Method of Indirect Cost Allocation

1. Allocation Principle

• Cause & Effect:
  A product should absorb the cost of any department whose services it uses.

2. Department Groups

• Production Departments
  • Directly involved in manufacturing (e.g., Assembly, Maintenance, Inspection, Packing, Stores, Design).
• Service Departments
  • Support functions (e.g., Human Resources, Accounting, Legal, IT, Sales & Distribution).

Challenge: No direct “usage” link between service departments and products.

3. Two‑Stage Allocation

1. Allocate service‑department costs → production departments
2. Allocate combined production‑dept costs → individual products
3. Issue: Service departments often serve one another as well

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4. Allocation Methods

4.1 Equal‑Split (Ad Hoc)

• Pool all service costs
• Divide equally across production departments
• Drawback: Ignores actual usage

4.2 Simple Ratio Basis

• Choose one driver (e.g., headcount or machine‑hours)
• Allocate in proportion of that driver
• Drawback: Single driver may misrepresent true service usage

4.3 Step‑Wise (Sequential) Allocation

1. Rank service departments (e.g., by cost size or share of service to other SDs)
2. Allocate smallest (or lowest‑service) department’s cost to all other departments (prod + service) using estimated usage percentages
3. Remove that department; move to next
4. Ignore any back‑services to already‑allocated departments

Yields different totals depending on sequence.

4.4 Reciprocal (Simultaneous) Allocation

• Fully account for mutual services among all service departments
• Set up & solve simultaneous equations for each SD’s total cost allocation
• More accurate, but more complex computationally

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5. Sunshine Chemicals Example

5.1 Data

Department	Type	Cost (₹ lakhs)
Plant X (Chemical X)	Production	—
Plant Y (Chemical Y)	Production	—
Maintenance	Service	20
Personnel (HR)	Service	6
Accounting	Service	11

Usage Data

• Employees: Maint 40; Pers 10; Acct 20; X 200; Y 300
• Machine‑hours: X 12,000 hrs; Y 28,000 hrs

5.2 Option 1: Equal Split

• X = ₹18.5 L; Y = ₹18.5 L

5.3 Option 2: Single Ratio

• By employees (200:300 → 2:3) or machine‑hrs (12k:28k → 12:28)
• No guarantee actual service usage matches these ratios

5.4 Option 3: Step‑Wise Allocation

1. Choose sequence (e.g., lowest cost first: Personnel → Accounting → Maintenance)
2. Allocate Personnel (₹6L) by headcount:
   • X: (200/(200+300+40+20))≈… → ₹…
   • Y: …
   • Maint: …
   • Acct: …
3. Allocate Accounting (₹11L + alloc from Pers) by service estimates:
   • X: 40% → …
   • Y: 57% → …
   • Maintenance & Personnel: …
4. Allocate Maintenance (₹20L + previous allocs) by its service percentages
5. Results:
   • X total SD cost ≈ ₹13.20 L
   • Y total SD cost ≈ ₹23.80 L

Alternate sequence (highest inter‑service share first) yields slightly different totals.

5.5 Option 4: Reciprocal Method

• Form simultaneous equations for “total cost” of each service dept
• Solve to allocate fully reciprocal service loads → most precise

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