PRINCIPAL’S COLLEGE OF HEALTH AND BUSINESS

ADAMA  022-2114-688, A.A 0911-061389, 522 code 1033 A.A Ethiopia

ADAMA CAMPUS 2ND YEAR 3rd semester for Degree Students

CHAPTER SIX
SERVICE DEPARTMENT COST ALLOCATION
- OH refers to the operating costs other than direct labor and direct material. It includes all
costs with an indirect relationship to the cost object. Thus OH can be associated with the cost
object only through a process of allocation. Before being allocated to products/jobs, OH is
distributed to the various departments; after being allocated, it is applied to the products.
- In other words, three steps are required for recording OH:
1. Costs are first distributed to the corresponding departments, hence establishing
responsibility.
2. The service departments’ costs then are allocated to various operating departments,
thereby ensuring proper matching of costs and cost objects.
3. Finally, the costs are applied to the product, which ensures product costing, inventory
valuation, and income determination.
- Applying OH to jobs and products (step 3) was discussed in the previous chapters using actual
or POR. In this chapter we will see how costs are first distributed to departments (briefly)
(step 1) and then reallocation of service department costs to other departments (step 2) in
detail.
Step 1: OH Distribution to Departments
- The goal of cost accounting is to obtain specific, precise product/job cost information. The
OH costs must be associated with products or jobs. Distributing OH costs to each department
is the first step in this overall allocation process.
- There are two categories of department: Producing departments and Support departments.
• Producing (Operating) departments are directly responsible for creating the products
or services sold to customers. E.g Machining, Assembly, Finishing
• A support (Service) department provides the services that assist other operating and
support departments in the organization. They are indirectly connected with an
organization’s services or products. Products do not pass through a support department.
Examples are: Purchasing, Materials storeroom, Maintenance, Inspection and quality
control. Engineering, Personnel, Cafeteria, Cost accounting etc
- Once the producing and support departments have been identified, the OH incurred by each
department is determined. This requires identifying direct and indirect department costs.
- It is important to keep in mind that departments tend to be relatively larger areas within a
company. As a result, many FOH costs are traceable to a specific department; these costs are
called direct departmental costs. Examples are: supervisory salary, and depreciation on
equipment used in that department only, utilities(if measured in that department), indirect
labor, indirect material etc
- In most cases, however, indirect costs are incurred to benefit more than one department and
should be distributed in proportion to the service used. The selection of the distribution base
is important. Among the more likely choices for a distribution base are the following

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Type of OH Distribution base

Power, Heat, and Cooling Square footage, rated horsepower hours, cubic
of space used
Factory rent Square footage
Inspection Number of units completed
Deprecation-building Square footage
Superintendents Number of employees
Lighting Kilowatt hours or number of bulbs
Telephone and telegraph Number of telephones or number of employee
Depreciation – Eqt. Number of operating hours
Property tax Square footage
Worker’s compensation insurance Departmental payroll
Freight in Material used
Building repairs Square footage
Note that other alternatives may exist and should be considered to ensure equity and
fairness throughout the allocation.
- The distribution of OH to departments is recorded using both the general and subsidiary
ledger. Accordingly, OH distribution takes place using, first, the subsidiary ledger accounts
(which may take the form of departmental OH analysis sheet) and, second, the general ledger
accounts.
- The subsidiary ledgers (departmental OH analysis sheets) are set up for each department and
include as many columns as the number of detailed OH accounts required. Each departmental
cost ledger includes a column for allocation from other departments, whether producing or
service departments, and other columns for the other possible OH items such as depreciation,
repairs, and so forth.
- Departmentalizing OH costs has the advantages of improving product costing by allowing
different department to have different OH rate and promoting responsibility accounting and
control of OH costs by making costs a responsibility of each department’s manager.
- FOH Control, a general ledger account, is debited summarizing actual OH costs of each
department with a credit to various accounts.
Step 2: Distribution of Service Department Costs
- Once the company has been departmentalized and all OH costs have been determined for all
departments, support department costs are redistributed to producing department in
proportion to the amount of services rendered to these departments.
- What happens to service department costs after they are allocated to production departments?
 Allocated service department costs become a part of the FOH in each production
department that is applied to products with a predetermined OH rate (if departmental
OH rates are computed). If a plant-wide rate is used the distinction between service
areas and producing areas is ignored and the entire plant is treated as a single
department.

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 Since the amounts allocated are presumed to represent each department’s “fair share”
of the cost of services provided for it, the allocation are included in performance
evaluations of the operating departments and also included in determining their
individual profitability.
- A service department cannot have an OH rate that assigns OH costs to units produced,
because goods do not pass through the service department.
- How are service department costs allocated?
 First, we identify the factor that drives costs in the service department. This cost
driver is called the allocation base.
 Second, we measure the consumption of the allocation base in the production
departments.
 Third, we allocate the service department cost based on the relative amount of the
allocation base consumed in ach production department.
Selecting Allocation Base
- Costs of a service department are allocated to other departments using an allocation base. The
allocation base should be a measure of whatever activity causes variations in the costs of the
service department; it should drive the service department’s costs.
- Using causal factors results in product costs being more accurate. Furthermore, if the casual
factors are known, managers are more able to control the consumption of services.
- Examples of commonly used cost allocation bases are the following.
Service Department Allocation base
Power Kilowatt-hours, Machine hours
Cafeteria Number of employees, DL hours worked, Meals served
Personnel Number of employees, labor turnover (no. of new
hires), direct labor cost
Purchasing Number of orders, Cost of orders
Shipping Number of orders
Showroom Weight, units, size
Maintenance Number of machines, machine hours
Engineering Number of change orders, number of hours
Material handling Number of material moves, hours of material
handling used, the pounds of material moved
Medical Number of cases, number of employees
Cost accounting Number of transactions, labor hours
Production planning
and control Machine hours, labor hours
When competing activity drivers exist, managers need to assess which factor provides the
most convincing relationship.
Purpose of Service Department Cost Allocations
- Companies that allocate service department costs do so for one or more of the following
reasons:

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1. To provide more accurate product cost information― Allocating service department

costs to production departments, and then to products, recognizes that these services
constitute an input in the production process. This improves decision-making within the
organization, the quality of external financial reporting, or to comply with contractual
agreements in regulatory settings where cost-based pricing is used.
2. To improve decisions about resource utilization― By imposing on division managers
the cost of the service department resources that they use, division managers are
encouraged to use these resources only to the extent that their benefit exceeds their cost.
This is particularly related to variable costs of service departments which directly vary in
proportion of the activity of the production departments. But note that the service
department’s fixed costs will not be affected by the manager’s decision.
3. To ration limited resources― When production departments have some discretion over
their utilization of a service department resource, charging production departments for
the resource usually results in less demand for it than if the resource were “free” to the
production departments. In connection with this, 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 validity of these reasons depends, however, on the accuracy and fairness of the cost
assignments made. Although it may not be possible to identify a single method of allocation
that simultaneously satisfies all these objectives, several guidelines have been developed to
assist in determining the best allocation method. These guidelines are:
• Cause and effect― Using this criterion, managers identify the variable or variables
that cause resources to be consumed. Causal factors are variables or activities within
a producing department that provoke the incurrence of support costs. For example,
hours of testing may be used as the variable when allocating the costs of quality-
testing areas to products. Allocation based on this criterion is likely to be the most
credible to operating personnel.
• Benefits received― allocate costs among the beneficiaries in proportion of the
benefits each receive. This is the most frequently used criterion when cause and
effect cannot be determined.
• Fairness or equity― allocate costs in such a manner as to be “fair” or “reasonable”
for al parties. It is less frequently used because fairness is an especially difficult
criterion to obtain agreement on. What one party views as fair, another party may
view as unfair.
• Ability to bear― allocates cost based on who can best absorb them. It is less
frequently used as it tends to penalize the most profitable division by allocating to it
the largest proportion of a support department cost. This raises issues related to
cross subsidization across users of resources in an organization. As a result, no
motivational benefits of allocation are realized.
- In determining how to allocate support department costs, the guideline of cost-benefit must
be considered. In other words, the costs of implementing a particular allocation scheme must

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be compared to the benefits expected to be derived. As a result, companies try to use easily
measured and understood bases for allocation.
- Accountants universally agree that a cost allocation method is neither right nor wrong but
rather reasonable or unreasonable. For example, if all costs of maintenance were allocated to
one of the three products that a company produced, this would generally be deemed
inappropriate and misleading but not wrong. If this product were more valuable than the other
two products, then it would be reasonable to allocate more than one third of those costs to the
product. However, if the cost accountant nevertheless for simplicity and convenience allocated
exactly one third of the cost to the more valuable product, we would say that this was poor
choice and might lead to incorrect decision making rather than asserting that it was wrong.
Methods of Support Department Cost Allocation
- Historically, there have been three alternative methods of allocating service department costs:
the direct method, the step (step-down) method, the reciprocal method. The methods differ
in the extent to which they account for the fact that service departments provide services to
other department as well as to production departments.
- The following data shows the budgeted activity and budgeted costs for two support
departments and two producing department of ABC Company.
Support Departments Producing Departments
Power Maintenance Grinding Assembly
Costs $250,000 $160,000 $100,000 $60,000
Normal activity:
Kilowatt-hours ------ 200,000 600,000 200,000
Maintenance hrs 1,000 ------ 4,500 4,500
Assume that the casual factor for power costs is kilowatt-hours and the causal factor for
maintenance costs is maintenance hours. These causal factors are used as the bases for
allocation. To simplify the illustration, no distinction is made between fixed and variable
costs. (i.e., use single rate). Now let us illustrate the three methods using this data.
Direct Method
- The direct method, which is the simplest and most widely used allocation method, allocates
each service department’s costs directly to the production departments, ignoring services
rendered to other service departments. No costs are allocated from one service department to
another. This method would be appropriate when there is no possibility of interaction among
support departments.
- The result of this procedure using our data for ABC Co. is as follows:
Step 1: The power department costs are allocated on the basis of kilowatt-hours used in
both producing departments only. 75% (600,000/800,000) for Grinding and
25%(200,000/800,000) for Assembly department. i.e., Rate(power) =
$250,000/800,000kw hrs = $0.3125 per kw hr.
Step 2: The Maintenance department costs are allocated on the basis of the number of
maintenance hours used in both producing departments only. 50% (4,5400/9,000)

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for Grinding and 50% (4,500/9,000) for Assembly department. i.e., Rate (Maint.)
= $160,000/9,000 Mhrs = $17.7777 per Maint. Hour.
Support Departments Producing Departments
Power Maintenance Grinding Assembly
Costs $250,000 $160,000 $100,000 $60,000
Power Allocation
(0.75, 0.25) (250,000) ----- 187,500 62,500
Maint. Allocation
(0. 05, 0.50) ----- (160,000) 80,000 80,000
Total $0 $0 $367,500 $202,500

NB.
 The service departments must be excluded from the allocation base under the direct
method. Why? If service departments are included in the allocation base, less than 100%
of the service department costs will be allocated to the operating departments.
 Ignoring interactions among support departments and allocating support costs directly to
producing departments may produce unfair and inaccurate cost assignments.
Step-Down Method
- The step-down (or sequential ) method allocates the costs of some service departments to
producing and service departments in a sequential manner, but once a service department’s
costs have been allocated, no subsequent service department costs are allocated back to it.
Thus it partially recognizes interdepartmental interactions.
- The choice of which department to start with is important. The sequence typically begins with
the service department that provides the highest percentage of its total service to other service
departments, or the service department that provides to the most number of service
departments, or the service department with the highest costs, or some similar criterion and
continue the sequence in a step-by-step fashion.
- The results of this procedure using our data for ABC Co. is as follows:
Step 1: Rank support departments. Based on either the percentage or total dollars of
service provided to other support departments, Power is ranked first.
Step 2: Allocate the first -ranked support department (Power) costs to other support and
operating departments based on kw hours used. 20% (200,000/1mill.) to
Maintenance, 60% (600,000/1mill.) to Grinding, 20%(200,000/1mill.) to Assembly.
Rate (Power) = $250,000.1million kw hrs = $0.25 per kw hr.
Step 3: Allocate the second-ranked support department cost(Maintenance) which includes
costs that have been allocated to it from the first department to Producing
departments (Grinding and Assembly) based on maintenance hours used. 50%
(4,500/9,000) to Grinding, 50% (4,500/9,000) to Assembly.
Rate (Maint.) = $160,000 + $50,000/9,000 Mhrs = $23.3333 per Maint. Hr.
Support Departments Producing Departments
Power Maintenance Grinding Assembly

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 PRINCIPAL’S COLLEGE OF HEALTH AND BUSINESS
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ADAMA CAMPUS 2ND YEAR 3rd semester for Degree Students

Costs $250,000 $160,000 $100,000 $60,000

Power Allocation
(0.20, 0.60, 0.20) (250,000) 50,000 150,000 50,000
Maint. Allocation
(0. 05, 0.50) ----- (210,000) 105,000 105,000
Total $0 $0 $355,000 $215,000
 Never include in the allocation base the service department whose cost is being allocated
and once a service department’s cost has been allocated, pretend that the department
doesn’t exist anymore.

- The strength of this method is it reduces the subsidization of service department use of other
service departments. Its weaknesses are some service departments are not charged for the use
of other service departments and selection of which department is allocated first results in
different cost allocations.
Reciprocal Method
- The reciprocal method is the most accurate of the three methods for allocating service
department costs, because it recognizes reciprocal services among service departments. It is
also the most complicated method, because it requires solving a set of simultaneous linear
equations and is seldom used in practice.
- Total cost that participates in the cost allocation exceeds the cost of the department. This total
costs is identified as reciprocated total cost.
- The results of this procedure using our data for ABC Co. is as follows:
Step 1: Express support department costs and reciprocal relationships in linear equation
form.
Let P be Reallocated cost of the Power department
Let M be Reallocated cost of the Maintenance department
Reallocated cost = basic cost + Share of the reallocated cost of the other
service department
The cost equation is:
P = $250,000 + 0.1M
M = $160,000 + 0.2P
Step 2: Solve these two simultaneous equations to obtain the complete reciprocated costs
of each support departments.
Substitute the Power cost equation into the Maintenance cost equation
M = $160,000 + 0.2 ($250,000 + 0.1 M)
M = $160,000 + $50,000 + 0.02M
0.98M = $210,000
M = $214,286
Substitute the value for M into the Power cost equation:

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P = $250,000 + 0.1($214,286)
= $250,000 + $21,429
= $271,429
Rate (Power) = $271,429/1million kw hrs = $0.271429 per kw hr.
Rate (Maint.) = $214,286/10,000 M hrs = $21.4286 per Maint. hr.
Step 3: Allocate the complete reciprocate costs of each support department to all other
departments (both support departments and operating departments):
Note that unlike the step-down method, service provided by Maintenance to Power
is recognized. From the total maintenance hour of 10,000 Power used 1,000 (10%),
Grinding used 4,500 (45%), and Assembly used 4,500 (45%).

Support Departments Producing Departments

Power Maintenance Grinding Assembly
Costs $250,000 $160,000 $100,000 $60,000
Power Allocation
(0.20, 0.60, 0.20) (271,429) 54,286 162,857 54,285*
Maint. Allocation
(0. 10, 0.45,0.45) 21,428 (214,286) 96,429 96,429
Total $1* $0 $359,286 $210,714
* rounding effects
NB.
 Notice that the total costs allocated to the producing department equals $410,000
(259,286 + $150,714), the total direct costs of the two support departments ($250,000 +
$160,000).
 To save our time it will be wise to allocate the reciprocated costs to producing
department only using in fact the appropriate ratios.
 Since the relative difficulty of solving simultaneous equations expands rapidly when
additional service departments are involved, solutions to simultaneous equations are
usually obtained using computer software designed for this purpose.
Comparing the Three Methods
- Does it really matter which method is used? Yes. Depending on the degree of interaction of
the support departments, the allocation methods can give radically different results. Because
allocation methods do affect the cost responsibilities of managers, it is important for the
accountant to understand the consequences of the different methods and to have a good
reason for the eventual choice.
- A different OH allocation rate in the producing department will result under each of the three
methods. Note that OH rates used in producing departments to cost products/jobs include
OH costs allocated from support departments resulting in different cost for a product
depending on which of the three methods is used.

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- For example, assume OH costs are allocated in Grinding and Assembly department using
machine hours and labor hours respectively with the following budgeted data:
Grinding Assembly
Direct labor hours: 45,000 107,500
Machine-hours 71,000 30,000
The various overhead rates using the three methods are the following:
Grinding Assembly
i) Direct Method $367,500 = $5.17 $202,500 = $1.88/Lhr
71,000 mhrs 107,500 Lhrs
ii) Step-down Method $355,000 = $5.00 $215,000 = $2.00/Lhr
71,000 mhrs 107,500 Lhrs
iii) Reciprocal Method $359,286 = $5.17 $210,714 = $1.96/Lhr
71,000 mhrs 107,500 Lhrs
- Like any accounting method, the cost–benefit guideline should also be considered in the
selection of a method of support department cost allocation.
- Note that even though most service departments are cost centers and therefore generate no
revenues, a few service departments such as the cafeteria may charge for the services they
perform. If a service department generates revenue, these revenues should be offset against
the department’s costs, and only the net amount of cost remaining after this offset should be
allocated to other departments within the organization. In this manner, the other departments
will not be required to bear costs fro which the service department has already been
reimbursed.

Additional Guidelines
- Additional guidelines that should be followed in allocating service department costs are
discussed in the following sections.
- Support department costs are allocated through the use of an allocation rate. Considerations
that go into determining an appropriate allocation rate include (1) the choice of a single or a
dual rate and (2) the use of budgeted versus actual support department costs.
Dual Rate vs. Single Rate
Single Rate
- A single rate allocates costs in each cost pool (i.e., each support department) to cost objects
(i.e., operating departments) using the same rate per unit of a cost-allocation base. No
distinction is made between fixed and variable costs in this method. In the previous examples
we used a single allocation rate.
- The advantage of this method is its low cost of implementation. It avoids the often expensive
analysis to classify costs as fixed and variable.
- The problem with the single rate method is that it treats the fixed cost as if it were variable. It
ignores the differential impact of changes in usage on costs. Fixed costs do not vary with the
level of services. This could lead operating department manager to make outsourcing decision

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that are in their own best interest but are not in the best interest of the organization as a
whole.
- The allocation of service department cost to operating department is as follows:
1) The budgeted service department costs are established for each service department.
2) Allocation base is determined
3) Allocation rate is computed:
Allocation rate = budgeted service dept cost/ allocation base
4) The service department costs are allocated to each producing department on the
basis of their proportional use of the service provided, as measured in terms of the
allocation base.
Budgeted rate × Actual usage of the allocation base
Example:
Suppose a firm’s medical services are allocated to the two production departments on the
basis of the number of their employees. The budgeted cost behavior pattern of the service
department is $20,000 plus $1 per employee operating in department I and II. In January,
the firm has 2,000 employees, three-fourth of them employed in department I and one-
fourth in department II. Allocate the service department cost to the two operating
departments based on number of employees.
1) The budgeted service department costs = $20,000 + ($1 × 2000 employees)
= $22,000
2) Allocation base is equivalent of 2,000 employees
3) The budgeted allocation rate is:
= $22,000/ 2000 = $11 per employee
Not that the budgeted rate of $11 per employee includes an allocated amount
of $10 per employee for fixed costs.
4) The service department costs are reallocated as follows:
Department I: 1,500 employees x $11 = $16,500
Department II: 500 employees x $11 = 5,500
Total Service Department. Costs = $22,000

Although straightforward, this principle of allocating service department costs is subject

to improvements described in the following sections.

Dual Rate:
- Whenever possible, service department costs should be separated into variable and fixed
classifications and allocated separately. This approach is necessary to avoid possible
inequities in allocation, as well as to provide more useful data for planning and control of
departmental operations.
Developing a Variable Rate:

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 Variable costs represent direct costs of providing services and will generally vary in
total in proportion to fluctuations in the level of service consumed.
 As a general rule, variable costs should be charged to producing departments
according to whatever activity (miles driven, direct labor-hours, number of employees
etc) causes the incurrence of the costs involved. For example, variable maintenance
cost of a maintenance department may be allocated (better called charged) to
producing departments on machine hour basis.
a) If the allocations are being made at the beginning of the year, they should be
based on the budgeted activity level planned for the consuming departments.
The allocation formula would be:
Cost allocated = Budgeted rate × Budgeted activity(allocation base)
b) If the allocations are being made at the end of the year, they should be based on
the actual activity level that has occurred during the year. The allocation formula
would be:
Cost allocated = Budgeted rate × Actual activity (allocation base used)
Developing a Fixed Rate:
 Fixed costs can be considered capacity costs; they are incurred to provide the capacity
necessary to deliver the service units required by the producing departments. This
capacity may reflect the peak period needs of the other department, or it may reflect
their long-run average or “normal” servicing needs.
 Thus the cost driver of the fixed-cost pool is the amount of capacity required when the
support department facilities were acquired and it seems reasonable to allocate fixed
costs based on those needs (capacity) as follows:
Budgeted fraction of capacity available for use × total budgeted fixed costs
 Once set, allocation should not vary from period to period, since they represent each
consuming department’s “fair share” of having a certain level of service capacity
available.
Example:
Assume in the previous example the service department had provided a basic maximum
capacity to serve other departments with the assumption that department I would employ
1,600 employees and department II 400 employees.
The fixed costs would have been allocated to the two departments on the basis of the capacity
to serve, as follows:
Department I: 1,600/2000 × $20,000 = $16,000
Department II: 400/2000 × $20,000 = $4,000
The variable cost would have been allocated to the two departments on the basis of the
services utilized:
Department I: $1 × 1,500 = $1,500
Department II: $1 × 500 = $500

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The total cost allocated would have been:

Department I: $16,000 + $1,500 = $17,500
Department II: $4,000 + $500 = 4,500
Total service department costs = $22,000

Pitfalls in Allocating Fixed Costs

- Generally, it is found to be preferable to allocate fixed costs based on capacity available,
under the approach that fixed costs provide capacity and variable costs allocated based on
actual usage.
- In developing the fixed cost rate some companies choose to allocate fixed costs in
proportion to actual usage or budgeted usage.
- Since usage may vary from year to year, allocation of fixed costs would then use a variable
base. Variable bases, however, have a significant drawback: they allow the actions of one
department to affect the amount of fixed cost allocated to another department. The result is
that it distorts decisions and creates serious inequities between departments. This will not
bring the desired motivational effects with respect to the ordering of services in both the short
run and the long run.
Actual usage:
- Actual usage should not be used to allocate fixed costs. Why? Because
 Fixed costs would be treated as if they were variable costs, so
 The allocation wouldn’t capture the cause and effect of cost incurrence (fixed costs are
“caused” by long-run expected usage and
 Changes in one division’s usage would affect another division’s allocation
Example:
Suppose department I has actually used 850 employees and department II 400 employees.
Based on actual capacity used, total fixed cost would be allocated as follows:
Department I: 850/1,250 × $20,000 = $13,600
Department II: 400/1,250 × $20,000 = $6,400
Department II has done nothing differently, but it must bear higher costs of $2,400 because of
the action of Department I. This weakness is avoided by using a predetermined lump-sum
allocation of fixed costs, based on capacity available, not capacity used. Such a budgeted
lump-sum approach is more likely to have the desired motivational effects with respect to the
ordering of services in both the short run and the long run.
Note that as long as the capacities of the producing departments remain at the level originally
anticipated, there is no reason to change the allocation ratio for fixed cost.

Budgeted usage:
- Budgeted usage can also be used as an allocation base for fixed costs. When budgeted usage is
the allocation base, user division will know in advance their allocated costs regardless of actual
usage. This information helps the user divisions with both short-run and long-run planning.

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- But allocating fixed costs on the basis of budgeted long-run usage may tempt some managers
to deliberately underestimate their planned usage. This will result in their department bearing a
lower percentage of fixed costs (assuming all other managers do not act similarly). To
discourage such underestimates, some companies offer rewards and bonuses-the carrot
approach-to managers who make accurate forecasts of long-run usage. Other companies
impose cost penalties-the stick approach-for underestimating long-run usage. For instance, a
higher cost rate is charged after a division exceeds its budgeted usage.
Note: If capacity costs are the result of a long-term decision by top management, it may be
desirable to allocate to each department the cost of capacity used based on actual usage. The
users are then not allocated the costs of unused capacity.

Should Actual or Budgeted Costs Be Allocated?

- Should a service department allocate its actual costs to operating department, or should it
allocate its budgeted costs? The answer is that budgeted costs (whenever possible) should
be allocated. In developing the allocation rates (both variable and fixed) in the previous
example we used the budgeted cost.
- The use of budgeted cost rate rather than actual cost rates for allocating variable cost of
service department has several attractive features to the manager of a user department:
 Budgeted rates let the user department know in advance the cost rates they will be
charged. User department managers face no uncertainness about the rates to be used in
that budget period. Users can then determine the amount of the service to request and-if
the option exists-whether to use the internal department source or an external vendor.
 The cost allocated to a particular user department does not depend on the amount of
resources used by other user departments, and
 Inefficiencies/efficiencies at the department providing the service do not affect the costs
allocated to the user department. During the budget period, the supplier department, not
the user departments, bears the risk of any unfavorable cost variances. Why? Because the
user departments do not pay for any costs that exceed the budgeted rates. This will help
motivate the manager of the supplier (support) department to improve efficiency.
 Budgeted rates are also needed to have timely job/product cost information.

- What is wrong with allocating actual costs?

 Allocating actual costs burdens the operating departments with the inefficiencies of the
service department managers. If actual costs are allocated, then any lack of cost control
on the part of the service department manager is simply buried in a routine allocation to
other departments. Actual rate holds user-department managers responsible for costs
beyond their control and provides less incentive for service department to be efficient.
 The actions of other departments affect the cost allocated to another department. i.e.,
One department may be heavily penalized for greater use of the services.

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 When actual rates are used for cost allocation, managers do not know the rates to be
used until the end of the budget period. i.e., rate affects the level of uncertainty user
department face.

Example:
Referring to the previous example, assume that the actual variable costs in the service
department were $10,000 because of inefficiencies instead of $2,000 ($1x2,000 employees)
budgeted. Reallocating the actual costs on the basis of the actual usage would lead to the
following results:
Department I: 1,500/2,000 × $10,000 = $7,500
Department II: 500/2,000 × $10,000 = $2,500
Actual variable cost allocated = $10,000
A good cost-accounting scheme would charge only the $2,000 to the user departments and
would let the $8,000 remain as an unfavorable budget variance of the support department.
This scheme holds support department managers responsible for the $8,000 variance and
reduces the resentment of user manages.

- Any variance over budgeted costs should be retained in the service department and closed
out at year-end against the company’s revenues or against cost of goods sold, along with
other variances. Operating department managers rarely complain about being allocated a
portion of service department costs, but they complain bitterly if they are forced to absorb
service department inefficiencies.
- If it is not feasible to maintain a distinction between variable and fixed costs in a service
department, then the costs of the department should be allocated to consuming
departments according to the base that appears to provide the best measure of benefits
received.

Cost Accounting, AAUCC, 2011 Page 14 of 14