ALLOCATION OF SERVICE DEPARTMENT COSTS TO PROFIT AND INVESTMENT CENTERS
A potential source of disharmony among responsibility centers in decentralized firms is the allocation of service
department costs. Most businesses have departments that do not produce goods but rather service other
departments. Examples are data processing, accounting, planning, personnel, and cafeteria and medical facilities.
Service departments carry out essential auxiliary services for an organization. There are several reasons for
allocating service department costs.
1.
2.
3.
4.
Other departments receive benefits from service departments and should be charged for the benefits received.
Allocation helps other departments realize the cost of the services received and decide how much service to
request.
Allocation usually results in a more effective distribution of services among departments.
Allocation helps in costing the company’s products, because service department costs should be viewed as
part of a product’s cost.
The general principle is that service department costs should be allocated using a base that measures the amount of
services or benefits received by each user department. To illustrate, we will assume that Palmer Company has four
departments: home products, commercial, manufacturing, and the cafeteria. The cafeteria services the other three
departments and incurs a loss of $100,000, which could be allocated on the basis of sales revenue or number of
employees. During 2003, the three user departments had the following operating data:
Sales Revenue
Variable Costs
Fixed Costs
Number of Employees
Home Products
$600,000
320,000
180,000
70
Commercial
$400,000
200,000
120,000
60
Manufacturing
$200,000
80,000
60,000
20
If cafeteria losses are allocated on the basis of sales revenue, the three user departments would bear the following
cafeteria costs.
Home Products
Commercial
$600,000
$1,200,000* x $100,000 = $50,000
$400,000
$1,200,000 x $100,000 = $33,333
Manufacturing
$200,000
$1,200,000 x $100,000 =
$16,667
*$600,000 + $400,000 + $200,000
On the other hand, if cafeteria losses are allocated on the basis of the number of employees in each user
department, the allocation of the cafeteria’s losses would be:
Home Products
Commercial
70 x $100,000 = $46,667
150*
60 x $100,000 = $40,000
150
Manufacturing
20 x $100,000 = $13,333
150
*70 + 60 + 20
In this case, both home products and manufacturing would argue for an allocation based on the number of
employees, whereas the commercial department would want cafeteria losses allocated on the basis of total sales
revenue. Which base best measures service received? Management must make this judgement. In this case, number of
employees would seem to be better, because it indicates the amount of service performed. A department with higher
revenue does not necessarily use more cafeteria service.
Because allocated service costs increase a segment’s costs, the manager must decide if the benefits received
exceed the additional costs. If not, there is an incentive to avoid using the services. Management must therefore
consider several issues before deciding how to allocate services costs. For example:
1.
Which cost-allocation methods will encourage managers to make the most goal-congruent decisions? A method
based on the measurement of usage by each segment is usually best. Segment managers can control usage and can
evaluate the resulting benefits in relation to the costs. Following are some examples of service-cost allocation
usage bases.
Service Department
Cafeteria
Custodial and Utility Costs
Data Processing
Personnel
Basis for Service-Cost Allocation
Number of employees in each division
Square footage of each division
Usage by each division
Number of employees in each division
2.
Should all service costs be allocated? Perhaps the costs of services that top management requires of all
departments to use (services that segment managers may not choose to use voluntarily) should not be allocated at
all. Examples are internal auditing and personnel training. Since charging on the basis of usage often discourages
use, some other arrangement, such as a flat fee, should be established if allocation is considered necessary.
3.
Should actual or standard service costs be allocated? If actual costs are allocated, user departments may be
burdened with the inefficiences of the service departments. Because of this potential inequity, standard rates,
multiplied by the actual level of activity, are usually used. Any remaining costs created by inefficiences are the
responsibility of the service departments. Applying a standard rate that is tied to usage allows the user
departments to concerntrate on controlling usage and the service departments to concentrate on controlling costs.
This leads to goal congruenct decisions within a company.
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To Summarize: Most businesses have departments that do not produce goods but rather service other
departments. Service departments carry out essential auxiliary services for an organization. They are usually
allocated to profit and investment enters because:
Other departments receive benefits from service departments and should be charged for the benefits received.
Allocation helps other departments realize the cost of the services received and decide how much service to
request.
Allocation usually results in a more effective distribution of services among departments.
Allocation helps in costing the company’s products, because service department costs should be viewed as part of
a product’s cost.
Service department costs should be allocated to user departments using a basis that measures the services or
benefits received.