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1. External financial reporting decisions
2. Planning, budgeting, and forecasting
3. Performance management
4. Cost management
4.1 Measurement concepts
4.2 Costing systems
4.3 Overhead costs
4.3.1 Overhead classification and cost behavior
4.3.2 Overhead allocation methods
4.3.3 Overapplied and underapplied overhead
4.3.4 Allocation of service department costs: overview
4.3.5 Allocation of service department costs: direct method
4.3.6 Allocation of service department costs: step-down method
4.3.7 Allocation of service department costs: reciprocal method
4.4 Supply chain management
4.5 Business process improvement
5. Internal control
6. Technology and analytics
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4.3.5 Allocation of service department costs: direct method
Achievable CMA Part 1
4. Cost management
4.3. Overhead costs
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Allocation of service department costs: direct method

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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.

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. Using the direct method, the cost drivers within the service departments are ignored.

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

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

Direct method of allocation

  • Allocates service department costs only to operating (production) departments
  • Ignores services provided between service departments
  • Uses allocation bases (e.g., machine hours, labor hours, headcount) for cost assignment

How it works

  • Assign each service department’s total cost directly to operating departments
  • Remove service departments from cost structure after allocation
  • Allocated costs become part of production department overhead

Key features

  • Inter-service support not considered
  • Simple and easy to implement
  • Less accurate when reciprocal services between support units are significant

Benefits of direct method

  • Straightforward and easy to apply
  • Minimal calculations required
  • Best for organizations with little inter-service activity

Limitations of direct method

  • Overlooks support services exchanged between service departments
  • Can distort product costs in complex organizations with significant inter-service support

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Next  | 4.3.6 Allocation of service department costs: step-down method
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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.

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. Using the direct method, the cost drivers within the service departments are ignored.

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

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
Key points

Direct method of allocation

  • Allocates service department costs only to operating (production) departments
  • Ignores services provided between service departments
  • Uses allocation bases (e.g., machine hours, labor hours, headcount) for cost assignment

How it works

  • Assign each service department’s total cost directly to operating departments
  • Remove service departments from cost structure after allocation
  • Allocated costs become part of production department overhead

Key features

  • Inter-service support not considered
  • Simple and easy to implement
  • Less accurate when reciprocal services between support units are significant

Benefits of direct method

  • Straightforward and easy to apply
  • Minimal calculations required
  • Best for organizations with little inter-service activity

Limitations of direct method

  • Overlooks support services exchanged between service departments
  • Can distort product costs in complex organizations with significant inter-service support

More from Overhead costs

  • Overhead classification and cost behavior
  • Overhead allocation methods
  • Overapplied and underapplied overhead
  • Allocation of service department costs: overview
  • Allocation of service department costs: step-down method