To understand the step method of management accounting, it’s important to understand what this accounting practice entails, as well as the other methods of cost allocation. Business commentators use the terms “management accounting,” “cost accounting” and “managerial accounting” interchangeably. Cost allocation methods are diverse and include direct, step, fixed and variable.
Management accounting enables a company's leadership to figure out the best way to cut expenses and increase revenues, raise personnel's awareness with respect to profit management, prevent excessive spending and engage in sound budgeting that gradually brings the bottom line up. Cost accounting has an inward perspective -- unlike financial accounting, a discipline with an external focus that helps an organization tell the public how it fared over a given period. In managerial accounting activities, department heads and segment chiefs share their concerns about topics such as expense rise, runaway budget deficits and mediocre manufacturing efficiency.
In the step method of cost allocation, a company sequentially spreads service departments' expenses to other service and operating departments, starting with the department that has the highest cost amount and finishing with the unit featuring the lowest amount. For example, Department A and Department B spent $2 million and $1 million, respectively. Cost accountants also note that Segment A, Segment B and Segment C spent $500,000, $600,000 and $700,000, respectively. The cost allocation model at the end of the period is as follows: Department A: 50 percent, 30 percent and 20 percent to Segment A, Segment B and Segment C, respectively; and Department B: 60 percent, 20 percent and 20 percent to Segment A, Segment B and Segment C, respectively. Department A's allocation yields $1 million ($2 million times 50 percent) for Segment A, $600,000 for Segment B and $400,000 for Segment C. Department B's allocation yields $600,000 ($1 million times 60 percent) for Segment A, $200,000 for Segment B and $200,000 for Segment C. At the end of the first step of cost allocation, Segment A has $2.1 million ($500,000 plus $1 million plus $600,000), Segment B has $1.4 million and Segment C has $1.3 million. If the three segments serve other units, cost accountants would keep on allocating their costs until there's no expense spreading needed.
The step method of cost allocation helps a company accurately calculate expenses it incurs in different functions. This correctness is beneficial in budgeting and profit-planning discussions, as senior leaders may cut costs in one area if they believe that its expense-to-income ratio is not conducive to long-term profitability.
The direct method of cost allocation ignores reciprocal or interdepartmental services, spreading all expenses incurred in service departments directly to operating departments. This method is more straightforward, easy to implement and convenient for smaller manufacturing operations or service businesses, such as warehouse management entities and shipping companies.