Allocation of service department costs: step-down method

Step-down method of allocation

The step-down method, also known as the sequential method, provides a more refined approach than the direct method by partially accounting for inter-service department support. It recognizes that some service departments provide services to other service departments, but it only allocates these once and only in one direction, based on a predetermined sequence.

How it works

In the step-down method, service departments are ranked in order of importance or usage (e.g., based on total dollars, extent of services provided to other departments, or management judgment). The department that provides the most service to others is allocated first, distributing its costs to both service and operating departments. Once a service department’s costs are allocated, it is “closed,” and no subsequent allocations are made back to it.

Key features

• Partially accounts for inter-service support: Better than the direct method in environments with significant service overlap.
• Sequencing matters: The allocation order affects final results.
• Unidirectional: Once a department is allocated, it does not receive any allocations from others.

Example: Assume a company has the following departments:

Service departments:

• Human Resources (HR): $60,000
• Information Technology (IT): $40,000

Operating departments:

• Department A
• Department B

Department	Number of Employees	Number of Computers
HR	10	20
IT	50	20
Dept A	100	100
Dept B	150	100

Let’s allocate HR costs based on the number of employees and IT costs based on the number of computers. Note that we need to ignore the cost drivers in the department itself (i.e. number of computers in IT) because we need to allocate the service department costs to the other departments.

Ranking of the service departments: Note that the ranking can be judgemental to the Company.

• HR: $60,000 (ranked 1st, allocates to IT, Dept A, and Dept B)
• IT: $40,000 (allocates only to Dept A and Dept B after receiving from HR)

Step 1: Allocate HR ($60,000)

Base: Number of employees (only for IT, A, B)
Total employees = 50 (IT) + 100 (A) + 150 (B) = 300

• IT: (50 ÷ 300) × 60,000 = $10,000
• Dept A: (100 ÷ 300) × 60,000 = $20,000
• Dept B: (150 ÷ 300) × 60,000 = $30,000

New IT total to be allocated further = $40,000 + $10,000 = $50,000

Step 2: Allocate IT ($50,000)

Base: Number of computers (only for Dept A and B)
Total = 100 + 100 = 200

• Dept A: (100 ÷ 200) × 50,000 = $25,000
• Dept B: (100 ÷ 200) × 50,000 = $25,000

Final allocated costs:

Department	From HR	From IT	Total
Dept A	$20,000	$25,000	$45,000
Dept B	$30,000	$25,000	$55,000

Benefits of the step-down method

• More accurate than direct method, as it considers some inter-service department interactions
• Balances accuracy and simplicity
• Appropriate for mid-sized firms with moderate service interdependency

Limitations of the step-down method

• Only partial inter-service support is captured
• Allocation sequence can skew results
• More complex than direct method, especially with many service departments