Is depreciation a direct cost or indirect cost?
/What is Depreciation?
Depreciation is the systematic allocation of the cost of a tangible fixed asset—such as machinery, vehicles, or buildings—over its useful life. It reflects the wear and tear, usage, or obsolescence of an asset as it helps generate revenue over time. Depreciation reduces the asset’s book value on the balance sheet and is recorded as an expense on the income statement, impacting a company’s reported net income. The purpose of depreciation is to match an asset’s cost to the periods in which it provides economic benefits, ensuring more accurate financial reporting in line with the matching principle of accounting.
Determining Whether Depreciation is a Direct or Interest Cost
Before determining whether depreciation is a direct cost or indirect cost, we must first clarify the related terms, which are as follows:
Direct cost. A direct cost is one that varies in concert with changes in a related activity or product. For example, the cost of direct materials is considered a direct cost, since these materials are incorporated into the product.
Indirect cost. An indirect cost is one that is not directly associated with an activity or product. For example, the utilities expense incurred to run a factory is not directly associated with the goods produced by the factory, but must still be incurred to ensure that the factory operates.
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The determination of depreciation as a direct or indirect cost depends upon what it is associated with. For example, a cost center such as the power generation facility of a university contains an electric turbine. The turbine is the entire responsibility of the power generation cost center. Since the depreciation expense associated with the turbine is charged entirely to the cost center, depreciation can be considered a direct cost of the power generation cost center.
Conversely, the depreciation charge for the turbine may then be added to a cost pool that is allocated out to the departments of the university, based on their consumption of electricity. Since the actual depreciation expense incurred does not vary in direct proportion to the departmental use of electricity, depreciation can be considered an indirect cost of the various user departments.
In the production department of a manufacturing company, depreciation expense is considered an indirect cost, since it is included in factory overhead and then allocated to the units manufactured during a reporting period. The treatment of depreciation as an indirect cost is the most common treatment within a business.