Costs, when categorized according to traceability to the product or cost object, can be classified into: (1) direct costs and (2) indirect costs.
Direct costs are those that can be easily traced to or associated directly with a specific cost object. A cost object is something for which cost is measured such as a specific product, a specific department or a specific branch.
For instance, ABC Company produces plastic food containers. The cost of plastic used in production can be easily traced to the food containers. However, the cost spent for electricity is not directly traceable to the food containers since such cost was not used solely for the production of the product.
Examples of direct costs include direct materials, direct labor, and other costs incurred for a particular product such as advertising and promotion costs for, say "Product A".
If the cost object is a department or a branch, all costs that can be associated directly to a particular department or branch are direct costs. For example, salaries of sales personnel are directly traceable to the selling department of the organization. Also, the salaries of the sales personnel of "Branch A" can be traced directly to that branch.
Indirect costs are difficult to trace directly to a specific cost object. These costs are commonly shared by multiple products, different departments, or branches; hence, such costs cannot practically be traced to a cost object.
Examples of indirect costs include factory overhead costs, organization-wide advertising, taxes, and other common or joint costs.
Classify the following costs as (D) direct costs or (I) indirect costs in relation to a specific product. Suppose the company produces trousers and shoes.
Answers: (1) D; (2) I; (3) I; (4) D; (5) I; (6) I; (7) D; (8) I; (9) I; (10) D
Direct costs can be traced easily to a cost object. For example, raw materials can be traced directly to the product.
Indirect costs, on the other hand, are difficult to or cannot be traced to a single cost object. They are also known as joint costs or common costs. For example, electricity costs may not be straightforwardly traced to a specific product as usage was shared by different departments.