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Service Department Costing - An Activity Approach
Learning Objectives
1. Allocate service department costs to other departments using the
direct method.
2. Allocate service department costs to other departments using the
step method.
3. Allocate variable and fixed service department costs separately
at the beginning of a period and at the end of the period.
Lecture Notes
A. Overview of Cost Allocation. Most large organizations
have both operating and service departments.
1. Operating departments. Operating departments are those
departments or units where the central purposes of the organization
are carried out. Ordinarily, the operating departments are responsible
for the major activities that ultimately generate revenue.
2. Service departments. Service departments provide services
or assistance to the operating depart-ments. Service departments
engage in activities that do not generate significant revenue.
3. Purpose of service department allocations. Service department
costs are allocated to operating de-partments for four reasons:
a. To encourage managers of operating departments to make wise use of services provided by service departments.
b. To provide more complete cost data for making decisions in opearting departments.
c. To help measure profitability in the operating departments.
d. To put pressure on the service departents to operate efficiently.
e. To develop overhead rates in the operating departments.
f. To help determine the cost base in cost-plus pricing.
B. Allocation Bases. Costs of a service department are allocated
to other departments using an alloca-tion base. The allocation base
should be a measure of whatever activity causes variations in the
costs of the service department; it should drive the service department's
costs. Operating departments should be charged for whatever costs
they cause-no more and no less.
C. Direct and Step Methods of Handling Reciprocal Services. Services provided by one ser-vice department to another are known
as interdepartmental or reciprocal services. The text discusses three
approaches to handling the costs of interdepartmental services-the
direct method, the step method, and the reciprocal method.
1. The Direct Method. The direct method ignores interdepartmental
services. Service department costs are directly allocated to operating
departments-bypassing other service depart-ments. This method is
slightly easier to use than the step method, but is less accurate.
NOTE: You might be confused about what to
include in the allocation base. For example, if Personnel Department
costs are allocated based on headcount, should the headcount of
the Personnel Department itself and of other service departments
be included in the allocation base? The service de-partments must
be excluded from the allocation base under the direct method. Why?
If service depart-ment head-counts are included in the allocation
base, less than 100% of the service department costs will be allocated
to the operating departments.
2. The Step Method. The step method takes some interdepartmental
services into ac-count, but not all of them.
a. To use the step method, the service departments must first
be lined up in some sort of order. The sequence typically begins
with the department that provides the greatest amount of service
to other departments and moves down through the service departments
to the one that provides the least amount of service to the other
departments. In practice it isn't always clear what the order
should be, but in all of the illustrations in the text and in
all of the exercise and problem material, the order of allocation
is given so that there is no ambiguity.
b. The procedure followed in the step method is not inherently
difficult, but it does contain some booby traps for unwary students.
Starting with the first service department in the sequence, allo-cate
its costs out to all of the other departments-including all of
the other service departments as well as all of the operating
departments. Ignore the first service department in all subsequent
allocations. Now move on to the second service department in order.
Add together its direct costs and all of the service department
costs that have been allocated to it. Allocate these costs out
to all of the remaining service departments (that is, all of the
service departments except for itself and the first service department)
and to all of the operating departments. Continue like this to
the bottom of the list of the service departments. When the final
service department is considered, there won't be any service departments
left to allocate costs to, so its costs (both direct and allo-cated
from other service departments) will be allocated solely to the
operating departments. Working through an example is absolutely
indispensable.
NOTE: You might be confused concerning what
should be included in the allocation base in the step method. The
rule is simple: never include in the allocation base the service department
whose cost is being allocated and once a service department's cost
has been allocated, pretend that the department doesn't exist anymore.
In other words, at each step allocate a service department's cost
to the remaining service departments and to all of the operating departments.
NOTE: In the step method, some people often
try to allocate just the direct costs of the service de-partments.
They forget to include the costs that have already been allocated
to the service department in previous steps. It is a good idea to
point out this particular source of error when discussing the step
method.
3. The Reciprocal Method. The direct method ignores interdepartmental
services. The step method attempts to take into account the most
important of the interdepartmental service relationships. The reciprocal
method takes into account all of the interdepartmental service relationships.
The reciprocal method doesn't require any more information than
the step method, but it uses more sophisticated mathematics (matrix
algebra) to do the allocations. Despite the elegance of this approach,
it is rarely used. The reasons for the lack of interest in the reciprocal
method are probably a lack of familiarity with the method, a general
perception that it is a difficult and esoteric technique, and the
likelihood that in most situations the results from using the reciprocal
method are not a lot different from the re-sults obtained with the
step method.
NOTE: Some people will often object to the
inaccuracies of the step method. This provides an op-portunity to
explain how the reciprocal method works. Ask yourself what would
happen if every service department's costs were allocated to all
of the service departments (including itself). You might answer
that there would still be some costs left in the service departments
when you finish the allocations. Ask what would happen if you started
all over and used the same procedure to allocate the service department
costs that remain. Hopefully you will answer that there would still
be some costs left in the service departments, but there will be
less than before. If you keep repeating this process many times
until there are no costs left in the service departments, you will
have essentially performed a reciprocal allocation.
D. Cost Allocation Guidelines. Whenever possible, service
department costs should be separated into fixed and variable classifications
and allocated separately. This approach is necessary to provide
more useful data for planning and control of departmental operations
as well as to avoid inequities.
1. Allocations of variable service department costs.
As a general rule, variable costs should be charged to consuming
departments on the basis of whatever activity causes the costs
that are being allocated. Budgeted, or predetermined, rates should
be used. There are two reasons for this. First, it is difficult
for departmental managers to decide how much service to demand
if they don't know until the end of the period what the rates
are going to be. Second, if rates based on actual realized costs
for the period are used, the consumer of services is implicitly
held responsible for how well the service department controls
its costs.
2. Allocations at the beginning and end of the period.
The measure of activity that should be used in assigning variable
costs depends on whether the allocation is carried out at the
beginning or at the end of the period.
a. If allocations are made at the beginning of the period,
variable costs should be allocated to departments at the budgeted
rate based on the budgeted level of activity.
Cost allocated at beginning of the period = Budgeted rate X
Budgeted activity
b. If allocations are made at the end of the period, variable
costs should be allocated to departments at the budgeted rate
based on the actual level of activity.
Cost allocated at the end of the period = Budgeted rate X
Actual activity
NOTE: Ask yourself why the actual rather
than the budgeted level of activity level should be used in allocations
at the end of the year. Eventually you would determine that if the
budgeted level of activity were used, then the actual use of services
during the year would be free. That is, the charge for variable
costs would be a fixed amount independent of actual usage. This
would not be a good idea since departments will tend to overuse
these services if their marginal costs are zero.
3. Allocations of fixed service department costs. Generally
speaking, the fixed costs of service departments are incurred to
provide capacity and the greater the capacity that is provided,
the higher the fixed cost is likely to be. Presumably, before deciding
how much service department capacity to provide, managers are asked
how much service they are going to need. Based on these estimates,
the capacity level of the service department is set and the required
fixed costs are incurred. In order to provide some check on how
much service the managers say they are going to require, the operating
departments should be charged for the portion of the capacity they
claimed they would require. This should be a lump-sum charge determined
at the beginning of the period.
NOTE: Ask yourself why it is better to charge
managers a lump-sum for access to service departments rather than
including a "markup" for fixed costs in the charge for
the use of services. The answer is that if the charge for the use
of services exceeds variable cost and there is excess capacity,
managers will demand too little of the service from the standpoint
of the company as a whole. This dis-cussion can be used to reinforce
ideas developed when covering transfer pricing.
NOTE: Have you ever worked in a large organization
where charges for work done by service departments seemed exorbitant?
Why does this happen? The reason quite often
is that charges for internal work include arbitrary allocations
of fixed general administrative overhead as well as an allowance
for the fixed costs of the service department itself. This creates
a spiraling effect. Since the charges are so high, demand falls
and the rates are pushed even higher.
E. Behavioral Considerations. Apart from the sound economics
underlying lump-sum allocations of fixed costs, there is a strong
behavioral reason to avoid allocating fixed costs the same way variable
costs are allocated. If the allocations of fixed costs to departments
are on the basis of some actual measure of activity such as actual
sales or actual direct labor-hours, then the costs allocated to a
given department will depend on what happens in other departments.
The activity in other departments will influence the denominator in
the allocation rate. If activity in other departments falls, the rate
will go up and if their activity increases, the rate will go down.
These effects can generate quite a lot of heated (and counter-productive)
arguments among managers.
NOTE: Suppose you are a division manager in
a company that allocates fixed costs on the basis of actual sales.
The fixed costs that are allocated to your division will depend on
sales in the other divisions. Do you think this is fair? How does
this differ from grading on a curve? If you do better on an exam than
others, your grade will be higher and other students' grades will
be lower. However, if your sales go up in a company relative to other
divisions, the amount of fixed costs allocated to you will increase
and the amount allocated to others will decrease.
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