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1. Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
11th Edition
Chapter 15

2. Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin
Service Department
Costing: An Activity
Approach
Chapter Fifteen

3. Copyright © 2006, The McGraw-Hill Companies, Inc.
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Reasons for Allocating Service
Department Costs
To encourage operating
departments to wisely
use service department
resources.
To provide operating
departments with more
complete cost data
for making decisions.
To help measure the
profitability of operating
departments.
To create incentive
for service departments
to operate efficiently.
To value inventory for
external financial
reporting purposes.
To include all overhead
in the cost base when
cost-plus pricing is used.

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$
Selecting Allocation Bases
Operating
Departments
Service
Departments
The allocation bases used should
“drive” the cost being allocated.
For example, when allocating costs
of the employee cafeteria, the number
of meals served would be a good
choice for the allocation base.

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Selecting Allocation Bases
Operating
Departments
Service
Departments
$
A service department’s costs may be
allocated using more than one base.
For example, a portion of the human resource department
costs might be allocated based on the number of employees
in each operating department and another portion might be
allocated based on hours spent in training employees in
each operating department.

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Examples of Allocation Bases
Service Department Allocation Bases
Laundry Pounds of laundry
Airport Ground Services Number of flights
Cafeteria Number of meals
Medical Facilities Cases handled; number of employees;
hours worked
Materials Handling Hours of service; volume handled
Information Technology Number of personal computers;
applications installed
Custodial Services Square footage occupied
Cost Accounting Labor hours; customers served
Power KWH used; capacity of machines
Human Resources Number of employees; training hours
Receiving, Shipping, and Stores Units handled; number of requisitions;
space occupied
Factory Administration Total labor hours
Maintenance Machine hours
Exh.
15-1

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Interdepartmental Services
Problem
Allocating costs when service departments
provide services to each other
Solutions
Direct Method
Step Method
Reciprocal Method

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

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Direct Method Example
Service Department Allocation Base
Cafeteria Number of employees
Custodial Square feet occupied

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Direct Method Example

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Direct Method Example
Allocation base: Number of employees
$360,000 ×
20
20 + 30
= $144,000

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Direct Method Example
Allocation base: Number of employees
$360,000 ×
30
20 + 30
= $216,000

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Direct Method Example
Allocation base: Square feet occupied
$90,000 ×
25,000
25,000 + 50,000
= $30,000

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Direct Method Example
Allocation base: Square feet occupied
50,000
25,000 + 50,000
$90,000 × = $60,000

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Operating
Department
(Machining)
Operating
Department
(Assembly)
Step Method
Once a service
department’s costs
are allocated,
other service
department costs
are not allocated
back to it.
Service
Department
(Cafeteria)
Service
Department
(Custodial)

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Step Method
There are three key points to understand
regarding the step method:
 In both the direct and step 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.

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Step Method Example
Service Department Allocation Base
Cafeteria Number of employees
Custodial Square feet occupied
We will use the same data used
in the direct method example.

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Step Method Example
Allocate Cafeteria costs first since
it provides more service than Custodial.

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Step Method Example
$360,000 ×
10
10 + 20 + 30
= $60,000
Allocation base: Number of employees

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Step Method Example
$360,000 ×
20
10 + 20 + 30
= $120,000
Allocation base: Number of employees

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Step Method Example
$360,000 ×
30
10 + 20 + 30
= $180,000
Allocation base: Number of employees

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Step Method Example
New total = $90,000 original Custodial cost
plus $60,000 allocated from the Cafeteria.

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Step Method Example
$150,000 ×
25,000
25,000 + 50,000
= $50,000
Allocation base: Square feet occupied

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Step Method Example
$150,000 ×
50,000
25,000 + 50,000
= $100,000
Allocation base: Square feet occupied

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Reciprocal Method
Interdepartmental
services are given
full recognition
rather than partial
recognition as with
the step method.
Service
Department
(Cafeteria)
Service
Department
(Custodial)
Operating
Department
(Machining)
Operating
Department
(Assembly)
Because of its mathematical complexity,
the reciprocal method is rarely used.

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Revenue Producing
Service Departments
If a service department
generates revenue, such as a
cafeteria that charges for the service it
provides, the revenue generated should
be offset against the costs incurred.
Only the remaining net amount
of costs should be allocated
to other departments.

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

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

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How much cost will be allocated from
Administration to Accounting?
a. $ 36,000
b. $144,000
c. $180,000
d. $ 27,000
Quick Check ✓
$180,000 ×
20
20 + 80
= $36,000

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Quick Check ✓
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

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Quick Check ✓
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
18 + 102
= $13,500

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

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Quick Check ✓
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

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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
Quick Check ✓

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Allocating Costs by Behavior
When possible,
variable and fixed
service department costs
should be allocated
separately.

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Variable service
department costs should be
allocated to consuming departments
according to the activity
causing incurrence
of the cost.
Allocating Costs by Behavior

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Allocate fixed service department costs to
consuming departments in predetermined
lump-sum amounts that are based on the
consuming departments’ peak or long-run
average needs. Fixed cost allocations:
Are based on amounts of
capacity each consuming
department requires.
Should not vary from
period to period.
Allocating Costs by Behavior

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Allocating Costs by Behavior
Budgeted variable
and fixed service department
costs should be allocated to
operating departments.

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Allocating Costs by Behavior
If variable cost allocations are made at the
beginning of the year, the budgeted variable
rate should be multiplied by the budgeted
activity level of each consuming department.
Allocations made
at the beginning of the
year provide data for
pricing and other
decisions.

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Allocating Costs by Behavior
If variable cost allocations are made at the
end of the year, the budgeted variable
rate should be multiplied by the actual
activity level of each consuming department.
Allocations made at
the end of the year provide
data for performance
evaluation.

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SimCo has a maintenance department and two operating
departments: cutting and assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixed
maintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:
Allocate maintenance costs to the two operating departments.
SimCo: An Example

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Hours planned
SimCo: Beginning of the Year

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Percent of peak-period capacity.
SimCo: Beginning of the Year
Hours planned

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Hours used
SimCo: End of the Year

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Percent of peak-period capacity.
SimCo: End of the Year
Hours used

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Fixed cost allocations are the same at the
end and at the beginning because they are
based on capacity instead of usage.
SimCo: Comparison of Results

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SimCo: Comparison of Results
Only budgeted variable and fixed service
department costs were allocated to the
two operating departments.
The cost of service department inefficiencies,
contained in the actual costs, should not
be passed along to operating departments.

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Quick Check:
Allocating Costs by Behavior
Foster City has an ambulance service that is used
by the two public hospitals in the city. Variable
ambulance costs are budgeted at $4.20 per mile.
Fixed ambulance costs are budgeted at $120,000
per year. Data relating to the current year are:
Percent of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500

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Quick Check ✓
How much ambulance service cost will be
allocated to Mercy Hospital at the beginning
of the year?
a. $117,000
b. $254,400
c. $114,480
d. $119,250

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How much ambulance service cost will be
allocated to Mercy Hospital at the beginning
of the year?
a. $117,000
b. $254,400
c. $114,480
d. $119,250
Quick Check ✓

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Quick Check ✓
How much ambulance service cost will be
allocated to Mercy Hospital at the end of the
year?
a. $114,000
b. $118,800
c. $110,400
d. $121,200

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How much ambulance service cost will be
allocated to Mercy Hospital at the end of the
year?
a. $114,000
b. $118,800
c. $110,400
d. $121,200
Quick Check ✓

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Effect of Allocations on
Operating Departments
Once service department cost
allocations are completed, they are
included in operating departments’:
Performance
evaluations
Profitability
determination
Overhead rate
computations

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First Stage Allocations
Service department costs are
allocated to operating departments.
Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
Operating
Department
(Machining)
Operating
Department
(Assembly)
The
Products
Effect of Allocations on
Operating Departments

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Service
Department
(Cafeteria)
Service
Department
(Accounting)
Service
Department
(Personnel)
Operating
Department
(Machining)
Operating
Department
(Assembly)
The
Products
Second Stage Allocations
Operating department overhead costs and
allocated service department costs are
applied to products.
Effect of Allocations on
Operating Departments

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Pitfall 1
Allocating fixed
costs using a variable
allocation base
Allocation Pitfalls to Avoid
Result
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.

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Kolby Products: An Example
Kolby Products has two sales territories,
the Eastern Territory and the Western Territory.
Both sales territories are serviced by one auto
service center whose costs are all fixed. Contrary
to good practice, Kolby allocates the fixed service
center costs to the sales territories on the basis
of actual miles driven (a variable base).

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Kolby Products: An Example
Year 1 Year 2
Auto service center costs (all fixed) 120,000
$ 120,000
$
Miles driven
Western sales territory 1,500,000 1,500,000
Eastern sales territory 1,500,000 900,000
Total miles driven 3,000,000 2,400,000
Allocation rate per mile 0.04
$ 0.05
$
$120,000 ÷ 3,000,000 miles
$120,000 ÷ 2,400,000 miles

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Kolby Products:
First–year Allocations
Western sales territory
1,500,000 miles @ $0.04 per mile 60,000
$
Eastern sales territory
1,500,000 miles @ $0.04 per mile 60,000
Total cost allocated 120,000
$
The two sales territories share the service
center’s costs equally because the miles
driven in each territory are equal.

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Kolby Products:
Second–year Allocation
Western sales territory
1,500,000 miles @ $0.05 per mile 75,000
$
Eastern sales territory
900,000 miles @ $0.05 per mile 45,000
Total cost allocated 120,000
$
Western territory has the same number of miles as
last year, but $15,000 more cost allocated
because Eastern’s miles declined in year 2.

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Pitfall 2
Using sales
dollars as an
allocation base
Allocation Pitfalls to Avoid
Result
Sales of one department
influence the service
department costs
allocated to other
departments.

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Clothier Inc. – An Example
Clothier Inc., a men’s clothing store has one
service department and three sales departments,
Suits, Shoes, and Accessories. Service department
costs total $60,000 for both years in the example.
Contrary to good practice, Clothier allocates the
service department costs based on sales.

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Clothier Inc. – First-year Allocation
Suits Shoes Accessories Total
Sales by department 260,000
$ 40,000
$ 100,000
$ 400,000
$
Percentage of total sales 65% 10% 25% 100%
Allocation of service
department costs 39,000
$ 6,000
$ 15,000
$ 60,000
$
Departments
$260,000 ÷ $400,000 65% of $60,000
In the next year, the manager of the Suit Department
increased sales by $100,000. Sales in the other departments
are unchanged. Let’s allocate the $60,000 service department
cost for the second year given the sales increase.

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Clothier Inc. – Second-year Allocation
Suits Shoes Accessories Total
Sales by department 360,000
$ 40,000
$ 100,000
$ 500,000
$
Percentage of total sales 72% 8% 20% 100%
Allocation of service
department costs 43,200
$ 4,800
$ 12,000
$ 60,000
$
Departments
$360,000 ÷ $500,000 72% of $60,000
If you were the suit department manager, would
you be happy with the increased service department
costs allocated to your department?

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End of Chapter 15