How do you apply the direct allocation method?

The direct allocation method (for service department allocation) is a method of allocating support department (or activity) costs that only considers services to production department (or cost objects) and thus ignores all services provided by a support department to another. The total cost accumulated in each service department is “directly” allocated to the cost objects.

You can get all the data and solutions by downloading the same Excel as before (I only put this link again in case you missed it the first time).

The direct method is simple to implement and therefore inexpensive. However, by ignoring the services support departments provide to each other, this method has two major drawbacks. First, the allocation rates it produces do not inform about the real cost of providing each service. Indeed, the cost of maintenance is not only the costs initially accumulated in maintenance, but also the resources consumed by HR to manage the maintenance personnel. The allocation rate computed with the direct allocation method does not take into account the resources consumed in HR to provide maintenance services and reciprocally; moreover, it also underestimates the number of times maintenance or HR services were provided. Therefore, the resulting allocation rates are misleading because both the numerator and denominator are partial.

Second, if there are huge imbalances between the services provided by each support department to each other, the direct method will introduce distortions in costing and cause cross-subsidization. For instance, applying the direct method in the example of the bakery, HR costs are integrally allocated at 90% for Pastries and 10% for Bread. But this is wrong because HR works 50% of its time for maintenance; therefore 50% of its time should be sent to maintenance and then divided at 20% for Pastries and 80% for Bread. This would not result in a distortion if maintenance provided as much services for HR as HR does for maintenance, because the two flows of resources would “cancel” each other. But this is not the case here, so the direct method over-costs Pastries and under-costs Bread.

These two problems are partially addressed by the sequential allocation method, and fully addressed by the reciprocal allocation method.

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