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How to Calculate Indirect Costs?The indirect cost for any company can be computed by using the following three simple steps:
Step 1: Firstly, it is to determine which input costs are indirect by nature for manufacturing a product or service delivery. Next, combine all these costs to arrive at the total manufacturing overhead.
Step 2: Next, calculate all the administrative and general costs that can’t be directly allocated to manufacturing the product or service delivery. Add all these costs together to arrive at the total administrative overhead.
Step 3: Finally, add together the total manufacturing overhead and administrative overhead that will eventually give the total indirect cost of the production.
ExampleGiven below is the example mentioned:
Let us consider a factory named XYZ Ltd that has the following information, and from the below-furnished information, the total indirect cost of production has to be calculated.
Raw material cost: $300,000
Labor wages: $150,000
Depreciation – $5,000
Repairs and maintenance – $50,000
Office electricity expense – $10,000
Salaries – $100,000
Factory supplies – $3,000
Accounting expense – $10,000
Audit expense – $5,000
Legal expense – $3,000
Total Indirect Manufacturing Overhead = Depreciation + Repairs and Maintenance + Office Electricity Expense + Salaries + Factory supplies
Total Indirect Manufacturing Overhead = $5,000 + $50,000 + $10,000 + $100,000 + $3,000
Total Indirect Manufacturing Overhead = $168,000
Again, the Total Indirect Administrative Overhead is calculated below.
Total Indirect Administrative Overhead = $10,000 + $5,000 + $3,000
Total Indirect Administrative Overhead = $18,000
A few of the abovementioned expenses are not included in the Total cost calculation because they are direct costs. Those excluded costs in the above cases comprise raw material costs and labor wages.
Finally, the Total Indirect Cost can be calculated as below,
Total Indirect Cost = Total Indirect Manufacturing Overhead + Total Indirect Administrative Overhead
Total Indirect Cost = $168,000 + $18,000
Total Indirect Cost = $186,000
Relevance and Uses of Indirect Costs
It can help companies to make significant pricing decisions. Usually, an accountant will add all the overhead costs and then allocate them based on the per-unit cost to compute the company’s overhead per product. This eventually helps a company ensure they are still making a profit on each unit, even after incorporating all the overhead costs.
Ultimately, this becomes the foundation for the product pricing strategy before setting the desired profit margin. In the case of manufacturing companies, indirect material costs include items utilized for the production of the end product, which again is not part of the finished goods inventory. Such items can be glue, plastic wraps, staples, and tapes needed in production. Even though indirect material costs may vary widely depending on the nature of operations, it is crucial to include them when calculating overhead costs. Senior management should know the actual production cost, considering all input costs necessary in the manufacturing process. Otherwise, the financial reporting and the subsequent analysis may be inaccurate.
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