The Advantages of the Direct Method of Cost Allocation

by Eric Bank Google

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 one of several cost allocation methods to assign indirect costs to cost objects.


The reason to allocate overhead costs to cost objects is to figure each object’s contribution to or drain upon company profits. Some objects are more profitable than others. The direct method allocates administrative overhead costs to inventory items and is a component of cost of goods sold. Management is keen to produce only the types and amounts of inventory that are profitable, or at least do not lose money, when the company assigns all direct and overhead costs to each item. The advantages of the direct method are that it provides reasonably useful information about product costs and that it allows management to assign overhead costs using simple procedures.


In the direct method, companies fully allocate overhead from service departments to inventory, even though there might be cross-costs between service departments. For example, suppose you manufacture chocolates, gumdrops and peppermints. Your company’s information technology department needs clean facilities and the maintenance staff may use computers to track operations. In the direct method, you ignore the costs that occur between the IT and maintenance departments. Instead, you sum the overhead costs of each production department and prorate the inter-departmental costs shared by the service departments to the overhead costs assigned to each production department.


Suppose you allocate maintenance department costs to the chocolate, gumdrop and peppermint production units in the following percentages respectively: 25 percent, 40 percent and 25 percent, totaling 90 percent. You initially allocate the remaining 10 percent of maintenance costs to the IT department. In the direct method, you must reallocate this 10 percent overhead cost away from the IT department on a prorated basis. For example, the chocolate unit would get 25 percent of 90 percent, or 22.5 percent of the reallocated overhead. You follow the same procedure for reallocating the IT department’s costs initially allocated to the maintenance department.


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.

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