ALLOCATION OF

SERVICE COSTS
PATRICK LOUIE E. REYES,
CTT, MICB, RCA, CPA
Introduction
• Organizations incur two types of overhead costs:
• Directly related to operations/production
• Indirectly related to operations/production → support
• Support departments include both:
• Service departments
• Administrative departments
• Support department costs must be allocated to operating
departments for (1) full cost computation, (2) managerial
motivation, and (3) managerial decision making.
Objectives of Cost Allocation
(1) FULL COST COMPUTATION
Pros
Provides for cost recovery
Instills a consideration of support costs in
production managers
Reflects production’s “fair share” of
support costs
Meets regulations in some pricing
instances
Cons
Provides costs that are beyond production
manager’s control
Provides arbitrary costs that are not useful
in decision making
Confuses the issues of pricing and costing.
Prices should be set high enough for each
product to provide a profit margin that
should cover all nonproduction costs
Objectives of Cost Allocation
(2) MANAGERIAL MOTIVATION
Pros
Instills a consideration of support costs in
production managers
Relates individual production unit’s profits
to total company profits
Reflects usage of services on a fair and
equitable basis
Encourages production managers to help
support departments control costs
Encourages the usage of certain services
Cons
Distorts production division’s profit figures
because allocations are subjective
Includes costs that are beyond production
manager’s control
Will not materially affect production
division’s profits
Creates interdivisional ill will when there is
lack of agreement about allocation base or
method
Not cost beneficial
Objectives of Cost Allocation
(3) MANAGERIAL DECISION-MAKING
Pros
Provides relevant information in
determining corporatewide
profits generated by alternative
actions
Provides best available estimate
of expected changes in costs due
to alternative actions
Cons
unnecessary if alternative actions
will not cause costs to change
Presents distorted cash flows or
profits from alternative actions
because allocations are
arbitrary
Bases for Allocation
•The basis for allocation of support department costs
must be rational and systematic.
•The basis should:
• measure the benefit the operating department receives
from the support department
• capture the causal relationship existing between factors
in the operating department and costs incurred in the
support department
Bases for Allocation
•The basis should also (continuation from previous
slide):
• reflect the fairness or equity of the allocations among
operating departments
• measure the ability of operating departments to bear the
allocated costs
Bases for Allocation

Appropriate
Service/
Administrative Cost
Allocation Bases:
Methods of Allocation
•Direct Method
•Step Method
•Algebraic Method
Methods of Allocation
For purposes
of illustrating
all three
methods, let
us use the
following
situation:
Methods of Allocation
Direct Method - support department costs are assigned
using the specified bases only to the operating areas
Methods of Allocation
Step Method - Costs
are assigned using an
appropriate, specified
allocation base to the
departments receiving
support. After costs
have been assigned
from a department, no
costs are charged back
to that department. Notice that Administration costs were allocated to HR, Maintenance and the operating divisions. Once the Administration
costs are fully allocated, it is “eliminated”. HR costs will not have to allocate to Administration anymore. Once HR costs are
fully allocated to Maintenance and the operating divisions, it is likewise “eliminated”. In the Direct Method, the support
departments allocate directly to the operating divisions. They don’t allocate to the other support departments.
Methods of Allocation
Step Method
Methods of Allocation
Algebraic Method – involves formulating a set of
equations that reflect reciprocal service among
departments
Methods of Allocation – Algebraic
The Algebraic Method recognizes all interrelationships among
departments, therefore we analyze the inter-departmental
proportional relationships between the support departments
and the operating divisions:
Note that the N/A
just means that
there is no
allocation from
one department to
itself. For example,
in Administration,
there are
allocations to be
given to HR,
Maintenance,
Multi-vitamins,
and Therapeutics,
but none for itself.
The same is true
with HR and
Maintenance.
Methods of Allocation – Algebraic
Three equations can be derived from the table in the
previous slide:
The original direct costs of Administration is
Php 3,001,200, but since there is a
recognized interdependence with other
support departments, it will receive
allocations from HR and Maintenance. In this
case, 17.39% of HR’s direct costs are
allocated to Administration, and 0.00% of
Maintenance’s direct costs are allocated to
Administration (see table in previous slide).
The same is done with HR and Maintenance
to arrive at these three equations.
Methods of Allocation – Algebraic
These three equations are solved by substitution, until there
is one variable left. Let’s eliminate A and M, so that H will be
left. (You may choose any variable to eliminate)
Methods of Allocation – Algebraic
Substitute the value of H into the first equation to derive
the value of A. (Note: It’s not always the first equation.
It’s just easier this way in this particular case. It’s on a
case-to-case basis)
Methods of Allocation – Algebraic
Now that we have values of A, and H, we can now derive
M.
Methods of Allocation – Algebraic
Here is how the support departments’ direct costs are
allocated to the other departments, considering the
interdependence of these support departments with other
support departments:
Methods of Allocation – Algebraic
Here is how the support departments’ direct costs are
allocated to the operating divisions:

Differences from the Direct and Step methods are due to rounding off.