Learning Outcomes
Show In process costing, all of the processing departments are classified as operating departments. Other departments, called service departments are needed for the business to operate, but do not directly engage in operating processes. Service departments include accounting, human resources and purchasing. These departments all provide services to each of the operating departments. So with our Ultimate Planner business, the product itself is produced in the production/manufacturing department, but in order for that department to run, payroll needs to be prepared, employees need to be hired and product needs to be purchased. There are two main ways to allocate these service costs to the operating departments to make sure we are including all of the costs when we price our products. The first method is the direct method. This is the simplest and most commonly used method of allocation.  In this method, we will be ignoring the fact that one service department may offer services to another service department. For example, the HR department will offer services to the accounting department by hiring staff and providing training. Instead, we will allocate ALL of the services of each of these departments to the operating departments. We can allocate using a couple of different methods of allocation. Some costs may be allocated based on employee hours. Administration costs are a good example here. So the hours incurred by administrative departments such as payroll, purchasing, accounting and HR, would be allocated, based on the number of hours worked in each of the operating departments and allocated accordingly. Here, if process 1 of manufacturing our Ultimate Planner takes 5,000 hours per period, while packaging (process 3) only takes 1,000 hours per period, then allocation based on employee hours would be the most effective way to allocate service costs. Custodial services on the other hand, may be better allocated based on the square footage of each of the operating departments. If the press area (process 1) of the Ultimate Planner business occupies 10,000 square feet, while the packaging area only occupies 2,000 square feet, it probably takes more custodial effort in the press area! So allocation on space would work best. The second method is called the step-down method. This method is more complicated than the direct method, as it also takes into account the services that one service department offers another. Note in this method, the human resources costs are allocated between custodial and all of the operational processes, while in the direct method, human resources and custodial are directly allocated to the operational processes. So if the custodial department cleans the HR department, some costs from the custodial department should be allocated to the HR department, right? Also, the HR department provides services to the custodial department, by hiring and training the employees, so some of the HR costs should be allocated to the custodial department. There are many reasons companies may use each of these allocation methods. Here is another explanation of this concept if you would like further clarification. Practice QuestionsContribute!Did you have an idea for improving this content? We’d love your input. Improve this pageLearn More What is the direct method of cost allocation?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.
What are the methods used to allocate support costs?There are three methods commonly used to allocate support costs: (1) the direct method; (2) the sequential (or step) method; and (3) the reciprocal method. Many instructors choose to defer coverage of the reciprocal method to cost accounting.
What is the best way to allocate costs?How to allocate costs. Identify your chosen cost object. To allocate costs, begin by deciding which cost objects you want to connect with specific costs. ... . Accumulate associated costs. ... . Choose a cost allocation method. ... . Perform your calculations.. Can direct costs be allocated?Because direct costs can be specifically traced to a product, direct costs do not need to be allocated to a product, department, or other cost objects. Direct costs usually benefit only one cost object. Items that are not direct costs are pooled and allocated based on cost drivers.
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