Direct Method of Cost Allocation: Process, Pros & Cons

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Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

While the direct method of cost allocation may be the easiest for the accounting department to use, this lesson will outline the process and show how it is often inaccurate in truly spreading the burden of overhead costs among different groups.

The Direct Method of Cost Allocation

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. So how do you get across just how much value your department provides to the company? In short, you pass the costs on using cost allocation.

There are a number of ways to allocate overhead costs from service departments to those departments that actually participate in production. The direct method of cost allocation is one of the most straightforward, although it is flawed. However, its ease of use has meant that it is one of the most commonly used methods of cost allocation. In short, it assumes that service departments provide no services to one another; it simply breaks up the cost of the service departments amongst the production departments of the firm. In this lesson, we'll see how that works, as well as looking more deeply at the advantages and disadvantages of such as system.

How Does the Direct Method Work?

The direct method of cost allocation works by simply splitting up the cost of the overhead from service departments and tacks it on to the cost for departments that bring in money. Let's look at an example. Let's say that your widget firm has two departments that bring in money: corporate sales and individual sales. Likewise, it also has two departments that are service-oriented: the custodial department and the accounting department. Let's also say that the custodial department costs $50,000 a month, while the accounting department costs $60,000. These costs include everything from the salaries of the workers in those departments to the overhead costs that they incur. These costs range from new mops for the custodial department to bookkeeping software for the accounting department.

Now let's divide the costs. The two sales departments have equal amounts of office space, so according to the direct method, we'd simply divide the custodial department's budget into two halves and assign one to the costs of each sales team. As a result, each side pays $25,000. That is the number that the custodial department would pass on to each of the sales departments for its ledger. The two add up to $50,000, which is the total cost of the department for that month. Now despite these going on the ledger, companies don't actually transfer money internally all that often. Instead, this information is used as justification for the continued funding of the service departments.

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