Management And Accounting Web

Gordon, L. A. and M. P. Loeb. 2001. Distinguishing between direct and indirect costs is crucial for internet companies. Management Accounting Quarterly (Summer): 12-17.

Summary by Jennifer Beck
Master of Accountancy Program
University of South Florida, Fall 2004

E-Commerce Main Page | Cost Allocation Main Page | Overhead Related Main Page

The purpose of this article is to explain what the authors believe to be the correct way to allocate costs in an Internet-based company. Cost management is important for running a company successfully because it plays a role in determining profitability as well as in making pricing and product line decisions. The authors mention that there is a growing concern about the ability of Internet-based companies to accurately distinguish between direct and indirect costs, with many people arguing that it is not important. The authors contend that it is important for these companies to measure direct and indirect costs, but that the cost objective should be the customer rather than products or services.

A Traditional View

Direct costs are those that can be easily traced to a specific cost objective, while indirect costs are those that must be allocated (e.g., factory overhead). The cost objective is the purpose for which the cost is measured and the costs determined to be direct and indirect change as the cost objective changes. Traditionally, cost objectives have been products, services, or departments. Different cost objects tend to be used in different industries.

Using products as cost objects in a manufacturing company makes sense because product cost information can be used to determine product profitability and to make various strategic decisions. Services are more appropriate cost objects for many other firms in the service industry. For example, banks might use loan processing as a cost object. On the other hand a retailer might find it more useful to treat departments as cost objects.

Electronic commerce represents a fundamental change in the way companies do business. As a result, when these companies attempt to use the traditional cost objectives such as products, services, or departments, the distinction between direct and indirect costs is difficult to determine. This is due mainly to the increased significance of intangible assets. This difficulty does not mean that direct and indirect costs are no longer relevant; rather, it means that the traditional cost objects are no longer valid or useful in the e-commerce environment.

Direct vs. Indirect Costs in Internet-based Firms

In an e-commerce environment, transactions with customers are handled electronically. This leads to new ways of interacting with customers. The low cost of information and low switching costs produce a situation where companies must continually adjust prices and “expend continuous real-time efforts at attracting and tracking customers.” Companies need to ensure that their customers receive a user friendly, secure, and hassle-free experience. It is not enough for Internet-based companies to compete on price alone. It is necessary to focus on quality customer service. Providing superior service on the Internet requires specialized software and intellectual capital.

Because of the significant resources that are spent on attracting and retaining customers in an Internet-based firm, the appropriate cost object is the customer. Product, advertising, and service costs can all be traced to customers, or to classes of customers, i.e., become direct costs rather than indirect costs. Companies that do not treat customers as cost objectives “face the danger of being outsmarted by the competition and left with the least profitable customers in the marketplace.” Companies that do treat customers as the primary cost objective will allocate resources more effectively as they find ways to effectively attract and retain profitable classes of customers.

Use Management Accounting Techniques Properly

The Direct vs. Indirect cost issue is only one aspect of the new Internet-based economy. E-commerce changes the way management accounting information is prepared and used, but it does not diminish its importance.

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