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Cost Allocation of Service Department Costs

Cost allocation is used to assign service department costs to the departments that actually consume these costs. This is done in an attempt to control costs in organizations and make other departments aware of, and responsible for, the organizational resources they consume. Three approaches are used to allocate service department costs to other departments: the direct method, the step-down method, and the reciprocal method.

The Direct Method: In the direct method, interactions between service departments are ignored and costs are allocated just to operating departments.

Step Down Method: In the step down method, one service department’s costs are allocated to another service department as well as operating departments that use it. Any amount of the allocation base attributable to the service department whose cost has already been allocated is ignored. Each service department assigns its own costs to operating departments plus the costs that have been allocated to it from other service departments.

Reciprocal Method: The reciprocal method is a method of allocating service costs between departments that gives full recognition of interdepartmental services. The reciprocal method uses a system of equations to solve for the true costs of the service departments. These costs are then allocated to the operating departments.

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