___A _.+__.._ -.----.-548 ACCOUNTING AND ENGINEERING ECONOMY
Direct and Indirect Costs
Costs incurred to produce a product or service are traditionally classified as eitherdirect
orindirect (overhead).Direct costs come from activities directly associated with the final
product or serviceproduced.Examples include material costs and labor costs for engineering
design, component assembly,painting, and drilling.
Some organizational activities are difficult to link to specific projects, products, or
services. For example, the receiving and shipping areas of a manufacturingplant are"used
by all incoming materials and all outgoing products. Materials and products differ in their
weight, size, fragility, value, number of units, packaging, and so on, and the receiving and
shipping costs depend on all these factors. Also, different materials arrive and different
products are shipped together, so these costs are intermingled and often cannot be tied
directly to each product or material.
Other costs, such as the organization'smanagement, sales, and administrativeexpenses,"
are difficultto link directly to individualproducts or services.These indirect or overheadex-
penses also include machine depreciation, engineering and technical support, and customer
warranties.Indirect Cost Allocation
To allocate indirect costs to different departments, products, and services, accountants use
quantitiessuchas direct-laborhours,direct-laborcosts,materialcosts,andtotaldirectcost.~
One of these is chosen to be the burden vehicle. The total of all indirect or overhead costs is
divided by the total for the burden vehicle. For example, if direct-labor hours is the burden
vehicle, then overhead will be allocated based on overhead dollar per direct-labor hour.
Then each product, project, or department willabsorb(or be allocated) overhead costs,
based on the number of direct-labor hours each has.
This is the basis for calling traditional costing systemsabsorption costing.For de-
cision making, the problem is that the absorbed costs represent average, not incremental,
performance.
Four common ways of allocating overhead are direct-labor hours, direct-labor cost,.
direct-materials cost, and total direct cost. The first two differ significantly only if the
cost .per hour of labor differs for different products. Example 18-2 uses direct-labor and
direct-materials cost to illustrate the difference choices of burde~ vehicle.Industrial Robots does not manufacture its own motors or computer chips. Its premium product
differs from its standard product in having heavier-duty motors and more computer chips for
greater flexibility. "
As a result, Industrial Robots manufactures a higher fractidh 6f the standaril protluet's v"IDlTe-
itself, and it purchases a higher fraction of the premium product's value. Use the following data
to allocate $850,000 in overhead on the basis of labor cost and materials cost.~,--. ~ 0". ~. a a ~ It 15
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