Direct allocation method definition

The two stage activity based

costing approach is illustrated in Chapter 7 and focuses on eliminating the distortions that tend to occur when the traditional two stage approach is used. The simplest approach involves combining all overhead costs so that a single plant wide overhead rate can be calculated and used to apply overhead to products. The distinction

between service areas and producing areas is ignored and the entire plant is treated as a single department. For example, when we applied factory overhead to

products in Chapter 4 we were using a single plant wide overhead rate. If Product X consumes 10 percent of one indirect resource, it must consume 10

percent of all indirect resources for a single plant wide rate to provide accurate product costs. If a firm produces many different products that consume

indirect resources in different proportions, then a two stage approach is needed to provide accurate product costs.

As indicated in the exhibit, $11,111 of Power Department costs is allocated to the Maintenance Department

recognizing that 100 kilowatt hours of power were used by Maintenance. This improves the accuracy of the allocations to both producing departments by $1,667

which represents about a 5.57% decrease for Cutting and about an 8.29% increase for Assembly. The underlying concepts of cost allocations relate to the purposes of assigning costs to cost objects as well as the principles, or supporting logic for the cost allocation methods chosen.

Step Three: Allocate Fixed Costs Among Departments or Projects

These costs form a portion of the overhead cost of production, which is then allocated to inventory and the cost of goods sold. This method provides a better picture of how costs are incurred, but requires more accounting effort. It also tends to delay the recognition of expenses until a later period, when some portion of the produced goods are sold. There are many ways to allocate expenses, including the high/low method and step-up/down. There’s also a simple way called the direct materials cost method that uses an allocation base of the same value as the variable rate. Using FAC or Variable costing can provide more accurate reporting on your company’s financials.

• A circular reference is when the formula in a cell refers to other cells that in turn refer to the original cell.
• Thus, the equations show

  that the total costs of a producing department includes the department’s direct cost (Di), plus the allocations from the various service departments

  (i.e., the sum of [(Kji)(Sj)]).

• Although each product passes through both departments, the products do not consume the department

  resources in the same proportions.

• Now assume that the actual number of purchase orders completed during the period was 290 for the Cooking Department and 100 for the Canning Department.

Services used by other service departments are ignored. This means the direct method does not recognize service performed by other service departments. For example, if Service Department A uses some of Service Department B’s services, these services would be ignored in the cost allocation process. Because these services are not allocated to other service departments, some accountants believe the direct method is not accurate. The three service cost-allocation methods vary in terms of ease and accuracy because of how they approach this problem.

Step-by-step explanation

They’re also valuable for rationing demand for internal services—if no price is charged for a service, for example, the service may be overconsumed by operating departments. In addition, they make it possible https://turbo-tax.org/the-internal/ to assess the department’s operational efficiency. If the internal cost for a service is greater than the price charged by an external supplier, the service department could be considered for elimination.

(See Exhibit 6-1 and See the

Baggaley & Maskell summary for an illustration of support functions within a manufacturing environment). For example, suppose the Virginia Chicken Company can sell chicken parts such as feet, beaks and gizzards for five cents per pound at the split-off point. Since these parts of

the chicken have relatively little value, they tend to fall into the category of by-products.

AccountingTools

The direct allocation method is a technique for charging the cost of service departments to other parts of a business. This concept is used to fully load operating departments with those overhead costs for which they are responsible. For example, the janitorial staff provides services to clean all company facilities, while the maintenance department is responsible for company equipment, and the IT department maintains the information technology systems. The answers to these questions are found by examining the proportions of the resources consumed by each product in each department.

Now assume the Thurow Company produces two products as indicated below. These entries reduce cost of goods sold by $75 which is the net amount received from the by-product sales. Now, let’s say that the Production department produced 800 units of Product A and 200 units of Product B during that month. Presenting this set of slides with name – Cost Allocation Direct Method With Service Department Percent Allocable. The stages in this process are Cost Allocation, Assigning Costs, Costs Management. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.

How to Account for the Cost of Service Departments

Other issues include not performing cost allocation at all or using arbitrary rates rather than industry standards. When deciding how to allocate these types of expenses, companies should consider their company’s size and what it will cost to produce a certain amount of output. Discuss how a plant wide overhead rate tends to distort product costs. If the company uses the sales value at the split-off point as the allocation basis, the products will appear to be equally profitable at the point of separation. Although some

observers might argue that the products are not equally profitable at the split-off point, this method produces allocations that will not tend to confuse

the decisions involved.

• P1’s allocated cost is 50% of S1’s cost and 10% of S2’s cost, and P2’s allocated cost is 30% of S1’s cost and 40% of S2’s cost.
• Thus, the denominator for developing the proportions for S1 is 800,

  not 950 and the denominator for developing the proportions for S2 is 250, not 300.

• An accurate, clear understanding of service department costs is valuable in several ways.

Joint cost allocations are presented in Exhibit 6-17 based on the four allocation methods discussed above. The dual rate or flexible budget method refers to using separate rates, or allocations for fixed and variable service costs. The purpose of this method is to prevent the actual

cost allocations to users from being influenced by the quantity of service consumed by other users. Allocating fixed and variable service costs using a

single actual rate can result in a variety of cost distortions.

Accounting Methods for Overhead Calculation

The direct method works well when the cost structure is relatively simple and there are no significant indirect costs to consider. The direct method offers a suitable and efficient allocation solution in situations where it is possible to directly trace the majority of costs to specific cost objects. The direct method of cost allocation is relatively simple to understand and implement.

Although each product passes through both departments, the products do not consume the department

resources in the same proportions. As indicated in Exhibit 6-14, X1 requires a larger proportion of cutting time, while X2 requires a larger proportion of

assembly time. The first step involves developing equations to reflect the relationships between the service departments and the producing

departments, i.e., equation form [2] presented above.