Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 14

Under what conditions are the results from using the direct method of allocation the same as those from using the other two methods? Why?

Step 1 of 2

Cost accounting system

This is a system designed for inhouse or internal managers and their decision making. Cost accounting information is not needed for comparison with other companies. This information is commonly used in financial accounting also, but it is primarily used by company managers for their decision making. It is important that cost accounting information is relevant for the decision making of the manager.

Reciprocal method

Under reciprocal method, service costs of all service departments are allocated among all service departments in the proportion of their usage. This method overcomes the limitation of direct method and step method of cost allocation.

An equation is prepared for service department which includes the cost of other service departments. This method is complex method to be applied as compared to other two methods i.e. direct method and step method.

Direct method

Under direct method, costs of service departments are not allocated to other service departments. Service department costs are allocated to production departments only.

Step method

Under step method of cost allocation, it is recognized that services of one service department are used other service departments. Once the service costs of one department are allocated to other service departments, then the cost of other service departments cannot be allocated to the first service department whose service cost are already allocated.

For example, if the service cost IT department are allocated to administration, accounts and other departments, then service cost of administrative department cannot be allocated back to IT department.