1. Service Department Cost Allocations
Appendix 4B

2. Operating Departments
An operating department carries out the central purpose of the organization. Examples of operating departments include:
The Geography Department at the University of Washington.
The Surgery Department at Mount Sinai Hospital.
The Production Departments at Mitsubishi.

3. Service Departments The Accounting Department at Macy’s.
Service departments do not directly engage in operating activities. They provide services or assistance to the operating departments. Examples of service departments include:
The Accounting Department at Macy’s.
The Human Resources Department at Walgreens.
The Cafeteria at Genesco.
The Internal Audit Department at Exxon.

4. Interdepartmental Services
Service Department
Operating Department
Allocating service department costs to operating departments to enable calculating various types of unit costs.

5. Allocation Approaches
Two approaches for the allocation of service department costs to other departments are illustrated in this appendix—the direct method and the step-down method.
Step-Down Method 
Direct Method 

6. Reciprocal Services Service Department 1 Service Department 2
When service departments provide services to each other we call them reciprocal services.

7. Learning Objective 10
Allocate service department costs to operating departments using the direct method.

8. Direct Method Service Department (Cafeteria) Operating Department
(Machining)
Interactions between service
departments are ignored and all
costs are allocated directly to operating departments.
Service Department
(Custodial)
Operating Department
(Assembly)

9. Direct Method – An Example – Part 1

10. Direct Method – An Example – Part 2
How much of the Cafeteria and Custodial costs should be allocated to each operating department using the direct method of cost allocation?

11. Direct Method – An Example – Part 3
$360,000 × 20
= $144,000
Allocation base: Number of employees

12. Direct Method – An Example – Part 4
$360,000 × 30
= $216,000
Allocation base: Number of employees

13. Direct Method – An Example – Part 5
$90,000 ×
25,000
25, ,000
= $30,000
Allocation base: Square feet occupied

14. Direct Method – An Example – Part 6
50,000
25, ,000
$90,000 ×
= $60,000
Allocation base: Square feet occupied

15. Learning Objective 11
Allocate service department costs to operating departments using the step-down method.

16. Step-Down Method Service Department (Cafeteria) Operating Department
(Machining)
Once a service department’s costs are allocated, other service department costs are not allocated back to it.
Service Department
(Custodial)
Operating Department
(Assembly)
The allocation process is sequential and the sequence usually begins with the department that provides the greatest amount of service to other service departments.

17. Step-Down Method – Key Points
There are three key points to understand regarding the step- down method:
In both the direct and step-down methods, any amount of the allocation base attributable to the service department whose cost is being allocated is always ignored.
Any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored.
Each service department assigns its own costs to operating departments plus the costs that have been allocated to it from other service departments.

18. Step-Down Method Example – Part 1
Recall the data used in the direct method example.

19. Step-Down Method Example – Part 2
Allocate Cafeteria costs first since it provides more service than Custodial.

20. Step-Down Method Example – Part 3
$360,000 × 10
= $60,000
Allocation base: Number of employees

21. Step-Down Method Example – Part 4
$360,000 × 20
= $120,000
Allocation base: Number of employees

22. Step-Down Method Example – Part 5
$360,000 × 30
= $180,000
Allocation base: Number of employees

23. Step-Down Method Example – Part 6
New total = $90,000 original Custodial cost plus $60,000 allocated from the Cafeteria.

24. Step-Down Method Example – Part 7
$150,000 ×
25,000
25, ,000
= $50,000
Allocation base: Square feet occupied

25. Step-Down Method Example – Part 8
$150,000 ×
50,000
25, ,000
= $100,000
Allocation base: Square feet occupied

26. Reciprocal Method: A Definition
The reciprocal method gives full recognition to interdepartmental services. While the step-down method only allocates costs forward – never backwards – the reciprocal method allocates costs in both directions. Reciprocal allocation requires the use of simultaneous linear equations and is beyond the scope our book.

27. Quick Check Data for Direct and Step-Down Methods
The direct method of allocation is used.
Allocation bases:
Business school administration costs (ADMIN): Number of employees
Business Administration computer services (BACS): Number of personal computers

28. Quick Check 1
How much cost will be allocated from Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000

29. Quick Check 1a
How much cost will be allocated from Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
$180,000 × 20
= $36,000

30. Quick Check 2
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500

31. Quick Check 2a
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?
a. $ 52,500
b. $135,000
c. $270,000
d. $ 49,500
$90,000 × 18
= $13,500

32. Quick Check Data The step-down method of allocation is used.
Allocation bases:
Business school administration costs (ADMIN): Number of employees
Business Administration computer services (BACS): Number of personal computers

33. Quick Check 3
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333

34. Quick Check 3a
How much total cost will be allocated from ADMIN and BACS combined to the Accounting Department?
a. $35,250
b. $49,072
c. $18,000
d. $26,333

35. End of Chapter 4B