SERVICE

DEPARTMENTS
CHAPTER 4
ALLOCATION COST
 LEARNING OBJECTIVES

After studying Chapter 4, you will be able to:

1- Describe the difference between Service departments and producing
departments.
2- Explain why service department costs are assigned to production
departments.
3- Select the appropriate basis for allocating service department costs.
4- Allocate service department costs to other departments, using the direct
method.
5- Allocate service department costs to other departments, using the step
method.
 Overview of Cost Allocation

A. 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 departments. Service departments engage
in activities that do not generate significant revenue.
Reasons for Allocating Service Department Costs

To encourage operating To provide operating

departments to wisely departments with more
use service department complete cost data
resources. for making decisions.

To help measure the To create incentive

profitability of operating for service departments
departments. to operate efficiently.

To value inventory for

To include all overhead
external financial
in one cost base.
reporting purposes.
 ALLOCATION BASES

Costs of a service department are allocated

to other departments using an allocation
base.
The allocation base should be 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.
 Selecting Allocation Bases

The allocation bases used should

“drive” the cost being allocated.

For example, when allocating costs

of the employee cafeteria, the number
of meals served would be a good
choice for the allocation base.

Service
Departments
$ Operating
Departments
 Selecting Allocation Bases

A service department’s costs may be

allocated using more than one base.

For example, a portion of the human resource department

costs might be allocated based on the number of employees
in each operating department and another portion might be
allocated based on hours spent in training employees in
each operating department.

Service
Departments
$ Operating
Departments
 Exh.
15-1
Examples of Allocation Bases

Service Department Allocation Bases

Laundry Pounds of laundry
Airport Ground Services Number of flights
Cafeteria Number of meals
Medical Facilities Cases handled; number of employees;
hours worked
Materials Handling Hours of service; volume handled
Information Technology Number of personal computers;
applications installed
Custodial Services Square footage occupied
Cost Accounting Labor hours; customers served
Power KWH used; capacity of machines
Human Resources Number of employees; training hours
Receiving, Shipping, and Stores Units handled; number of requisitions;
space occupied
Factory Administration Total labor hours
Maintenance Machine hours
 Interdepartmental Services

Problem
Allocating costs when service departments
provide services to each other

Solutions
Direct Method
Step Method
Reciprocal Method
 DIRECT METHOD

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.
 Direct Method

Service Operating
Interactions Department Department
between service (Cafeteria) (Machining)
departments are
ignored and all
costs are
allocated directly
to operating Service Operating
departments. Department Department
(Custodial) (Assembly)
 Direct Method Example

Service Department Allocation Base

Cafeteria Number of employees
Custodial Square feet occupied
Direct Method Example
 Direct Method Example

20
$360,000 × = $144,000
20 + 30

Allocation base: Number of employees

 Direct Method Example

30
$360,000 × = $216,000
20 + 30

Allocation base: Number of employees

 Direct Method Example

25,000
$90,000 × = $30,000
25,000 + 50,000

Allocation base: Square feet occupied

 Direct Method Example

50,000
$90,000 × = $60,000
25,000 + 50,000

Allocation base: Square feet occupied

 STEP METHOD

The step 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.
 Step Method

Service Operating
Department Department
Once a service (Cafeteria) (Machining)
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
Service Operating
Department Department
(Custodial) (Assembly)
 Step Method

There are three key points to understand

regarding the step method:
 In both the direct and step methods, any amount of
the allocation base attributable to the service
department whose cost is being allocated is always
ignored.
 Any amount of the allocation base that is
attributable to a 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.
 Step Method Example

We will use the same data used

in the direct method example.

Service Department Allocation Base

Cafeteria Number of employees
Custodial Square feet occupied
 Step Method Example

Allocate Cafeteria costs first since

it provides more service than Custodial.
 Step Method Example

10
$360,000 × = $60,000
10 + 20 + 30

Allocation base: Number of employees

 Step Method Example

20
$360,000 × = $120,000
10 + 20 + 30

Allocation base: Number of employees

 Step Method Example

30
$360,000 × = $180,000
10 + 20 + 30

Allocation base: Number of employees

 Step Method Example

New total = $90,000 original Custodial cost

plus $60,000 allocated from the Cafeteria.
 Step Method Example

25,000
$150,000 × = $50,000
25,000 + 50,000

Allocation base: Square feet occupied

 Step Method Example

50,000
$150,000 × = $100,000
25,000 + 50,000

Allocation base: Square feet occupied

 Quick Check Data
for Direct and Step Methods

The direct method of allocation is used.

Allocation bases:
⚫Business school administration costs (ADMIN):
Number of employees
⚫BusinessAdministration computer services
(BACS): Number of personal computers
 Quick Check ✓

How much cost will be allocated from

Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
 Quick Check ✓

How much cost will be allocated from

Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000

20
$180,000 × = $36,000
20 + 80
 Quick Check ✓

How much total cost will be allocated from

ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
 Quick Check ✓

How much total cost will be allocated from

ADMIN and BACS combined to the
Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500

18
$90,000 × = $13,500
18 + 102
 Quick Check Data

The step method of allocation is used.

Allocation bases:
⚫Business school administration costs (ADMIN):
Number of employees
⚫Businessadministration computer services
(BACS): Number of personal computers
 Quick Check ✓

How much total cost will be allocated from

ADMIN and BACS combined to the
Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
 Quick Check ✓

How much total cost will be allocated from

ADMIN and BACS combined to the
Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333
 Effect of Allocations on
Operating Departments
First Stage Allocations
Service department costs are
Service allocated to operating departments.
Department
(Cafeteria) Operating
Department
Service (Machining)
The
Department
Products
(Accounting) Operating
Department
Service (Assembly)
Department
(Personnel)
 Effect of Allocations on
Operating Departments
Second Stage Allocations
Operating department overhead costs and
Service allocated service department costs are
applied to products.
Department
(Cafeteria) Operating
Department
Service (Machining)
The
Department
Products
(Accounting) Operating
Department
Service (Assembly)
Department
(Personnel)
Problem 1:

You have the following information related to

production and services centers ABC factory

during 2020:
 Allocation
You have the following information related to
Prod. centers Services centers
base

production
A andB services
C centers ABCstores
maintenance factoryHRduring
FOH
2015 50000 30000 20000 10000 15000 25000

Allocate HR No. of
10 5 5 3 2 -
employees

No. of
Allocate stores 8 5 2 2 - - material
issued

Allocate No. of
9 6 5 - - -
maintenance maintenance

No. of DL hours 36000 23000 13500

No. of machine
72000 46000 27000
hours
Calculate the total FOH for each Prod. center using :

a- Direct method.

b- Step down method

Problem 2:

You have the following information related to production and services centers in
Cardiff Factory during 2021

Required:

Calculate the total factory overhead for each production center using direct
method.
 Production centers Services centers Allocation
base
A B C maintenance stores Human
resources
factory overhead 50000 30000 20000 13000 15000 18000

Allocate of HR 10 10 5 - - - No. of
employees
Allocate of Stores 8 5 2 - - - No. of
material
issued
Allocate of 5 3 2 - - - No. of
maintenance maintenance
No. of DL hours 73000 24000 14500

No. of machine hours 36500 12000 29000