Support departments play a crucial role in many organizations, as they provide services and resources that are necessary for the core functions of the company to operate smoothly. However, allocating the costs of these support departments can be a challenge, particularly when it comes to deciding how much of each department’s costs should be allocated to each of the production departments.
There are three methods of allocating support department costs: the direct, step-down, and reciprocal methods. The key differences among the methods are the assumptions as to how services provided by one support department are allocated to other support departments.
Direct Method
The direct method allocates support department costs to operating departments based on the direct usage of services by each department. For example, if the IT department provides 100 hours of support to the Marketing department and 200 hours of support to the Sales department, then the Marketing department would be allocated 50% of the IT department’s costs and the Sales department would be allocated 100% of the IT department’s costs.
Step-Down Method
The step-down method is a simple way of allocating support department costs that involves dividing the costs into two categories: direct and indirect costs. Direct costs are those that are directly related to the production process, such as the cost of raw materials and direct labor. Indirect costs are those that are not directly related to the production process, such as the cost of support departments.
To allocate the support department costs using the step-down method, the costs are first allocated to the department that has the most direct interaction with the support department. This department is known as the primary department. Once the primary department has been allocated its share of the support department costs, the remaining costs are allocated to the next department with the highest level of interaction, and so on, until all departments have been allocated their share of the costs.
For example, let’s say a company has two support departments, IT and HR, and two production departments, Production A and Production B. The IT department interacts more with Production A than Production B, while the HR department interacts equally with both production departments. Using the step-down method, the IT department’s costs would be allocated to Production A first, since it has the highest level of interaction. Once Production A has been allocated its share of the IT department’s costs, the remaining costs would be allocated to Production B. The HR department’s costs would be allocated equally to both production departments.
Reciprocal Method
The reciprocal method is a more complex way of allocating support department costs that takes into account the fact that support departments often provide services to each other. For example, the IT department might provide services to the HR department, and vice versa.
To allocate the support department costs using the reciprocal method, the costs are first allocated based on each department’s direct interaction with the production departments, as in the step-down method. However, the reciprocal method also takes into account the services that support departments provide to each other. This is done by creating a matrix that shows how much each support department provides in services to each other support department. This matrix is then used to adjust the allocation of costs between support departments.
For example, let’s say a company has three support departments, IT, HR, and Accounting, and two production departments, Production A and Production B. Using the reciprocal method, the costs would be allocated to the production departments based on each support department’s direct interaction with them. Then, a matrix would be created that shows how much each support department provides in services to each other support department. This matrix might show that the IT department provides $10,000 worth of services to the HR department, while the HR department provides $5,000 worth of services to the IT department, and so on. This matrix is then used to adjust the allocation of costs between the support departments.
The allocation of support department costs is important because it helps to ensure that operating departments are charged for the services that they use. This information can be used to make decisions about how to allocate resources and to improve efficiency.