Examples would be charging departments a “rental fee” for their use of vehicles from the motor pool, or for their use of a corporate conference facility. The biggest advantage of the step-down method is that it makes it clear that some departments, which otherwise might not be seen as doing so, make significant contributions to the business. 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. For example, it might be worth knowing if the custodial department has to spend as much to the accounting office suite as it does to clean the warehouse. The amounts in the far left column are the costs incurred by each service department.
- Because of this lack of reciprocal allocations, the step allocation method is not the most theoretically correct.
- 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.
- As another example, defense contractors that provide the U.S. military “big ticket” items such as airplanes and ships often operate under cost-plus contracts, under which they are reimbursed for their production costs plus a guaranteed profit.
- Let’s go back to our example of the custodial department and the accounting department.
- Despite the concerns just noted, many organizations employ the step allocation method.
- Examples would be charging departments a “rental fee” for their use of vehicles from the motor pool, or for their use of a corporate conference facility.
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.
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Historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they recognize that service departments provide services to other service departments as well as to production departments. All three methods ultimately allocate all service department costs to production departments; no costs remain in the service departments under any of the three methods. Unlike direct method, the step method (also known as step down method) allocates the cost of a service department to other service departments as well as to operating departments. 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.
- This reasoning suggests that only the service department’s variable costs should be charged out.
- Historically, there have been three alternative methods for allocating service department costs.
- There are no service departments left, so the legal department can only allocate costs to operating departments.
- We will start with Maintenance and allocate the cost to all remaining operating AND service departments (administration, operating dept 1 and operating dept 2).
For example, fixed costs might be allocated based on an estimate of long-term usage by the production departments. 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. Despite the concerns just noted, many organizations employ the step allocation method.
Disadvantages of the Step Allocation Method
As can be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it.
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.
What is the Step Allocation Method?
Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics. 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).
In such settings, the calculation of cost includes a reasonable allocation of overhead, including overhead from service departments. 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).
What Is the Step-Down Method?
There are no service departments left, so the legal department can only allocate costs to operating departments. Many companies in all sectors of the economy, and not-for-profit and governmental organizations as well, allocate service department costs to “production” or user departments, and ultimately to the products and services that they provide. For example, hospitals use sophisticated methods for allocating costs of service departments such as Housekeeping, Patient Admissions, and Medical Records to patient wards and outpatient services, and then to individual patients. Historically, these allocations were important to hospitals because Medicare reimbursement was based on actual costs.
The sequence in which the service departments are allocated usually affects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence. The distinction between the second and third reasons is important in the context of fixed versus variable costs. The manager should ignore the service department’s fixed costs if these costs will not be affected by the manager’s decision.
Step down method of cost allocation
This reasoning suggests that only the service department’s variable costs should be charged out. 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. We will use the operating departments only since we have already allocate all of maintenance costs and there are no other service departments.
