Cost Allocation of

Service
Department
By Garcia, Valente & Aristorenas
MBA 209:Managerial
Accounting
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MBA 209 2
 Learning Objectives:

1 2 3 4

Explain the major reasons Allocate costs of service Allocate service Allocate service
for the need for allocationg deparments to other department costs using the department costs using the
nonmanufacturing costs. operating direct method. step-down method.
departments/units using
the cost behavior concept.

MBA 209 3
Learning Objective 1
Major Reasons for the Need for Allocating Nonmanufacturing
Costs
 To Review

Management Accounting

Is a process involving identification, measurement , and accumulation of financial

information.

Its root purposes is to Plan, Evaluate and Control.

Cost Allocation plays an important role in these aspects.

MBA 209 5
 Types of Cost
Manufacturing Overheads

Nonmanufacturing overheads or SERVICE DEPARTMENT EXPENSES

Economic Value or Full Cost of the Product

MBA 209 6
 Economic Value Used for
Or Income Statement
Full Cost of the Product And
Asset Valuations Purposes

MBA 209 7
 Typical Service Department
Expenses
• Salaries and fringe benefits of selling, general and admin personnel.
• Rent, property taxes, utilities for the space used by nonmanufacturing functions of the
company.
• Insurance for areas outside the factory,
• Interest on business loans.
• Marketing and advertising.
• Depreciation and maintenance of equipment and buildings outside of manufacturing,
• Supplies for the offices.
• Financial Reporting vs. Individual Products and Customers.

MBA 209 8
 Reasons for Allocating
NonManufacturing Cost
1 2 3

Helps managers make Stimulates management Help achieve more

better decisions when and workers’ motivation efficient and effective use
planning including of resources or even
assessment of risk and reduction of costs.
potential consequences.

MBA 209 9
“
The cost-benefit evaluation plays an
important role in providing checks and
balances to ensure that allocations are
justification and cost efficiency
conducted. ”

10
 Factors to Consider Which
Allocation Method to Use
1. Cause and effect
2. Benefits received
3. Ability to bear
4. Fairness or equity

MBA 209 11
 Service Department Charges
Operating Department Service Department

a. Production a. Cafeteria
b. Sales b. Internal Auditing
c. Marketing c. Human Resources
d. Engineering d. Cost Accounting
e. Purchasing

MBA 209
 Reasons including:
1. To encourage operating department resources to make wise use of service
department resources.

2. To provide operating departments with more complete cost data for making
decisions.

3. To help measure the profitability of operating departments.

4. To create an incentive for service departments to operate efficiently.

MBA 209 13
Learning Objective 2
Allocate Cost of Service Departments Using The Cost Behavior
Concept
 Charging cost by behaviour
If a cost is directly influenced by the determinants (cost
drivers), then it is perfect example of a cause-and-effect
relationship.

Therefore, whenever possible, variable and fixed service

department costs should be charged to operating departments
separately to provide more useful data for planning and control
of departmental operations.

MBA 209 15
 Variable Cost

A variable cost should be charged to consuming departments

according to whatever activity causes the incurrence of the cost.

Whenever possible, costs vary in total in proportion to changes

in the level of service provided.

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 Fixed Cost
The fixed costs of service departments represent the costs of making capacity
available for use. These costs should be charged to consuming departments in
predetermined lump-sum amounts that are determined in advance and do not
change.

The lump-sum amount charged to a department can be based either on the

department’s peak-period or long-run average servicing needs.

MBA 209 17
Should Actual or
Budgeted fixed
costs be charged?
18
 The budgeted fixed costs, rather than actual costs of a service department
should be charged to operating departments.
This ensures that service departments remain solely responsible for explaining
any differences between their actual and budgeted costs.
If service departments could base their charges on actual costs, then operating
departments would be unfairly held accountable for cost overruns in the
service departments.

MBA 209 19
 Guidelines for Service Department
Charges
1. Variable and fixed service department costs should be charged separately.

2. Variable service department costs should be charged using a predetermined rate applied to the
actual services consumed.

3. Fixed costs represent the costs of having service capacity available. These cost should be
charged in lump sums to each operating department in proportion to their peak-period needs or
long-run average needs. The lump-sum amounts should be based on budgeted fixed costs, not
actual fixed costs.

MBA 209 20
 Seaboard Airline
OPERATING SERVICE DEPARTMENT
DEPARTMENTS

 Freight Division  Maintenance Department

 Passenger Division

MBA 209 21
 Example
Seaboard Airlines
Variable servicing costs of Maintenance Department are budgeted at $10 per flight-hour. The department’s
fixed costs are budgeted at $750,000 for the year. The fixed costs of the Maintenance Department are budgeted based
on the peak-period demand, which occurs during the Thanksgiving to New Year's holiday period. The airline wants
to make sure that none of its aircraft are grounded during this key period due to unavailability of maintenance
facilities.
Approximately 40% of the maintenance during this period is performed on the Freight Division's equipment,
and 60% is performed on the Passenger Division's equipment.

These figures and the budgeted flight hours for the coming year are as follows:

MBA 209 22
 These figures and the budgeted flight hours for
the coming year are as follows:
Percent of Peak-Period Budgeted Flight Hours
Capacity Required

Freight Division 40% 9,000

Passenger Division 60% 15,000

Total 100% 24,000

MBA 209 23
 � Year-end records show that actual variable and fixed costs in the aircraft Maintenance
Department for the year were $260,000 and $780,000, respectively. One division logged more
flight-hours during the year than planned, and the other division logged fewer fight hours than
planned, as shown below:

Flight-Hours

Budgeted (see previous) Actual

Freight Division 9,000 8,000

Passenger Division 15,000 17,000

Total flight-hours 24,000 25,000

MBA 209 24
 � The amount of Maintenance Department cost charged to each division for the year would be as
follows:

MBA 209 25
 Things to
Note
 Variable servicing costs are charged to the operating divisions based on the budgeted rate ($10
per hour) and the actual activity for the year.

 The charges for fixed costs are based entirely on budgeted data.

 The two operating divisions are not charged for the actual costs of the service department, which
are influenced by how welI the service department is managed. Instead, the service department
is held responsible for the actual costs not charged to other departments as shown on the next
slide.

MBA 209 26
MBA 209 27
 Pitfalls in Allocating Fixed
Costs
Rather than charge fixed costs to operating departments in predetermined lump-sum
amounts, some companies allocate them using a variable allocation base that fluctuates
from period to period. This practice can distort decisions and create serious inequities
between departments. The inequities arise from the fact that the fixed costs allocated to
one department are heavily influenced by what happens in other departments.

MBA 209 28
 � For example, let us assume that a large men's clothing store has one service department and
three sales departments-Suits, Shoes, and Accessories. The service department’s costs total $60,000
per period and are allocated to the three sales departments according to sales dollars. A recent period
showed the following allocation:

MBA 209 29
� In the following period, let us assume the manager of the Suits Department launched a successful program
to expand sales in his department by $100,000. Furthermore, let us assume that sales in the other two departments
remained unchanged, total service department costs remained unchanged, and the sales departments' expected
usage of service department resources remained unchanged. Given these assumptions, the service department cost
allocations to the sales departments would change as shown below:

MBA 209 30
 � The separation of variable and fixed charges discussed (also known as the dual rate
� method) can prevent the treatment of fixed costs as variable, a common problem in cost
� allocation. They can be summarized as follows:

MBA 209 31
Learning Objective 3
Allocate Cost of Service Departments Using
The Direct Method
 Cost of Service
Department
It is allocated to the operating
department because they exist to
support the operating departments.

Example of service departments are

maintenance, administration, cafeteria,
personnel, cleaning or utility.

MBA 209 33
 Service department aid multiple operating departments and
other service departments at the same time.

This is also called as interdepartmental or reciprocal

services.

The goal is to allocate all service department costs to the

operating departments so that the costs of conducting
business are clearly and accurately reflected.

MBA 209 34
 Direct Method

 It is the simplest method.

 Allocates each of service department cost to each operating
department based on each department’s share of the
allocation base.
 Services used by other service department are ignored.
 Some believe it is less accurate because it ignores
interdepartmental services.

MBA 209 35
 Accountants allocate service department costs using
some type of base.

Example of bases used to allocate costs are:

 Number of employees
 Machine hours
 Direct labor-hours
 Square footage
 Electricity usage

MBA 209 36
 Mountain View Hospital
SERVICE DEPARTMENT OPERATING DEPARTMENT

1. Hospital Administration 1. Laboratory

2. Custodial Services 2. Patient Care

MBA 209 37
 Allocation Base of Service Dep’t
Cost

Hospital Employee Hours

Administration

Custodial Square Foot Occupied

Services

MBA 209 38
 Before Cost Allocation
Service Operating
 
Departments Departments

Hospital Custodial Patient

Laboratory Total
Administration Services Care

Departmental costs
before allocation $ 360,000.00 $ 90,000.00 $ 261,000.00 $ 68,000.00 $ 1,400,000.00

Employee hours 12,000 6,000 18,000 30,000 66,000

Space occupied square

feet 10,000 200 5,000 45,000 60,200

MBA 209 39
 Things to Note
 Under DIRECT METHOD, any of the allocation base to
the service departments themselves is ignored.

 Only the amount of the allocation base attributable to

the operating departments is used in the allocation.

MBA 209 40
 During Cost Allocation
Service Operating
 
Departments Departments

Hospital Custodial Patient

Laboratory Total
Administration Services Care

Departmental costs
before allocation $ 360,000.00 $ 90,000.00 $ 261,000.00 $ 68,000.00 $ 1,400,000.00

Employee hours 18,000 30,000 48,000

Space occupied square feet 5,000 45,000 50,000

MBA 209 41
 Direct Method Allocation
All Service Department Cost

Operating Department

MBA 209 42
 Direct Method Allocation
All Service Department Cost

Hospital Administration Custodial Services

Operating Department

Laboratory Patient Care

MBA 209 43
 Direct Method Allocation
All Service Department Cost
Hospital Administration
$360, 000.00

Laboratory Patient Care

$360, 000.00 $360, 000.00

Employee Hours (18/48) (30/48)

$135, 000.00 $225, 000.00

MBA 209 44
 Direct Method Allocation
All Service Department Cost
Custodial Services
$90, 000.00

Laboratory Patient Care

$90, 000.00 $90, 000.00

Space occupied (5/50) (45/50)

square feet

$9, 000.00 $81, 000.00

MBA 209 45
 Total Cost After Allocation
Service Operating
Departments Departments
  Total
Hospital Custodial Patient
Laboratory
Adminstration Services Care

Departmental costs
before allocation 360,000.00 90,000.00 261,000.00 68,000.00 1,400,000.00

After Allocation

Hospital
Administration (360, 000)   (18/48) 135,000 (30/48) 225,000  

Custodial
Services   (90, 000) (5/50) 9,000 (45/50) 81,000  

Total Cost After $ - $

Allocation
$ - $ 405,000.00 $ 995,000.00
1,400,000.00

MBA 209 46
 Final Note
 After all allocations have been completed, all service
department costs are contained in the two operating
departments.

MBA 209 47
Learning Objective 4
Allocate Cost of Service Departments Using
The Step-down Method
 Step-Down Method
 Also known as sequential method.
 Allocates service department costs to both operating department
and other service departments sequentially
 Allocates in one direction only
 Does not allocate back to it from other service departments
 More accurate than direct method

MBA 209 49
 Step-Down Method
 Begins with the service department that incurs the most
costs to other service departments

 Works downward, process continues, step-by-step, ending

with the department with the least costs.

MBA 209 50
 Step-Down Method
Hospital Administration

Costs are allocated to other

departments on the basis of
employee-hours.

Custodial Services

Costs are allocated to

operating departments
on the basis of square
feet occupied.
Laboratory
Patient Care

MBA 209 51
 Before Cost Allocation
Service Operating
 
Departments Departments

Hospital Custodial Patient

Laboratory Total
Administration Services Care

Departmental costs
before allocation $ 360,000.00 $ 90,000.00 $ 261,000.00 $ 68,000.00 $ 1,400,000.00

Employee hours 6,000 18,000 30,000 54,000

Space occupied square

feet 5,000 45,000 50,000

MBA 209 52
 Step-Down of Allocation
Service Operating
Departments Departments
  Total
Hospital Custodial Patient
  Laboratory
Adminstration Services Care

Departmental costs
360,000.00   90,000.00 261,000.00 68,000.00 1,400,000.00
before allocation

After Allocation

Hospital
(360, 000) (6/54) 40,000 (18/54) 120,000 (30/54) 200,000  
Administration

Custodial
    (130, 000) (5/50) 13,000 (45/50) 117,000  
Services

Total Cost After Allocation $ -   $ - $ 394,000.00 $ 1,006,000.00 $ 1,400,000.00

MBA 209 53
 3 Key Points to Note
 There are 2 allocations or steps

 1st step, cost of Hospital Admin are allocated to another service

department then to operating dep’t

 Allocation base of employee hours now include those from

Custodial Services

MBA 209 54
 3 Key Points to Note
 2nd step, cost of Custodial Services are allocated to two operating
department

 None are allocated to Hospital Administration

 In step-down method, any amount allocation base that is

attributable to a service department whose cost has already been
allocated is ignored.
MBA 209 55
 3 Key Points to Note
 The cost of Custodial Services are allocated to other department in
the 2nd step ($130, 000) includes the costs of Hospital
Administration that were allocated to Custodial Services in the first
step.

MBA 209 56
Summary

57
 Allocating of nonmanufacturing overheads to final products and services helps provide the full
cost of the products and services.

Many methods can be used for cost allocations and they are in general following one of the
principles of:
• cause-effect
• Benefit received
• Ability to bear
• Fairness/equity after cost-benefit evaluation on the coice

Costs could be allocated according to cost behavior:

• Fixed
• Variable

Common costs can be allocated using

• Direct
• Step-down
• Reciprocal
MBA 209
58
MBA 209
59
 Thanks!
Any questions?

60
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