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MANAGEMENT ACCOUNTING: CONCEPTS AND TECHNIQUES

 

By Dennis Caplan

 

PART 3: PRODUCT COSTING AND COST ALLOCATIONS

 

CHAPTER 12:  ALLOCATION OF SERVICE DEPARTMENT COSTS

 

Chapter Contents:

-                     Introduction

-                     The Direct Method

-                     The Step-Down Method

-                     The Reciprocal Method

-                     Summary of Service Department Cost Allocation Methods

-                     Dysfunctional Incentives from Service Department Cost Allocations

 

 

Introduction:

Many companies in all sectors of the economy, and not-for-profit and governmental organizations as well, allocate service department costs to “production” or user departments, and ultimately to the products and services that they provide. For example, hospitals use sophisticated methods for allocating costs of service departments such as Housekeeping, Patient Admissions, and Medical Records to patient wards and outpatient services, and then to individual patients. Historically, these allocations were important to hospitals because Medicare reimbursement was based on actual costs. To the extent that the hospital allocated service department costs to Medicare patients, Medicare covered these costs.

 

Companies that allocate service department costs do so for one or more of the following reasons:

 

1.                  To provide more accurate product cost information. Allocating service department costs to production departments, and then to products, recognizes that these services constitute an input in the production process.

 

2.                  To improve decisions about resource utilization. By imposing on division managers the cost of the service department resources that they use, division managers are encouraged to use these resources only to the extent that their benefit exceeds their cost.

 

3.                  To ration limited resources. When production departments have some discretion over their utilization of a service department resource, charging production departments for the resource usually results in less demand for it than if the resource were “free” to the production departments.

 

The motivation for the first reason, to provide more accurate product cost information, can be to improve decision-making within the organization, to improve the quality of external financial reporting, or to comply with contractual agreements in regulatory settings where cost-based pricing is used. As discussed above, Medicare was historically a cost-based reimbursement scheme. As another example, defense contractors that provide the U.S. military “big ticket” items such as airplanes and ships often operate under cost-plus contracts, under which they are reimbursed for their production costs plus a guaranteed profit. In such settings, the calculation of cost includes a reasonable allocation of overhead, including overhead from service departments.

 

The distinction between the second and third reasons is important in the context of fixed versus variable costs. In connection with the second reason, to improve decisions about resource utilization, from the company’s perspective, a division manager making a short-term decision about whether to utilize service department resources should incorporate into that decision the service department’s marginal costs, which are usually the variable costs. The manager should ignore the service department’s fixed costs if these costs will not be affected by the manager’s decision. This reasoning suggests that only the service department’s variable costs should be charged out.

 

However, in connection with the third reason, to ration a scarce resource, if the service department controls a fixed asset, and if demand for the asset exceeds capacity, charging users a fee for the asset allows the service department to balance demand with supply. The fee need not relate to the cost of obtaining the asset; rather, it is a mechanism for managing demand. Examples would be charging departments a “rental fee” for their use of vehicles from the motor pool, or for their use of a corporate conference facility.

 

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure that all service department costs are allocated. Budgeted rates provide service department managers incentives to control costs, and also provide user departments more accurate information about service department billing rates for planning purposes. In either case, service department costs should be allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible. Here are some examples:

 

-                     Allocate building maintenance costs based on square footage;

-                     Allocate costs of the company airplane based on miles flown;

-                     Allocate costs of the data processing department based on CPU time.

 

In some cases, companies benefit from allocating fixed costs using a different allocation base than variable costs. For example, fixed costs might be allocated based on an estimate of long-term usage by the production departments.

 

Historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they account for the fact that service departments provide services to other service departments as will as to production departments:

 

 

The Direct Method:

The direct method is the most widely-used method. This method allocates each service department’s total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments.

 

Example: Machining and Assembly are the only production departments that used the services of the Human Resources Department in March. Costs from Human Resources are allocated based on the number of new hires. Machining hired seven employees in March and Assembly hired three employees. Human Resources incurred total costs of $93,000 in March.

 

            Allocation of H.R. Department costs to Machining:        70% of $93,000 = $65,100

            Allocation of H.R. Department costs to Assembly:         30% of $93,000 = $27,900 

 

The characteristic feature of the direct method is that no information is necessary about whether any service departments utilized services of the Human Resources Department. It does not matter whether no other service department hired anybody, or whether three other service departments each hired five employees (implying that more than 50% of the hiring occurred in the service departments). Under the direct method, service department to service department services are ignored, and no costs are allocated from one service department to another.

 

 

The Step-Down Method:

The step-down method is also called the sequential method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it.

 

The choice of which department to start with is important. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence. The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

 

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other:

 

Total Cost

Service

Dept

% of services provided by the service department listed at left to:

 

H.R.

D.P.

R.M.

Machining

Assembly

$  80,000

H.R.

--

20%

10%

40%

30%

120,000

D.P.

8%

--

7%

30%

55%

40,000

R.M.

--

--

--

50%

50%

$240,000

 

 

 

 

 

 

 

The amounts in the far left column are the costs incurred by each service department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department are charged out.

 

The company decides to allocate the costs of Human Resources first, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. However, a case could be made to allocate Data Processing first, because it has greater total costs than either of the other two service departments. In any case, the company decides to allocate Data Processing second.

 

In the table below, the row for each service department allocates the total costs in that department (the original costs incurred by the department plus any costs allocated to it from the previous allocation of other service departments) to the production departments as well as to any service departments that have not yet been allocated.

 

 

H.R.

D.P.

R.M.

Machining

Assembly

Costs prior to allocation

$  80,000

$120,000

$40,000

--

--

Allocation of H.R.

($  80,000)

16,000

8,000

$32,000

$24,000

Allocation of D.P.

 

(136,000)

10,348

44,348

81,304

Allocation of R.M.

 

 

(58,348)

29,174

29,174

 

0

0

0

$105,522

$134,478

 

After the first service department has been allocated, in order to derive the percentages to apply to the production departments and any remaining service departments, it is necessary to “normalize” these percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P. can be allocated back to H.R. The percentages for the remaining service and production departments sum to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages are normalized as follows:

 

            Risk Management:          7% ÷ 92%     =     7.61%

            Machining:                    30% ÷ 92%     =   32.61%

            Assembly:                     55% ÷ 92%     =   59.78%

                        Total:                                           100.00%

 

For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to Assembly, not 55%.

 

The characteristic feature of the step-down method is that once the costs of a service department have been allocated, no costs are allocated back to that service department. As can be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations.

 

 

The Reciprocal Method:

The reciprocal method is the most accurate of the three methods for allocating service department costs, because it recognizes reciprocal services among service departments. It is also the most complicated method, because it requires solving a set of simultaneous linear equations.

 

Using the data from the step-down method example, the simultaneous equations are:

 

H.R. = $  80,000 + (0.08 x D.P.)

D.P. = $120,000 + (0.20 x H.R.)

R.M. = $  40,000 + (0.10 x H.R.) + (0.07 x D.P.)

 

Where the variables H.R., D.P. and R.M. represent the total costs to allocate from each of these service departments. For example, Human Resources receives services from Data Processing, but not from Risk Management. 8% of the services that Data Processing provides, it provides to Human Resources. Therefore, the total costs allocated from Human Resources should include not only the $80,000 incurred in that department, but also 8% of the costs incurred by Data Processing. Solving for the three unknowns (which can be performed using spreadsheet software):

 

H.R.     =          $  91,057

D.P.     =          $138,211

R.M.    =          $  58,781

 

Hence, costs are allocated as follows:

 

 

H.R.

D.P.

R.M.

Machining

Assembly

Costs prior to allocation

$80,000

$120,000

$40,000

--

--

Allocation of H.R.

($91,057)

  18,211

    9,106

$36,423

$  27,317

Allocation of D.P.

      11,057  

 (138,211)

    9,675

  41,463

    76,016

Allocation of R.M.

 

 

(58,781)

  29,390

    29,390

 

$            0

$         0

$        0

$107,276

$132,723

 

To illustrate the derivation of the amounts in this table, the $36,423 that is allocated from Human Resources to Machining is 40% of H.R.’s total cost of $91,057.

 

 

Summary of Service Department Cost Allocation Methods:

The direct method and step-down method have no advantages over the reciprocal method except for their simplicity, and the step-down method is sometimes not very simple. Nevertheless, the reciprocal method is not widely used. Given advances in computing power, the reciprocal method would seem to be accessible to many companies that are not using it. Presumably, these companies believe that the benefits obtained from more accurate service department cost allocations do not justify the costs required to implement the reciprocal method. In fact, many companies do not allocate service department costs at all, either because they do not think these allocations are beneficial, or because they do not believe that the benefits justify the costs.

 


Dysfunctional Incentives from Service Department Cost Allocations:

The incentives that service department cost allocations impose on managers and employees should be carefully considered. In some cases, these allocations have unintended and undesirable consequences. For example:

 

1.                  At one university, professors are “charged” for office telephone usage, which includes a fixed monthly fee similar to the flat fee that is charged for residential telephone service. The “charge” comes out of the professor’s “research allowance,” which can otherwise be used for professional expenses such as journal subscriptions, professional organization dues, and travel to conferences. Since the flat fee (as opposed to the long distance charges) is unavoidable, it does not affect the professors’ behavior, but it is viewed negatively, because the research allowance is effectively several hundred dollars a year less than “advertised” by the administration.

 

2.                  At another university, state-of-the-art computer equipment in the classrooms is purchased out of student fees. Consequently, this equipment is readily available and “free” to the faculty when they teach. However, when a professor reserves a room for a non-teaching purpose, such as a research presentation to fellow faculty, the Instructional Technology service center “charges” the professor’s department approximately $50 to use the equipment, which is far in excess of the equipment’s marginal cost (the depreciation on the bulb in the projector). The $50 charge is sufficient to dissuade many departments from using the equipment for non-instructional purposes, so the equipment sits idle, and the professors use a “low tech” solution: an overhead projector and transparencies. 

 

 

 

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