Abstract
Firms should allocate service department costs (i.e., human resources, information technology, etc.) to production departments to, among other things, avoid possible significant distortions in final product costs, monitor efficiency of resource utilization, assist in determining appropriate internal transfer prices, and satisfy cost-based contractual obligations. Defense contractors and high-tech firms are good examples of firms who have difficulty managing these allocations. Most of the literature regarding service department cost allocation has been tied to traditional-based costing methods. However, when there is significant cross-servicing among these departments, firms utilizing an activity-based costing system can also experience significant product cost distortions if service department costs are not appropriately assigned to activity cost pools (Milne, 1997).
Although spreadsheet software has allowed the reciprocal method, regarded as the most accurate service department cost allocation method, to be more easily applied, it has not been widely accepted in practice. As an alternative, firms may employ the step (or step-down) allocation method. This method partially recognizes the relative cross-servicing among service departments. At issue in implementing the step method is the appropriate departmental sequencing of the service department costs. This article identifies and tests the accuracy of the different sequencing techniques under the step method. Our results show that for one or more of the sample problems included in our analysis, each particular sequencing method tested provides production department cost allocations that are closest to the amounts derived under the reciprocal method. This finding indicates that no one sequencing method is superior; but instead, the relative accuracy of sequencing methods depends on the particular circumstances.