The step allocation method is an approach used to allocate the cost of the services provided by one service department to another service department. The essential steps in this allocation process are:
- The service department that provides service to the largest number of other service departments or which has the largest percentage of its costs consumed by other service departments allocates its costs to them first. It also allocates its other costs to the operating departments.
- The service department that provides service to the next-largest number of other service departments or which has the second-largest percentage of its costs consumed by other service departments allocates its costs. Again, its other costs are allocated to the operating departments at this time.
- The process continues until the service department that provides service to the smallest number of other service departments or has the smallest percentage of its costs consumed by other service departments has allocated its costs. Once these allocations have been completed, the process stops.
For example, a company ranks its service departments by the percentage of its costs that are consumed by other service departments. Based on this analysis, the accounting department is ranked first, followed by the human resources department and then the legal department. The accounting department has $100,000 to allocate, of which $80,000 goes to the human resources department and $20,000 to the legal department. The human resources department goes next; this department must add the $80,000 allocation from the accounting department to its own costs. Human resources allocates $7,000 to the legal department (its other costs are allocated to operating departments). The legal department goes last; this department must add the $7,000 allocation from the human resources department to its own costs. There are no service departments left, so the legal department can only allocate costs to operating departments.
At no point in the step allocation process is there any reciprocal allocation of service costs back to the service departments that have already allocated their costs out to other departments. For example, if the human resources department is ranked higher than the legal department, the human resources department can allocate its costs to the legal department, but the legal department cannot allocate its costs back to the human resources department. Because of this lack of reciprocal allocations, the step allocation method is not the most theoretically correct. However, it is a relatively simple method, and so is commonly used.