Reciprocal Allocation

Reciprocal allocation, also called the reciprocal method or algebraic method, is the most complete of the classic methods for allocating support department costs. Support departments such as IT, human resources and finance often serve each other as well as the operating departments of the business. IT runs the HR system, and HR recruits and supports IT staff. The reciprocal method accounts for all of these mutual services when assigning costs.

Because it recognizes services in every direction, the reciprocal method produces the most accurate picture of what each operating department actually consumes. The trade-off is complexity. It requires solving a set of simultaneous equations, which is straightforward with a spreadsheet or modeling tool but harder to explain to business leaders than the direct or step-down methods.

Definition of Reciprocal Allocation

Reciprocal allocation is a cost allocation method that calculates the total cost of each support department, including the costs it receives from other support departments, before allocating those totals to all departments that use its services. The calculation is done simultaneously for all support departments, so no department is treated as coming first.

It is one of three classic approaches to allocating support department costs, alongside direct allocation and step-down allocation. All three allocate the same total cost to operating departments, but reciprocal allocation distributes it most faithfully to actual service use.

The Simultaneous Equations

For each support department, an equation expresses its total cost as its own direct costs plus its share of every other support department's total cost. With two support departments, the equations might state that total IT cost equals IT's own costs plus 20 percent of total HR cost, and total HR cost equals HR's own costs plus 10 percent of total IT cost.

Solving the equations together gives the total, or reciprocal, cost of each support department. These totals are larger than the departments' own costs, because they include services received from each other. The totals are then allocated to all departments using the same service percentages.

With more than two or three support departments, the equations are best expressed as a matrix and solved with a spreadsheet function or a cost modeling tool. The same approach underlies many Technology Business Management (TBM) tools, which handle internal service charges between IT teams using similar logic so that shared platforms are costed correctly.

Why the Totals Balance

Although the reciprocal totals are larger than the support departments' own costs, the amounts allocated to operating departments still add up to the original total of all support department costs. The extra amounts circulate between support departments and cancel out.

This property makes the method reliable for reporting. The full cost of support departments is assigned to operating departments, with nothing lost or double counted, while every service relationship is reflected in the result.

Importance of Reciprocal Allocation in IT Financial Management

In many organizations, IT and other support functions depend heavily on each other. Shared platforms, enterprise systems and internal services mean that a large part of IT's work supports other support departments. The reciprocal method is the only classic method that captures all of this accurately.

Accuracy matters most when allocated costs drive real decisions, such as chargeback, pricing or decisions about outsourcing a support function.

Accurate Full Costs

By recognizing services in both directions, the reciprocal method avoids the distortions of the simpler methods. Operating departments bear support costs in proportion to the services they consume, both directly and through other support departments.

This accuracy supports better decisions. When a business unit's full cost includes a fair share of IT and HR, its leaders can make informed choices about demand, and executives can compare business units on a consistent basis.

Fair Internal Pricing

Organizations that charge internal services to business units through IT chargeback need rates that reflect true costs. The reciprocal method calculates the full cost of each support service, including the support it receives, which makes it a sound basis for internal rates.

It is also useful when comparing internal services with outside providers. A support department's reciprocal cost shows what the organization really spends to provide the service, which is the right figure to compare with an external quote.