Question

In order to allocate service departments' costs to production departments, there are three allocation methods (direct, step-down, and reciprocal). Use your own example to show the calculation and difference among these methods.

Answer 1

Cost allocation is used to assign service department costs to the departments that actually consume these costs. This is done in an attempt to control costs in organizations and make other departments aware of, and responsible for, the organizational resources they consume. Three approaches are used to allocate service department costs to other departments: the direct method, the step-down method, and the reciprocal method.

The Direct Method: In the direct method, interactions between service departments are ignored and costs are allocated just to operating departments.

*Department A’s cost has been allocated on the basis of employee hours:

9,000 hours + 15,000 hours = 24,000 hours.

Allocated to department X: $180,000 × (9/24) = $67,500
Allocated to department Y: $180,000 × (15/24) = $112,500

**Department B’s cost has been allocated on the basis of spaces occupied:

3,000 square feet + 22,000 square feet = 25,000 square feet.

Allocated to department X: $45,000 × (3/25) = $5,400
Allocated to department Y: $45,000 × (22/25) = $39,600

The two service departments provide ser

Step Down Method: In the step down method, one service department’s costs are allocated to another service department as well as operating departments that use it. Any amount of the allocation base attributable to the 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.

The Robert Company uses the step method for allocating the costs of its service departments to operating departments. The company has two service departments and two operating departments. The selected information for the four departments is given below:

The company uses employee hours as the base for allocating the cost of department A and space occupied for allocating the cost of department B.

Required: Allocate the cost of service departments to operating departments using step down method.

Solution

Allocation of department A’s cost:

Allocation ratio:
Department B: 3,000/(3000 + 9000 + 15,000 ) = 3,000/27000 or 3/27
Department X: 9,000/(3000 + 9000 + 15,000 ) = 9,000/27000 or 9/27
Department Y: 15,000/(3000 + 9000 + 15,000 ) = 15,000/27000 or 15/27

Allocated to department B: $180,000 × (3/27) = $20,000
Allocated to department X: $180,000 × (9/27) = $60,000
Allocated to department Y: $180,000 × (15/27) = $100,000

Allocation of department B’s cost:

Allocation ratio:
Department X: 3,000/(3,000 + 22,000) = 3,000/25,000 or 3/25
Department Y: 22,000/(3,000 + 22,000) = 22,000/25,000 or 22/25

Total cost of department B: $45,000 + $20,000 = $65,000

Allocated to department X: $65,000 × (3/25) = $7,800
Allocated to department Y: $65,000 × (22/25) = $57,200

Important points to remember

Consider the following important points regarding the above example of cost allocation under step method:

1. You can see two steps of cost allocation. In first step, the cost of department A has been allocated to other service department (department B) as well as to operating departments (department X and Y). The allocation base of department A has been ignored.
   The amount of allocation base of a service department whose cost is being allocated to other departments is always ignored under both step down method and direct method of cost allocation.
2. In second step, the total cost of department B ($45,000 + $20,000 = $65,000) has been allocated to department X and Y. No portion of department B’s cost has been allocated to department A.
   Any amount of allocation base of a service department whose cost has already been allocated to other departments is ignored under step method of cost allocation.

Reciprocal Method: The reciprocal method is a method of allocating service costs between departments that gives full recognition of interdepartmental services. The reciprocal method uses a system of equations to solve for the true costs of the service departments. These costs are then allocated to the operating departments.