How service costs are allocated to producing departments using direct method?

Direct allocation method is one of the four techniques used to reallocate service departments' overheads to production departments. It is different from the other reallocation methods because it completely disregards any services provided by one service department to another. This means that no portion of the overhead of a service department is reallocated to other service departments. All is reallocated to production departments in the ratio of their specified percentages.

Direct method is generally an inaccurate method of service departments' overheads reallocations and very inaccurate when service departments receive significant help from each other. Therefore it is only recommended in cases where service departments do not depend much on the services of other departments.

Direct allocation method is better explained using an example.

Example

Let us use the same problem we used earlier:

γ ltd. has three production departments (P, Q and R) and two service departments (X and Y). The overheads for the departments before reallocation are given below:

The reallocation percentages of the service departments' costs are given below:

Use the direct allocation method to reallocate the overheads of service departments to production departments.

Solution

First we have to calculate the factors to apportion service department overheads:

We then multiply the service department overhead by the above factors to obtain the amount of overhead to be allocated to each production department.

From clean toilets to working computers, your company incurs many costs that it cannot assign to one particular “cost object” -- a product, project, department or service. You must nonetheless cover these company-wide overhead costs with profitable sales, which requires that revenues exceed all costs. The direct allocation method is reasonably simple to perform, though it is easier to charge off all indirect overhead as departmental expenses without allocating to cost units. However, charge-off will not help you understand how and why you incurred the costs. The indirect allocation method is a more complex scheme in which you first reallocate service department overhead to service centers and then to cost units. Though indirect allocation can give you finely tuned results, it requires more accounting work than does the direct allocation method. The direct method serves the purpose of reminding production management that services like IT and maintenance are not “free” but rather are part of the costs of goods and services sold.

See Also:
Agency Costs
Make-or-Buy Business Decision
Lease Agreements
Lessor versus Lessee
National Association of Professional Employer Organizations (NAPEO)

In accounting, the costs of support service departments are allocated to the different departments within the organization that make use of those support services. There are several methods for allocating the costs of support service departments, including both the direct method allocation and the step method.

Direct Method Allocation

Using the direct method of allocating service department costs, allocate all of the service department costs to production departments. That is, all service department costs end up as overhead costs to production departments. Then, allocate none of the costs incurred from operating a support service department to other service departments; even though other service departments may in fact be utilizing the services provided by that department.

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