The second method of allocating service department costs is the step method. This method allocates service costs to the operating departments and other service departments in a sequential process. The sequence of allocation generally starts with the service department that has incurred the greatest costs. After this department’s costs have been allocated, the service department with the next highest costs has its costs allocated, and so forth until the service department with the lowest costs has had its costs allocated. Costs are not allocated back to a department that has already had all of its costs allocated.
For this example, we will use the same data as before which was:
| Service Dept | Operating Dept | |||
| Maintenance | Administration | 1 | 2 | |
| Costs | $8,000 | $4,000 | $32,000 | $36,000 |
| Machine-hours used | 1,000 | 2,000 | 1,500 | 2,500 |
| Number of Employees | 100 | 200 | 250 | 150 |
In the step method, we typically begin with the highest service cost first. We will start with Maintenance and allocate the cost to all remaining operating AND service departments (administration, operating dept 1 and operating dept 2). When calculating the allocation rate, we never use the service department cost driver itself (so do not use the maintenance machine hours used).
| Maintenance Cost | = $8,000 | =$8,000 | = $1.3333 per machine hour |
| Machine Hours (all but maintenance) | (2,000 + 1,500 + 2,500) | 6,000 |
We would allocate maintenance to Administration, Operating Departments 1 and 2 using the machine hours for each department x the maintenance rate per machine hour (round final answer to nearest dollar).
| Admin | Oper. Dept 1 | Oper. Dept 2 | |
| Maintenance | 2,667 | 2,000 | 3,333 |
| (2,000 MH x 1.333) | (1,500 MH x 1.3333) | (2,500 MH x 1.3333) |
Next, we would allocate the administration department. The total administration cost has changed since we have the original department costs of $4,000 + maintenance cost allocated above of $2,667 making the new administration cost $6,667. Administration will be allocated based on number of employees. We will use the operating departments only since we have already allocate all of maintenance costs and there are no other service departments.
| Administration Cost | = $6,667 | =$6,667 | = $16.6675 per employee |
| Employees (operating depts only) | (250 + 150) | 400 |
We would allocate administration to the operating departments only by taking each department number of employees x the administration rate per employee (round final answer to nearest dollar).
| Oper. Dept 1 | Oper. Dept 2 | |
| Administration | 4,167 | 2,500 |
| (250 employees x 16.6675) | (150 employees x 16.6675) |
The final cost allocation would appear as follows:
| Service Dept | Operating Dept | |||
| Maintenance | Administration | 1 | 2 | |
| Costs | $8,000 | $4,000 | $32,000 | $36,000 |
| Maintenance cost allocated | ($8,000) | 2,667 | 2,000 | 3,333 |
| Administration cost allocated | ($6,667) | 4,167 | 2,500 | |
| Total Costs | $0 | $0 | $38,167 | $41,833 |
Remember, the step method recognizes a one-way relationship between service departments and once the service department cost has been allocated out to other departments, we do not go back and give additional costs to that department.
April 03, 2022 April 03, 2022/ Steven Bragg
The step allocation method is an approach used to allocate the cost of the services provided by one service department to another service department. The essential steps in this allocation process are as follows:
The service department that provides service to the largest number of other service departments or which has the largest percentage of its costs consumed by other service departments allocates its costs to them first. It also allocates its other costs to the operating departments.
The service department that provides service to the next-largest number of other service departments or which has the second-largest percentage of its costs consumed by other service departments allocates its costs. Again, its other costs are allocated to the operating departments at this time.
The process continues until the service department that provides service to the smallest number of other service departments or has the smallest percentage of its costs consumed by other service departments has allocated its costs. Once these allocations have been completed, the process stops.
A company ranks its service departments by the percentage of its costs that are consumed by other service departments. Based on this analysis, the accounting department is ranked first, followed by the human resources department and then the legal department. The accounting department has $100,000 to allocate, of which $80,000 goes to the human resources department and $20,000 to the legal department. The human resources department goes next; this department must add the $80,000 allocation from the accounting department to its own costs. Human resources allocates $7,000 to the legal department (its other costs are allocated to operating departments). The legal department goes last; this department must add the $7,000 allocation from the human resources department to its own costs. There are no service departments left, so the legal department can only allocate costs to operating departments.
Disadvantages of the Step Allocation Method
At no point in the step allocation process is there any reciprocal allocation of service costs back to the service departments that have already allocated their costs out to other departments. For example, if the human resources department is ranked higher than the legal department, the human resources department can allocate its costs to the legal department, but the legal department cannot allocate its costs back to the human resources department. Because of this lack of reciprocal allocations, the step allocation method is not the most theoretically correct.
Advantages of the Step Allocation Method
Despite the concerns just noted, many organizations employ the step allocation method. The reason for this high usage level is that this approach is clear and easy to use, and can be completed within a relatively short period of time. Given its moderate level of simplicity, controllers who want to minimize the amount of time required to close the books and produce financial statements are more likely to use it, even though the level of cost allocation accuracy provided is not the best.
April 03, 2022/ Steven Bragg/