This allocation method doesn’t allow costs to be allocated between multiple support departments. For example, what if legal also provides services to the HR department? When you rank the support departments and allocate out the costs, you can’t allocate costs back in. When cost accounting, the step-down allocation method allows support departments to allocate path act tax related provisions costs to each other — and ultimately to the operating departments. The ranking is often based on the percentage of costs that a support department incurs to support other support departments. The right financial reporting software gives you instant visibility into your costs allowing you to put an accurate and efficient cost allocation plan in place.
Reciprocal Method
Then the equations representing theproducing departments are solved to provide the desired allocations. The step-down method is more accurate than the direct method, but less accurate thanthe reciprocal method. In conclusion, selecting the appropriate cost allocation method—whether direct, step-down, or reciprocal—depends on your business’s specific needs and complexity. The step-down cost allocation method effectively distributes general expenses accurately across profit centers and products.
Cost allocation methods
Instead of working with rough estimates, teams can optimize their operations based on actual costs. Better resource management, more strategic planning, and ultimately, stronger business performance. Put simply, cost allocation is the process of identifying and assigning costs to departments, projects, products or branches in your company. Just like dividing up a shared bill in a restaurant, cost allocation is the process of identifying the costs (and shared expenses) of an organization and assigning them to different parts of the whole. Discuss the advantages and disadvantages of the NRV less an average gross profit method of allocating joint costs.
5: Allocation of Service Department Costs
Discuss the different conceptual bases for allocating costs to cost objects.3. Describe three general methods of assigning costs to products including one stage and two stage approaches.4. Discuss the circumstances under which each of the methods referred to in learning objective 3 will provide accurate product costs.5. Describe the direct, step-down and reciprocal methods of allocating service department costs to producing departments.6. Solve stage I cost allocation problems using the three methods referred to in the previous learning objective.7.
- Instead of waiting for month-end financial reports, you can monitor specific costs as they happen, spot trends and anomalies instantly, model different scenarios before making changes, and generate stakeholder reports on demand.
- The total producing department costs, after all allocations, is equal to the total direct costs budgeted, i.e., $500,000 (Seethe note at the bottom of Exhibit 6-4).
- Also, this method makes sure that different departments are charged for using the services of other departments, and it more closely reflects the real nature of the company.
- Different allocation bases may yield different cost distributions, leading to potential bias.
Types of Costs
Equations forthe service departments [1] are developed to allocate the service department costs in sequence starting with the department that serves the greatest numberof other service departments. An alternative approach is to start with the service department that provides the highest percentage of its’ service toother service departments. In determining the sequence of allocations, ties can be broken by using the alternative approach.
Unfortunately, this method is also criticized because it tends to recognize income before the time of sale.Resolving this conflict leads back to the previous method, i.e., go one step further and subtract an average profit margin. Of course, this leads back to thecontroversy discussed above. From the performance evaluation and behavioral perspectives, the amount of fixed service cost allocated to a user is more meaningful if it is not influenced by variations inthe short term consumption levels of other users. The dual rate method simply provides a way to implement this idea which reduces the inevitable behavioralconflicts created by the cost allocation process. Another advantage of the dual rate method is that spending variances for both fixed and variable costs can becalculated when the actual service costs differ from budgeted costs. A disadvantage of using the dual rate method is that idle capacity costs for theservice departments are allocated to the user departments.
The step-down method finds application in various industries, such as healthcare, manufacturing, and service sectors. For example, in a hospital setting, this method can allocate costs from support departments, such as maintenance and administration, to patient care departments like surgery and radiology. This method assumes that the sequence of allocations accurately reflects the actual flow of resources.
To simplify the illustration, we will use the direct method for service cost allocations and ignore maintenance costs. Budgeted power cost allocations based on the dual rateconcept are presented in Exhibit 6-10. Fixed costs are allocated in proportion to the original capacity available to the user departments. Variable costs areallocated using a rate of $100 per kilowatt hour. The Cutright Company has a small factory with two service departments and two producing departments. The service departments, Power and Maintenance provide support to the producingdepartments, Cutting and Assembly, to each other and also use some of their own services.
Producing more ofone product in the group means producing more of all products in the group. The key characteristic is that the products cannot be obtained separately. Forexample, the lumber products derived from a tree are joint products. The products obtained from a hog such as the chops, ham, and bacon are jointproducts. In fact, joint products are common in a variety of industries including petroleum, flour milling, meat packing, dairy, coal, copper, salt,chemicals, soap, gas, leather, and tobacco. The term “by-products” refers to a sub-category of joint products that have relatively insignificantsales values as a proportion of the value of the entire group from which they are derived.
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. From the management decision perspective, joint cost allocations are useless because they are not relevant in decisions concerning the separate products. For example, decisionsconcerning whether to continue or discontinue producing the joint products depend on their combined value, not the value of any particular product at thesplit-off point. Therefore, it has been argued that the joint costs should not be allocated at all. However, if the joint costs are not allocated, a valuestill needs to be placed on the unsold inventory for financial reporting purposes. To solve this dilemma some companies value the inventory at finalsales value, less after split-off cost, i.e., NRV.