Direct Allocation Method

The direct allocation method is a way of assigning the costs of service departments, such as maintenance, information technology or human resources, to the producing departments that make a company's products. Under this method each service department's costs are allocated directly and only to producing departments. Any work that one service department does for another is ignored.

It is the simplest of three common methods for service department allocation in cost accounting, alongside the step-down (sequential) method and the reciprocal method. After allocation, each producing department's total overhead, including its share of service costs, is used to set a departmental overhead rate for charging overhead to products. The method is sometimes called simply the direct method.

Imagine a school where the cleaning team and the IT team support the classrooms, but also help each other: the cleaners tidy the IT office and the IT team fixes the cleaners' tablets. If the head wants to know what each classroom really costs to run, the support teams' costs need to be shared out among the classrooms.

The direct method takes the shortcut. It pretends the cleaners and the IT team only ever work for the classrooms and shares their costs among the classrooms alone. The favors they do for each other are left out. This is quick and easy, though slightly less precise.

1. Identify the service and producing departments, and gather each service department's total costs for the period.
2. Choose an allocation base for each service department that reflects how its services are used, such as machine hours for maintenance or number of computers for IT.
3. Calculate each producing department's share of the base, counting only usage by producing departments.
4. Allocate each service department's costs to producing departments in those proportions.

A company has two service departments, Maintenance with costs of $90,000 and IT with costs of $60,000, and two producing departments, Machining and Assembly.

• Maintenance allocates on machine hours. Machining used 6,000 hours, Assembly 3,000 and IT 1,000. Under the direct method the 1,000 IT hours are ignored, so Machining receives six-ninths of $90,000, or $60,000, and Assembly receives three-ninths, or $30,000.
• IT allocates on the number of computers supported. Machining has 10, Assembly 30 and Maintenance 5. Ignoring Maintenance, Machining receives one quarter of $60,000, or $15,000, and Assembly three quarters, or $45,000.

In total Machining is charged $75,000 and Assembly $75,000, which together equal the $150,000 of service costs. These amounts are added to each producing department's own manufacturing overhead before rates are calculated.

All three methods allocate the same total cost to producing departments; they differ only in how it is split. The more service departments rely on each other, the more the direct method's results drift from those of the reciprocal method.

The direct method is popular because it is easy to explain and to apply, and the results are often close enough when service departments do little work for one another. It is used for product costing under absorption costing, for internal reporting, and in cost-based pricing or reimbursement arrangements.

Its weakness is that ignoring support between service departments can misstate the cost of each producing department, which then affects product costs, prices and performance evaluation. Managers may also over-use a service department that appears free from their perspective. Like all allocation methods, it shares common costs that do not change with a single department's decisions, so allocated figures should be used with care in relevant cost decisions such as whether to outsource a service. Companies with complex support structures may prefer the step-down or reciprocal method, or activity-based costing.