A direct cost can be traced to the goods being made. An indirect cost is spent in the factory but shared by all the goods, so it is collected as a factory overhead. Costs of the office and of selling are not production costs at all.
This skill opens manufacturing accounts, because every later figure depends on putting each cost in the right group. Questions often give a mixed list and ask you to pick out one subtotal.
How do you sort a cost?
Use three questions, in this order.
- Is it spent on making the goods? If it is for the office, the showroom or delivery to customers, it is not a production cost.
- Can it be traced to the goods? Materials that become part of the product are direct materials. Wages of workers who make the product are direct labour.
- If not, is it still a factory cost? Then it is a factory overhead, such as indirect materials, indirect wages, factory rent, factory power and depreciation of machinery.
Some syllabuses also mention direct expenses, such as a royalty paid for each unit made. Check the Cambridge page for your exam year. A direct expense joins direct materials and direct labour in prime cost.
Worked example
Sinar Jaya Woodworks makes wooden chairs. Sort these costs for the year, in RM.
| Cost | RM |
|---|---|
| Timber used in chairs | 12,000 |
| Wages of workers who assemble chairs | 9,000 |
| Wages of the factory supervisor | 3,200 |
| Glue and screws, small amounts | 800 |
| Factory rent | 4,800 |
| Depreciation of machines | 1,500 |
| Electricity for the factory | 1,200 |
| Office salaries | 5,000 |
| Delivery to customers | 700 |
| Showroom advertising | 900 |
Step 1, direct costs: timber 12,000 and assembly wages 9,000. Total direct costs: RM 21,000.
Step 2, factory overheads: supervisor 3,200, glue and screws 800, rent 4,800, depreciation 1,500, electricity 1,200. Total: RM 11,500.
Step 3, not production costs: office salaries 5,000, delivery 700, advertising 900. Total: RM 6,600.
Check: 21,000 + 11,500 + 6,600 = 39,100, which equals the sum of all ten items. Every cost has been used once.
Glue and screws are materials, but each chair uses only a tiny amount, so businesses treat them as indirect materials.
The mistake to watch for
A common slip is to treat all factory wages as direct labour.
Mistaken answer: direct wages = 9,000 + 3,200 = 12,200.
The student reasoned that the supervisor works in the factory, so the wages are direct.
The supervisor does not make any chair. The supervisor looks after everyone, so the wages are shared and indirect.
The correct direct wages are RM 9,000, and the RM 3,200 belongs in factory overheads. Ask “does this person or material go into the product?” rather than “is it in the factory?”.
Check yourself
Try these on paper first, then open each answer.
1. Classify each cost for a shoe factory: (a) leather used in shoes, (b) oil for the machines, (c) wages of a factory cleaner, (d) salary of the sales manager.
Show answer
(a) Direct material. (b) Indirect material, so a factory overhead. (c) Indirect labour, so a factory overhead. (d) Not a production cost, so a selling expense in the income statement.
2. A factory records direct materials RM 8,000, direct wages RM 5,000, factory overheads RM 3,000 and office costs RM 2,000. Find the total direct costs and the total production costs.
Show answer
Direct costs: 8,000 + 5,000 = RM 13,000. Production costs: 8,000 + 5,000 + 3,000 = RM 16,000. The office costs of RM 2,000 are excluded.
3. Why is depreciation of a factory machine an indirect cost, even though the machine is used every day to make the goods?
Show answer
The machine serves all products together, so the depreciation cannot be traced to one unit. It is a factory overhead, collected in the manufacturing account.
Where this leads next
Once sorting feels automatic, move on to calculating prime cost, then test the whole topic with the manufacturing accounts practice set. The double-entry and ledger trainer lets you test which account each cost is posted to.
Some students can follow the sorting in class but lose marks when a question words a cost in an unusual way. That is the kind of pattern our teachers look for in online one-to-one Accounting tuition.