Which of the following would not be considered a service department in a hospital

1. Last updated
2. Save as PDF

Allocating Costs to Profit Centers

Many companies in all sectors of the economy, and not-for-profit and governmental organizations as well, allocate service department costs to “production” or user departments, and ultimately to the products and services that they provide. For example, hospitals use sophisticated methods for allocating costs of service departments such as Housekeeping, Patient Admissions, and Medical Records to patient wards and outpatient services, and then to individual patients. Historically, these allocations were important to hospitals because Medicare reimbursement was based on actual costs. To the extent that the hospital allocated service department costs to Medicare patients, Medicare covered these costs. 

Companies that allocate service department costs do so for one or more of the following reasons:

1. To provide more accurate product cost information. Allocating service department costs to production departments, and then to products, recognizes that these services constitute an input in the production process.
2. To improve decisions about resource utilization. By imposing on division managers the cost of the service department resources that they use, division managers are encouraged to use these resources only to the extent that their benefit exceeds their cost.
3. To ration limited resources. When production departments have some discretion over their utilization of a service department resource, charging production departments for the resource usually results in less demand for it than if the resource were “free” to the production departments. 

The motivation for the first reason, to provide more accurate product cost information, can be to improve decision-making within the organization, to improve the quality of external financial reporting, or to comply with contractual agreements in regulatory settings where cost-based pricing is used. As discussed above, Medicare was historically a cost-based reimbursement scheme. As another example, defense contractors that provide the U.S. military “big ticket” items such as airplanes and ships often operate under cost-plus contracts, under which they are reimbursed for their production costs plus a guaranteed profit. In such settings, the calculation of cost includes a reasonable allocation of overhead, including overhead from service departments. 

The distinction between the second and third reasons is important in the context of fixed versus variable costs. In connection with the second reason, to improve decisions about resource utilization, from the company’s perspective, a division manager making a short-term decision about whether to utilize service department resources should incorporate into that decision the service department’s marginal costs, which are usually the variable costs. The manager should ignore the service department’s fixed costs if these costs will not be affected by the manager’s decision. This reasoning suggests that only the service department’s variable costs should be charged out. 

However, in connection with the third reason, to ration a scarce resource, if the service department controls a fixed asset, and if demand for the asset exceeds capacity, charging users a fee for the asset allows the service department to balance demand with supply. The fee need not relate to the cost of obtaining the asset; rather, it is a mechanism for managing demand. Examples would be charging departments a “rental fee” for their use of vehicles from the motor pool, or for their use of a corporate conference facility. 

Service department costs can be allocated based on actual rates or budgeted rates. Actual rates ensure that all service department costs are allocated. Budgeted rates provide service department managers incentives to control costs, and also provide user departments more accurate information about service department billing rates for planning purposes. In either case, service department costs should be allocated using an allocation base that reflects a cause-and-effect relationship, whenever possible. Here are some examples:

• Allocate building maintenance costs based on square footage;
• Allocate costs of the company airplane based on miles flown;
• Allocate costs of the data processing department based on CPU time.

In some cases, companies benefit from allocating fixed costs using a different allocation base than variable costs. For example, fixed costs might be allocated based on an estimate of long-term usage by the production departments.

Historically, there have been three alternative methods for allocating service department costs. These methods differ in the extent to which they recognize that service departments provide services to other service departments as well as to production departments. All three methods ultimately allocate all service department costs to production departments; no costs remain in the service departments under any of the three methods.

The three methods for allocating service department costs are the direct method, the step-down method, and the reciprocal method.  We will focus on the step-down method in this course.  If you are interested in learning  more about the other two methods, go to http://denniscaplan.fatcow.com/Chapter12.htm

The Step-Down Method

The step-down method is also called the sequential method. This method allocates the costs of some service departments to other service departments, but once a service department’s costs have been allocated, no subsequent costs are allocated back to it.

The choice of which department to start with is important. The sequence in which the service departments are allocated usually affects the ultimate allocation of costs to the production departments, in that some production departments gain and some lose when the sequence is changed. Hence, production department managers usually have preferences over the sequence. The most defensible sequence is to start with the service department that provides the highest percentage of its total services to other service departments, or the service department that provides services to the most number of service departments, or the service department with the highest costs, or some similar criterion.

Example: Human Resources (H.R.), Data Processing (D.P.), and Risk Management (R.M.) provide services to the Machining and Assembly production departments, and in some cases, the service departments also provide services to each other:

The amounts in the far left column are the costs incurred by each service department. Any services that a department provides to itself are ignored, so the intersection of the row and column for each service department shows zero. The rows sum to 100%, so that all services provided by each service department are charged out. 

The company decides to allocate the costs of Human Resources first, because it provides services to two other service departments, and provides a greater percentage of its services to other service departments. However, a case could be made to allocate Data Processing first, because it has greater total costs than either of the other two service departments. In any case, the company decides to allocate Data Processing second.

In the table below, the row for each service department allocates the total costs in that department (the original costs incurred by the department plus any costs allocated to it from the previous allocation of other service departments) to the production departments as well as to any service departments that have not yet been allocated.

After the first service department has been allocated, in order to derive the percentages to apply to the production departments and any remaining service departments, it is necessary to “normalize” these percentages so that they sum to 100%. For example, after H.R. has been allocated, no costs from D.P. can be allocated back to H.R. The percentages for the remaining service and production departments sum to 92% (7% + 30% + 55%), not 100%. Therefore, these percentages are normalized as follows:

• Risk Management: 7% ÷ 92% = 7.61%
• Machining: 30% ÷ 92% = 32.61%
• Assembly: 55% ÷ 92% = 59.78%
• Total: 100.00%

For example, in the table above, 59.78% of $136,000 (= $81,304) is allocated to assembly, not 55%.

The characteristic feature of the step-down method is that once the costs of a service department have been allocated, no costs are allocated back to that service department. As can be seen by adding $105,522 and $134,478, all $240,000 incurred by the service departments are ultimately allocated to the two production departments. The intermediate allocations from service department to service department improve the accuracy of those final allocations.