April 04, 2020

What is Indirect Cost?

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What is Indirect Cost?

The concept of indirect costs is international. Indirect costs are understood as costs that are impossible or economically impractical to attribute directly to the cost of a particular type of product, activity, service, grant, project, or contract. These are all the costs that an organization would have to pay but actually are not linked to the product or service that they would produce. Direct costs, on the other hand, can be traced easily. 

Indirect costs are also known as overhead costs. They can vary depending on what the business actually does. Indirect costs are also divided into fixed and variable costs, and the latter is adjusted by the percentage of completion of the plan for the production of marketable products or services.

Let’s take a look at a cake shop example. The costs that the cake shop will have to pay, which are not linked to the making of the cakes can include rent, phone, internet, administration, marketing, employee salary, and staff uniform. 

So, the cake shop will have to pay its rent regardless if it makes cakes. Telephone and internet are also not used to make cakes, but they might be necessary for managing the website. Administration work and marketing are also not directly related to the actual baking of the cake.

Analyzing these indirect costs allows us:

  • to analyze the composition and structure of indirect costs of production and sales to determine the methods to reduce them;
  • to study the dynamics of indirect costs compared with the previous (base) period and the plan as a whole and for individual cost items;
  • to establish and quantify the factors that influenced the change in indirect costs for the production and sale of goods or services;
  • to determine the contribution of each unit of the organization to the overall result of the organization as a whole to reduce costs;
  • to determine the price of products or services.

What is an indirect cost rate?

Indirect costs are distributed between individual products in accordance with the organization’s chosen methodology reflected in the accounting policies of the organization. Indirect cost or overhead rate is used to determine what proportions of departmental/organization indirect costs each department or project should bear. In other words, it is the ratio between the total indirect costs and benefiting direct costs (with distorting or unallowable costs being excluded).

While a single indirect rate is the most commonly used approach, some organizations do choose to develop multiple rates. For example, a government organization might want one rate for public projects and another rate for transit. The organization might designate a special rate for use only during emergency relief efforts.

How are indirect cost rates determined?

The indirect cost rate is determined using a formula that states: Indirect Rate = Indirect Costs / Direct Cost. It is established on the basis of a Federally approved indirect cost rate proposal and supporting documentation submitted by organizations. So, while the calculation is fairly straightforward, considerations should be made about what to include in the indirect costs and the direct costs. 

  • Indirect costs: It is up to your organization to decide whether or not the indirect cost will include central services – those departments that process payroll and provide legal advice. Capital expenditures and other unallowable costs are not included. 
  • Direct costs: It is also up to your organization to determine whether the direct allocation base will be limited to direct salaries and wages, like project inspectors or project managers, or if it will also include other project costs like contractor payments.

Indirect cost rate calculation

To calculate the indirect cost rate, you will need to follow these steps:

  1. Calculate total indirect costs for a year or a month in a specific department or the entire enterprise.
  2. Calculate the sum of direct material and direct labor costs. This indicator summarizes the costs for the period in this department or the entire enterprise. 
  3. Calculate the indirect cost rate. Calculations are performed according to the formula: Indirect Cost Rate = Indirect Costs/Direct Cost.
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Author: Charles Lutwidge

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