Managerial Accounting Project

Operating Costing and Cost Allocation in Service Departments

Student: Dea Elmas

Introduction

Operating costing is a method of costing applied by companies which provide service rather

than production of commodities. Like unit costing and process costing, operating costing is

thus a form of operation costing. The emphasis under operating costing is on the certainty of

cost of rendering services rather than on the cost of manufacturing a product. It is applied by

transport companies, gas and water works, electricity supply companies, canteens, hospitals,

theatres, school, etc. Within an organization itself certain departments are also known as

service departments which provide additional services to the production departments.

Operation costing offers a better scope for control. It facilitates the computation of unit

operation cost at the end of each operation by dividing the total operation cost by total input

units. It is the category of the basic costing method, applicable, where standardized goods or

services result from a sequence of repetitive and more or less continuous operations, or

processes to which costs are charged before being averaged over the units produced during

the period. The two costing methods included under this head are process costing and service

costing.

Because of the varied nature of activities carried out by the service undertaking, the cost

system used is obviously different from that followed in manufacturing concerns.

Classification of Operating Costs

The operating costs can be classified under three categories:

Fixed or Standing Charges: These are expenses which are more or less fixed in nature. For

example, in case of transport service these include garage charges, insurance, taxes, license

and depreciation. In case of hospitals, the depreciation pertaining to the cost of building,
equipment, beds, beds insurance etc. are fixed charges. These expenses are constant and are

incurred irrespective of the extent of service.

Maintenance Charges: These are costs of semi-variable nature and include expenditure on

repairs, maintenance, tyres, tubes, accessories, and spares.

Running or Operating Charges: These are variable costs. For example, in the case of

hospitals, the cost of medicine, diet, laundry etc. will represent the running charges. In case of

transport service, petrol or diesel, lubricating oil, wages of driver or cleaner are operating or

running charges.

Application of Operating Costing

Transport Service: Under this method of costing, the operating cost of each vehicle is

determined. The common unit of service is tone kilometer in case of goods transport, and

passenger kilometer in case of passenger transport. Examples include truck operators, road

transport, railways, airlines, etc.

Supply Service: It includes services like electricity, steam, gas, water, etc. where steam is

used for the purpose of generating electricity, it is possible to compute the cost of electricity

generated by aggregating the steam production costs with other related cost of electricity

generation. A cost unit is generally in terms of kilograms.

Welfare Services: It includes services like canteen, hospital, library, etc. Hotels and

restaurants employ operating costing. The total operation of a hotel can be divided into

number of cost centers like restaurant, housekeeping, laundry, etc. The cost unit is generally

in terms of per meal/dish.

Transport Costing

Transport operating costs refer to costs that vary with vehicle usage, including fuel, tires,

maintenance, repairs, and mileage-dependent depreciation costs. Projects that alter vehicle

miles traveled, traffic speed and delay, roadway surfaces, or roadway geometry may affect

travelers’ vehicle operating costs, which should be considered in a benefit-cost analysis.

Vehicle ownership costs refer to fixed costs that are not directly affected by vehicle mileage,

including time-dependent depreciation, insurance and registration fees, financing, and

residential parking.

Hospitality Costing

Hotel and lodges, providing daily accommodation facility to general public, have

mushroomed all over the country due to the incentive provided by modern civilization to

“travel” both on personal and commercial work. The Operating costing system is applied in

lodging houses in order to find out the cost of accommodation provided.

The convenient form measuring the accommodation facility is in terms of “room day.” Cost

per room day means the cost of maintaining facility on room in usable condition for one day

when occupied. While determining the cost per room day, factors such as room

accommodation available (whether cubicles or dormitories), number of people lodging,

facilities provided to the lodgers, etc. are to be taken into account.

Most of the costs in the lodging houses are fixed in nature like depreciation, staff salaries,

maintenance, etc. Hence, the distinctions between fixed and operating charges are rarely

observed. In case the customers are provided food and drinks along with accommodation

facility, a separate charge may be levied from them. The cost per room day is arrived at by

dividing the total cost with the number of room day. Some amount of profit is added to the
cost per room per day to determine charge per room day. Once the charge per room day is

determined, the same is to be multiplied with the assigned weights to arrive at the rate to be

charged for different classes of room per day.

Types of Costs in Hotels

 Fixed costs are not expected to change in the short run of an operating period of a

year or less, and will not vary with increases of decreases in sales revenue. Examples

are management salaries, fire insurance expense, rent paid on a square-foot basis, or

the committed cost of an advertising campaign.

 Variable costs are costs that change in direct proportion to a change in sales revenue.

The costs of sales of food and beverages are considered strictly variable costs. The

more food and beverages sold, the more costs will be incurred.

 Most costs do not fit neatly into the fixed or the variable category. These costs are

called semi-fixed or semi-variable costs and they include payroll, maintenance, and

utilities.

Cost Allocation in Service Departments

Departments within an organization can be divided into two broad classes: (1) operating

departments and (2) service departments. Operating departments include those departments

or units where the central provide services or assistance that facilitate the activities of the

operating departments. Examples of such services include cafeteria, internal auditing,

personnel, X-ray, cost accounting, and purchasing. Although service departments do not

engage directly in the operating activities of an organization, the costs that they incur are

generally viewed as being part of the cost of the final product or service, the same as are

materials, labor, and overhead in a manufacturing company or medications in a hospital.

Selecting Allocation Bases

Costs are assigned from service departments to operating departments by identifying the

activity that drives costs in a service department and then measuring the consumption of this

activity by other departments. A cost-driving activity in a service department is generally

referred to as an allocation base. Allocation bases may include number of employees, labor-

hours, square footage of space occupied, or any other measure of activity in a department.

Once allocation bases have been chosen, they tend to remain unchanged for long periods

unless it can determined that some inequity exists that is resulting in costing errors.

Service Department Bases (Cost Drivers) Involved

Laundry Pounds of laundry; number of items processed

Airport ground services Number of flights

Cafeteria Number of employees

Medical facilities Cases handled; number of employees; hours worked

Materials handling Hours of service; volume handled

Custodial services (building and Square footage occupied

grounds)

Power Kwh used; capacity of machines

Maintenance Machine-hours; total labor-hours

Two approaches are used to allocate the costs of service departments to other departments.

These are known as the direct method and step method.

Direct Method
The direct method is a very simple allocation approach that ignores the costs of services

between service departments and allocates all costs directly to operating departments. Even if

a service department (such as personnel) renders a large amount of service to another service

department (such as the cafeteria), no allocations are made between the two departments.

Rather, all costs would go directly to the operating departments of the company. Hence the

term direct method.

Step Method

Unlike the direct method, the step method provides for allocation of a service department’s

costs to other service departments, as well as to operating departments, in a sequential

manner. The sequence typically begins with the department that provides the greatest amount

of service to other departments. After its costs have been allocated, the process continues,

step by step, ending with the department that provides the least amount of service to other

departments.