Depreciation cost is the amount of a fixed asset that has been charged to expense through a periodic depreciation charge. The amount of this expense is theoretically intended to reflect the to-date consumption of the asset. Before determining whether depreciation is a direct cost or indirect cost, we must first clarify the related terms, which are:
- A direct cost is one that varies in concert with changes in a related activity or product.
- An indirect cost is one that is not directly associated with an activity or product.
Thus, 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.