When cost accounting, the step-down allocation method allows support departments to allocate costs to each other — and ultimately to the operating departments. To accomplish this, the support departments are ranked. The ranking is often based on the percentage of costs that a support department incurs to support other support departments.
The support department with the highest percentage is allocated first. All of its costs are allocated out — whether to an operating department or to another support department. After that, the support department with the second-highest percentage is allocated. Step by step, the costs for each support department are fully allocated. In the end, the calculation “goes flat,” because all costs are allocated.
Your company has both a human resources (HR) department and a legal department which support two operating departments: assembly and shipping. Say $10,000 of the human resources cost is allocated to the legal department. Legal doesn’t allocate any costs to human resources. So you rank the HR department higher than legal. That’s because HR allocates support costs to another support department and legal doesn’t. This table shows that allocation.
| Legal | Assembly | Shipping | ||
|---|---|---|---|---|
| Beginning balance | $300,000 | $1,000,000 | $75,000 | |
| HR cost allocation | ||||
| $100,000 | $10,000 | $10,000 | $80,000 | $10,000 |
| Legal cost allocation | -$10,000 | |||
| $200,000 + $10,000 | $189,000 | $21,000 | ||
| Total allocation | -$310,000 | $269,000 | $31,000 | |
| Ending balance | $0 | $0 | $1,269,000 | $106,000 |
All good, except there’s a drawback. This allocation method doesn’t allow costs to be allocated between multiple support departments. For example, what if legal also provides services to the HR department? When you rank the support departments and allocate out the costs, you can’t allocate costs back in.
