Reciprocal service department cost allocation and decision making

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, and so forth. The costs of such service departments must be allocated to the production departments, which in turn will allocate them to the product. It is known that one can view the cost allocation problem as an absorbing Markov process, with the production departments as the absorbing states and the service departments as the transient states. Using Markov analysis, we will show that this yields additional insight into the underlying concept of reciprocal service department cost allocation by proving that the “full service” department costs can be used to determine the price that should be paid to an external supplier of the same service currently supplied by the service department.