Cost allocation is crucial in managerial accounting for distributing costs across departments, products, or activities. It assigns costs to different cost centers within an organization, facilitating accurate determination of product/service costs. Hierarchical organizations commonly employ the step-down method, which sequentially allocates costs, considers interdependencies among cost centers, and reflects the resource flow. This method recognizes service provisions between centers, ensuring a more accurate allocation process.
The Step-Down Method Approach
The step-down method starts by identifying the primary cost center, often the one with no services received from other centers. The center allocates its costs to different cost centers based on a predetermined allocation basis, such as direct labor hours or machine hours. It allocates the costs of the primary cost center and then moves on to the next cost center, taking into account the costs already allocated to it. This sequential process continues until all cost centers have received their allocated costs.
Example of Step-Down Method
Example:
The XY Company uses the step method for allocating the costs of its service departments to operating departments. The company has two service departments and two operating departments.
Required: Allocate the cost of service departments (A, B) to operating departments (X, Y) using the step-down method.
Solution:
Allocation of Department A’s cost:
Allocation ratio:
- Department B: Employee Hours in Department B / Total Employee Hours (Except A)
- Department X: Employee Hours in Department X / Total Employee Hours (Except A)
- Department Y: Employee Hours in Department Y / Total Employee Hours (Except A)
The allocation ratios are as follows:
Department B: 1/2, Department X: 1/10, Department Y: 2/5
1st Allocation
- Allocated to Department B: $250,000 × (1/2) = $125,000
- Allocated to Department X: $250,000 × (1/10) = $25,000
- Allocated to Department Y: $250,000 × (2/5) = $100,000
Allocation of Department B’s cost:
Allocation ratio:
- Department X: Space Occupied by Department X / Total Space Occupied (Except A and B)
- Department Y: Space Occupied by Department Y / Total Space Occupied (Except A and B)
The allocation ratios are as follows:
Department X: 6/11, Department Y: 5/11
2nd Allocation
- Total cost of Department B: $400,000 + $125,000 = $525,000
- Allocated to Department X: $525,000 × (6/11) = $286,363.64
- Allocated to Department Y: $525,000 × (5/11) = $238,636.36
Important things to remember in Step-Down Method
- First step: Department A’s cost is allocated to Department B, as well as to operating departments X and Y. The allocation base of Department A is ignored.
- The allocation base of a service department is always ignored in both step-down and direct methods of cost allocation when allocating costs to other departments.
- Second step: Department B’s total cost ($400,000 + $125,000 = $525,000) is allocated to departments X and Y. No portion of Department B’s cost is allocated to Department A.
- Under the step-down method of cost allocation, any allocation base of a service department that has already been allocated to other departments is ignored.
- The total costs before and after each allocation are equal. It is because no money is lost during the process.
- The sum of allocation ratios is unity. (No allocation outside the defined scope)
- In the above figure, please see the matching color cells to check whether the calculations are right or not.
Advantages of the Step-Down Method
The step-down method offers several advantages:
a) Reflects interdependencies:
By considering the flow of services between cost centers, the step-down method provides a more accurate representation of the actual resource consumption within the organization.
b) Hierarchical structure consideration:
This method is particularly suitable for organizations with a clear hierarchical structure, where some cost centers provide services to others.
c) Simplicity:
It is relatively straightforward to understand and implement compared to more complex cost allocation techniques.
Limitations of the Step-Down Method
While the step-down method has its advantages, it also has limitations:
a) Subjectivity in allocation basis:
The choice of allocation basis can influence the resulting cost allocations. Different allocation bases may yield different cost distributions, leading to potential bias.
b) Simplified assumptions:
This method assumes that the sequence of allocations accurately reflects the actual flow of resources. However, in reality, this may not always be the case, as complex interactions can exist among cost centers.
c) Inaccurate cost representation:
Despite considering interdependencies, this method may not capture all intricate relationships within an organization, potentially leading to distorted cost representations.
Application of the Step-Down Method
The step-down method finds application in various industries, such as healthcare, manufacturing, and service sectors. For example, in a hospital setting, this method can allocate costs from support departments, such as maintenance and administration, to patient care departments like surgery and radiology.
Conclusion
The step-down method of cost allocation is a useful tool for distributing costs in organizations with hierarchical structures. It acknowledges interdependencies among cost centers and provides a reasonable approximation of resource consumption. However, it is essential to consider the limitations and potential biases associated with this method. By understanding its strengths and weaknesses, managers can make informed decisions when implementing the step-down method for cost allocation.