable indirect costs bears to the base selected. This method should also be used where an organization has only one major function encompassing a number of individual projects or activities, and may be used where the level of Federal awards to an organization is relatively small.

b . Both the direct costs and the indirect costs must exclude capital expenditures and unallowable costs. However, unallowable costs which represent activities must be included in the direct costs under the conditions described in § 200.413(e) .

c . The distribution base may be total direct costs (excluding capital expenditures and other distorting items, such as subawards for $25,000 or more), direct salaries and wages, or other base which results in an equitable distribution. The distribution base must exclude participant support costs as defined in § 200.1 .

d . Except where a special rate(s) is required in accordance with section B.5 of this Appendix, the indirect cost rate developed under the above principles is applicable to all Federal awards of the organization. If a special rate(s) is required, appropriate modifications must be made in order to develop the special rate(s).

e . For an organization that receives more than $10 million in direct Federal funding in a fiscal year, a breakout of the indirect cost component into two broad categories, Facilities and Administration as defined in paragraph (a) of § 200.414 , is required. The rate in each case must be stated as the percentage which the amount of the particular indirect cost category ( i.e., Facilities or Administration) is of the distribution base identified with that category.

3. Multiple Allocation Base Method

a . General. Where an organization's indirect costs benefit its major functions in varying degrees, indirect costs must be accumulated into separate cost groupings, as described in subparagraph b. Each grouping must then be allocated individually to benefitting functions by means of a base which best measures the relative benefits. The default allocation bases by cost pool are described in section B.3.c of this Appendix.

b . Identification of indirect costs. Cost groupings must be established so as to permit the allocation of each grouping on the basis of benefits provided to the major functions. Each grouping must constitute a pool of expenses that are of like character in terms of functions they benefit and in terms of the allocation base which best measures the relative benefits provided to each function. The groupings are classified within the two broad categories: “Facilities” and “Administration,” as described in section A.3 of this Appendix. The indirect cost pools are defined as follows:

( 1 ) Depreciation. The expenses under this heading are the portion of the costs of the organization's buildings, capital improvements to land and buildings, and equipment which are computed in accordance with § 200.436 .

( 2 ) Interest. Interest on debt associated with certain buildings, equipment and capital improvements are computed in accordance with § 200.449 .

( 3 ) Operation and maintenance expenses. The expenses under this heading are those that have been incurred for the administration, operation, maintenance, preservation, and protection of the organization's physical plant. They include expenses normally incurred for such items as: janitorial and utility services; repairs and ordinary or normal alterations of buildings, furniture and equipment; care of grounds; maintenance and operation of buildings and other plant facilities; security; earthquake and disaster preparedness; environmental safety; hazardous waste disposal; property, liability and other insurance relating to property; space and capital leasing; facility planning and management; and central receiving. The operation and maintenance expenses category must also include its allocable share of fringe benefit costs, depreciation, and interest costs.

( 4 ) General administration and general expenses. The expenses under this heading are those that have been incurred for the overall general executive and administrative offices of the organization and other expenses of a general nature which do not relate solely to any major function of the organization. This category must also include its allocable share of fringe benefit costs, operation and maintenance expense, depreciation, and interest costs. Examples of this category include central offices, such as the director's office, the office of finance, business services, budget and planning, personnel, safety and risk management, general counsel, management information systems, and library costs.

In developing this cost pool, special care should be exercised to ensure that costs incurred for the same purpose in like circumstances are treated consistently as either direct or indirect costs. For example, salaries of technical staff, project supplies, project publication, telephone toll charges, computer costs, travel costs, and specialized services costs must be treated as direct costs wherever identifiable to a particular program. The salaries and wages of administrative and pooled clerical staff should normally be treated as indirect costs. Direct charging of these costs may be appropriate as described in § 200.413 . Items such as office supplies, postage, local telephone costs, periodicals and memberships should normally be treated as indirect costs.

c . Allocation bases. Actual conditions must be taken into account in selecting the base to be used in allocating the expenses in each grouping to benefitting functions. The essential consideration in selecting a method or a base is that it is the one best suited for assigning the pool of costs to cost objectives in accordance with benefits derived; a traceable cause and effect relationship; or logic and reason, where neither the cause nor the effect of the relationship is determinable. When an allocation can be made by assignment of a cost grouping directly to the function benefitted, the allocation must be made in that manner. When the expenses in a cost grouping are more general in nature, the allocation must be made through the use of a selected base which produces results that are equitable to both the Federal Government and the organization. The distribution must be made in accordance with the bases described herein unless it can be demonstrated that the use of a different base would result in a more equitable allocation of the costs, or that a more readily available base would not increase the costs charged to Federal awards. The results of special cost studies (such as an engineering utility study) must not be used to determine and allocate the indirect costs to Federal awards.

( 1 ) Depreciation. Depreciation expenses must be allocated in the following manner:

( a ) Depreciation on buildings used exclusively in the conduct of a single function, and on capital improvements and equipment used in such buildings, must be assigned to that function.

( b ) Depreciation on buildings used for more than one function, and on capital improvements and equipment used in such buildings, must be allocated to the individual functions performed in each building on the basis of usable square feet of space, excluding common areas, such as hallways, stairwells, and restrooms.

( c ) Depreciation on buildings, capital improvements and equipment related space (e.g., individual rooms, and laboratories) used jointly by more than one function (as determined by the users of the space) must be treated as follows. The cost of each jointly used unit of space must be allocated to the benefitting functions on the basis of:

( i ) the employees and other users on a full-time equivalent (FTE) basis or salaries and wages of those individual functions benefitting from the use of that space; or

( ii ) organization-wide employee FTEs or salaries and wages applicable to the benefitting functions of the organization.

( d ) Depreciation on certain capital improvements to land, such as paved parking areas, fences, sidewalks, and the like, not included in the cost of buildings, must be allocated to user categories on a FTE basis and distributed to major functions in proportion to the salaries and wages of all employees applicable to the functions.

( 2 ) Interest. Interest costs must be allocated in the same manner as the depreciation on the buildings, equipment and capital equipment to which the interest relates.

( 3 ) Operation and maintenance expenses. Operation and maintenance expenses must be allocated in the same manner as the depreciation.

( 4 ) General administration and general expenses. General administration and general expenses must be allocated to benefitting functions based on modified total costs (MTC). The MTC is the modified total direct costs (MTDC), as described in § 200.1 , plus the allocated indirect cost proportion. The expenses included in this category could be grouped first according to major functions of the organization to which they render services or provide benefits. The aggregate expenses of each group must then be allocated to benefitting functions based on MTC.

d . Order of distribution.

( 1 ) Indirect cost categories consisting of depreciation, interest, operation and maintenance, and general administration and general expenses must be allocated in that order to the remaining indirect cost categories as well as to the major functions of the organization. Other cost categories should be allocated in the order determined to be most appropriate by the organization. This order of allocation does not apply if cross allocation of costs is made as provided in section B.3.d.2 of this Appendix.

( 2 ) Normally, an indirect cost category will be considered closed once it has been allocated to other cost objectives, and costs must not be subsequently allocated to it. However, a cross allocation of costs between two or more indirect costs categories could be used if such allocation will result in a more equitable allocation of costs. If a cross allocation is used, an appropriate modification to the composition of the indirect cost categories is required.

e . Application of indirect cost rate or rates. Except where a special indirect cost rate(s) is required in accordance with section B.5 of this Appendix, the separate groupings of indirect costs allocated to each major function must be aggregated and treated as a common pool for that function. The costs in the common pool must then be distributed to individual Federal awards included in that function by use of a single indirect cost rate.

f . Distribution basis. Indirect costs must be distributed to applicable Federal awards and other benefitting activities within each major function on the basis of MTDC (see definition in § 200.1 ).

g . Individual Rate Components. An indirect cost rate must be determined for each separate indirect cost pool developed. The rate in each case must be stated as the percentage which the amount of the particular indirect cost pool is of the distribution base identified with that pool. Each indirect cost rate negotiation or determination agreement must include development of the rate for each indirect cost pool as well as the overall indirect cost rate. The indirect cost pools must be classified within two broad categories: “Facilities” and “Administration,” as described in § 200.414(a) .

4. Direct Allocation Method

a . Some nonprofit organizations treat all costs as direct costs except general administration and general expenses. These organizations generally separate their costs into three basic categories:

( i ) General administration and general expenses,

( ii ) fundraising, and

( iii ) other direct functions (including projects performed under Federal awards). Joint costs, such as depreciation, rental costs, operation and maintenance of facilities, telephone expenses, and the like are prorated individually as direct costs to each category and to each Federal award or other activity using a base most appropriate to the particular cost being prorated.

b . This method is acceptable, provided each joint cost is prorated using a base which accurately measures the benefits provided to each Federal award or other activity. The bases must be established in accordance with reasonable criteria and be supported by current data. This method is compatible with the Standards of Accounting and Financial Reporting for Voluntary Health and Welfare Organizations issued jointly by the National Health Council, Inc., the National Assembly of Voluntary Health and Social Welfare Organizations, and the United Way of America.

c . Under this method, indirect costs consist exclusively of general administration and general expenses. In all other respects, the organization's indirect cost rates must be computed in the same manner as that described in section B.2 of this Appendix.

5. Special Indirect Cost Rates

In some instances, a single indirect cost rate for all activities of an organization or for each major function of the organization may not be appropriate, since it would not take into account those different factors which may substantially affect the indirect costs applicable to a particular segment of work. For this purpose, a particular segment of work may be that performed under a single Federal award or it may consist of work under a group of Federal awards performed in a common environment. These factors may include the physical location of the work, the level of administrative support required, the nature of the facilities or other resources employed, the scientific disciplines or technical skills involved, the organizational arrangements used, or any combination thereof. When a particular segment of work is performed in an environment which appears to generate a significantly different level of indirect costs, provisions should be made for a separate indirect cost pool applicable to such work. The separate indirect cost pool should be developed during the course of the regular allocation process, and the separate indirect cost rate resulting therefrom should be used, provided it is determined that (i) the rate differs significantly from that which would have been obtained under sections B.2, B.3, and B.4 of this Appendix, and (ii) the volume of work to which the rate would apply is material.

C. Negotiation and Approval of Indirect Cost Rates

1. Definitions

As used in this section, the following terms have the meanings set forth in this section:

a . Cognizant agency for indirect costs means the Federal agency responsible for negotiating and approving indirect cost rates for a nonprofit organization on behalf of all Federal agencies.

b . Predetermined rate means an indirect cost rate, applicable to a specified current or future period, usually the organization's fiscal year. The rate is based on an estimate of the costs to be incurred during the period. A predetermined rate is not subject to adjustment.

c . Fixed rate means an indirect cost rate which has the same characteristics as a predetermined rate, except that the difference between the estimated costs and the actual costs of the period covered by the rate is carried forward as an adjustment to the rate computation of a subsequent period.

d . Final rate means an indirect cost rate applicable to a specified past period which is based on the actual costs of the period. A final rate is not subject to adjustment.

e . Provisional rate or billing rate means a temporary indirect cost rate applicable to a specified period which is used for funding, interim reimbursement, and reporting indirect costs on Federal awards pending the establishment of a final rate for the period.

f . Indirect cost proposal means the documentation prepared by an organization to substantiate its claim for the reimbursement of indirect costs. This proposal provides the basis for the review and negotiation leading to the establishment of an organization's indirect cost rate.

g . Cost objective means a function, organizational subdivision, contract, Federal award, or other work unit for which cost data are desired and for which provision is made to accumulate and measure the cost of processes, projects, jobs and capitalized projects.

2. Negotiation and Approval of Rates

a . Unless different arrangements are agreed to by the Federal agencies concerned, the Federal agency with the largest dollar value of Federal awards directly funded to an organization will be designated as the cognizant agency for indirect costs for the negotiation and approval of the indirect cost rates and, where necessary, other rates such as fringe benefit and computer charge-out rates. Once an agency is assigned cognizance for a particular nonprofit organization, the assignment will not be changed unless there is a shift in the dollar volume of the Federal awards directly funded to the organization for at least three years. All concerned Federal agencies must be given the opportunity to participate in the negotiation process but, after a rate has been agreed upon, it will be accepted by all Federal agencies. When a Federal agency has reason to believe that special operating factors affecting its Federal awards necessitate special indirect cost rates in accordance with section B.5 of this Appendix, it will, prior to the time the rates are negotiated, notify the cognizant agency for indirect costs. (See also § 200.414 .) If the nonprofit does not receive any funding from any Federal agency, the pass-through entity is responsible for the negotiation of the indirect cost rates in accordance with § 200.332(a)(4) .

b . Except as otherwise provided in § 200.414(f) , a nonprofit organization which has not previously established an indirect cost rate with a Federal agency must submit its initial indirect cost proposal immediately after the organization is advised that a Federal award will be made and, in no event, later than three months after the effective date of the Federal award.

c . Unless approved by the cognizant agency for indirect costs in accordance with § 200.414(g) , organizations that have previously established indirect cost rates must submit a new indirect cost proposal to the cognizant agency for indirect costs within six months after the close of each fiscal year.

d . A predetermined rate may be negotiated for use on Federal awards where there is reasonable assurance, based on past experience and reliable projection of the organization's costs, that the rate is not likely to exceed a rate based on the organization's actual costs.

e . Fixed rates may be negotiated where predetermined rates are not considered appropriate. A fixed rate, however, must not be negotiated if

( i ) all or a substantial portion of the organization's Federal awards are expected to expire before the carry-forward adjustment can be made;

( ii ) the mix of Federal and non-Federal work at the organization is too erratic to permit an equitable carry-forward adjustment; or

( iii ) the organization's operations fluctuate significantly from year to year.

f . Provisional and final rates must be negotiated where neither predetermined nor fixed rates are appropriate. Predetermined or fixed rates may replace provisional rates at any time prior to the close of the organization's fiscal year. If that event does not occur, a final rate will be established and upward or downward adjustments will be made based on the actual allowable costs incurred for the period involved.

g . The results of each negotiation must be formalized in a written agreement between the cognizant agency for indirect costs and the nonprofit organization. The cognizant agency for indirect costs must make available copies of the agreement to all concerned Federal agencies.

h . If a dispute arises in a negotiation of an indirect cost rate between the cognizant agency for indirect costs and the nonprofit organization, the dispute must be resolved in accordance with the appeals procedures of the cognizant agency for indirect costs.

i . To the extent that problems are encountered among the Federal agencies in connection with the negotiation and approval process, OMB will lend assistance as required to resolve such problems in a timely manner.

D. Certification of Indirect (F&A) Costs

( 1 ) Required Certification. No proposal to establish indirect (F&A) cost rates must be acceptable unless such costs have been certified by the nonprofit organization using the Certificate of Indirect (F&A) Costs set forth in section j. of this appendix. The certificate must be signed on behalf of the organization by an individual at a level no lower than vice president or chief financial officer for the organization.

( 2 ) Each indirect cost rate proposal must be accompanied by a certification in the following form:

Certificate of Indirect (F&A) Costs

This is to certify that to the best of my knowledge and belief:

( 1 ) I have reviewed the indirect (F&A) cost proposal submitted herewith;

( 2 ) All costs included in this proposal [identify date] to establish billing or final indirect (F&A) costs rate for [identify period covered by rate] are allowable in accordance with the requirements of the Federal awards to which they apply and with subpart E of this part .

( 3 ) This proposal does not include any costs which are unallowable under subpart E of this part such as (without limitation): Public relations costs, contributions and donations, entertainment costs, fines and penalties, lobbying costs, and defense of fraud proceedings; and

( 4 ) All costs included in this proposal are properly allocable to Federal awards on the basis of a beneficial or causal relationship between the expenses incurred and the Federal awards to which they are allocated in accordance with applicable requirements.

I declare that the foregoing is true and correct.

Nonprofit Organization:

Name of Official:

Date of Execution:

[ 78 FR 78608 , Dec. 26, 2013, as amended at 80 FR 54410 , Sept. 10, 2015; 85 FR 49579 , Aug. 13, 2020]

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• New indirect costs rates

New F&A rates, negotiated by the university and the Department of Health and Human Services, will be charged on most new federal awards over the next four years.  

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September 6, 2024

To: Principal investigators; Lead administrators in FAS, SEAS, YSE, YSN, YSPH, and YSM departments [Summary: New F&A rates, negotiated by the university and the Department of Health and Human Services, will be charged on most new federal awards over the next four years. Faculty who have questions or need assistance incorporating these F&A rates into proposals can contact the Office of Sponsored Projects or YSM Research Administration .] Dear Colleagues, As you know, Yale University receives substantial federal funding for the conduct of research. In 2023-2024 the university was awarded $1.2 billion to support the direct and indirect costs of research and other scholarly projects across the campus. To remain eligible for federal research funding, the university is required periodically to enter into negotiations with a designated federal agency (in Yale’s case the Department of Health and Human Services, DHHS) to review the indirect costs associated with sponsored projects and determine the appropriate level of contribution by the federal funding agencies to those indirect costs. The last indirect cost negotiations conducted by Yale with the federal government took place in 2017. We write to share the results of the most recent round of these negotiations and to thank the research community for its assistance. Many of you provided data on the use of space, location of equipment, and other details necessary for preparing the cost study that supports the negotiations. A collaborative team involving central offices and schools developed and negotiated rates based on this study. Indirect costs (also called “facility and administrative” or “F&A” costs) include the expenses of building and operating facilities to support research, administering federally-mandated compliance programs, and providing administrative support to investigators. The federal F&A recovery rate is calculated by comparing the university’s F&A costs to the total funds it receives in direct support of research. As you know, the university has invested substantially in research infrastructure over recent years through the extensive renovation of existing laboratory space and the addition of new research buildings such as the Yale Science Building and 100 College Street. The new F&A rates negotiated by the university and DHHS reflect the costs of these and other investments. The rates also incorporate a projection for the growth of direct research funding that is aligned with federal agency forecasts and Yale’s planned investment in new research facilities for the School of Medicine and Central Campus. Yale’s F&A rate has been 67.5% since 2016-2017 (FY17). It will remain at that level for two years, and then increase by 0.5% in FY27 and in FY28. The current F&A rate and the rates that will be used on most new federal awards over the next four years are below:  

Federal policy requires that existing awards continue to charge the rate in effect at the beginning of the award, so many grants will continue at the current 67.5% rate until the next competitive review. The university also negotiated an uncapped research rate that remains at the current rate of 69.9% and then increases in FY27 and in FY28. This rate more closely approximates the true indirect costs of carrying out research and should be used whenever possible for non-federally sponsored projects.  

An upcoming “Research Administrators News and Updates” email will provide further guidance and details, and the School of Medicine will issue specific guidance on their internal processes for applying these new F&A rates. In the meantime, if you need assistance incorporating these rates into your proposals or if you have other questions about current and pending awards or proposals, please contact Amy Ellis in the Office of Sponsored Projects or Jill Ely in YSM Research Administration. Sincerely, Michael Crair Vice Provost for Research William Ziegler III Professor of Neuroscience and Professor of Ophthalmology and Visual Science

Cc:     Scott Strobel, Provost Stephen C. Murphy, Vice President for Finance and Chief Financial Officer Pamela Caudill, Senior Associate Provost, Research Administration James Luther, Research Compliance Officer Arnim Dontes, Deputy Dean, YSM Finance & Administration Shannon N. Smith, Assistant Vice President and University Controller

F&A rate changes

Yale’s F&A rate has been 67.5% since 2016-2017 (FY17). It will remain at that level for two years, and then increase by 0.5% in FY27 and in FY28.