Cost Allocation Direct method Example | Cost Accounting | CPA Exam BAR | CMA Exam

In this video, we explain direct method of cost allocation.
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Introduction 0:00
Introduction to Cost Allocation (0:02-0:23): The video explains that there are three methods for cost allocation: the direct method, the step method, and the reciprocal method.
Explanation of the Direct Method (0:26): The direct method allocates service costs directly to production departments. Its advantage is simplified calculation, but it ignores service to service interaction (0:46-1:07).
Illustrative Example (2:44): Green Leaf Manufacturing, which has two service departments (maintenance and IT support) and two production departments (assembly and packaging), is used to show an example of cost allocation.
Applying the Direct Method (4:39): The video walks through how to ignore any allocation to other service departments (5:17-5:27) and allocate directly to the production (assembly and packaging) departments.
Calculating and Applying Percentages (6:35): The video shows how to find the relative value of assembly and packaging (5:36-5:52) by dividing each department's allocation by the total allocation percentage.
Total Production Cost (8:46): The direct costs and the allocated costs are added to arrive at a total production cost (9:03).




Direct Method of Cost Allocation
The direct method of cost allocation is one of the simplest and most commonly used approaches to distributing indirect costs within an organization. This method allocates overhead costs from service departments (e.g., HR, IT, maintenance) directly to production departments, without considering any interactions or services exchanged between the service departments themselves.

What is the Direct Method?
Definition: The direct method assigns all costs incurred by service departments directly to production or operating departments based on a predetermined allocation base (like machine hours, labor hours, or square footage).
Assumption: This method assumes that service departments only support production departments and do not provide services to each other. Therefore, it does not account for inter-service department allocations.
Purpose of the Direct Method
Simplifies Cost Allocation: Provides a straightforward approach by focusing only on allocating costs from service departments to production departments.
Facilitates Budgeting: Helps in preparing departmental budgets by clearly identifying cost assignments.
Enhances Cost Control: By directly linking service department costs to production departments, it helps track and control indirect costs more effectively.
How the Direct Method Works
Identify Service and Production Departments

Service departments: Those that provide support services (e.g., IT, HR, maintenance).
Production departments: Those directly involved in producing goods or delivering services (e.g., manufacturing, assembly, packaging).
Select an Allocation Base

Choose a cost driver that best represents how each production department consumes the service department's resources (e.g., labor hours, machine hours, number of employees).
Allocate Service Department Costs

Assign the total costs of each service department directly to the production departments based on the chosen allocation base.
Example of the Direct Method
Scenario:
A company has two service departments (HR and IT) and two production departments (Assembly and Packaging).
The costs for each service department are:
HR: $50,000
IT: $30,000
The allocation bases are as follows:
HR costs are allocated based on the number of employees in each department.
IT costs are allocated based on the number of computers in each department.

Step 1: Determine the allocation bases for each department:
Assembly: 60 employees, 30 computers
Packaging: 40 employees, 20 computers

Step 2: Allocate HR costs:
Total employees = 100 (60 in Assembly + 40 in Packaging)
HR cost per employee = $50,000 / 100 = $500
HR cost to Assembly = 60 × $500 = $30,000
HR cost to Packaging = 40 × $500 = $20,000

Step 3: Allocate IT costs:
Total computers = 50 (30 in Assembly + 20 in Packaging)
IT cost per computer = $30,000 / 50 = $600
IT cost to Assembly = 30 × $600 = $18,000
IT cost to Packaging = 20 × $600 = $12,000

Final Allocation:
Assembly: HR ($30,000) + IT ($18,000) = $48,000
Packaging: HR ($20,000) + IT ($12,000) = $32,000
Advantages of the Direct Method
Simplicity: Easy to understand and implement, making it suitable for smaller organizations.
Cost Efficiency: Requires minimal data, reducing administrative overhead.
Clear Allocation: Provides straightforward cost assignments that can aid in cost control.





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