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Direct Method of Cost Allocation-Service Department Costing:

Definition:

Direct method is a cost allocation method under which any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation.

Explanation:

The direct method is the simplest of the three cost allocation methods. It ignores reciprocal or interdepartmental services (services provided by a service department to another service department) and allocates all costs of service departments directly to operating departments. Even if a service department (such as personnel department) provides a large amount of service to another service department (such as the cafeteria department), no allocations are made between the two departments. Rather all costs are are directly allocated to the operating departments, bypassing the other service departments. Hence the term direct method.

Example:

To provide an example of the direct method, consider Mountain View Hospital, which has two service departments and two operating departments as shown below:

Description

Service Department

Operating Department

Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Employee hours
Space occupied square feet
$360,000
12,000
10,000
$90,000
6,000
200
$261,000
18,000
5000
$689,000
30,000
45,000
$1,400,000
66,000
60,200

Hospital administration costs will be allocated on the basis of employee-hours and Custodial Services costs will be allocated on the basis of square feet occupied.

The direct method of allocating the hospital's service department costs to the operating departments is shown below:

Description

Service Department

Operating Department

Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation

Allocation:

Hospital administration costs (18/48, 30/48)*

Custodial service department costs (5/50, 45/50)**

Total costs allocation

$360,000

 

(360,000)



-----------
$0
======

$90,000

 

 


(90,000)

----------
$0
=====

$261,000

 

135,000


9,000

-----------
$405,000
======

$689,000

 

225,000


81,000

----------
$995,000
=======

$1,400,000

 

 

 


1,400,000
=======

*Based on the employee-hours in the two operating departments, which are 18,000 hours + 30,000 hours = 48,000 hours
**Based on the space occupied by the two operating departments, which is 5,000 square feet + 45,000 square feet = 50,000 square feet

Several things should be carefully noted in this example. First, even though both the hospital administration department and custodial services department have recorded employee-hours. These employee hors are ignored when allocating service department costs using direct method. Under the direct method, any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation. Note that the same rules used when allocating the costs of the custodial services department. Even though the Hospital Administration and Custodial Service departments occupy some space, this is ignored when the custodial services costs are allocated. Finally, note that after all allocations have been completed, all of the departmental costs are contained in the two operating departments. These costs will be used to prepare overhead rates for purpose of costing products and services produced in the operating departments.

Advantages and Disadvantages of Direct Method:

Although the direct method is simple , it is less accurate than the other methods since it ignored interdepartmental services. This can lead to distorted product and service costs. Even so, many organizations use the direct method because of its simplicity.

You may also be interested interested in other articles from "service department costing" chapter:

  1. Selecting Allocation Bases
  2. Direct Method of Cost Allocation in Service department costing
  3. Step Method of Cost Allocation in Service Department Costing
  4. Reciprocal Method of Cost Allocation-Service Department Costing

 

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