In process costing, all of the processing departments are classified as operating departments. Other departments, called service departments are needed for the business to operate, but do not directly engage in operating processes.  Service departments include accounting, human resources and purchasing. These departments all provide services to each of the operating departments.

So with our Ultimate Planner business, the product itself is produced in the production/manufacturing department, but in order for that department to run, payroll needs to be prepared, employees need to be hired and product needs to be purchased. There are two main ways to allocate these service costs to the operating departments to make sure we are including all of the costs when we price our products.

The first method is the direct method. This is the simplest and most commonly used method of allocation.

In this method, we will be ignoring the fact that one service department may offer services to another service department. For example, the HR department will offer services to the accounting department by hiring staff and providing training. Instead, we will allocate ALL of the services of each of these departments to the operating departments.

We can allocate using a couple of different methods of allocation. Some costs may be allocated based on employee hours.  Administration costs are a good example here. So the hours incurred by administrative departments such as payroll, purchasing, accounting and HR, would be allocated, based on the number of hours worked in each of the operating departments and allocated accordingly.  Here, if process 1 of manufacturing our Ultimate Planner takes 5,000 hours per period, while packaging (process 3) only takes 1,000 hours per period, then allocation based on employee hours would be the most effective way to allocate service costs.

Custodial services on the other hand, may be better allocated based on the square footage of each of the operating departments. If the press area (process 1) of the Ultimate Planner business occupies 10,000 square feet, while the packaging area only occupies 2,000 square feet, it probably takes more custodial effort in the press area! So allocation on space would work best.

The second method is called the step-down method. This method is more complicated than the direct method, as it also takes into account the services that one service department offers another.

Note in this method, the human resources costs are allocated between custodial and all of the operational processes, while in the direct method, human resources and custodial are directly allocated to the operational processes.

So if the custodial department cleans the HR department, some costs from the custodial department should be allocated to the HR department, right? Also, the HR department provides services to the custodial department, by hiring and training the employees, so some of the HR costs should be allocated to the custodial department.

There are many reasons companies may use each of these allocation methods. Here is another explanation of this concept if you would like further clarification.