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Cost Allocation

JOINT PRODUCTION duction department uses (or, for budgeting purposes,
ALLOCATIONS intends to use) the services of the service department. This
Allocations are also required in a joint production process. extent is determined on a percentage basis by either the
When two or more separately identifiable final products amount of services actually provided by the service depart-
initially share a common joint production process, the ment to all the production departments or by the amount
products are called joint products. The point at which of services the service department is capable of providing
they become separately identifiable is referred to as the at normal or full capacity. Variable and fixed costs may be
split-off point. Manufacturing costs incurred prior to this allocated separately, resulting in a dual allocation process
split-off point are referred to as joint costs and need to be (for example, variable costs based on actual usage and
allocated across the different joint products for product fixed costs based on budgeted usage).
costing purposes. The bases for allocating the joint costs The step method partially takes reciprocal services
typically include (1) relative sales value at split-off, (2) net into account by allocating service department costs to
realizable value at split-off (as an approximation of the production departments on a sequential basis. The service
sales value at split-off), (3) final sales value at the comple- department that provides the greatest amount of service to
tion of the production process, and (4) the number of the other service departments is allocated first; the one
physical units of the joint products at split-off. providing the second greatest amount of service to the
Many would consider this list of bases to be in an other service departments is allocated second; and so
order of descending preference of use. Normally there are forth. The absolute dollar amounts of costs incurred
additional production costs beyond the split-off point. within service departments can be used to break a tie in
These additional costs are incurred in order to complete usage, the larger amount allocated first. Once a service
each joint product. For a given joint product, the net real- department has been allocated, it is ignored for all subse-
izable value at split-off is calculated by subtracting the quent allocations.
additional costs to complete from the final sales value of The reciprocal method takes into account all the
the finished joint product. reciprocal services by setting up a set of simultaneous equa-
tions, one equation per service department. For any given
SERVICE DEPARTMENT service department, its equation is: Total allocable cost =
(RE)ALLOCATIONS direct costs of the service department + costs allocated
from each of the other service departments based on this
There are three basic methods to allocate service depart- department’s use of the other service departments. Once
ment costs to production departments or programs in a
these equations are solved, the resultant allocable cost
not-for-profit: (1) the direct method; (2) the step method;
(sometimes referred to as the reciprocal or artificial cost) is
and (3) the reciprocal method. The basis for allocation of
reallocated across all the other departments, service and
service area costs should ideally be causally related to the
production, according to the original percentage usages.
demands made on that area by other areas. Both cause-
and-effect and benefits-received criteria are taken into Two additional issues, fairness and acquiring the serv-
account. If the service areas provide service to each other ice from the inside or from the outside, concern the allo-
(referred to as reciprocal services), the reciprocal method cation of a common cost. The amount of common service
is the most accurate, the step method next, and the direct cost allocated to a using department may be greater that
method the least accurate. With different service and pro- what it would cost that department to obtain the same
duction departments as cost objects, costs are initially service from the outside. A variation of the reciprocal
accumulated on a department-by-department basis. method provides an analysis to help the manager of a
Departments working directly on programs or units of using department decide whether to obtain the service
product or service are production departments. The other from another department within the organization or to
departments are service departments. The allocation prob- contract outside for the service from another organization.
lem then is to reassign service department costs to produc- The amount of a particular service department’s cost allo-
tion departments or programs for both performance cated to a using department may be dependent on the
evaluation and product or program costing. Within a pro- extent to which other departments also use this service
duction department, these allocated service costs are then department.
reallocated to units of service or product according to the SEE ALSO Costs
bases of allocation that each respective production depart-
ment uses for its indirect costs.
BIBLIOGRAPHY
The direct method ignores reciprocal services. A serv- Blocher, Edward J., Chen, Kung H., and Lin, Thomas W.
ice department’s costs are allocated to the production (2005). Cost Management: A Strategic Emphasis.Boston:
departments according to the extent to which each pro- McGraw-Hill/ Irwin.

166 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION