Learning Resource

Direct Method of Allocation

The direct method allocates costs of each of the service departments to each operating department based on each department’s share of the allocation base. Services used by other service departments are ignored. This means the direct method does not recognize service performed by other service departments. For example, if Service Department A uses some of Service Department B’s services, these services would be ignored in the cost allocation process. Because these services are not allocated to other service departments, some accountants believe the direct method is not accurate.

Let’s look at another example. A company has two service departments, maintenance and administration, and two operating departments, called Department 1 and Department 2 for simplicity. The costs of the maintenance department are allocated based on the machine-hours used. For the administration department, the cost allocation is based on the number of employees. The following information is provided:

 

Service department: Maintenance

Service department: Administration

Operating department 1

Operating department 2

Costs

$8,000

$4,000

$32,000

$36,000

Machine-hours used

1,000

2,000

1,500

2,500

Number of employees

100

200

250

150

We will need to modify formula for predetermined overhead rates to calculate the allocation rate for service department cost:

Notice, we use the operating department cost drivers only since we are allocating the service department cost to operating departments only and not to another service department. Maintenance uses machine-hours as the cost driver and administration uses number of employees. We can calculate the service department allocation rates as follows:

\begin{array}{l}\frac{service\;department\;department\;cost}{total\mathit\;cost\;driver\;(operating\;depts.\;only)}=\frac{\$8,000}{(1,500+2,500)}=\frac{\$8,000}{4,000}=\$2\;\text{per machine hour}\\\end{array}
\[\begin{array}{l}\\\frac{administration\;department\;cost}{total\;employees\;(operating\;depts.\;only}=\frac{\$4,000}{250+140}=\frac{\$4,000}{400}=\$10\text{ per employee}\end{array}\] 

To allocate the service department costs to each operating department, we will take the amount of the cost driver (machine hours for maintenance and employees for administration) and multiply it by the allocation rate we just calculated.

 

Operating department 1

Operating department 2

Maintenance

$3,000

(1,500 machine hour × $2 per machine hour)

$5,000

(2,500 machine hour × $2 per machine hour)

Administration

$2,500

(250 employees × $10 per employee)

$1,500

(150 employees × $10 per employee)

Notice how the total maintenance amount allocated to the two departments (3,000 + 5,000) equals the maintenance department cost of $8,000. The same applies to administration, as the total cost is $4,000 and we allocated a total of $4,000 (2,500 + 1,500). We can summarize the changes to the costs of each department:

 

Service department: Maintenance

Service department: Administration

Operating department 1

Operating department 2

Costs

$8,000

$4,000

$32,000

$36,000

Allocation of maintenance

($8,000)

 

3,000

5,000

Allocation of administration

 

($4,000)

2,500

1,500

Total Costs

$0

$0

$37,500

$42,500

Licenses and Attributions

Direct Method of Allocation from Managerial Accounting by Lumen Learning is available under a Creative Commons Attribution 4.0 International license. UMGC has modified this work and it is available under the original license.