Whether costs are direct or indirect, accountants attribute them to three categories-materials, labour and expenses. As such, there are direct and indirect materials; direct and indirect labour; and direct and indirect expenses. ICs are also known as overheads. Total production cost represents the sum of prime cost (all direct costs) and production overheads (ICs associated with production).
Production overheads are all indirect costs (wages, expenses and materials) that are associated with the order, product or service. In addition, overheads apply to other functions as well, such as administration, distribution and selling. Even if you relate overheads to other functions, it still refers to wages, expenses and materials that are ICs.
Distilling direct and indirect costs can be somewhat tricky to the beginner. The key words for a direct cost is that it must be “fully traceable” to the product, service or department. This suggests an objective measure of costs. Materiality also plays an important role in determining the traceability of costs. Some costs are so immaterial or negligible that it is not feasible to trace them, even if they are fully traceable.
For example, assume that you are producing 20 chairs for a custom order. Some of the expenses associated with producing the chairs for the order would be classified as follows:
a) Wood used in the 20 chairs: Direct material cost
b) Overtime required by the customer for workers on the order: Direct labour cost
c) Rent for equipment used specifically for the custom order: Direct expenses
d) Staples used to fix the fabric to the chair: Indirect material cost
e) Wages for the foreman who oversees all custom orders: Indirect labour cost
f) Electricity used when making the 20 chairs: Indirect expense
In the example, staples are a negligible cost, although you could trace them fully if you wish. However, it is impractical to trace the cost of the few staples used per chair, making it an IC. If the wages for the foreman were specifically attributed to the custom order, then that would have been a direct cost. However, that foreman oversees all custom orders, so his wages can only be apportioned to the 20 chairs-i.e. not fully traced to the chair production. The example identified aspects of prime costs and production overheads. Other overheads may be incurred in selling, distribution and administration yet.
And now, you can read about another way that accountants classify costs, http://www.helium.com/items/1718341-cost-classification-fixed-costs-and-variable-costs
