Chapter 3 Service Department Costing

Service Department Costing

M ost of large organisations have both operating (production) departments and service
departments. The central purpose of the organisation are carried out in the operating
departments. In contrast, service departments do not directly engage in the operating
activities. Instead, they provide services or assistance to the operating departments. In a typical
manufacturing firm the products are manufactured in the production department and cost is
collected for the product or job using job costing or process costing in the production department.
In this way the service department cost does not transfer to the product, which creates costing and
pricing problem for the jobs. Therefore, the cost of the support departments should be transferred
to the jobs so that pricing of the product can be done, cost can be accurately estimated and
controlled etc. Following are some of the reasons for which the service department costs are
allocated to operating departments:

 To encourage operating departments to make wise use of service department resources. If

services were provided free, operating managers would be inclined to waste these
resources.
 To provide operating departments with more complete cost data for making decisions.
Actions taken by operating departments have impact on service departments.
 To help measure the profitability of operating departments. Allocating service department
costs to operating departments provides a more complete accounting of the costs incurred
as a consequences of activities in the operating departments.
 Allocating service department costs to operating departments provides a system of checks
and balances in the sense that cost-conscious operating departments will take an active
interest in keeping service department costs low.
 To value inventory for external financial reporting purposes.
 When cost-plus pricing is used, service department costs are commonly allocated to the
operating departments so as to include these costs in the cost base.

Allocations of Service department costs to operation departments

The cost is collected for each and every service departments. Sometimes few of the costs incurred in
the organisation can directly be identified with individual department. In such cases collecting cost
for service department is very easy. Suppose for each and every department separate electricity
meters are installed to measure the electricity consumption for a certain period. It can easily be
calculated the amount of electricity consumed by each departments. Similarly based on separate
telephone line connections, we can also find out the telephone bill of individual departments. But in
case it is centrally located, it becomes very challenging to find out the actual amount of these
expenses for individual departments. In those cases it is distributed among the departments on
certain basis. This initial distribution of overheads among various departments using some basis is
called primary distribution. Once the primary distribution is done and it has been transferred to
individual service departments then the cost is required to be transferred from service departments
to production or operation departments, where the products are manufactured. Then on the basis
of services consumed by individual production departments, the service department costs are
allocated/apportioned among production departments. This process is called secondary
distribution of overhead.

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Chapter 3 Service Department Costing

Exhibit 4-1
Service Dept-I Allocation of overhead

Operating
Department-I

Service Dept-II Product or

service

Operating
Department-II

Service Dept-III

Service department Operating department overhead

costs are allocated to costs, plus allocated service
operating department department costs are applied to
product and services

Primary Distribution of Overheads:

As it is discussed in the previous paragraph, first costs are directly identified with each and every
departments including service departments. There after we try to see the expenses incurred in the
firm which cannot be directly identified with the service departments but are also incurred for the
service departments. Then for those expenses we have to find out a suitable allocation base using
which we will allocate or distribute the cost among all departments and collect it for service
departments. For example, if separate electricity meters are not there to measure the unit
consumed in individual departments then we have to count the electric points for fan, light, ACs, etc
and on the basis of those points we have to divide the electricity expenses among various
departments.

Allocation base is selected keeping in mind the base which drives the cost. Ideally, all of the costs
that are being allocated should be driven by the allocation base in the sense that the costs being
allocated are directly proportional to the allocation base. Exhibit 1-1 gives a list of overhead
expenses which can be allocated/ apportioned among all the departments in the following basis:

Exhibit 4-2

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Apportionment of overheads among departments

Overheads Allocation base

a) Stores service expenses ............................. Value of materials consumed
b) Factory rent ............................................... Floor area
c) Municipal rent, rates and taxes................. Floor area
d) Insurance on Building and machinery........ Insurable value
e) Labour Welfare department expenses..... Number of employees/Direct wages
f) Supervision ............................................... Number of employees/Direct wages
g) Amenities to employee’s ......................... Number of employees/Direct wages
h) Employees liability for insurance............. Number of employees/Direct wages
j) Lighting power .......................................... Plug point
k) Stores overheads....................................... Direct material
l) General overheads .................................... Direct wages

After collecting the cost for all service departments we have to find out the way the production
departments are consuming the services of service departments. The service department costs are
apportioned among the production departments in the ratio of their consumption or services availed
from service departments. Following is given a chart of service departments and the way their cost is
apportioned among the production or operating departments.

Exhibit 4-3
Reallocation/ Reapportionment of service department cost to production department :-
1) Maintenance dept ......................................... Hours worked for each dept.
2) Pay roll and time keeping .............................. Total labour (or) machine hours (or) Number of
employees in each department
3) Personnel(HR) department........................... Rate of labour T.O (or) No. of
employees in each department
4) Stores Keeping department........................... No. of requisitions (or) value of materials of each
department
5) Purchase department ................................... No. of purchase orders value of materials of each
6) Welfare, ambulance, canteen, department
service, recreation room expenses....................
7) Building service department ........................ No. of employees in each department.
8) Internal transport service (or) Relative area each dept.
overhead crane service..................................... Weight, value graded product handled, weight
9) Transport department................................... and distance travelled
Crane Hours, truck hours, truck mileage, Number
10) Power house ............................................... of packages.
(electric power cost) Housing power, horse power machine hours,
No. of electric points etc.

The above table shows how the service department costs are to be allocated to production
department. But while doing so we face a challenge, when we see one service department's services

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are used by another service department. In such a situation, if we transfer directly cost of service
departments to production department them we don't get correct cost figure therefore we need to
first find out the cost incurred for the service department. For example, we see accounts
department maintain accounts related data of all department, similarly IT or computer department
also provides services for all the department. Hence, here both the departments provide services to
each other. In some other cases we find that one service department provides services to other
departments but don't availed services from them or provides services to many departments but
avails services from few. Now, these issues are to be handled properly. Otherwise, accurate costing
of product and services will not happen. Therefore, companies follow any of the following three
methods for redistribution of their service department costs to production or operation
departments.
Some time they follow the method, which suits them better and some time they compromise with it
when they find it very time consuming and expensive and the service department costs are not very
substantial.
1) Direct redistribution method:
This method is the simple method, where assumptions are service departments avail no service from
other service departments and only provides services to the production department. Practically may
not be the thing like that but allocation becomes simple as cost flows from service departments to
only production or operations departments. Small firms prefer to follow this method, as well as firms
with less proportion of service cost can afford to follow this method. Two features are give below:
 Service department costs are divided over production department.
 Ignore service rendered by one dept. to another

2) Step method of secondary distribution (or) Non reciprocal method:

This method is suitable to those situations where we can make hierarchy of service departments on
the basis of services provided by them to number of other service departments. Here, service
department which serves largest number of service department is divided first and thus it goes on.
We move one step down each and every time we allocate the cost of one service department. The
problem with this is to make that hierarchy, many a time we will have a tie, then we have to take a
call as to which is to be allocated first.

3) Reciprocal Distribution method:

Under this method the assumption is one service department provides services to as well as avails
services from other service department. Therefore, this allocation of cost is repeated a number of
time get their individual and independent cost which is then allocated to production departments.
There are few ways in which the calculation can be carried out for the allocation, which are given
below:
i) Simultaneous equation method (or) Algebraic method
 Equation is formed between service departments and is solved to find the amount due.

ii) Repeated distribution method:

 Service department cost separated repeatedly till figure of service dept. is exhausted or too
small.
iii) Trial and Error method:

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Chapter 3 Service Department Costing

 Cost of service department is apportioned among them repeatedly till the amount is
negligible and the total is divided among production department.

Practice Questions:
Q.No.1. KSOM has provided the following data to be used in its service department cost allocations:
Service Departments Operating Departments
Administrat Facility Undergraduate Graduate
-ion Services Programme Programme
Departmental costs before
allocation ₹ 24,00,000 ₹ 16,00,000 ₹2,68,00,000 ₹ 57,00,000
Student credit-hours 20,000 5,000
Space occupied-square feet 25,000 10,000 70,000 30,000

Required: Using the direct method, allocate the costs of the service departments to the two
operating departments. Allocate administrative costs on the basis of student credit-hours and facility
services costs on the basis of space occupied.
Sol: Second stage allocation of support department overhead(direct method)
Administration Facility Undergraduate Graduate
Services Programme Programme
Allocated overhead 24,00,000 16,00,000 2,68,00,000 57,00,000
Administration (24,00,000) -- 19,20,000 4,80,000
Facility Services -- (16,00,000) 11,20,000 4,80,000
Total overheads 2,98,40,000 66,60,000

Note: We can find out the POHR for both the programmes by dividing the total overheads of
Individual programmes by their individual credit hours.

Q.No.2. Royal Garden Co-op, a whole foods grocery and gift shop, has provided the following data to
be used in its service department cost allocations:
Service Departments Operating Departments
Administrat Janitorial Groceries Gifts
-ion
Departmental costs before
allocation ₹ 7,50,000 ₹ 2,00,000 ₹46,40,000 ₹ 19,00,000
Employee-hours 640 320 6,200 1480
Space occupied-square feet 500 200 8000 2000

Required: Using the step method, allocate the costs of the service departments to the two operating
departments. Allocate administrative costs first on the basis of employee-hours and then janitorial
costs on the basis of space occupied.

Q.No.3. The Vrinda Publishing Company has three service departments and two operating
departments. Selected data from a recent period on the five departments follow:
Service Departments Operating
Departments
Administration Janitorial Maintenanc Binding Printing
e
Overhead costs ₹ 1,40,000 ₹1,05,000 ₹ 48,000 ₹ 2,75,000 ₹4,30,000
Number of employees 60 35 140 315 760

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Square feet of space

occupied 15,000 10,000 20,000 40,000 1,85,000
Hours of press time 30,000 90,000

The company allocates service department costs by the step method in the following order:
Administration (number of employees), Janitorial (Space occupied), and Maintenance (hours of press
time).
Required:
Using the step down method, allocate the service department costs to the operating departments
and find out POHR taking press time as the basis.
Q.No.4. Modern Manufacturers Ltd. have three production departments P 1, P2,P3 and two service
departments S1 and S2 , the details pertaining to which are as under:
Particulars P1 P2 P3 S1 S2
Direct Wages(₹ ) 3000 2000 3000 1500 195
Labour hours 3070 4475 2419 - -
Value of machines (₹ ) 60000 80000 100000 5000 5000
H.P. of machines 60 30 50 10 -
Light points 10 15 20 10 5
Floor space(sq.ft.) 2000 2500 3000 2000 500

The following figures extracted from the accounting records are relevant: ₹
Rent and rates 50000
General lighting 6000
Indirect wages 19390
Power 15000
Depreciation 100000
Sundries 96950

The expenses of the service departments are allocated as under:

P1 P2 P3 S1 S2
S1(%) 20 30 40 -- 10

S2(%) 40 20 30 10 --

Find out the total cost of product X which is processed for manufacture in Departments P 1,P2 and P3
for 14, 8 and 7 hours respectively, given that its direct material cost is ₹1,500 and direct labour cost
₹ 1300.

Sol:
Ist stage and Second stage allocation of overhead
Amoun
Particulars t Basis P1 P2 P3 S1 S2

Rent and 1000 1250

rates 50000 Floor Space 0 0 15000 10000 2500
General
lighting 6000 Light points 1000 1500 2000 1000 500
Indirect 19390 Direct wages 6000 4000 6000 3000 390

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wages
Power 15000 H.P. of machines 6000 3000 5000 1000 0
2400 3200
Depreciation 100000 Value of machines 0 0 40000 2000 2000
3000 2000
Sundries 96950 Direct wages 0 0 30000 15000 1950
Direct Wages* 1500 195

7700 7300
Allocated overhead 0 0 98000 33500 7535
1005
S1 33500 6700 0 13400 0 3350
S2 10885 4354 2177 3266 1089 0
S1 1089 218 327 435 0 109
S2 109 44 22 33 11 0
S1 11 2 3 6 0 0
8831 8557
Total overheads 7 8 115140
Labour hours 3070 4475 2419
POHR 28.77 19.12 47.60

*Direct wages of support department is taken in second stage allocation because we have to
transfer all the cost incurred in Support department to production department
Cost of the job ₹
Material 1500
Labour 1300
Manuf. O/h:
P1 = 28.77 x 14 403
P2 = 19.12 x 8 153
P3 = 47.60 x 7 333
Total 3689

Q.No.5. Premier Ltd. has three production departments A,B and C and two service departments D
and E. The following figures are extracted from the records of the company:
₹
Rent and rates 5000
General lighting 600
Indirect Wages 1500
Power 1500
Depreciation of machinery 10000
Sundries 10000

The following further details are available:

Particulars Total A B C D E
Floor area(sq.ft.) 10000 2000 2500 3000 2000 500
Light points(Nos.) 60 10 15 20 10 5
Direct wages (₹) 10000 3000 2000 3000 1500 500
Horse power of machines 150 60 30 50 10 -

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Value of machinery(₹) 250000 60000 80000 100000 5000 5000

Working hours 6226 4027 4066 - -

The expenses of service departments D and E are allocated using repeated distribution method as
follows:
A B C D E
D 20% 30% 40% - 10%
E 40% 20% 30% 10% -

What is the total cost of an article if its raw material cost is ₹ 250, labour cost ₹ 130 and it passes
through departments A, B and C for 14, 15 and 8 hours respectively?

Q.No.6. Goodson Company has two support departments—Human Resources and General Factory
—and two producing departments—Grinding and Assembly. Budgeted data for each department is
given below:

Human General Grinding Assembly

Resources Factory
Direct costs ₹70,000 ₹230,000 ₹63,900 ₹39,500
Square feet 4,000 -- 2000 6,000
Direct labour hours 600 11,000 20,000 80,000
Machine hours --- 1,000 4,000 1,000
Required:
1. Allocate overhead costs to the producing departments using the direct method.
2. Calculate departmental overhead rates, using machine hours for Grinding and direct labour
hours for Assembly.
3. If a unit has a prime costs of ₹123 and spends one hour in Grinding and 12 hours in
Assembly, what is the unit cost?

Q.No.7. ATLAS Ltd. has got three production cost centres of Machining, Finishing and Assembly and
two service cost centers, Materials handling and Quality. The costs incurred by the service centers
are re-apportioned to the production centers. The following are the overhead cost which have been
allocated and apportioned to the five cost centers: (₹ ‘000)

Machining 400
Finishing 200
Assembly 100
Materials Handling 100
Quality 50

Estimates of the benefits received by each cost center are as follows:

Machining Finishing Assembly Materials handling Quality
Materials Handling(%) 30 25 35 -- 10
Quality (%) 20 30 45 5 --
You are required to :

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Calculate the charge for overhead to each of the three production cost centers, including the
amounts reapportioned from the two service centers, using:
Repeated distribution method(Reciprocal)

Q.No.8. The Sendai Co., Ltd., of Japan has budgeted costs in its various departments as follows for
the coming year:

Factory Administration ......................... ¥ 270,000,000

Custodial Services ................................. 68,760,000
Personnel............................................... 28,840,000
Maintenance ......................................... 45,200,000
Machining - overhead............................ 376,300,000
Assembly- overhead.............................. 175,900,000
Total cost .............................................. ¥ 965,000,000
The Japanese currency is the yen, denoted by ¥. The company allocates service department costs to
other departments in the order listed below.

Department Number of Total Square Feet of Direct Machine-

Employees Labour- Space Labour- hours
Hours Occupied Hours
Factory Administration 12 --- 5,000 --- ---
Custodial Services 4 3,000 2,000 --- ---
Personnel 5 5,000 3,000 --- ---
Maintenance 25 22,000 10,000 --- ---
Machining 40 30,000 70,000 20,000 70,000
Assembly 60 90,000 20,000 80,000 10,000
146 150,000 110,000 100,000 80,000

Machining and Assembly are operating departments; the other departments are service
departments. The company does not make a distinction between fixed and variable service
department costs. Factory Administration is allocated on the basis of labour-hours; Custodial
Services on the basis of square feet occupied; Personnel on the basis of number of employees; and
Maintenance on the basis of machine-hours.

Required:

1. Allocate service department costs to consuming departments by the step method. Then compute
predetermined overhead rates in the operating departments using a machine-hours basis in
Machining and a direct labour-hours basis in Assembly.

2. Repeat (1) above, this time using the direct method. Again compute predetermined ovehread
rates in Machining and Assembly.

3. Assume that the company doesn't bother with allocating service department costs but simply
computes a single plantwide overhead rate based on total overhead costs (both service department
and operating department costs) divided by total direct labour-hour Compute the plantwide
overhead rate.

4. Suppose a job requires machine and labour time as follows:

Machine- Direct Labour-

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hours Hours
Machining department 190 25
Assembly department 10 75
Total hours 200 100

Using the overhead rates computed in (1), (2) and (3) above, compute the amount of overhead cost
that would be assigned to the job if the overhead rates were developed using the step method, the
direct method, and plantwide method.

Q.No.9. “This is really an odd situation,” said Jim Carter, general manager of Moonland Publishing
Company. “We get most of the jobs we bid on that require a lot of press time in the Printing
Department, yet profits on those jobs are never as high as they out to be. On the other hand, we lost
most of the jobs we bid on that require a lot of time in the Binding Department. I would be inclined
to think that the problem is without overhead rates, but we’re already computing separate overhead
rates for each department. So what else could be wrong?”

Highland Publishing Company is a large organization that offers a variety of printing and binding
work. The Printing and Binding departments are supported by three service departments. The cost
of these service departments are allocated to other departments in the order listed on the following
page. (For each service department, use the allocation base that provides the best measure of
service provided, as discussed in the chapter.)

Department Total Square Feet Number of Machine- Direct

Labour of Space Employees Hours Labour-
Hours Occupied Hours
Personnel 20,000 4,000 10
Custodial Services 30,000 6,000 15
Maintenance 50,000 20,000 25
Printing 90,000 80,000 40 150,000 60,000
Binding 260,000 40,000 120 30,000 175,000
450,000 150,000 210 180,000 235,000
Budgeted Overhead costs in each department for the current year are shown below:

Personnel ₹ 360,000
Custodial Services 141,000
Maintenance 201,000
Printing 525,000
Binding 373,500
₹1,600,500
Because of its simplicity, the company has always used the direct method to allocate service
department costs to the two operating departments.
Required:
1. Using the step-down method, allocate the service department costs to the consuming
departments. Assuming that Personnel Department is providing services to all the rest of the
departments, then Custodial service which does not provide service to Personnel
department but to all others and last Maintenance Department which provides services to
Production departments only. Then compute predetermined overhead rates for the current

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year using machine-hours as the allocation base in the Printing Department and direct
labour-hours as the allocation base in the Binding Department.
2. Repeat(1) above, this time using the direct method. Again compute predetermined
overhead rates in the Printing and Binding departments.
3. Give your comment on the problem faced by Jim Carter based on your above calculations.

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