In cost accounting, the direct allocation method allocates support costs directly to each operating department. It’s simple, because you allocate every dollar out of the support department to an operating department. Because all costs are allocated, none of the support costs remain at the head office. Ta-DAH!
Here’s a direct allocation example. Say your human resources and legal departments support two operating departments: assembly and shipping. After some analysis, you conclude that 80 percent of your HR costs and 90 percent of your legal costs are incurred to support the assembly area. The remainder is allocated to shipping.
This table shows that all support costs are allocated to the two operating departments. The assembly area gets 80 percent of the human resources cost ($100,000 x 0.80 = $80,000) and 90 percent of the legal costs ($200,000 x 0.90 = $180,000). The “leftover” support costs are allocated to shipping. Both support departments have a zero balance after costs are allocated.
| Assembly | Shipping | ||
|---|---|---|---|
| Beginning balance | $300,000 | $1,000,000 | $75,000 |
| HR cost allocation | |||
| $100,000 | $80,000 | $20,000 | |
| Legal cost allocation | |||
| $200,000 | $180,000 | $20,000 | |
| Total allocation | -$300,000 | $260,000 | $40,000 |
| Ending balance | $0 | $1,260,000 | $115,000 |
There’s a downside to this method, however. Direct allocation doesn’t allow you to allocate support department costs to other support departments. That’s likely to happen, depending on your business.
Consider an HR department and a legal department. 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. All costs have been allocated out.
But (there’s always a “but”) during the same time period, human resources provides support for the legal department (it helps the legal area interview and hire an attorney). Naturally, some human resources costs should be allocated to the legal department. But the legal department costs have already been fully allocated to an operating division.
Consider where those new costs from human resources should go and when they should go. They need to be allocated to the legal department first, and then to an operating department. If the costs don’t end up somehow allocated to an operating department, they never get attached to a product or service. The direct allocation method would be fairly inaccurate in this situation.