Indirect Expenses

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Indirect Expenses Meaning

Indirect Expenses are those expenses that cannot be assigned directly to any activity since these are completely incurred while operating a business or as a part of a business, examples of which include business permits, rent, office expenses, telephone bills, depreciation, audit, and legal fees.

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Examples of Indirect Expenses

Below are examples of Indirect Expenses –

  • Depreciation Expenses
  • Rent Expenses
  • Taxes
  • Insurance
  • Advertising Expenses
  • Salaries to Management
  • Commission paid to Agents
  • Telephone Bills
  • Audit Fees
  • Legal Fees
Indirect Expenses

Types of Indirect Expenses

It classifies into three types-

  • Factory Expenses - Expenses incurred at the production time are labeled as factory expenses. Works overhead and factory overheads are also the other terms for indirect expenses. Examples- Depreciation charged on buildings, plants, and machinery, rent, and taxes, insurance, indirect labor wages, expenditure on indirect raw materials, etc.;
  • Administrative Expenses - Expenses incurred towards administration activities are labeled administrative expenses. Examples- Salaries, office rent, repairs and maintenance, electricity bills, office insurance, stationery and printing expenses, depreciation of furniture, etc.;
  • Selling and Distribution Expenses - Expenses incurred by the sales team are selling expenses. In contrast, the expenses incurred from when a product attains its completion status until it reaches its destination are regarded as distribution expenses. Examples- advertisement expenses, salaries of sales personnel, commission paid to agents, discounts given to customers, etc.

Calculate Indirect Expenses

From the following information, calculate the total indirect expenses of the company for the month ending on September 30, 2019.

  • Depreciation charged on buildings and plant and machinery: $ 50,000
  • Raw material purchased $1,500,000
  • Direct labour cost $ 700,000
  • Rent and taxes: $ 10,000
  • Insurance: $5,000
  • Utility expenses paid: $10,000
  • Advertisement expenses: $ 25,000
  • Salaries paid to the employees: $ 100,000
  • Commission paid to agents: $200,000

Solution

Indirect expenses are indirect expenses, and we cannot assign these directly to the manufactured goods and services. Out of all the transactions given above, all the expenses listed are the indirect expenses except the raw material cost and the direct labor cost, as they are part of the direct expenses.

So, total indirect expenses will be calculated as follows:

Indirect Expenses Example
  • = 50,000+10,000+5,000+10,000+25,000+100,000+200,000
  • Total = 400,000

Thus the total indirect expenses of the company for the month ending on September 30, 2019, are $400,000

Advantages

The different advantages related to the indirect expenses are as follows:

  • Lower-level of tax liability- With indirect expenses, an organization can reduce its taxable income and lower its tax liability.
  • Effective product pricing- Product pricing is an essential mechanism for organizations. With indirect costs, organizations can effectively price their products, leverage their sales, and earn better revenues.

Disadvantages

The different advantages related to the indirect expenses are as follows:

  • Probabilities of price-out- Managing indirect expenses could be challenging for organizations, and the failure in doing so could even price them out of the industry. It is high because, with the rise in overhead expenses, companies may feel compelled to raise the price of their products, which may ultimately price them out of the industry they operate in.
  • Recurring nature- The indirect overheads are recurring in nature. These expenses will continue to incur even if the company is not earning revenues or during manufacturing downtime.

Limitations

The different advantages related to the indirect expenses are as follows:

  • Irrelevant while making decisions- The management cannot make decisions based on the indirect costs incurred for choosing whether to manufacture or buy, the minimum price that must be fixed, the quantity that must be sold to earn predetermined profit numbers, etc.
  • Difficulty in comparing and controlling costs- Indirect costs make it difficult for managers to examine and control costs since it highly relies on the output level, which keeps fluctuating at all levels.
  • Exclusion of fixed costs- It has been argued by various accountants that fixed costs are period costs, and these don't add or generate future benefits, and hence, the same must be excluded from the product's overall cost.
  • Failure to help in the preparation of flexible budgets- Indirect expenses are of no use since it becomes difficult to differentiate between fixed and variable costs.
  • Failure to determine the actual cost associated with production- In real practice, indirect costs are apportioned through arbitrary methods. It ultimately impacts the product costs; hence, the evaluation of the same becomes difficult, and the results are often unreliable.

Important Points

  • They are costs that cannot be apportioned to a particular cost object since various activities absorb these.
  • Identification of indirect expenses is always essential so that the same does not form a part of the quick pricing decisions taken by the management for finalizing prices above the products' variable costs.
  • Indirect costs can either be fixed or variable.
  • Indirect costs cannot be applied directly to manufacturing a particular product or service.
  • The identification of indirect costs could be tricky. A cost regarded as an indirect expense in one organization might be considered a direct cost in another.

Conclusion

Indirect costs are also known as overhead costs.

These are the expenses that can be applied to multiple business activities. Professional fees, rent, taxes, insurance, utilities, employee salaries, advertising, office rent, depreciation, office supplies, etc., are some indirect costs. These expenses are indirect; hence, the same cannot be directly assigned to manufactured goods and services. The three types of indirect expenses are factory expenses, administrative expenses, and selling and distribution expenses. With the help of these expenses, organizations can minimize their cost of production, enhance their revenues, and reduce their tax burden. Organizations can also reduce their expenses by evaluating the importance of the costs of operating the business and appropriately choosing the best ways to reduce them.