Cost allocation for outside sources replacing service departments

Abstract

The validity of the linear algebra model to solve the reciprocal service department cost allocation problem has been widely recognized since Kaplan’s seminal paper in The Accounting Review in 1973 [2]. In a manufacturing company, certain departments can be characterized as production departments and others as service departments. Examples of service departments are purchasing, computing services, repair and maintenance, security, food services etc. The costs of such service departments must be allocated to the production departments, which in turn will allocate them to the product. We shall determine the exact price that should be paid to external suppliers of the same services currently supplied by the service departments. We shall also prove that once the costs of services allocated to each production department is obtained, then they will stay the same even if some of the service departments are replaced by outside sources.