What Are the Three Methods of Cost Allocation? (Explain and Example)

Service departments incur expenditures passed on to the operating departments, as those services aid the operating departments. Management, administrations, cafes, laundry rooms, and processing are just a few of the service departments that exist. At the same moment, service departments help various manufacturing units, and accounting professionals must distribute and explain all the expenditures associated with this assistance. The service department expenditures must be assigned to the operational departments for production costs in the operating departments to be explicitly and correctly represented.

The multiple operational sections of a manufacturing plant are typically divided into two sorts of departments.  Production departments and service departments are examples of such groups. Manufacturing departments are responsible for converting materials or direct resources into final goods. The service departments of a company offer services and support to another department inside the facility.

Accounting professionals assign service department expenses based on a predetermined foundation. When the management of the firms decide which foundations to employ, they consider various factors such as the sorts of services offered, the advantages obtained, and the impartiality of the distribution system. The percentage of workers, machine hours, labor costs, space area, and power consumption are examples of grounds employed to apportion service department expenses.

Three methods can do the cost allocation from the service department in the manufacturing department.

  • Direct method
  • Step method
  • Reciprocal method

Direct Method

A firm generates various expenses that can be assigned to a specific “cost item” — such as a commodity, program, function, or service. These costs include anything from mop floors to functional equipment. You should, however, generate enough income to pay such corporation overhead expenditures. This means that revenue must surpass total costs. The direct allocation technique is one of numerous cost allocation strategies used to allocate indirect costs to activities. It is one of the most often used techniques.

The direct technique is the easiest in terms of cost allocation, even though it has several shortcomings.  Nevertheless, because of its simplicity of using it, it became one of the most widely applied cost allocation techniques in recent years. In a nutshell, it assumes that service departments do not give facilities or services to each other, and it merely distributes the service departments’ costs in the company’s manufacturing departments. 

The direct approach of transferring service department costs to the operational department is the simplest way of allocating costs between divisions. As a result of this technique, the expenses involved by service departments are not assigned to one another. Still, they are instead allotted straight to operational departments using a suitable rate of allocation. As a result, we may argue that the direct approach of cost allocation between different departments overlooks the services offered by the service departments to their employees and additional service departments.

The Way it Works

The direct approach assigns the expenses of all the support departments to every other manufacturing unit calculated based on the rates of each operational department rates. Services that other support departments receive are not considered in this method of cost allocation. With the help of this approach, it is possible to completely charge operational departments with the overhead expenditures for which they are accountable. Firms that use the direct method completely transfer excess costs from service departments to inventories, even though there may be cross-costs across service departments, because of the nature of the business.

For instance, the cleaning crew offers services to sanitize all business buildings. In contrast, the maintenance department oversees the firm’s machinery, and the information technology department oversees maintaining the organization’s computer networks. Assume that a service Department 1 utilizes a few of the facilities provided by Service Department 2. Such services will be excluded from consideration throughout the cost allocation procedure. Because such services are not assigned to certain other service divisions, many auditors think that the direct approach is not as precise as other methods.

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Pros and Cons of the Direct Method

The direct allocation technique is very straightforward to implement, but it is ideal for writing off all indirect expenses as department expenditures rather than distributing them to cost components. Although indirect allocation can produce more accurate results, it is more time-consuming than the direct allocation technique regarding the accounting effort involved. The direct method is intended to remind production management that services such as information technology and repair are not “free of cost” but are included in the cost of the goods and services provided.

There is, however, a disadvantage to using this approach. Direct allocation does not enable companies to shift expenditures from one support department to another support department and vice versa. Depending on the nature of your company, this is a possibility. Assume that there is an HR and maintenance department.  Allowing for the possibility that almost all the HR and maintenance department support expenditures are assigned to an operational unit through direct allocation. As a result, HR and maintenance department expenses are completely depleted. All the expenses have been assigned.

On the other hand, the human resources department assists the maintenance department throughout the same time frame.  It goes without saying that the maintenance department should bear a portion of the costs of human resources. However, the expenditures of the maintenance department have already been transferred in whole to another operating unit.

Assess where the additional expenses from human resources must be allocated and when they must be allocated. Before anything else, they must be assigned to the maintenance department and subsequently to an operating unit.  If the expenses do not eventually wind up being allocated to an operational department in any way, they are never associated with a particular product or service. The direct allocation might be a poor choice in this circumstance due to its high degree of ambiguity.

Step Method of Cost Allocation

The step technique of distributing service department expenses is the second way of allocating costs. As part of a sequential process, service expenses are allocated to operational departments and other service departments by using this approach. The following are the critical phases in the allocation process:

  1. Service departments that offer services to the greatest number of other service departments or that have the greatest proportion of their expenses used by the other service departments receive priority in allocating their expenses to certain other service departments. It also distributes the remainder of its expenses across the operational divisions.
  2. The service department that offers services to the second-highest number of other services departments or has the second-highest proportion of its expenses absorbed by other service departments, oversees allocating its expenses towards the other service departments. At this point, all the company’s other expenses have been assigned to the operational divisions.
  3. Till the service department offering services to the fewest amount of other service departments or having the lowest proportion of its expenses absorbed by the other service departments is assigned its expenses, the procedure is repeated. The procedure comes to an end when all the allotment has been accomplished.

The Way it Works

The percentage of a firm’s expenditures that other service departments absorb is used to evaluate the service departments within the organization. According to the study results, the finance department comes in top, next is the legal department, and finally the HR department.  The finance department has been given a $70,000, of which $40,000 will go to the legal department, and $30,000 would be allocated to the HR department. Afterward, the legal department is responsible for adding the $40,000 in allocations from the finance department to its expenses to be compliant. The human resource department receives a $7,000 allocation from legal (its other costs are allocated to operating departments). Next is the human resource department, which must apply the $7,000 allotment from the legal department to its expenditures.  When there are no longer any service departments, the HR department may assign expenditures to the remaining operational departments.

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Limitations of the Step Allocation Method

In this method, if a support department’s expenses are distributed to other departments, no reciprocating distribution is allocated again to the specific department. This is true at all stages of the step allocation process. Suppose the legal department is rated better than the HR department. The legal department can assign the expenses to the HR department, but the HR department will not transfer its expenses back to the legal department. This is an application of cost allocation. Because of the unavailability of reciprocating distributions, the step allocation technique may not be the most conceptually accurate way of calculating resources.

Advantages of Step Allocation Method

Given the difficulties highlighted above, the step allocation technique is used by many companies. A major explanation for the high degree of adoption is because this technique is easy and uncomplicated to execute and can be finished quickly. Due to the higher level of convenience, supervisors willing and eager to reduce the time spent on record keeping and forming accounting reports are far more likely to select it, even though the precision offered is not the highest in this cost allocation.

Reciprocal Method of Cost Allocation

Unless cross-departmental services are fully recognized and included in the cost allocation technique, the distribution of service department expenses is seriously compromised. In the service sector, cross-departmental services are services offered by two or even more service departments to one another. Take the following scenario: service department 1 gives service to service department 2, and department 2, in turn, offers service to service department 1.

Indirect cost allocation disregards cross-departmental operations, whereas the step approach only partially acknowledges them because it assigns costs forward – not reverse – in the process of cost allocation. Fortunately, a concept designed as the reciprocal approach has been developed to address this issue. This technique properly acknowledges cross-departmental services while also providing more precision in distributing the costs of service departments to certain other departments.

The reciprocal approach allocates expenditures incurred by service departments to many other departments through numerical methods; distributions are also performed amongst the service departments. This approach produces an accurate allocation of expenses.  The approach is hardly applied as far less precise ways mean minimal computations that are more commonly employed. The reciprocal technique acknowledges the correlations between the support departments.  Therefore, the department expenses are distributed to the other support department according to the requirements.

Use of Reciprocal Approach of Cost Allocation

This approach is infrequently applied in operation for two main reasons. The first is that it is time-consuming. The calculations are rather complicated. Though technology offers the potential to alleviate the complication problem, there is little indication that technology has increased the popularity of the reciprocal approach in general. Secondly, the step approach often yields findings that are a fair representation of the findings that would also be obtained by using the reciprocal method in most cases. Because of this, firms have no incentive to employ the more difficult reciprocal methodology.

Benefits of Reciprocal Cost Allocation Method

The goal of cost allocations in the services team should be to have correct prices on products, services, and customer interactions. The choice of an allocation technique is essential in tracking expenses for many organizations, particularly those where the number of service departments and the prices and services supplied is growing rapidly. The most significant advantage of the reciprocal approach is that it fully includes the cross-departmental service. Consequently, it is a far more precise technique of distributing department expenses when compared to the other two approaches.

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Since this acknowledges all services provided by both support and operational departments, the reciprocal technique should be employed wherever possible. Service departments’ reciprocal costs are computed as the total expenses plus expenses assigned from all their fellow service departments’ expenses. Users of the reciprocal approach sometimes experience difficulties when resolving reciprocating expenses across many service departments. Excel matrices methods, which can design and handle complicated situations of service departments, make the reciprocal approach easier to use than before.

Importance of Cost Allocation

Even though service departments are not often involved in the direct manufacturing of services or goods, they are crucial in driving an organization’s processes to function. Although accounting professionals and learners frequently express apprehension or fear at the possibility of distributing service department expenses, this is not always the case.

There are numerous advantages to having a precise and clear grasp of service department expenses. Primarily, service department expenses are taken into consideration when determining the total cost of a certain product. Moreover, they are useful for limiting the demands for internal services—if zero cost is asked for a facility, for instance, it is possible that the operational departments would overconsume the service. It is also feasible to evaluate the efficiency and productivity of the department because of their use. A service department may be evaluated for removal of the internal cost of providing a service that is more than the offered price by an external provider for the same service.

Consider the following scenario: you are working in the HR department for a firm and being summoned to the company owner’s room. According to reports, demand is low, and because the department does not generate any revenue, you are being requested to justify your department’s budget amounts. The only drawback is that you wouldn’t have much to report for your efforts in terms of financial gain. So, how can you communicate to your colleagues precisely what more value your department brings to the organization? In a nutshell, cost allocation is a method of passing expenses forward to others.

Which Method to Use?

It is crucial to remember that irrespective of which way of allocating service department expenditures is adopted, the overall cost of manufacturing remains constant. In other words, the various cost allocation techniques essentially distribute the expenses differently across the various manufacturing divisions.

The three main methods of allocating the costs are used by companies depending on the nature of the business and resources available. There are benefits and limitations of all the methods that are faced by the companies using them. The direct and sequential methods are the easiest and the most convenient ways of allocating the costs. On the other hand, the reciprocal method of allocating the costs is the most difficult and is rarely used by companies. There is no rule as to which method is best for a specific company. Each organization uses the method of cost allocation depending on the resources and time that can be given. When all expenses are transferred from the service departments to the manufacturing department, it is possible to compute the overhead rates of every manufacturing department individually.