Direct Method of Cost Allocation: Process, Pros & Cons Video & Lesson Transcript

direct method of cost allocation

We can also fill in the original equations for the service departments to find the reciprocal transfers. The direct method transfers the cost of a service department directly to the productive departments that rely on the services. The allocation is usually based upon some logical benchmark. For example, janitorial services may be allocated to productive departments based on square footage used by the productive departments. Cafeteria costs may be allocated based on the number of employees within each production department.

What is an example of direct cost in research?

Examples of Direct Costs:

Computer costs and services directly identifiable with the activity or program Consultants. Direct materials and supplies (e.g., lab supplies, chemicals, biological supplies, electronics) Equipment used exclusively for the activity or program. Patient care costs.

The General Products Company is a manufacturing firm with six service departments and five producing departments. Many of the service departments serve each other in addition

to providing service to the producing departments. The various departments and applicable variable direct cost, (i.e., the cost identified with these

departments before reciprocal service cost allocations) are presented in Table 1 for the most recent accounting period. The service departments and

allocation proportions for the direct variable costs appear in the lower part of Table 1.

How is cost allocation done?

The equations for the reciprocal method are also developed from

equations [1] and [2] above. However, there are some differences in the values that appear in the equations. First, the service department costs (Si

and Sj) are different because all of the self service and reciprocal relationships are considered in determining these amounts.

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Direct allocation doesn’t allow you to allocate support department costs to other support departments. That’s likely to happen, depending on your business. Indirect costs should be allocated between departments, projects, and products based on a fair allocation plan that reflects their use in those areas. Can joint costs be allocated to joint products based on a “cause and effect” relationship? The term “joint products” refers to a group of products that are produced simultaneously by a common process. A group of joint products is inseparable until the products

reach a certain point where they are divided or split into separate products.

Step-Down Method of Cost Allocation: Example, Calculation

The most common way of doing so is with the direct method of cost allocation. In the second step, the equations for the service departments are solved first in the sequence established by the rules mentioned above. Then the equations representing the

producing departments are solved to provide the desired allocations. The step-down method is more accurate than the direct method, but less accurate than

the reciprocal method. The direct allocation method focuses only on those departments that have direct involvement with the production process or the service provided.

How do you calculate direct method?

Formulas of the Direct Method

Cash Received from Customers = Sales + Decrease (or – Increase) in Accounts Receivable. Cash Paid for Operating Expenses (Includes Research and Development) = Operating Expenses + Increase (or – decrease) in prepaid expenses + decrease (or – increase) in accrued liabilities.

As indicated in Chapter 1, performance evaluation systems are interactive in that they simultaneously

measure and influence the behavior of the participants within the system. Let’s use a hypothetical manufacturing company as an example to illustrate the direct allocation method. Also, because it’s so easy to pass charges on, it’s easy for bigger costs to simply get passed on. This couples with the fact that you can’t charge a service department for services or goods it receives from another service department.

What are common mistakes people make when allocating costs?

Therefore, the joint cost allocations should not imply that true

profitability has been obtained. Critics rebut the previous argument by pointing out that this method sometimes produces a negative cost allocation to some of

the less profitable products (See the example below). Certainly, approximations of the true costs are better than these confusing cross-subsidies. The plant wide rates provide inaccurate product costs because the products do not consume the indirect resources in the same proportions in each of the two departments.

  • Kenneth W. Boyd has 30 years of experience in accounting and financial services.
  • 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).
  • As indicated in the exhibit, $11,111 of Power Department costs is allocated to the Maintenance Department

    recognizing that 100 kilowatt hours of power were used by Maintenance.

  • Nearshoring, the process of relocating operations closer to home, has emerged as an explosive opportunity for American and Mexican companies to collaborate like never before.
  • Using the methods described in Chapter 3 (e.g., regression and correlation analysis) the system designer might attempt to define

    a relationship between the cost and the cost drivers objectively.

Equations for

the service departments [1] are developed to allocate the service department costs in sequence starting with the department that serves the greatest number

of other service departments. An alternative approach is to start with the service department that provides the highest percentage of its’ service to

other service departments. In determining the sequence of allocations, ties can be broken by using the alternative approach. If there is still a tie, then

choose the department with the largest dollar amount of service provided to the other service departments.

Common Cost Allocation Methods

5 A similar, but less severe criticism can be made concerning the allocations based

on sales values at the split-off point since this method creates equal profit ratios at the point of separation. The three methods for stage 1 allocations are illustrated in the example provided below. 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. For example, suppose you’re using a full absorption costing (FAC) system and another department within your company is using a direct labor cost system. Cost allocation is a process in which businesses and individuals identify the costs incurred by activity and distribute them to appropriate accounts.

  • Revised income statements are presented in Exhibit 6-19 to underscore this point.
  • The underlying concepts of cost allocations relate to the purposes of assigning costs to cost objects as well as the principles, or supporting logic for the cost allocation methods chosen.
  • Resolving this conflict leads back to the previous method, i.e., go one step further and subtract an average profit margin.
  • Using the direct method of allocating service department costs, allocate all of the service department costs to production departments.
  • Then allocate the reciprocated costs to the other departments.

Conceptually, this is the same logical argument discussed in

Chapter 4 under the heading of reasons for using a predetermined overhead rate. From the performance evaluation and behavioral perspectives, the amount of fixed service cost allocated to a user is more meaningful if it is not influenced by variations in

the short term consumption levels of other users. The dual rate method simply provides a way to implement this idea which reduces the inevitable behavioral

conflicts created by the cost allocation process. Another advantage of the dual rate method is that spending variances for both fixed and variable costs can be

calculated when the actual service costs differ from budgeted costs.

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. Businesses exist to sell things to their customers, but most companies have at least some costs that aren’t directly attributable to the production of those things. These include support services such as human resources and accounting. For internal accounting purposes, companies often want to assign those costs to production departments.

What are the 7 types of allocation methods we use?

  • Direct Allocation.
  • Indirect Allocation (Expense).
  • Indirect Allocation (Revenue).
  • Indirect Allocation (Misc.).
  • Indirect Cost Allocation.