CHAPTER 5

SERVICE DEPARTMENT COST ALLOCATIONS

 CHAPTER LEARNING OBJECTIES
 After studying Chapter 5, you should be able to:
1) Explain why service costs are allocated.
2) Understand criteria to guide cost allocation decisions
3) Allocate service department costs using the direct method.
4) Allocate service department costs using the step method.
5) Allocate service department costs using the reciprocal
method.
 Learning Objective 1

Explain why service costs are

allocated.
 Purposes of Cost Allocation

 Companies allocate costs for four major

reasons:
1) To provide information needed for decision making.
2) To reduce the frivolous use of common resources.
3) To encourage managers to evaluate the efficiency of internally
provided services.
4) To calculate the full cost of products for financial reporting
purposes and for determining cost-based prices.
Purpose #1:To Provide Information for
Decision Making
Generally, as resources are consumed during production, cost
allocations are made to the products, departments etc… much
like a fee or charge. From a decision making standpoint, the
allocated cost should measure the opportunity cost of using a
company resource. Unfortunately this is difficult to implement
in practice as opportunity costs can change quickly.
 Purpose #2: To Reduce Frivolous Use
of Common Resources
It may be argued that fixed costs should not be allocated at all.
But without charging a fee (or allocating these costs), resources
are often used frivolously or for nonessential purposes. Consider
fixed costs associated with computer resources. Examples
include recreational web surfing, playing games, sending
personal e-mail etc… One way to eliminate frivolous use is to
charge for it.
Purpose #3: To Encourage Evaluation
of Services
▬ Cost allocation is also useful because it causes
management to evaluate the services for which they are
being charged (e.g. costs allocated to their departments or
products). For example, centrally administered services
such as janitorial or computer services should be allocated
to various departments. If these services were free and
no allocation were made, users would not consider them.
But if a charge is levied, management has a strong
incentive to evaluate these services and charges and
consider alternatives.
Purpose #4: To Provide “Full” Cost
Information
▬ First of all, GAAP requires “Full Costing” for external
reporting purposes. As a result indirect production costs
must be allocated to goods produced. Furthermore, full
cost information is required when a contract calls for “Cost
Plus” pricing. In this case not only is manufacturing
overhead allocated, but so are other general and
administrative costs.
 Learning Objective 2

Understand criteria to guide cost

allocation decisions
 Criteria to Guide
Cost-Allocation Decisions

Cause-and-effect:
Using this criterion, managers identify the
variable or variables that cause resources
to be consumed.
Benefits-received:
Using this criterion, managers identify the
beneficiaries of the outputs of the cost object.
 Criteria to Guide
Cost-Allocation Decisions

Fairness or equity:
This criterion is often cited on government
contracts when cost allocations are the basis
for establishing a price satisfactory to the
government and its suppliers.

Ability to bear:
This criterion advocates allocating costs in proportion
to the cost object’s ability to bear them.
 Role of Dominant Criteria

The cause-and-effect
and the benefits-
Fairness and ability
received criteria
to bear are less
guide most
frequently used.
decisions related
to cost allocations. Why?
 Role of Dominant Criteria

Fairness is an especially difficult criterion

to obtain agreement on.
The ability to bear criterion raises issues
related to cross-subsidization across users
of resources in an organization.
 Operating Departments

An operating department carries out the central

purpose of the organization

The Accounting and Finance

The Surgery Department at A Production
Department at Department at
Dire Dawa University.
Tikur Anbesa National Cement
Hospital. Factory.
 Service Departments

Service departments do not directly engage in operating activities.

A service department (support department )provides the

services that assist other operating and support departments in
the organization.
Finance Department at The Human Resources
Dire Dawa University. Department at University.
 Interdepartmental Services

Service Operating
Department Department
Costs of the service
department become
overhead costs to the
operating department
 Allocation Approaches
▬ three approaches

Direct
Method

Step-Down 
Method

Reciprocal
Method

 Allocation Approaches
 Direct method:
– Allocates support department costs to operating departments only.
 Step-down (sequential allocation) method:
– Allocates support department costs to other support departments
and to operating departments
– charge rates are calculated for support departments according to
a rank order. Those departments rank highest that get the least
from other departments
– at each step support is charged only from the departments whose
charge rate has already been calculated
 Reciprocal allocation method:
– Allocates costs by services provided among all support
departments
– simultaneous equations approach

18
 Reciprocal Services

Service Service
Department 1 Department 2
When service
departments provide
services to each other
we call them reciprocal
services.
 Learning Objective 3

 Allocate service department costs to operating departments

using the direct method.
 Direct Method

Service Operating
Interactions between Department Department
Service departments (Cafeteria) (Machining)
are ignored and all
costs are allocated
directly to operating
departments.
Service Operating
Department Department
(Custodial) (Assembly)
Direct Method – An Example

Service Department Allocation Base

Cafeteria Number of employees
Custodial Square feet occupied
 Direct Method – An Example

How much of the Cafeteria and Custodial costs should be

allocated to each operating department using the direct method
of cost allocation?
Direct Method – An Example

20
$360,000 × = $144,000
20 + 30

Allocation base: Number of employees

Direct Method – An Example

30
$360,000 × = $216,000
20 + 30

Allocation base: Number of employees

Direct Method – An Example

25,000
$90,000 × = $30,000
25,000 + 50,000

Allocation base: Square feet occupied

Direct Method – An Example

50,000
$90,000 × = $60,000
25,000 + 50,000

Allocation base: Square feet occupied

 Learning Objective 4

To allocate service department costs to operating departments

using the step-down method.
 Step-Down Method

Service Operating
Department Department
Once a service (Cafeteria) (Machining)
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
Service Operating
Department Department
(Custodial) (Assembly)
 Step-Down Method
There are three key points to understand regarding the step-
down method:
 In both the direct and step-down methods, any
amount of the allocation base attributable to the
service department whose cost is being allocated is
always ignored.
Any amount of the allocation base that is
attributable to a service department whose cost has
already been allocated is ignored.
Each service department assigns its own costs to
operating departments plus the costs that have
been allocated to it from other service departments.
 Step-Down Method – An Example

We will use the same data used in the direct method example.

Service Department Allocation Base

Cafeteria Number of employees
Custodial Square feet occupied
 Step-Down Method – An Example

Allocate Cafeteria costs first since it provides more service than Custodial.
Step-Down Method – An Example

10
$360,000 × = $60,000
10 + 20 + 30

Allocation base: Number of employees

Step-Down Method – An Example

20
$360,000 × = $120,000
10 + 20 + 30

Allocation base: Number of employees

Step-Down Method – An Example

30
$360,000 × = $180,000
10 + 20 + 30

Allocation base: Number of employees

Step-Down Method – An Example

New total = $90,000 original Custodial cost

plus $60,000 allocated from the Cafeteria.
Step-Down Method – An Example

25,000
$150,000 × = $50,000
25,000 + 50,000

Allocation base: Square feet occupied

Step-Down Method – An Example

50,000
$150,000 × = $100,000
25,000 + 50,000

Allocation base: Square feet occupied

 Learning Objective 5

To allocate service department costs to operating departments

using the reciprocal method
 Reciprocal Method

Service Operating
Department Department
Interdepartmental (Cafeteria) (Machining)
services are given
full recognition
rather than partial
recognition as with
the step method. Service Operating
Department Department
(Custodial) (Assembly)
 Quick Check Data
for Direct and Step-Down Methods

The direct method of allocation is used.

Allocation bases:
 Business school administration costs (ADMIN):
Number of employees
Business Administration
computer services (BACS):
Number of personal computers
 Quick Check 

How much cost will be allocated from Administration to Accounting?

A. $ 36,000
B. $144,000
C. $180,000
D. $ 27,000
 Quick Check 

How much cost will be allocated from Administration to

Accounting?
a. $ 36,000 b. $144,000 c. $180,000 d. $ 27,000

20
$180,000 × = $36,000
20 + 80
 Quick Check 

How much total cost will be allocated from ADMIN and BACS
combined to the Accounting Department?
A. $ 52,500
B. $135,000
C. $270,000
D. $ 49,500
 Quick Check 
How much total cost will be allocated from
ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500

18
$90,000 × = $13,500
18 + 102
 Quick Check Data

The step method of allocation is used.

Allocation bases:
 Business school administration costs (ADMIN):
Number of employees
 Business administration computer services (BACS):
Number of personal computers
 Quick Check 

How much total cost will be allocated from ADMIN and

BACS combined to the Accounting Department?
A. $35,250
B. $49,072
C. $18,000
D. $26,333
 Quick Check 

How much total cost will be allocated from ADMIN and BACS
combined to the Accounting Department?
a. $35,250 b. $49,072 c. $18,000 d. $26,333