Concept: Indirect Costs Explained

Now, here is one of the major questions that may arise: Why have we not included the truck rental cost in the production cost?

Businesses can classify costs into direct and indirect costs based on their ability to attribute a cost to a separate unit. A business incurs various costs that are not directly attributed to a single product or unit. Such costs are called 'indirect costs'. 

Let’s learn more about it in detail.

In this video, you learnt that the truck rental cost is not included in the production cost because of the following:

• The truck rental cost for the pizza food truck is an indirect cost for the business because it is used for production, advertising and selling purposes.

  • An indirect cost serves several business units, multiple projects or products in a company. 

  • An allocation key is required to allocate specific fractions of indirect cost to their area of utility. Allocation keys can be based on the area of production, units produced, time spent on production, etc.

  • Allocation keys are subject to biases.

  • To eliminate such bias, the truck rental cost is not included in the production cost.

• The aim is to keep the financial statements transparent, simple and easy to read by outsiders. 

Note: There is leeway in choosing the method of treating the indirect cost. However, one must be consistent with the chosen method over different periods.

In the next segment, you will see how different activities for the month of March impact the three financial statements.