Businesses exist to sell things to their customers, but most companies have at least some costs that aren't directly attributable to the production of those things. These include support services such as human resources and accounting. For internal accounting purposes, companies often want to assign those costs to production departments. The most common way of doing so is with the direct method of cost allocation. Its advantage is simplicity.
As a hypothetical example, assume that you run an auto body shop that offers three services: repair, painting and detailing. You want to know how profitable these services are, so for each one, you calculate the revenue it brings in as well as the costs it incurs. The costs of direct labor and materials are fairly easy to determine. If you have a full-time bookkeeper and office manager who handles support services such as billing and ordering, that person's wages are obviously a cost of doing business; the issue is how to split up those costs among the three services.
In the direct method, you take the cost of a support department and allocate it directly to production departments according to whatever criteria management wants to use. For example, if your auto body shop's support person makes $800 a week, you could allocate the cost to each service according to how many cars were worked on. If in one week you had 10 cars in for repairs, 15 in for painting, and 25 in for detailing, for a total of 50 cars, you could allocate the cost at $16 per car (50 x $16 = $800). So you'd allocate $160 in costs to repair, $240 to painting, and $400 to detailing.
The direct method is widely used because of its simplicity. Unlike other cost allocation methods, it disregards interactions between support departments. If you had a dedicated receptionist in addition to your office manager, the office manager likely provided assistance and support for the receptionist, and the receptionist likely provided support for the office manager. But the direct method doesn't worry about that; it acts as if all support went to the production departments. It should be noted that the lack of consideration of reciprocal support among non-production departments is also one of the weaknesses of the direct method.
The most common alternative to the direct method is the "step-down" method. In this method, you choose a support department and then allocate its costs among all other departments in the company -- both the production and support departments. You then move to the next support department and allocate all of its costs -- including those allocated to it from the first department -- to the remaining departments in the company. With each step, you're allocating costs to fewer and fewer departments. You do this until all support costs have been allocated to production departments. The order in which you go through the support departments will influence how the total costs wind up allocated among production departments. That could produce a distorted result. The direct method doesn't have this issue. Since all support costs are allocated individually and separately, the final result doesn't depend on the order in which you go.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.