Cost Allocation for Service Department
Introduction:
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
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