Service Department Costing:

Difference between service department and operating department:

Most of the large organizations have both operating departments and service departments. The central purpose of the organization are carried out in the operating department. In contrast, service departments do not directly engage in operating activities. Instead, they provide services or assistance to the operating departments. Examples of operating departments include the surgery departments at hospitals, geography departments at universities, the marketing departments insurance companies, and production departments at manufacturing companies like Mitsubishi, Hewlett-Packard. Examples of service departments include Cafeteria, Internal Auditing, Human Resources, Cost Accounting, and Purchasing.

The costs incurred by service departments are usually allocated to the operating departments, and from the operating departments to the products and services. Many service departments also provide services to other service departments within organization. The cafeteria department, for example, provides food for all employees, including those assigned to other service departments. In return cafeteria department may receive services from other service departments such as from custodial services or personnel. Services provided between service departments are known as interdepartmental services or reciprocal services.

Several different methods are used to allocate costs of service departments to operating departments. Regardless of the allocation method that is ultimately selected, an allocation base must be selected for each service department.

Selecting Allocation Base:
Costs are ordinarily assigned to products and services by using a two stage process. In first stage, service department and other costs are allocated to operating departments. In second stage, the costs that have been assigned to operating departments are allocated to products and services. Here we will focus on the first stage, in which service department costs are allocated to operating departments.

In the first stage, service department costs are allocated to operating departments by using a unique allocation base for each service department. The allocation base that is used to allocate a particular service department's costs should "drive" those costs. For example, the number of meals served would commonly be used as the allocation base for cafeteria costs because the costs incurred in the cafeteria are driven to a large extent by the number of meals served. Ideally the total cost incurred in the service department should be directly proportional to the allocation base. If the allocation base increases or decreases by 10%, the service department cost should increase or decrease by 10% as well. Managers also often argue that an allocation base should reflect as accurately as possible the benefits that the various departments receive from the service department.

For example the most managers would argue that square feet building space occupied by each department should be used as the allocation base for janitorial services because both the benefits and costs of janitorial services tend to be proportional to the amount of space occupied by a department. A given service department's cost may be allocated using more than allocation base (see examples below). For example, data processing costs may be allocated on the basis of CPU minutes for mainframe computers and on the basis of number of personal computers used in each operating department.

In addition to explanation of how to select an allocation base, another critical factor should not be overlooked. The allocation base should be clear and straightforward and easily understood by the managers to whom the costs are being allocated.

Direct Method of Cost Allocation-Service Department Costing:

Definition:
Direct method is a cost allocation method under which any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation.

Explanation:
The direct method is the simplest of the three cost allocation methods. It ignores reciprocal or interdepartmental services (services provided by a service department to another service department) and allocates all costs of service departments directly to operating departments. Even if a service department (such as personnel department) provides a large amount of service to another service department (such as the cafeteria department), no allocations are made between the two departments. Rather all costs are are directly allocated to the operating departments, bypassing the other service departments. Hence the term direct method.

Example:
To provide an example of the direct method, consider Mountain View Hospital, which has two service departments and two operating departments as shown below:
Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Employee hours
Space occupied square feet $360,000
12,000
10,000 $90,000
6,000
200 $261,000
18,000
5000 $689,000
30,000
45,000 $1,400,000
66,000
60,200

Hospital administration costs will be allocated on the basis of employee-hours and Custodial Services costs will be allocated on the basis of square feet occupied.
The direct method of allocating the hospital's service department costs to the operating departments is shown below:Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Allocation:

Hospital administration costs (18/48, 30/48)*

Custodial service department costs (5/50, 45/50)**

Total costs allocation
$360,000


(360,000)



-----------
$0
======
$90,000





(90,000)
----------
$0
=====
$261,000


135,000


9,000
-----------
$405,000
======
$689,000


225,000


81,000
----------
$995,000
=======
$1,400,000







1,400,000
=======



*Based on the employee-hours in the two operating departments, which are 18,000 hours + 30,000 hours = 48,000 hours
**Based on the space occupied by the two operating departments, which is 5,000 square feet + 45,000 square feet = 50,000 square feet

Several things should be carefully noted in this example. First, even though both the hospital administration department and custodial services department have recorded employee-hours. These employee hors are ignored when allocating service department costs using direct method. Under the direct method, any of the allocation base attributable to the service departments themselves is ignored; only the amount of the allocation base attributable to the operating departments is used in the allocation. Note that the same rules used when allocating the costs of the custodial services department. Even though the Hospital Administration and Custodial Service departments occupy some space, this is ignored when the custodial services costs are allocated. Finally, note that after all allocations have been completed, all of the departmental costs are contained in the two operating departments. These costs will be used to prepare overhead rates for purpose of costing products and services produced in the operating departments.

Advantages and Disadvantages of Direct Method:
Although the direct method is simple , it is less accurate than the other methods since it ignored interdepartmental services. This can lead to distorted product and service costs. Even so, many organizations use the direct method because of its simplicity.

Step Method of Cost Allocation:
Definition:
Step method is the method of allocating service department's costs to other service departments, as well as to operating departments, in a sequential manner. The sequence typically starts with the service department that provides the greatest amount of service to other departments.

Explanation:
Unlike the direct method, the step method provides for allocation of a service department's costs to other service departments, as well as to operating departments. The step method is sequential. The sequence typically begins with to department that provides the greatest amount of service to other service departments. After its costs have been allocated, the process continues, step by step, ending with the department that provides the least amount of services to other service departments.

Example:
To provide an example of the step method, consider Mountain View Hospital, which has two service departments and two operating departments as shown below:
Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Employee hours
Space occupied square feet $360,000
12,000
10,000 $90,000
6,000
200 $261,000
18,000
5000 $689,000
30,000
45,000 $1,400,000
66,000
60,200

Hospital administration costs will be allocated on the basis of employee-hours and Custodial Services costs will be allocated on the basis of square feet occupied.
The step method of allocating the hospital's service department costs to the operating departments is shown below:
Description
Service Department
Operating Department
Total

Hospital Administration Custodial Services Laboratory Daily Patient Care
Departmental costs before allocation
Allocation:

Hospital administration costs (6/54, 18/54, 30/54)*

Custodial service department costs (5/50, 45/50)**

Total costs allocation
$360,000



(360,000)



-----------
$0
======
$90,000



40,000


(130,000)
----------
$0
=====
$261,000



120,000


13,000
-----------
$394,000
======
$689,000



200,000


117,000
----------
$1,006,000
=======
$1,400,000








1,400,000
=======



*Based on the employee-hours in custodial services the two operating departments, which are 6,000 hours + 18,000 hours + 30,00 hours = 54,000 hours
**Based on the space occupied by the two operating departments, which is 5,000 square feet + 45,000 square feet = 50,000 square feet

Example shows the treatment of step method of cost allocation. Note the following three key points about these allocations.

First, under the allocation heading in the solution you see two allocations, or steps. In the first step, the costs of hospital administration are allocated to another service department (Custodial Services) as well as to the operating departments. In contrast to the direct method, the allocation base for Hospital Administration costs now includes the employee hours for custodial services as well as for the operating departments. However, the allocation base still excludes the employee-hours for Hospital Administration itself. 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.
Second, looking again on the example, note that in the second step under the allocation heading, the cost of custodial services is allocated to the two operating departments, and non of the cost is allocated to Hospital Administration even though Hospital Administration occupies space in the building. In the step method, any amount of the allocation base that is attributable to a service department whose cost has already been allocated is ignored. After a service department's cost have been allocated, costs of other service departments are not reallocated back to it.
Third, not that the cost of Custodial Services allocated to other departments in the second step ($130,000) in example, includes the costs of Hospital Administration that were allocated to Custodial Services in the first step.

Reciprocal Method of Cost Allocation-Service Department Costing:
Definition:
Reciprocal method is a method of allocating service department costs to other departments that gives full recognition to interdepartmental services.

Explanation:
The reciprocal method gives full recognition to interdepartmental services. Under the step method, only partial recognition of interdepartmental services is possible. The step method always allocates costs forward never backward. The reciprocal method, by contrast, allocates service department costs in both directions. The reciprocal allocation requires the use of simultaneous equations. This method is also known as algebraic method and simultaneous equations method.

Under this method the true cost of the service departments are computed first with the help of simultaneous equations and these are then distributed to producing departments on the basis of given percentage or ratio. Remember that true cost of the service department means the cost of the service department which includes original cost of the department plus the share of the other service department. The main advantage of this method is to have an accurate distribution in a single step in the distribution summary.

Example:
A company has two service and two producing departments. The two service departments serve not only to producing departments but also to each other. The departmental estimates for the next year are as follows.

Producing departments:
A
B
Service departments:
X
Y

50,000
40,000

10,000
8,800


The service departments costs are to be distributed as under:
Cost of X : 50% to A, 40% to B, and 10% to Y
Cost of Y : 40% to A, 40% to B, and 20% to X


Required:
Transfer the service departments costs to each other and to producing departments.


Solution:
Now we solve the given illustration first using the simultaneous equation method as follows:

Original costs of service departments:

X = Rs.10,000
Y = Rs. 8,800

After getting the share from distribution of service departments:

X = Rs. 10,000 + 20% Y
Y = Rs. 8,800 + 10% X

By putting the value of Y in equation (1)

X = Rs. 10,000 + 20%(Rs.8,800 + 10%X)
X = Rs. 10,000 + 1760 + 0.2X
X – 0.02X = Rs. 10,000 + Rs.1,760
0.98X = Rs. 11,760
X = 11760 / 0.98
= Rs. 12,000

By putting the value of X in equation (2)

Y = Rs. 8,800 + 10%(Rs. 12000)
Y = Rs. 8,800 + Rs. Rs. 1,200
= Rs. 10,000


Distribution Summary

Department
Producing Service

Original costs
Distribution of service department costs:
X
Y

Total departmental overheads
A
Rs
50,000
6,000
4,000
-------
60,000
=====
B
Rs
40,000
4,800
4,000
------
48,800
=====
X
Rs
10,000
(12,000)
2,000
-------
Nil
=====
Y
Rs
8,800
1,200
(10,000)
-------
Nil
=====


Use of Reciprocal Method:
This method is rarely used in practice for two reasons. First, the computations are relatively complex. Although the complexity issue could be overcome by use of computers, there is no evidence that computers have made the reciprocal method more popular. Second, the step method usually provides results that are a reasonable approximation of the results that the reciprocal method would provide. Thus, companies have little motivation to use the more complex reciprocal method.