99 10.1 Introduction

Chapter Contents:

– Introduction
– The Direct Method
– The Step-Down Method
– The Reciprocal Method
– Summary of service department cost allocation methods
– Dysfunctional incentives from service department cost allocations
– Exercises and problems

Introduction:

Many companies in all sectors of the economy, and not-for-profit and governmental organizations as well, allocate service department costs to “production” or user departments, and ultimately to the products and services that they provide. For example, hospitals use sophisticated methods for allocating costs of service departments such as Housekeeping, Patient Admissions, and Medical Records to patient wards and outpatient services, and then to individual patients. Historically, these allocations were important to hospitals because Medicare reimbursement was based on actual costs. To the extent that the hospital allocated service department costs to Medicare patients, Medicare covered these costs.

Companies that allocate service department costs do so for one or more of the following reasons:

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.

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.

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.

The motivation for the first reason, to provide more accurate product cost information, can be to improve decision-making within the organization, to improve the quality of external financial reporting, or to comply with contractual agreements in regulatory settings where cost-based pricing is used. As discussed above, Medicare was historically a cost-based reimbursement scheme. As another example, defense contractors that provide the U.S. military “big ticket” items such as airplanes and ships often operate under cost-plus contracts, under which they are reimbursed for their production costs plus a guaranteed profit. In such settings, the calculation of cost includes a reasonable allocation of overhead, including overhead from service departments.

The distinction between the second and third reasons is important in the context of fixed versus variable costs. In connection with the second reason, to improve decisions about resource utilization, from the company’s perspective, a division manager making a short term decision about whether to utilize service department resources should incorporate into that decision the service department’s marginal costs, which are usually the variable costs. The manager should ignore the service department’s fixed costs if these costs will not be affected by the manager’s decision. This reasoning suggests that only the service
department’s variable costs should be charged out.

However, in connection with the third reason, 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 fee need not relate to the cost of obtaining the asset; rather, it is a mechanism for managing demand. Examples would be charging departments a “rental fee” for their use of vehicles from the motor pool, or for their use of a corporate conference facility.

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure that all service department costs are allocated. Budgeted rates provide service department managers incentives to control costs, and also provide user departments more accurate information about service department billing rates for planning purposes. In either case, service department costs should be allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible. Here are some examples:

– Allocate building maintenance costs based on square footage;
– Allocate costs of the company airplane based on miles flown;
– Allocate costs of the data processing department based on CPU time.

In some cases, companies benefit from allocating fixed costs using a different allocation base than variable costs. For example, fixed costs might be allocated based on an estimate of long-term usage by the production departments.

Historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they recognize that service departments provide services to other service departments as well as to production departments. All three methods ultimately allocate all service department costs to production departments; no costs remain in the service departments under any of the three methods.