Direct Allocation Method Definition - AccountingTools

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What is the Direct Allocation Method?

The direct allocation method is a technique for charging the cost of service departments to other parts of a business. 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. These are all service departments.

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How to Account for the Cost of Service Departments

There are three ways to account for the cost of these service departments, which are noted below. In general, the indirect allocation method requires an excessive amount of accounting work, and so is not recommended. However, the direct allocation method represents a reasonable mix of modest additional clerical work and a more accurate cost allocation.

Direct Charge Off Method

Under the direct charge off method, simply charge the cost of service departments to expense as incurred. This is the simplest and most efficient method, but it does not reveal how costs are incurred, and tends to accelerate expense recognition. Nonetheless, it is an efficient accounting approach when your accounting staff is not overly skilled, and you have no interest in allocating costs.

For example, if the IT department incurs $50,000 in costs during the month, the full amount is recorded as an expense in the income statement. These costs are not assigned to products or other departments, which simplifies accounting but reduces cost accuracy.

Direct Allocation Method

Under the direct allocation method, charge the applicable cost of these departments directly to the production part of the business. These costs form a portion of the overhead cost of production, which is then allocated to inventory and the cost of goods sold. This method provides a better picture of how costs are incurred, but requires more accounting effort. It also tends to delay the recognition of expenses until a later period, when some portion of the produced goods are sold. The profit impact of using the direct allocation method is relatively minor when your business sells most of its produced goods immediately, rather than retaining them in stock at the end of each reporting period.

Indirect (or Interdepartmental) Allocation Method

Under the indirect allocation 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. This approach is more complicated, but results in the most fine-tuned cost allocation, based on cost usage patterns. The method is only useful if management intends to take action based on the outcome of the analysis.

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