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.

Example: Step-down allocation of HR and IT

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: Ranking involves management judgment. HR goes first here because it has the larger cost pool and serves IT more (50 of 300 employees, about 17%) than IT serves HR (20 of 220 computers, about 9%).

• 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)
HR’s 20 computers are excluded too: HR is already closed, so it receives nothing back from IT - ignoring that service is the step-down method’s partial recognition of inter-service support.
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

Comparing the allocation order

Sequence changes the split between departments, not the total. If IT is allocated first instead (computers: HR 20, Dept A 100, Dept B 100, total 220), IT sends HR about $3,636 and Dept A/Dept B about $18,182 each; HR’s pool then grows to about $63,636, split by employees (100/150) into about $25,455 to Dept A and $38,182 to Dept B. Combined, Dept A totals about $43,636 and Dept B about $56,364 - versus $45,000/$55,000 when HR is allocated first.

The direct method, which ignores inter-service usage entirely, gives Dept A $44,000 and Dept B $56,000. All three approaches total $100,000; only the split between departments changes. The reciprocal method, covered later, accounts for inter-service support in both directions.

Benefits and limitations of the step-down method

• More accurate than the direct method, since it captures some inter-service department interactions, though only in one direction.
• Balances accuracy and simplicity compared to the more complex reciprocal method.
• Sequencing matters: the order chosen affects the final cost split, as shown above.
• More complex to apply than the direct method, especially with several service departments.