Many organizations have departments that provide services to other departments. For example, a janitorial department delivers services to the rest of a company, including the production departments and the other service departments. Accountants can choose from three different methods to allocate the costs of service departments to other departments. The sequential, or step-down, method is intermediate between the easy-to-use direct method and the complex reciprocal method.
Service Cost Allocation
Companies have several reasons to allocate service costs to production departments. Primarily, companies allocate these costs to products so that the cost of goods sold reflects all relevant expenses. Service cost charges allow department managers to budget their service usage and incentivize managers to reduce their use of intra-company services. If services are in short supply, placing a high price on their usage acts as a way to ration them. Allocations are tied to some cause-and-effect relationship, such as square footage or employee count for each department.
In the sequential method, a company allocates service costs one department at a time. The company allocates these costs to other service departments and to production departments. Once accountants allocate a service department’s costs, the department doesn't receive any costs from other service departments. For example, a company might first assign 5 percent of the janitorial service costs to the lunchroom, but the lunchroom would then not be able to assign any of its costs back to the janitors. The company allocates 5 percent because it’s the percentage of non-janitorial company employees who work in the lunchroom.
Sequential vs. Direct
The sequential method provides more information than the direct method, which allocates service costs only to production departments. In other words, the direct method ignores the services provided to other service departments. In the example, the company assumes that the lunchroom doesn't use janitors and that the janitors don’t eat in the lunchroom. The direct method, while less precise, is the quickest to calculate and requires no information regarding service department-to -service department usage. However, under the direct method, service departments have no incentive to minimize their utilization of other service departments.
Sequential vs. Reciprocal
The reciprocal method is complicated because it attempts to allocate all service costs to all departments regardless of sequence. For example, under this method, some costs of the janitorial department are allocated to the lunchroom and some lunchroom costs are assigned to the janitorial department. The method of solution requires simultaneous equations and collection of additional service cost data -- in this case, the lunchroom costs assignable to the janitorial staff. Unlike the sequential method, the order of assignment in the reciprocal method makes no difference to the final results.
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