Support Department Costing

Overview

There are three methods available to use in the process of assigning support department costs to production
departments:

1) direct method
2) step-down method, and
3) reciprocal method of assigning support department costs.

Upon completion of this lesson, candidates should be able to:

➢ Explain why companies allocate the cost of service departments such as Human Resources or
Information Technology to divisions, departments, or activities (1.D.3.o).
➢ Calculate service or support department cost allocations using the direct method, the reciprocal
method, the step-down method, and the dual allocation method (1.D.3.p).

Study Guide

I. Why Allocate Costs of Shared Services?

A. As organizations grow in size and complexity, various business units within the organization are
established to focus on specific stewardships of responsibility.
• Initially, organizations will establish business units to focus on distinct segments of their business
model, such as specific product lines or customer groups.
• Ex. Operations, Marketing, Information Technology, Data Analytics, etc.
B. Once organizations begin instituting a structure of business units focused on the creation of products
(goods and services) to be sold to customers,
• organizations will often begin consolidating shared services into departments that support the
production departments
C. For example, rather than have each production department establish and manage its own HR (human
resource) process and IT (information technology) process,
• the organization can typically save costs while improving processes by establishing a separate HR
department and IT department, each of which is tasked to support all production departments.
D. The issue:
• How to track or allocate the pools of support department costs to production departments.
• Remember from your work in previous lessons that if the cost assignment taking place between a
cost pool and a cost object is based on a cost consumption driver, then we describe the relationship
as a cost tracking process.
• Alternatively, if the cost pool is fixed with respect to activity in the cost object, then assigning the
costs is described as a cost allocation process.
• Regardless of whether the process is based on cost tracking or cost allocation, organizations
generally work to accomplish four management objectives in the assignment of support department
costs to production departments.
• Choices regarding cost assignment processes will affect the accomplishment of each of these
goals.
1) First, the cost assignment process needs to be transparent to all departments involved.
Confusion, and even frustration, emerges naturally when managers don't understand the
process used to assign costs to their unit.
2) Second, the cost assignment process should emphasize equity in results of the cost
assignment.
Equity doesn't mean that every production department should receive the same amount of
support department costs.
It does mean that whenever possible the cost assignment represents actual consumption
of a variable cost, or at least that it represents an accurate measure of the use of a fixed
cost resource.
3) Third, the method(s) used to assign support department costs to production departments
should be relevant to the types of decisions being made based on those costs.
If the organization is making decisions regarding adding or dropping product lines, it is
important to avoid allocating fixed costs that are unaffected, for example, by the decision to
close out a product line.
4) Finally, cost assignment systems are most effective when they establish accountability within
the organization.
 If the costs are tracked to production departments based on consumption of variable cost
resources, then production departments are effectively held accountable for their impact on
support department costs.
When fixed costs of support departments are allocated to production departments, it
provides an opportunity for support departments to be held accountable to production
departments for spending decisions on the costs being allocated.
E. The rest of this lesson describes different methods used to assign or allocate support department costs
to production departments. Each of these methods can be used more or less effectively to accomplish
the management goals of transparency, equity, relevancy, and accountability.

II. The Direct Method

A. The rest of this lesson describes different methods used to assign or allocate support department costs
to production departments. Each of these methods can be used more or less effectively to accomplish
the management goals of transparency, equity, relevancy, and accountability.

B. Total quarterly costs for the Janitor Department are

$118,800. These costs are assigned based on the occupancy of
square footage in the office space. The quarterly costs for the
HR Department are $252,000 and are assigned using
headcount of personnel. The direct method solution for Bain is
presented below.

1) Using the direct method, the

Janitor Department will assign its costs
on the combined basis of 2,800 square
feet in Audit Department office space
and 6,000 square feet in the Tax
Department (2,800 + 6,000 = 8,800 total
square feet). The cost assignment rate
is $13.50 ($118,800 ÷ 8,800 ft2). The
Audit Department will receive $37,800
in Janitor costs ($13.50 × 2,800 ft2) and the Tax Department will receive $81,000 ($13.50 × 6,000
ft2). As a check figure, note that the costs assigned sum up to the original costs in the Janitor
Department.
2) Check yourself on the HR Department by (1) building the $2,800 rate per head and (2) using
headcount in the two producing departments to assign HR costs. Make sure your cost assignment
computations sum back up to the original $252,000 in the HR Department.
3) Finally, note that the direct method began with a total of $370,800 in support department costs
($118,800 + $252,000), and concludes with $370,800 costs assigned to the two producing
departments ($172,200 + $198,600).

III. The Step-Down Method

A. The direct method is a straightforward approach to assigning
support department costs to production departments, but that approach
avoids an important reality—support departments also provide support to
each other! Using a similar computational approach as the direct method,
the step-down method pays some attention to the fact that support
departments provide support to each other, although the step-down method
is far from a perfect solution on this issue. Nevertheless, it is a popular cost
assignment method used by many organizations.
B. The key characteristic (and limitation) of the step-down method is the order of service departments
selected by management for the computation. This order is often based on identifying the department
that provides the most support to the other departments, followed by the department that provides the
second most support, and so forth. For the Bain firm, we'll assume that management determines the
Janitor Department will be first in the step-down method process. Based on that decision, the step-down
method for Bain is illustrated below.

C. Using the same costs and activity bases, the step-down method solution for Bain is provided here.
 1) First, the basis used to
compute the cost assignment rate for
the Janitor Department includes the
square feet in the HR Department, as
well as the square feet in Audit and
Tax Departments. This works out to a
total basis of 10,000 square feet (1,200
+ 2,800 + 6,000) and results in a cost
assignment rate of $11.88 ($118,800 ÷
10,000 ft2).
2) Next, using this rate, the Janitor
Department directly assigns its costs to all three “downstream” departments (HR, Audit, and Tax).
The HR Department now has a new and higher amount of costs ($252,000 + $14,256 = $266,256)
that it subsequently needs to assign to Audit and Tax.
3) HR's combined costs results in a $2,958.40 per-head rate ($266,256 ÷ 90 headcount). Using this
rate, HR directly assigns its costs to the production departments.
4) The final cost assignments to Audit and Tax sum up to the original support departments’ total costs
of $370,800. Be sure to see, though, that the costs assigned to each of these production
departments are different using the step-down method compared to the direct method. For
example, costs assigned to Audit are $172,200 using the direct method, and are $175,267 using
this step-down method.
D. The decision about the order used in the step-down method is subjective. For example, there are likely
several ways an organization can define what it means for one department to provide comparatively
more support than another department. This ordering decision is important because it affects the costs
finally assigned to production departments.
1) For example, assume that Bain chooses instead to prioritize the HR Department first in the
approach it uses for the step-down cost assignment method, as illustrated below.

2) The impact on costs assigned to Audit and Tax is substantial. The

effect of changing the order in the step-down method reduces the Audit
Department's assigned cost from $175,267 to $166,778. And the Tax
Department's assigned costs increase from $195,533 to $204,022. (This
solution is provided below as a practice problem, but first you should
attempt to solve this step-down cost assignment yourself.)

IV. The Reciprocal Method

A. The step-down method comes closer than the direct method to representing the reality of support
departments providing service to other support departments, but it is limited in its computational
approach. It forces a one-way flow of cost assignments through a subjective order of support
departments.
B. In our example with the Bain firm, the Janitor and HR departments
obviously provide services to each other while serving the needs of the
two production departments. The actual flow of resources in and out of
the two support departments is better represented in the diagram below.
C. The reciprocal cost assignment method can create a two-step
solution that represents (1) a simultaneous assignment of costs between
the two support departments followed by (2) a direct assignment of costs
to the production departments. In the Bain firm example with two support
departments, we can establish a simultaneous cost assignment using a fairly basic algebraic approach
sometimes called “the substitution method for two unknowns.”
D. To create a simultaneous solution to that assigns costs back and forth between the two support
departments, first set up an equation for each department that represents its total cost after receiving an
assignment of costs from the other department.

1) For example, the Janitor Department has $118,800 of its own costs and it should be assigned 10% of
the costs coming from the HR Department. The 10% is computed by the 10 employees (headcount) in
the Janitor Department divided by the combined 100 employees in Janitor, Audit, and Tax (10 + 48 +
42). Hence, letting J represent the Janitor Department and H represent the HR Department, the total
cost equation for the Janitor Department is:
J = $118,800 + .10(H)
2) Similarly, the HR Department has $252,000 of its own costs, plus a 12% assignment of costs from the
Janitor Department, which is computed as 1,200 ft2 ÷ (1,200 ft2 + 2,800 ft2 + 6,000 ft2). The total cost
equation for the HR Department is:
H = $252,000 + .12(J)
E. With the cost equations established for each support department, the substitution method for two
unknowns takes place in three steps.
1) Select either of the two equations to solve first. We'll start with the equation for the Janitor
Department.
2) Solve the first equation by substituting the second equation into the first equation. This is done
below.
J = $118,800 + .10(H)
J = $118,800 + .10($252,000 + .12(J))
J = $118,800 + $25,200 + .012(J)
1(J) − 0.12(J) = $118,800 + $25,200
.988(J) = $144,000
J = $145,748.99
(or $145,749 rounded)
Now solve the second equation using the solution from the first equation, as is done below.
H = $252,000 + .12(J)
H = $252,000 + .12($145,748.99)
H = $252,000 + $17,489.88
H = $269,489.88
(or $269,490 rounded)
These simultaneous solutions for each department would be the same if the three-step process
began with the HR Department. (This alternative solution approach beginning with the HR
Department is provided below as a practice problem, which you should first attempt to solve
yourself.)
F. The simultaneous solution for each support department represents how much cost each department
now needs to assign to all other departments (both support and production departments). Note that the
$145,749 cost that the Janitor Department will assign is $26,949 more than the $118,800 in costs that it
actually has. However, simultaneous with the $145,749 that it will assign, the Janitor Department will
receive $26,949 cost assignment from the HR Department, which leaves the Janitor Department with
exactly zero costs remaining to be assigned. A similar offsetting cost assignment will go from the Janitor
Department to the HR Department. The full reciprocal cost assignment solution for Bain is shown below.

G. The reciprocal method is

reasonably simple to solve when it
involves only two support
departments. However, when more
than two support departments are
involved, the simultaneous equations
are based on a much more involved
mathematical solution using matrix
algebra, and is typically handled using
computer technology.
H. Once again, a different method used to assign the
support department costs results in a different amount
of total support costs landing on the Audit Department
and the Tax Department. For comparison, the results
of all three methods we worked through are presented
below.

V. Using Dual Rates

A. If you look back at the Dennis Bain, LLC example above, the discussion is careful to use the generic
word assign when describing the movement of costs from support departments to production
departments. Are these support costs being tracked to the production departments, or are they being
allocated to the production departments?
1) For example, if there is a consumption relationship between the pool of Janitor Departments costs
and the square feet of space being used by the organization (that is, if Janitor Department costs are
variable with respect to Bain having more or less square feet in each of its departments), then the
methods above are tracking costs to the Audit and Tax departments. Alternatively, if the janitorial
 costs are fixed (and they likely are fixed) with respect to square footage space (because square
footage space itself is fixed for Bain), then these support costs are being allocated to the production
departments.
2) While janitorial costs are probably fixed with respect to square footage of space, it may be that HR
costs are largely variable with respect to the headcount at Bain increasing and decreasing within
each department from quarter to quarter throughout the year. If this is the case at Bain, then the
process of assigning HR Department costs to Audit and Tax can be described as tracking costs to
these production departments.
B. This distinction between fixed cost allocation and variable cost tracking is important since many
organizations will use a dual rate approach to assign costs. In the case of assigning support department
costs, the dual rate approach splits costs into fixed and variable, then allocates fixed costs using a fixed
cost rate and tracks variable costs using a variable cost rate. In the traditional two-step cost assignment
process (compute a cost driver rate and then use the rate to assign the cost), the key difference is the
basis used to compute the cost driver rates.
1) For fixed cost allocation rates, the basis is established on the normal capacity of the activity. For
example, Bain's Janitor Department is likely set up to provide maintenance on all the square feet of
space that the firm occupies, regardless of whether every square foot of space will be used in the
upcoming quarter. The Janitor Department represents a fixed cost commitment to the capacity to
serve and maintain all the square feet available for Bain's use in its normal course of business. The
result of using a fixed cost allocation rate is relatively consistent assignments of support department
costs over time.
2) Conversely, for variable cost tracking rate, the basis is established on the budgeted use of the
activity, with an expectation that spending on the variable costs being assigned will be adjusted
depending on expected increases and decreases in the budgeted activity that uses the support
costs. In the case of Bain's HR Department, if spending in this department will fluctuate quarter to
quarter depending on the expected headcount in the organization, then a variable cost tracking rate
will be computed and multiplied by the various levels of expected headcount in each department
being assigned HR costs. Using a variable cost tracking rate, costs assigned are expected to
fluctuate over time based on changes in spending and usage.

Summary

Organizations strive for transparency, equity, relevancy, and accountability in the process of assigning costs
from one part of the organization to another. These characteristics may be more or less achieved as
organizations assign support department costs to production departments. There are three methods available for
the assignment of support department costs.

➢ The direct method assigns support department costs directly to production departments without
consideration of how support departments employ resources to support each other.
➢ The step-down method provides some representation of interdepartmental support by effectively
cascading cost assignments through a subjectively ordered set of support departments.
➢ The reciprocal method uses simultaneous algebraic solutions to objectively assign costs between
support departments before ultimately assigning costs to production departments.
➢ To the extent that support department costs can be separated into fixed costs and variable costs, a
dual rate approach can be used to allocate fixed costs and track variable costs.

PRACTICE QUESTIONS: