CHAPTER 7 DEPARTMENTALIZATION OF OVERHEAD AND ALLOCATION OF SERVICE DEPARTMENTS'
COST
CLASSIFICATION OF DEPARTMENTS
By DEPARTMENTALIZATION, every department can achieve a certain degree of
specialization that contributes to their efficient performance. the management of
the units is also made
easier since the smaller units are more manageable than the bigger ones.
Departments inside a factory are classified into PRODUCING DEPARTMENTS and SERVICE
DEPARTMENTS. PRODUCING DEPARTMENTS PERFORMING THE PRODUCTION activities. directly
involved in manufacturing the products. Examples of producing departments CUTTING,
STITCHING OR SEWING, ASSEMBLY, MIXING, AND FORMING. SERVICE DEPARTMENTS other
SATELLITE DEPARTMENTS in
the factory that SERVICE THE NEEDS OF THE PRODUCING DEPARTMENTS. Examples of
service departments QUALITY CONTROL, ENGINEERING & MAINTENANCE, RAW MATERIALS
WAREHOUSE, AND INDUSTRIAL
ENGINEERING.
DIRECT AND INDIRECT DEPARTMENTAL OVERHEAD COSTS
DIRECT DEPARTMENTAL OVERHEAD COSTS can be DIRECTLY TRACED to a SPECIFIC PRODUCTION
OR SERVICE DEPARTMENT. Examples of direct department overhead:
a. Salaries of employees assigned to the department.
b. Depreciation of machines, furniture, or equipment assigned specifically to the
department.
c. Repairs and maintenance costs incurred in the department.
d. Cost of utilities, if there is a separate meter to measure the power or water
consumption of the department.
e. Other overhead costs than can be directly traced to a specific department.
The TOTAL OVERHEAD COSTS of the PRODUCING DEPARTMENTS ARE DIRECT OVERHEAD because
they are DIRECTLY IDENTIFIED with a particular production operation.
Service departments SERVE not only one but ALMOST ALL THE PRODUCTION DEPARTMENTS
EVEN THE OTHER SERVICE DEPARTMENTS. Their overhead can hardly be identified with
any particular production
operation. This causes the difficulty of charging their overhead to production. It
is necessary to establish a reasonable basis for allocating their overhead to the
departments that they
serve.
The OVERHEAD OF SERVICE DEPARTMENTS is ALLOCATED to the PRODUCING DEPARTMENTS
because they are established to SUPPORT the PRODUCING DEPARTMENTS. Allocation is
necessary to provide more
accurate costs of the products.
CHOOSING THE ALLOCATION BASE
The one doing the allocation should try to SELECT THE BASE THAT IS REFLECTIVE of
HOW THE PRODUCING DEPARTMENTS CONTRIBUTE to the incurrence of the overhead of a
particular service
department. In allocating the overhead, THE PRODUCTION DEPARTMENT THAT CONTRIBUTES
MORE TO THE INCURRENCE OF OVERHEAD should have a BIGGER SHARE in the overhead of
such service department.
The allocation bases could be either of the following:
1. Number of employees
2. Area of square footage occupied by the department
3. Machine hours
4. Electricity consumption based on kilowatt-hours consumed
5. Direct labor hours
6. Cost of materials issued to the department
An allocation base is a number that affects the incurrence of overhead. In other
words, if the number of that allocation base changes the amount of overhead
incurred will also change.
For example, more overhead would be incurred if there are more employees. Likewise,
a larger area occupied will normally have more overhead than that in a smaller
area.
THE METHODS OF ALLOCATION
The overhead of service departments CAN NOT IMMEDIATELY be charged to the products
because THERE IS NO CLEAR AND DIRECT MEASUREMENT of how the overhead will be
charged. A method of
the allocation has to be established for this purpose.
THREE METHODS OF ALLOCATING THE OVERHEAD OF THE SERVICE DEPARTMENTS:
a. Direct method
b. Reciprocal method
c. Step method
DIRECT METHOD
DIRECT METHOD SIMPLEST of all allocation methods. Under THE DIRECT allocation
METHOD, the OVERHEAD COST OF THE SERVICE DEPARTMENTS is ALLOCATED ONLY to the
PRODUCING DEPARTMENTS. It is
important that the overhead of the service departments is allocated to the
producing departments to ensure that all overhead in the factory is charged to
production in computing the cost
of the product. When the overhead costs of the producing departments are finally
charged to production, the amount charged will be the production department's own
cost and
their share of the overhead of the service departments.
STEP DOWN METHOD
STEP METHOD is also called SEQUENTIAL METHOD. The OVERHEAD of a SERVICE DEPARTMENT
is ALLOCATED NOT ONLY TO THE PRODUCTION DEPARTMENTS but also some OTHER SERVICE
DEPARTMENTS. It cannot be
denied that some service departments provide service also to some other service
departments. For example, the maintenance department also services Quality Control
or Production Planning
Departments or the Raw materials Warehouse.
It is necessary to determine the sequence of allocation as the sequence will affect
the amount of overhead that will ultimately be allocated to the production
departments. Once
the overhead of a service department has been allocated, no other overhead shall be
allocated back to it. The best sequence to start with the department that services
the most number of
departments.
RECIPROCAL METHOD
RECIPROCAL OR ALGEBRAIC METHOD most COMPLEX METHOD REQUIRES MORE CALCULATIONS. MOST
ACCURATE METHOD of allocating the overhead cost of service departments. It also
considers the fact that
service departments may serve not only the production departments but may also
service each other. For example, the Raw Materials warehouse services the Quality
Control Departments for the
supplies requisitions. On the other hand, Quality Control Department services the
Raw Material Warehouse for the inspection of new arrivals of raw materials.
ILLUSTRATIVE EXAMPLE
A. DIRECT ALLOCATION METHOD
STEPS:
1. Total(32,000) the cutting(8,000), stitching(20,000), and finishing(4,000).
2. Find the ratio. Divide the cutting(8,000) by the total(32,000). Divide the
stitching(20,000) by the total(32,000). Divide the finishing(4,000) by the
total(32,000).
3. Write the total of the Raw Materials Warehouse, Quality Control, and
Engineering. Multiply their total by the ratio to get the portion for cutting,
stitching, and finishing.
4. Write the cost of cutting, stitching, and finishing. Total them.
5. Total the cutting, stitching, and finishing. Total their total.
B. STEP-DOWN ALLOCATION METHOD
STEPS:
C. RECIPROCAL OR ALGEBRAIC METHOD
STEPS:
1. Get the ratio or percentage of the service departments.
(1000/20500 = 0.0488 or 4.88%)
