Service Department and Joint Cost Allocation
Solutions to Review Questions
Companies allocate costs to estimate or assess the costs of their activities (products, processes, etc.). It is an estimate and subject to the problem that cost allocation contains an arbitrary element. Not allocating costs, however, is also an estimate—an estimate of zero. This may be appropriate for some decisions, but not for others.
Some of the disadvantages (costs) include:
(1) Additional bookkeeping;
(2) Additional management costs in selecting allocation methods and allocation bases;
(3) Costs of making the wrong decision if the allocations provide misleading information.
Some of the advantages (benefits) of cost allocation include:
(1) Instilling responsibility for all costs of the company in the division managers;
(2) Relating indirect costs to contracts, jobs and products;
(3) Constructing performance measures (“net profit”) for a division that may be more meaningful to management than contribution margins.
The essential difference is the allocation of costs among service departments. The direct method makes no inter-service-department allocation, the step method makes a partial inter-service-department allocation, while the reciprocal solution method fully recognizes inter-service-department activities. All three methods allocate costs to the production departments based on the production department’s relative use.
Allocations usually begin from the service department that has provided the greatest proportion of its services to other service departments, or that services the greatest number of other service departments. This criterion is used to minimize the unrecognized portion of reciprocal service department costs. (Recall that the amount of service received by the first department to allocate in the step allocation sequence is ignored.)
Another criterion employed is the amount of cost