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Chapter 04B - Lecture Notes
4B-1
I. Appendix 4B: Service Department Allocations (slide 1 is the
title slide)
A. Key definitions/concepts
i. Operating departments carry out the central purpose of
the organization. Examples of operating departments
include:
1. The Surgery Department at Mt. Sinai Hospital.
2. The Geography Department at the University of
Washington.
3. The production departments at Mitsubishi.
ii. Service departments do not directly engage in operating
activities. They provide services or assistance to the
operating departments. Examples of service departments
include:
1. Cafeteria, Internal Auditing, Human Resources, and
Accounting.
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Chapter 04B - Lecture Notes
4B-2
iii. The overhead costs of operating departments frequently
include allocations of costs from service departments. To
the extent service department costs are classified as
production costs, they should be included in unit product
costs and thus must be allocated to operating departments
in a process costing system.
iv. Three approaches are used to allocate service department
costs to other departments—the direct method, the
step-down method, and the reciprocal method.
v. Keep in mind that many service departments provide
services to each other, as well as to operating
departments. Services provided between service
departments are known as interdepartmental or
reciprocal services.
B. Methods of allocation
Learning Objective 10: Allocate service department costs to
operating departments using the direct method.
i. Direct method: a definition
1. The direct method is the simplest of the three cost
allocation methods because it ignores the services
provided by a service department to other service
departments. It allocates all costs directly to
operating departments.
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ii. Direct method: an example
1. Assume that a company has two service
departments (Cafeteria and Custodial) and two
operating departments (Machining and
Assembly) with accompanying information as
shown.
2. How much of the Cafeteria and Custodial costs
should be allocated to each operating
department?
3. The Machining Department would be allocated
$144,000 of the Cafeteria Department’s costs as
shown. Notice:
a. The allocation base is the number of
employees.
b. Quantities of the allocation base attributed
to the service departments are ignored.
4. The Assembly Department would be allocated
$216,000 of the Cafeteria Department’s costs as
shown. Notice:
a. The sum of the costs assigned to Assembly
($216,000) and Machining ($144,000) is
equal to the total costs assigned from the
Cafeteria ($360,000).
5. The Machining Department would be allocated
$30,000 of the Custodial Department’s costs as
shown. Notice:
a. The allocation base is square feet
occupied.
6. The Assembly Department would be allocated
$60,000 of the Custodial Department’s costs as
shown. Notice:
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Chapter 04B - Lecture Notes
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a. The sum of the costs assigned to Assembly
($60,000) and Machining ($30,000) is
equal to the total costs assigned from the
Custodial Department ($90,000).
Helpful Hint: What to include in the allocation base under
the direct method often confuses students. For example, if
Personnel Department costs are allocated on headcount,
should the Personnel Department headcount and that of
other service departments be included? While it doesn’t seem
to make much sense economically, the service departments
must be excluded to avoid allocating costs back to the service
departments.
Learning Objective 11: Allocate service department costs to
operating departments using the step-down method.
iii. Step-down method: a definition
1. The step-down method provides for allocation of
a service department’s costs to other service
departments, as well as to operating departments.
It is sequential and the sequence usually begins
with the department that provides the greatest
amount of service to other service departments.
a. Once a service department’s costs have
been allocated to other departments, other
service department costs are not allocated
back to it.
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2. There are three key points to understand
regarding the step-down method:
a. 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.
b. Any amount of the allocation base that is
attributable to a service department whose
cost has already been allocated is
ignored.
c. Each service department assigns its own
costs to operating departments plus the
costs that have been allocated to it from
other service departments.
iv. Step-down method: an example
1. Assume the same facts that were used for the
direct method example.
2. How much of the Cafeteria and Custodial costs
should be allocated to each operating
department?
a. Assume that the Cafeteria costs are
allocated first followed by the Custodial
Department.
3. The Custodial Department would be allocated
$60,000 of the Cafeteria Department’s costs as
shown. Notice:
a. The allocation base is the number of
employees, and the quantity of employees
in the denominator is 60.
4. The Machining Department would be allocated
$120,000 of the Cafeteria Department’s costs as
shown.
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5. The Assembly Department would be allocated
$180,000 of the Cafeteria Department’s costs as
shown. Notice:
a. The sum of the assigned costs ($60,000 +
$120,000 + $180,000) equals the total
Cafeteria Department costs of $360,000.
6. The Custodial Department will allocate
$150,000 in total costs. This amount includes the
department’s own costs of $90,000 plus the
amount allocated from the Cafeteria Department
of $60,000.
7. The Machining Department would be allocated
$50,000 of the Custodial Department’s costs as
shown. Notice:
a. The allocation base is square feet
occupied.
8. The Assembly Department would be allocated
$100,000 of the Custodial Department’s costs as
shown. Notice:
a. The sum of the costs assigned to Assembly
($100,000) and Machining ($50,000) is
equal to the total costs assigned from the
Custodial Department ($150,000).
Helpful Hint: What to include in the allocation base under
the step-down method often confuses students. Never include
in the allocation base the service department whose cost is
being allocated; once a service department’s cost has been
allocated, pretend the department does not exist anymore. In
other words, at each step allocate a service department’s
costs to the remaining service departments and to all of the
operating departments.
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Chapter 04B - Lecture Notes
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v. Reciprocal method: a definition
1. The reciprocal method gives full recognition to
interdepartmental services. While the step-down
method only allocates costs forward – never
backwards – the reciprocal method allocates costs
in both directions.
2. Reciprocal allocation requires the use of
simultaneous linear equations and is beyond the
scope our book.
Helpful Hint: Students may object to the inaccuracies of the
step-down method. This gives an opportunity to explain the
reciprocal method. Ask students what would happen if every
service department’s costs were allocated to all of the service
departments (including itself as appropriate). Someone
should answer that some costs would still be left in the
service departments when the allocations are finished. Ask
what would happen if you started over and used the same
procedure to allocate the service department costs that
remain. Someone should answer that some costs would still
be left in the service departments, but the costs would be less
than before. In fact, if this process is repeated many times
until no costs are left in the service departments, you have
essentially performed a reciprocal allocation.
Quick Check – direct and step-down methods
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