Direct method of cost allocation explanation, example, advantages and disadvantages

The total producing department costs, after all allocations, is equal to the total direct costs budgeted, i.e., $500,000 (See

the note at the bottom of Exhibit 6-4). Assume that all of the HR and legal department support costs are allocated to an operating division using direct allocation. So the bucket of HR and legal department costs is empty.

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

How Does the Direct Method Work?

Using the direct allocation method, we would ignore the costs of the HR and IT departments because they’re not directly involved in producing the products. We would allocate the Production department’s costs directly to the products, based on the number of units produced. 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. In our widget sales company, there wasn’t a lot of overlap between the different service departments.

The direct method is considered the most simple method of allocating the cost of service departments to operating departments. Under this method, the costs incurred by service departments are not allocated to each other; rather, they are directly allocated to operating departments using some appropriate allocation base. In other words, we can say that the direct method of departmental cost allocation https://turbo-tax.org/the-elderly-or-disabled-irs-tax-credit-for-2020-details/ ignores the service provided by a service department to itself and to other service departments. Because these services are not allocated to other service departments, some accountants

believe the direct method is not accurate. Cost allocation allows you to determine where costs can be reduced and provides accurate reporting on company financials based on its relative performance.

The Advantages of the Direct Method of Cost Allocation

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. The most common alternative to the direct method is the “step-down” method. In this method, you choose a support department and then allocate its costs among all other departments in the company — both the production and support departments.

The notes to the table show how the overhead rates were

calculated in each case. The Assembly Department manager is likely to complain that neither of the allocations in Exhibit 6-11 is equitable. He or she might logically argue that the dual rate method illustrated

above assigns the Power Department’s idle capacity costs to the Assembly Department. These idle capacity costs will in turn be allocated to the Assembly

Department’s products. Using a single budgeted rate, rather than either a single actual rate or dual rate (Exhibit 6-11) will normalize the service costs

allocations, provide more timely costing and aid in evaluating the service departments.

Sequential Method in Accounting

The products obtained from a hog such as the chops, ham, and bacon are joint

products. In fact, joint products are common in a variety of industries including petroleum, flour milling, meat packing, dairy, coal, copper, salt,

chemicals, soap, gas, leather, and tobacco. The term “by-products” refers to a sub-category of joint products that have relatively insignificant

sales values as a proportion of the value of the entire group from which they are derived. Let’s say that you work in human resources for a company and have been called into the CEO’s office. Apparently, business is lean, and since your department doesn’t make money, you’ve been asked to justify your department’s funding levels.

• In the wake of the COVID-19 pandemic and escalating tensions with China, American companies are actively seeking alternatives to mitigate their supply chain risks and reduce dependence on Chinese manufacturing.
• This method is straightforward and easier to implement compared to others, such as the step-down method or the reciprocal method.
• Since it skips the step of allocating costs to intermediate cost pools, it saves time and resources.

The Virginia Chicken Company combines a poultry business with a chain of restaurants that specialize in southern fried chicken. Two joint products emerge at the point of separation,

or split-off point. These products are referred to as white (W) and dark (D) meat. The details for a recent accounting period are provided in Exhibit 6-16.

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From the management decision perspective, joint cost allocations are useless because they are not relevant in decisions concerning the separate products. For example, decisions

concerning whether to continue or discontinue producing the joint products depend on their combined value, not the value of any particular product at the

split-off point. Therefore, it has been argued that the joint costs should not be allocated at all. However, if the joint costs are not allocated, a value

still needs to be placed on the unsold inventory for financial reporting purposes. To solve this dilemma some companies value the inventory at final

sales value, less after split-off cost, i.e., NRV.

• Producing more of

  one product in the group means producing more of all products in the group.

• No one wants to set up a spreadsheet with many rounds of cost allocations.
• Cost allocation can also show you which departments or products are spending too much money on indirect expenses, and which ones aren’t using enough of them.

Since X1 consumed 9/10 of the machine time in

the Cutting department, (i.e., 3,960÷4,400) it seems logical that X1 should receive 90 percent of the overhead costs. The purposes of cost allocations are closely related to the purposes of information systems outlined in Chapter 2 (See Exhibit 2-4 for a review). Cost allocations are needed to value inventory for external reporting purposes, for planning and monitoring the

cost of activities and processes, and for various short term and long term strategic decisions. In addition,

since cost allocation methods are components of the overall performance evaluation system, cost allocations tend to influence the behavior of the

participants within the system. Therefore, system designers must also carefully consider the motivational, or behavioral aspects of alternative cost allocation

methods.