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Much of the current management accounting literature focuses on the need for more accurate product costing. Inventory valuation and cost of goods sold calculations, necessary for external financial statement preparation, require accurate product costing systems. In addition, accurate product costing is important for internal use in pricing, special order, make-or-buy, and transfer pricing decisions, particularly as competition increases and manufacturing systems become more complex and advanced.
Activity-based costing (ABC), prominent in current accounting literature, is a method of increasing product cost accuracy by tracing costs to products based on activities that cause costs to be incurred. This increased accuracy results in improved planning decisions, and the ABC process allows managers to better identify and manage the cost-consuming activities required by each finished product.
Although ABC provides a more refined allocation of indirect product costs through its use of cause-and-effect cost relationships, cost allocation problems remain. Specifically, service department costs must still be allocated to production departments, and since service departments often provide services to other service departments as well as to production departments, the way in which service costs are allocated can have a significant effect on product cost accuracy.
This paper reviews three commonly-used methods for allocating service department costs and describes an additional method that is simple to understand and apply while providing accurate product cost information.
DESCRIPTION OF TRADITIONAL ALLOCATION METHODS
The direct, step, and reciprocal methods are the most common methods for allocating service department costs to production. These methods are best described with an example. Table 1 presents traceable service department costs and service usage percentages for a firm with three service departments and two production departments. (Table 1 omitted) The service usage percentages are assumed to be based on appropriate cost drivers selected for each service department. Without appropriate cost drivers, no allocation method can provide completely accurate allocations.
The direct method, illustrated in Table 2, allocates all service department costs directly to production departments, completely ignoring any services provided by one service department to another. (Table 2 omitted) For example, even though service department 1 provides services to service departments 2 and 3 and to both production departments, the $49,000 traceable cost is only allocated to the production departments. The allocations are based on the relative percentage...