Definition of Depreciation
Depreciation is defined as the systematic expensing of the cost of an asset such as equipment, building, vehicle, etc. over the useful life of the asset.
Definition of Direct and Indirect Costs
The depreciation expense associated with the asset can be direct cost or an indirect cost or both a direct and indirect cost.
Direct costs are traceable to a cost object (department, product, etc.) without any allocation. Indirect costs must be allocated to a cost object since the cost is not traceable to the cost object.
Example of Depreciation Being a Direct Cost and/or an Indirect Cost
Assume a company has a variety of manufacturing departments, one of which is the Finishing Department. The Finishing Department’s equipment is used for producing only one product line, which has three different versions (basic, deluxe, and premier). Each of the three versions uses a different amount of the equipment’s time.
The depreciation of the equipment is a direct cost to the Finishing Department. It is a direct cost because the equipment is used exclusively in the Finishing Department, and therefore does not require any allocation to get it to that cost object. If the annual depreciation on the equipment in the Finishing Departments is $60,000 a year, the $60,000 is a direct cost of the Finishing Department.
The depreciation of the equipment is also an indirect cost of the products using the equipment. It is an indirect cost because the company has to allocate the depreciation to the three versions of the product line that are processed in the Finishing Department. Let’s assume that the allocation is based on the amount of the equipment’s time that was used. If the equipment will operate for 6,000 hours a year, the depreciation could be allocated to the products using the Finishing Department’s equipment at the rate of $10 per hour ($60,000/6,000 hours). If the basic version of the product requires 1 hour, each basic version will be allocated $10. If the deluxe version requires 2 hours, each deluxe version will be allocated $20.
Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, or burden.
