Direct method costing is a technique businesses use to allocate, or assign, costs to the different parts of the organization. In managerial accounting, it can be useful to allocate costs to different parts of the company in order to provide a more accurate picture of company performance. Direct costing is one of the simplest methods of cost allocation. Understanding the advantages of this method can help you decide if this method is right for your company.
To use the direct cost method, first divide your company's departments into operating and support departments. Operating departments are business functions that directly work toward production. For example, a beverage company may have bottling and mixing operating departments. Support departments provide services to other departments. Common support departments include accounting, human resources and information technology. The ease of division between these two types of departments is one of the advantages of using direct method costing. Other costing methods can require much more detailed analysis before cost allocation can occur.
Direct method costing only allocates costs from support departments to production departments. This can greatly reduce the number of allocations that you have to make. For example, if your company has four support departments and two production departments, you will make eight allocation calculations using the direct costing method. However, if you were to use a method where support department costs are allocated to production departments and the other support departments, you would need to make 20 different allocation calculations. With other methods, the amount of time that allocation requires can increase quickly. However, with direct method costing, each additional support department only increases the number of calculations required by the number of production departments.
Because support center costs are only allocated to operating departments, you focus costs of supporting the business toward production. While this may not be the most accurate method of allocating costs, it has a strong theoretical basis. If not for the production departments, the support centers would not be needed. For example, your company probably wouldn't need an information technology function if production stopped. This method can help remind support staff members that their first priority should be to support production.
The primary disadvantage of the direct costing method is accuracy. Because support departments' costs are not allocated to other support departments, businesses systematically over-allocate production departments' costs and under-allocates support departments' costs. The extent of this inaccuracy depends on the amount of resources the production departments use compared to the support departments. For example, if the human resources department spends most of its time performing tasks and incurring costs related to production employees, then cost allocation should be fairly accurate. However, if human resources incurs most of its costs dealing with problems in the other support departments, then production is unfairly shouldering much of the cost.
