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Depreciation is direct or indirect cost

Saurabh Toshniwal (ca final) (2363 Points)

12 December 2014

Fixed assets are used inside the factory for production & also outside the factory eg in office premises, staff quarters etc. so, whether the depreiation is direct cost or indirect cost or it is both direct as well as indirect cost In case it both then is it required to segregate both for GP Ratio purpose.

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Arpit Shah (Accountant) (21438 Points)
Replied 12 December 2014

Fixed assets owned by a company can comprise land, manufacturing premises, systems of transportation pipes, containers, transport conveyers, trucks, warehouses, etc. as well as administration buildings, vehicles and office furniture.Depreciation expense can be direct or indirect depending on how the related asset is used and the cost object under question. For example, most manufacturing equipment will represent a direct cost in relation to the manufacturing department (cost object in this case is the manufacturing department), but it will most likely represent an indirect cost if the cost object under question is a single unit of production.

It is important to remember that in external financial reporting there is great emphasis on correctly determining the cost of inventory and related cost of sales (i.e., the cost of sales amount is used in calculating gross margins). In this context, depreciation as direct or indirect cost should be reviewed in light of inventory as the cost object. In most cases related to costing inventory, depreciation will be an indirect expense because equipment, tools, etc. are used to produce multiple types and volumes of products (i.e., cost objects). Such depreciation becomes part of manufacturing (factory) overhead. An exception would be situations when such fixed assets are used exclusively in producing a single inventory item (e.g., vessels in shipyard manufacturing). It is also beneficial to understand that depreciation of certain fixed assets not related to the manufacturing process, would not represent an inventory cost. For instance, depreciation related to trucks used in delivering products to customers is not an inventory cost, but a selling expense.

As we noted above, depreciation represents a direct expense when it is attributable to a specific cost object. Some examples of depreciation as a direct expense are listed in the table below:

Industry	Cost Object	Equipment Directly Linked to Cost Object
Oil and gas mining	Oil and gas division	Drilling rigs
Well-boring	Water well division	Drilling rigs
Pasta factory	Pasta manufacturing department	Flour mixer
Footwear manufacturing	Footwear manufacturing department	Sewing machine
Car manufacturing	Car manufacturing division	Assembly line
Construction company	Building construction department	Cranes
Software company	Big data management division	Servers

In case fixed assets are not exclusively associated with a cost object, their depreciation is classified as anindirect expense. Such expense is allocated, apportioned and absorbed by the company either as part of inventory cost or other operating expenses. For instance, sewing machines for attaching zippers may be used for handbags, backpacks, pullovers and boots (i.e., cost objects), and depreciation of the machines may be allocated to these cost objects. A respective cost driver should be used in this case to determine the depreciation expense per the unit of cost driver; the determined rate is then used to “assign” depreciation cost to units of production (i.e., cost objects)