What Is Direct Cost Allocation?

Direct cost allocation is a type of accounting process that seeks to identify and properly assign direct costs associated with the operation of a business enterprise. A direct cost is a type of expense that can be directly identified and attributed to specific departments or functions within the business model. The ability to properly engage in direct cost allocation aids in providing important data regarding the actual costs associated with each portion of the operation, and may also be helpful in identifying costs that are related to activities eligible for some sort of tax break or discount.

The process of direct cost allocation requires that an expense be obviously and easily related to some specific aspect of a company, either in terms of a project, a department, or even a product. For example, the wages and salary associated with an employee assigned to a specific department is often considered a direct cost to that department. In like manner, equipment purchased for the specific use in a given department of the operation could also be considered a direct cost, with that expense allocated in full to that department. Tracking costs to determine if they constitute a direct cost may also be done by assigned project codes or cost numbers to certain expenses, making it easy to allocate or assign that expense to the appropriate line item in the accounting records.

There are several benefits associated with the use of direct cost allocation. One has to do with making sure that the accounting records are in compliance with generally accepted accounting principles. This often makes the task of identifying expenses that may be eligible for tax breaks of some type much easier, which in turn may decrease the company’s overall tax burden to some extent. The proper assessment and allocation of direct costs also means that in the event of an audit, the records are more accurate and easier to assess, decreasing the chances of the auditors finding any serious issues with the way the business maintains its financial records.

Direct cost allocation is also helpful in tracking the actual expenses associated with various functions within a company operation. This can be critical in terms of making sure all areas of the business are operating within their designated budgets. If the direct expenses are not allocated properly, the accounting books may or may not accurately reflect the actual expenditures associated with a project or department, making the possibility of overspending somewhat higher. For this reason, most companies implement precise policies for identifying what constitutes a direct cost and also utilize specific procedures for posting those costs.