The direct allocation method, also known as the direct method, is a cost allocation approach used in cost accounting and managerial accounting. It involves assigning each department’s total costs directly to the products, services, or other cost objects without distributing costs between different departments first. The reciprocal method that uses simultaneous equations and matrix algebra provides additional information that isn’t available from our suggested method. Because this information isn’t available from the alternative method described here, the simultaneous equation method that uses matrix algebra is necessary if such information is needed. Consider where those new costs from human resources should go and when they should go. They need to be allocated to the legal department first, and then to an operating department.
When more than two service departments are involved, accounting textbooks recommend the use of simultaneous equations, matrix algebra, and a computer to solve the equations. Unfortunately, students and financial managers find the use of matrix algebra to be quite a challenge. An accurate, clear understanding of service department costs is valuable in several ways. First and foremost, service department costs are used to determine the full cost of a product.
How to Calculate Allocated Manufacturing Overhead
For this reason, some service departments may just pass on bigger costs, knowing that the likelihood of their actions being examined is reduced. Let’s say that you work in human resources for a company and have been called into the CEO’s office. Apparently, business is lean, and since your department doesn’t make money, you’ve been asked to justify your department’s funding levels. The only problem is that you don’t exactly have profits to show for your work.
This quickly becomes unwieldy when the number of rounds needed is much larger. Our alternative method uses Excel’s “iterative calculation option” and a template for the cost allocations to have Excel itself calculate a larger number of rounds. The direct method was used most in practice until the 1970s, when the Cost Accounting Standards Board (CASB) established a standard for service department cost allocation. The exposure draft for Cost Accounting Standard (CAS) 418, “Allocation of direct and indirect costs,” initially specified the reciprocal method. First charge the applicable cost of the service departments to the other service centers, and then allocate costs to the production part of the business.
What is the Direct Allocation Method?
The reciprocal method fully recognizes the other service departments by allowing reallocations back to each service department. As such, it’s more difficult to calculate but also more accurate than the other methods. To illustrate the methods, it’s convenient to convert the allocation bases from hours consumed by each department to percentages of the total base for each service department (see Figure 2). The major disadvantage of direct method is that it ignores interdepartmental services and can, therefore, lead to distorted products and services cost. Moreover, it is commonly considered a less accurate method when compared with other methods available for departmental cost allocation. This method is straightforward and easier to implement compared to others, such as the step-down method or the reciprocal method.
- This concept is used to fully load operating departments with those overhead costs for which they are responsible.
- This approach is more complicated, but results in the most fine-tuned cost allocation, based on cost usage patterns.
- We stopped at the sixth round, where the balance of S1 was $0.0003 (cell C23).
- (In Excel 2013, go to File, Options, Formula.) In the Calculations section, select the “Enable iterative calculations” checkbox.
- This simplification might be acceptable for some analyses, but it may not accurately represent the actual costs of producing each product, as it neglects the interdepartmental interactions and services.
- If the costs don’t end up somehow allocated to an operating department, they never get attached to a product or service.
So how do you get across just how much value your department provides to the company? The costs allocated to S1 and S2 are termed “reciprocated costs.” They are greater than the direct costs of S1 and S2 because costs are reallocated back to S1 and S2. Many organizations use direct method for allocating departmental costs because it is very simple and easy to employ. With the iterative calculation option enabled, Excel will allow circular references in formulas. A circular reference is when the formula in a cell refers to other cells that in turn refer to the original cell. Normally, Excel can’t automatically calculate a formula like that because it would by default keep recalculating indefinitely—almost like a basic go-to loop in programming that never ends.
Products
This concept is used to fully load operating departments with those overhead costs for which they are responsible. For example, the janitorial staff provides services to clean all company facilities, while the maintenance department is responsible for company equipment, and the IT department maintains the information technology systems. Despite those shortcomings, financial managers should find the reciprocal method much more accessible using this approach. Like the defense contractors that balked at the CASB’s recommendation to use the reciprocal method, many students today find the simultaneous equations method using matrix algebra too difficult to implement.
The department A’s cost is allocated on the basis of employee hours and department B’s cost is allocated on the basis of square feet occupied. To allocate the service department costs to each operating department, we will take the amount of the cost driver (machine hours for maintenance and employees for administration) x the allocation rate we just calculated. The three service cost-allocation methods vary in terms of ease and accuracy because of how they approach this problem.
Advantages and disadvantages of direct method of cost allocation
We also saw that it essentially just divides the total cost of service departments into proportions according to how they are used by the departments that make money, and allocates these costs as overhead. While the method is quick and easy to apply, it can leave some departments with an unfair burden of overhead and doesn’t acknowledge that service departments often provide services to each other as well. The direct method is considered the most simple method of allocating the cost of service departments to operating departments. Under this method, the costs incurred by service departments are not allocated to each other; rather, they are directly allocated to operating departments using some appropriate allocation base. In other words, we can say that the direct method of departmental cost allocation ignores the service provided by a service department to itself and to other service departments. The direct method allocates costs of each of the service departments to each operating department based on each department’s share of the allocation base.
The direct allocation method is one of several cost allocation methods to assign indirect costs to cost objects. But (there’s always a “but”) during the same time period, human resources provides support for the legal department (it helps the legal area interview and hire an attorney). Naturally, some human resources costs should be allocated to the legal department. But the legal department costs have already been fully allocated to an operating division. In our widget sales company, there wasn’t a lot of overlap between the different service departments.
In a real-world setting, the direct allocation method may not fully reflect the true cost of producing a product, as it doesn’t account for the support services provided by departments like HR and IT. Therefore, this method is most suitable for companies with simple, direct production processes and minimal interdepartmental service sharing. Using the direct allocation method, we would ignore the costs of the HR and IT departments because they’re not directly involved in producing the products.
