100 10.2 The Direct Method

The Direct Method:

The direct method is the most widely-used method. This method allocates each service department’s total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments.

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other, as reflected in the following table:

Percentage of services provided by the service department listed under Service Dept

The amounts in the far left column are the costs incurred by each service department. The percentages in the other columns are the percentage of each service department’s services provided to each department that utilizes the services of that service department. These percentages are derived from some relevant measure of service department activity. For example, the percentages for human resources might be based on the number of employees in each department, or the number of new hires in each department. The percentages for data processing might be based on the number of computers in each department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department to the other departments are accounted for.

Under the direct method, each service department is allocated separately, and the order in which the service departments are allocated does not matter. Taking one row at a time, the percentages of the production departments are normalized, so that they add up to 100% while still reflecting the relative usage by the production departments (relative to all of the other production departments). For example, in applying the direct method for the costs of human resources, Machining and Assembly are the only production departments that used the services of the Human Resources Department in March, so the percentages in the columns for machining and assembly are the only percentages that are relevant (the 20% for data processing and the 10% for risk management are ignored). The denominator in the normalization process is the sum of the percentages of all of the production departments. For example, for the human resources row in the table below, the 70% is the sum of 40% for machining and 30% for assembly in the table above.

The risk management service department percentages do not require normalization, because this service department provided services only to the production departments, it did not provide any services to the other service departments. The normalized percentages are then used to allocate each service department’s total costs to the production departments:

The normalization process ensures that the sum of the costs allocated to the production departments equals the total costs incurred by each service department, even though service-department-to-service-department services are ignored. For example, $42,000 of data processing costs are allocated to machining and $78,000 are allocated to assembly, and these two amounts sum to $120,000, the total costs incurred by data processing.