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:
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 recognize that service departments provide services to other service departments as well as to production departments. All three methods ultimately allocate all service department costs to production departments; no costs remain in the service departments under any of the three methods.
The three methods for allocating service department costs are the direct method, the step-down method, and the reciprocal method. We will focus on the step-down method in this course. If you are interested in learning more about the other two methods, go to http://denniscaplan.fatcow.com/Chapter12.htm
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 affects 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