Indirect Cost

Intermediate

An indirect cost is a cost that supports several products, services or activities and cannot be traced directly to any single one of them, such as factory rent, utilities or administrative salaries.

Indirect costs are necessary to run the business but are shared. A factory's electricity powers machines making many different products; the accounts team supports the whole company.

For example, a company making chairs and tables cannot say exactly how much of the factory's 10,000 monthly rent belongs to chairs and how much to tables. The rent is an indirect cost.

To work out the full cost of a product, businesses allocate indirect costs using a reasonable basis, such as machine hours, labour hours, floor space or sales value. If chairs use 60% of machine hours, they might be assigned 60% of the factory's indirect costs.

The allocation method can significantly affect how profitable each product appears. Poor allocation may make a profitable product look unprofitable, or the reverse, leading to bad decisions. Activity-based costing is one approach that tries to allocate indirect costs more accurately by linking them to the activities that actually drive them.

Indirect costs are often fixed, but not always. Collectively, indirect costs are often called overhead.

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