101 10.3 The Step-Down Method

The Step-Down Method:

The step-down method is also called the sequential method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it. The choice of which department to start with is important. The sequence in which the service departments are allocated usually effects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence. The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other:

Percentage of services provided by the service department listed under Service Dept

The amounts in the far left column are the costs incurred by each service department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department are charged out.

The company decides to allocate the costs of Human Resources first, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. However, a case could be made to allocate Data Processing first, because it has greater total costs than either of the other two service departments. In any case, the company decides to allocate Data Processing second.

In the table below, the row for each service department allocates the total costs in that department (the original costs incurred by the department plus any costs allocated to it from the previous allocation of other service departments) to the production departments as well as to any service departments that have not yet been allocated.

Percentage of services provided by the service department listed under Service Dept

Allocation of HR costs.

H.R. was allocated 20% to D.P., 10% to R.M., 40% to Machining and 30% to Assembly.

Since the Step-Down Method only allocates service department costs to departments on its right, the allocation basis for D.P has to be adjusted to base 92%, since 8% of its services are consumed by H.R. (a service department on D.P.’s left). The percentages used have to be normalized on the remaining 92% (100%-8%) as follows:

Allocation of D.P service costs

Risk Management         7% / 92%  =    7.6087%                          7.6087% x $136,000    = $ 10,348

Machining                   30% / 92%  = 32.6087%                          32.6087% x $136,000  = $44,348

Assembly                     55% / 92%  = 59.7826%                          59.7826% x $136,000   = $81,304

100.00%

Explanation of the above: The adjusted percentages are applied to D.P.’s own cost ($120,000) plus its share of H.R. costs ($16,0000), or $136,000.

Allocation of R.M costs

R.M. service department costs now contain R.M.’s share of H.R. and D.P. costs, and the this new total must be allocated to the Machining and Assembly departments, Similarly, R.M. service department costs. Each department gets 50% of these costs.

The characteristic feature of the step-down method is that once the costs of a service department have been allocated, no costs are allocated back to that service department. As can be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations.