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.
There are three ways to account for the cost of these service departments, which are:
- Direct charge off. Simply charge the cost of these 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.
- 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.
- Indirect (or interdepartmental) 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.
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.