Question

Explain the differences between direct and indirect costs. In addition, discuss why these costs are important to determine the return on assets and allocating overhead costs.

Answer 1

Direct costs are those that are traceable directly to the manufacture of a good/ product. Direct costs include direct materials, direct labour.. Indirect costs are those that are incurred for the manufacturing process as whole and cannot be traced to a particular product. Examples of indirect costs include factory overheads, indirect materials, indirect labour.

Return on assets is the ratio of net income to the total assets employed. A distinction between the costs is necessary to determine the net income that pertains to the assets and the costs incurred for maintaining the asset. For instance, depreciation on fixed assets used for manufacturing are a part of indirect costs and such a cost is detrimental in determining the ROA on these assets.

Overhead costs are that are directly traceable to the product are allocated to product cost and indirect overheads are charged to General P&L account. Hence, the differentiation is important.