How to allocate overhead

Overview: Reciprocal Method of Cost Allocation

Article written by EricBank

The topic of intra-company cost allocation can sometimes seem a little hairy. Many businesses are structured with departments that provide service and support to production departments and to other service departments. For example, your company might have a private gym and a food service department. Non-production departments can be costly to run, so using a cost allocation scheme ensures that production departments pick up their fair shares of these costs. One of three widely used techniques for allocating the costs of service departments is the reciprocal, or double-distribution, method. The direct and step-down methods are the two other popular ones, but as we discuss below, the reciprocal method usually gives the most accurate results.

Benefits of Cost Allocation

There is no better way to sensitize a department manager to the budgetary impact of service costs than to assign these costs to the manager's department. You know you are getting the manager's attention if the department suddenly adjusts its budget to reduce its utilization of overhead service from other departments once these services come with a price tag. Another benefit of overhead-cost allocation is to ration it, on the assumption that these costs involve scarce or expensive resources. For example, you might have a company with a central Information Technology Department that services requests from six other departments. No matter how many people you hire, you never have enough to quickly satisfy all requests. In this case, department managers might bid for IT services by rearranging their budgets to support more of this overhead. Presumably, those with the greatest needs would make the highest bids.

Cost Allocation Methods

The easiest technique for assigning service department costs is the direct method. That's because it allocates costs to production departments only and turns a blind eye to the overhead costs between service departments. For example, the food service department wouldn't charge the gym personnel for their snacks, and the gym wouldn't allocate costs to the food service employees who use the gym. The step-down method allocates service department costs in only one direction. For example, the company might allocate gym usage cost to the food service department but charge no food service costs to the gym. The reciprocal method would charge costs in both directions.

Reciprocal Method

The reciprocal method permits service departments to charge each other for the services they deliver. You must solve a set of simultaneous equations to use this method. Luckily, computer programs or spreadsheets provide this functionality. Some rational metric serves to allocate costs to each department. Metrics such as the physical square footage of a department or its number of employees are popular choices.

Example

Let's say your business has three support departments, A, B and C, and two production departments, M and N. To allocate costs using the reciprocal method, you first assign each support department a linear equation. Then you simultaneously solve all three equations. Suppose the annual budget of Dept. A is $70,000 and that it uses 9 percent of Dept. B's services. Thus, Dept. A's linear equation sets its assignable costs equal to $70,000 plus 9 percent of Dept. B's budget. Similarly, you set up linear equations for the other support departments, let the computer solve them, and then modify the budgets of the production departments to absorb these costs.