When you break it down, the real purpose for developing an indirect rate structure is to accurately allocate indirect costs to your products and services. Accurate allocations of indirect costs provide a better understanding of the “true” cost of your products and services and consequently what pricing is required to ensure a profitable return for your efforts.
Properly and efficiently allocating each individual indirect costs each time it is incurred is inefficient and open to the incurrence of errors and cost misallocations. The use of service centers to accumulate indirect support costs that benefit more than one indirect cost pool or cost objective and allocating the composite of these costs on an established basis representative of their usage simplifies the allocation process. The accumulation of these support costs in one place also provides management with a clearer picture of the actual cost of providing the services involved facilitating the make-or-buy/outsourcing decisions regarding the services involved.
The inclusion of support costs allocated via a general and administrative or overhead rate calculation broadly applies these costs over all efforts on a broad brush basis with no recognition of usage or variable cost utilization.
Some examples of service centers and the costs they accumulate that might be established include:
- Facilities (personnel, rent, depreciation, maintenance, utilities, etc.)
- Information Technologies (personnel, telephone, internet, web services, etc.)
- Transportation (personnel, maintenance, depreciation, lease costs, fuel, etc.)
- Security (personnel, training, electronic and physical support systems, etc.)
Once your service centers are established you will need to define the basis and process for allocating the costs accumulated in the service center. Careful consideration must be given to determining the allocation basis that most accurately represents the consumption or usage of the efforts provided by the subject service. Common metrics utilized include square footage of the facility, headcount, or an actual documented usage. Just as important, the metric chosen must be easily calculated and verifiable (i.e., audited).
There are multiple allocation practices, including many that can become a mathematical nightmare with minimal impact on the accuracy of the allocation. Two methods for allocation that are relatively simple and easily applied include the direct allocation and the step-allocation methods. With either method, it is important to remember that once a service center’s costs have been allocated, no other service center’s costs can be allocated to it. The metric used to allocate a given service center should exclude the service center itself to prevent allocating costs back on itself. Once the service center has been fully allocated, no costs are to remain in the service center.
The direct allocation method is a simple allocation of the costs accumulated in the service center based on its established basis of allocation. The total cost accumulated in the specific service center is allocated and the service center balance is brought to zero and the end of each allocation period (i.e., month). Once all costs in the service center are allocated no further costs are to be allocated to it.
The step method of allocation is more accurate than the direct method requiring the establishment of a hierarchy of allocation. First, one service center is completely allocated, including other applicable service centers, and then the next service center would be allocated until all service centers have been allocated.
Whichever method of allocation is selected, management must ensure that the service center cost has been completely allocated and the purpose and cost content of the service center and the allocation method utilized are fully defined in written policies and procedures.