Allocation of service department costs: direct method

Direct method of allocation

The direct method is the simplest and most widely used technique for allocating service department costs. Under this approach, service department costs are allocated directly and exclusively to operating (production) departments, completely ignoring any services provided between service departments themselves.

Companies allocate these costs to capture full product cost for inventory valuation and external reporting, support pricing decisions, and make managers aware of the support costs their departments use.

How it works

Each service department’s total cost is assigned to operating departments using an appropriate allocation base, such as machine hours, labor hours, square footage, or headcount, depending on the nature of the services provided.

Once the costs are allocated, the service departments are removed from the cost structure, and their costs become part of the overhead assigned to production departments.

Key features

• Inter-service support is ignored: Even if HR supports IT or vice versa, such support is not considered in the allocation.
• Ease of implementation: Simple calculations make this method suitable for companies with minimal inter-service activity.
• Less accurate in complex environments: May distort costs in companies with significant reciprocal services among support units.

Example: Assume a company has the following departments:

Service departments:

• Human Resources (HR): $60,000
• Information Technology (IT): $40,000

Operating departments:

• Department A
• Department B

Department	Number of employees	Number of computers
HR	10	20
IT	50	20
Dept A	100	100
Dept B	150	100

Let’s allocate HR costs based on the number of employees and IT costs based on the number of computers. Under the direct method, IT’s 50 employees and HR’s 20 computers are excluded from the bases (and so are each department’s own headcount and computer count), even though HR does serve IT.

Step 1: Allocate HR ($60,000) Total employees in A and B = 100 + 150 = 250

• Dept A: (100 ÷ 250) × 60,000 = $24,000
• Dept B: (150 ÷ 250) × 60,000 = $36,000

Step 2: Allocate IT ($40,000) Total computers in A and B = 100 + 100 = 200

• Dept A: (100 ÷ 200) × 40,000 = $20,000
• Dept B: (100 ÷ 200) × 40,000 = $20,000

Final allocated costs

Department	Allocated HR	Allocated IT	Total
Dept A	$24,000	$20,000	$44,000
Dept B	$36,000	$20,000	$56,000

Note that $44,000 + $56,000 = $100,000 — the full $60,000 HR + $40,000 IT cost, just reassigned entirely to Dept A and Dept B.

Benefits of direct method

• Easy to understand and apply
• Requires fewer calculations
• Suitable when inter-service support is immaterial

Limitations of direct method

• Ignores the reality of service departments supporting one another
• May result in less accurate product costing, especially when inter-service relationships are significant

Dual-rate allocation

Some companies split a service department’s cost into variable and fixed portions and allocate each separately—dual-rate allocation, which can pair with the direct, step-down, or reciprocal method. The variable portion follows actual usage; the fixed portion follows budgeted or practical-capacity usage, so one department’s usage doesn’t shift fixed costs onto another.

For example, if IT’s $40,000 splits into $25,000 fixed and $15,000 variable, the $15,000 follows actual usage (100/100 above) while the $25,000 follows budgeted shares (60% Dept A / 40% Dept B)—giving Dept A $15,000 and Dept B $10,000 of fixed cost regardless of actual usage.