Manufacturing Overhead:

Departmentalization
In a decentralized organization, the entity is divided into segments or
departments. These departments are headed by their respective
managers. These managers have the authority to decide matters in
their departments so the upper management can focus on long term
decisions what will affect the company's future. In a sales department,
the reordercan be set by the the manager for that department. There's
no need for the company president to be involved in such matters.

In cost accounting, it is important to identify which departments

indirectly contribute to the the manufacturing process. Departments
are grouped depending on which assets and employees are to serve a
specific purpose, and which duties must be segregated in order to
protect entity's assets and assure a more accurate financial reporting.
Failure to identify which departments provide support for the entity's
manufacturing process can seriously affect the entity's performance.
The costs incurred by these service departments will be included in the
overhead of the product to be sold. If the costing of the product is
understated, the proper price cannot be placed, resulting to a lower net
income.

Departments are divided into two:

1. Service departments
2. Producing department
Service Departments
Criteria that must be met to be considered service departments
1. It provides services to the producing entities.
2. It has no direct relation in the transformation of goods.

They must have some sort of activity performed in the producing departments. Not all
departments of an entity falls between these two categories. Some are neither service
nor producing departments. For example, the treasury department that seeks
opportunities to invest its idle cash for profit and maintain liquidity is neither a service
nor a producing department. Investments are not considered a normal business
operation if an entity is a manufacturing entity and does not provide support to its
producing department. Costs incurred in this department are expensed rather than
being capitalized as overhead.
Production Departments
Production departments are department that are responsible for the
direct transformation of goods. However, not all production
departments are manufacturing department since job order costing can
also be used for service entities, like hospital. In that case, all
departments where direct laborers are located are the so-called
“production departments”.
Steps in Allocating Service Departments'
Costs to Producing Departments
1. Accumulate the costs of the service department in a single cost pool
regardless of the activity basis and their nature (variable or fixed).
2. Identify the appropriate activity driver of the department. For
example, in a Building Maintenance Department, it might be
appropriate use the floor space occupied of the other departments as a
basis of distributing its cost.
3. Identify the most appropriate method of distributing the costs.
Methods of Allocating the Costs of Service
Departments
1. Direct Method
2. Step-down Method
3. Reciprocal Method
4. Dual-cost Method
Direct Method
• This method does not recognize the services rendered amongst
themselves. Costs are allocated to producing departments only.
• Simple and straightforward
• It does not matter the order in which the service departments costs
will be allocated.
Step-Down Method
• Recognizes the services rendered of the service departments amongst
themselves in a limited way.
• An order of priority is used to allocate the costs. The first priority is
given to the department who services the most. If two or more
departments are tied, the department which has the highest/higher
cost will be given the first priority.
Reciprocal Method
• Fully recognizes the services of the the service departments amongst
themselves. Costs are allocated to the service departments and
producing departments.
• Uses a mathematical formula to compute for for the cost of each
department.
Sample Problem:
Service Departments: Total Overhead Allocation Bases
Personnel Department 3,600 Number of Employees
Building Maintenance 2,000 Floor Space
Power Plant 1,000 Kilowatt Hours

# of Employees Floor Space kWh Total OH

Personnel 5 1,500 - 3,600
Building Maintenance 4 2,500 - 2,000
Power Plant 2 4,000 - 1,000
Machining 10 10,000 7,000 11,800
Assembly 20 10,000 3,000 8,600
Direct Method
Steps:
1. Identify the service departments. Let us allocate first the cost of the personnel
department. You may try doing the power plant first. The answer will be the same.
2. Accumulate the cost of the service department in a single cost pool. The total
cost for the personnel department is P3,600. This is assumed to be inclusive of all
variable and fixed costs.
3. Use the direct method.
a. Derive a fraction that will only consider the producing departments.
b. Multiply the cost by the fraction.
c. Do this to other service departments.
Personnel Cost: 3600
# of Employees Fraction Cost x Fraction
Machining 10 10/30 1200
Assembly 20 20/30 2400
30
Building Maintenance Cost: 2000
Floor Space Fraction Cost x Fraction
Machining 10000 10000/20000 1000
Assembly 10000 10000/20000 1000
20000

Power Plant Cost: 1000

Floor Space Fraction Cost x Fraction
Machining 7000 7000/10000 700
Assembly 3000 3000/10000 300
10000
Step-Down Method
Steps:
1. Identify the service departments.
2. Accumulate the cost of the service department in a single cost pool.
3. Apply the procedures of the step-method:
a. The order of priority must be observed. It will be given to the department that
serves the most. If there's a tie, it goes to the department with a higher cost.
b. Develop fractions which includes both service departments and producing
departments.
c. Once the service department's costs have been allocated, it must not receive any
more allocations.
d. Re-do step A for the remaining departments.
 # of Dept. Services
Personnel 4(BM, PP, M, A)
Building Maintenance 4(BM, PP, M, A)
Power Plant 2(M, A)

The personnel and building maintenance tied, serving 4

departments, excluding themselves. The power plant only serves
the machining and assembly departments. To determine who has
the first priority, compare the cost of the personnel and building
maintenance. Since the personnel has a higher cost, it will be
allocated first.
 Personnel Cost: 3600
# of Emp. Fraction Cost x Fraction
Machining 10 10/36 1000
Assembly 20 20/36 2000
Building M. 4 4/36 400
Power P. 2 2/36 200
36

Building Maintenance Cost: 2000+400

Floor Space Fraction Cost x Fraction The cost to be destributed in inclusive of the cost
Machining 10000 10/24 1000
Assembly 10000 10/24 1000
allocated by the Personnel Department
Power P. 4000 4/24 400 The Personnel Department is no longer included in
24000 the allocation.
Power Plant Cost: 1000+200+400
kWh Fraction Cost x Fraction The cost to be destributed in inclusive of the cost
Machining 7000 7/10 1120
Assembly 3000 3/10 480
allocated by the Personnel Department and Building
10000 Maintenance.
The Personnel Department and Building
Manitenance are no longer included in the allocation.
Reciprocal Method
Steps:
1. Identify the service departments
2. Accumulate the costs in a single cost pool per department.
3. Apply the procedures in using the reciprocal method.
a. Derive a formula for each service department that will equate the total costs
after interservice were recognized but before distribution to the producing
departments.
b. Solve the equation by substitution or elimination method.
c. Allocate the cost of the service departments to other service departments and
producing departments. Unlike the step-down method, there is no order of priority.
 Services Provided to Depts in Terms of # of Employees
Department Personnel Building M. Power P. Machining Assembly Total

Personnel - 4 2 10 20 36
% - 11% 6% 28% 56% 100%

Services Provided to Depts in Terms of Floor Space

Department Personnel Building M. Power P. Machining Assembly Total

Building M 1500 - 4000 10000 10000 25500

% 6% - 16% 39% 39% 100%

Services Provided to Depts in Terms of kWh

Department Personnel Building M. Power P. Machining Assembly Total

Power P. - - - 7000 3000 10000

% - - - 70% 30% 100%
 Department Personnel Building M. Power P. Machining Assembly

Personnel - 11% 6% 28% 56%

Building M. 6% - 16% 39% 39%
Power P. - - - 70% 30%

Deriving a formula is very simple. Equate the total costs by adding the allocations of the other
service departments to the service department's overhead. In this case, to derive the total cost
equation for the Personnel Department, get its cost, which is P3,600 and add the allocations
received from either the Building Maintenance or Power Plant(this is zero lol). Since it will receive
6% allocation from the Building Maintenance, the formula will look like this: P = 3,600 + 6%B
The same must be observed for the Building Maintenance. Its formula will look like this: B = 2,000 +
11%P.
There is no need to derive the formula for the Power Plant because it does not provide any
allocations to the other service departments.
 P = 3,600 + 6%B
B = 2,000 + 11%P

SUBSTITUTION METHOD:
ELIMINATION METHOD:
P = 3,600 + 6%B P = 3,600 + 6%B
B = 2,000 + 11%P
P = 3,600 + 6%(2,000+11%P)
P = 3,600 + 120 + .0066P let's eliminate B

P = 3,720 + .0066P P = 3,600 + 6%B B = 2,000 + 11%P

-11%P = 2,000 - B B = 2,000 + 11%(3,745)
.9934P = 3,720 B = 2,000 + 412
P = 3,600 + 6%B B = 2,412
P = 3,745 (-11%P = 2,000 - B)6%

P = 3,600 + 6%B
B = 2,000 + 11%P -.0066P = 120 - 6%B

B = 2,000 + 11%(3,745) P = 3,600

B = 2000 + 412 -.0066P = 120
.9934P = 3,720
B = 2,412
P = 3,745
Dual-cost Method
This method is different from the other three because the costs of each
service department must be classified and segregated. Variable costs
are allocated on a different basis, which utilizes the entity's short term
data. On the other hand, fixed costs are allocated based on the long
term data.