Direct and indirect costs

variable cost Get ready!

0 Before you read the passage, talk about
these questions.
1 What are direct costs?
2 What are indirect costs?

Reading
8 Read this article in an accounting
textbook. Then, mark the following
statements as true (T) or false (F).
1 _ The ABC method can account for fixed costs.
2 _ Variable overhead is directly tied to
production.

Accounting 3 _ Cost drivers are used to allocate direct costs.

Vocabulary
Costs
Some costs are easy to account for. Direct costs, which
8 Match the words (1-5) with the definitions
(A-E).

are also called variable costs, are easily attributed to a 1 _ variable cost 4 _ indirect cost
specific product or activity. For example, a company that 2 _ direct labor 5 _ cost drivers
makes pens has to buy plastic and ink and pay its 3 _ activity-based costing
employees to manufacture the pens. These are obviously
direct costs. But businesses also incur indirect costs, or A any expense tied to production
fixed costs, which remain constant and are not tied to B any expense not tied to production
specific products or services. Take, for example, a
manufacturing company. C units involved in production
D the cost of paying workers
Manufacturing firms have both direct and indirect costs.
E a method for allocating fixed costs
Direct costs include:
• Raw materials, often called direct materials
0 Check(.!) the sentence that uses the
• Direct labor - the wages paid to production-line underlined parts correctly.
employees
1 _ A Rent is an example of fixed overhead.
• Variable overhead - other costs that increase or
decrease with production (For example, if production _ B A loan payment is variable overhead.
requires water, the water bill will fluctuate with the
2 _ A Direct materials are used to make
volume of production.)
products.
Indirect manufacturing costs include: _ B An insurance premium is a direct cost.
• Fixed overhead - depreciation, insurance, rents
3 _A Variable overhead is not tied to production.
So how should indirect costs be accounted for? One
popular method is called activity-based costing _B A fixed cost is not tied to production.
(ABC). In this method, cost drivers are created for
4 _A An employee's wage is a direct cost.
each product. Then indirect costs are allocated
according to those cost drivers. For example, in a _ B .An executive's bonus is fixed overhead.
manufacturing plant, an indirect cost like rent could
5 _A The price of paint is a fixed cost.
be allocated to each piece of machinery based on
how much space it occupies. _B Variable overhead is costs tied to
production.
12
0 g Listen and read the article again. How might you Speaking
account for a cost like rent in a manufacturing company?
0 With a partner, act out the
roles below based on Task 7.
Listening Then switch roles.

0 g Listen to a conversation between two USE LANGUAGE SUCH AS:

accountants. Choose the correct answers. What would be ...
1 What is the dialogue mostly about? Do you own ... ?
A allocating direct costs C pairing costs with prices How should I account for ... ?
B renting versus owning D direct versus indirect costs

2 The cost of metal is Student A: You are a business

A a cost driver. C fixed overhead. owner. Talk to Student B about:
B a variable cost. D an indirect cost. • indirect costs
• how to record different types
@g Listen again and complete the conversation. of costs

Client: Hi, Sarah. Thanks for helping me Student B: You are an

set up my books. accountant. Answer Student A's
Accountant: No problem. That's what I'm here for. Let's start by questions.
listing your direct and indirect costs.
Client: Direct and indirect costs? I'm sorry ... I'm not sure I
understand. Writing
Accountant: Well, direct costs are tied directly to a product or 0 You are an accountant. Use
service. the article and the
Client: OK. Can you give me an example? conversation from Task 8 to
Accountant: Um, your company makes paper clips, right? The write a brief email to your
cost of the metal is a direct cost. client explaining different
types of costs. Talk about:
Client: So, then, what would be an indirect cost?
Accountant: Let's see ... do you own your manufacturing plant?
Client: No, I rent it.
is __
Accountant: Well, your rent 1 _ __ not
__based
_ _ _on
__ • direct/variable costs
how many paper clips you manufacture. It's an • indirect/fixed costs
indirect cost. • how to record costs
should
Client: Oh, I see. So, how 2 _ ___ I acount
_ _ _ for
__ • the ABC (activity-based
_ _ _ these different types of costs? costing) method
Accountant: It's easy with the direct costs. 3 just
_ _pair
_ _them
__ with
_ _ _ _ _ _ the money that you get from
selling your products.
Client: Right. But what about the indirect costs? 4 _ __
someone
___ told
__ me
_ there's a method called ABC.
What is that?
Accountant: It's a way to allocate indirect costs 5 _ __
as production cost
Client: Can you show me how to do that?
Accountant: Well, 6 It's pretty complicated. Let me explain ...