Complete all the reading assignments for this course (all 5 modules) prior to beginning work on this assignment. These readings have a direct relation to the case. Read Case 24: R

  1. Complete all the reading assignments for this course (all 5 modules) prior to beginning work on this assignment. These readings have a direct relation to the case.
  2. Read Case 24: River Community Hospital (A), Assessing Hospital Performance, on pp 159-160 of Pink and Song (2018) (Links to an external site.).
  3. Write a written report to the hospital's board of trustees (following APA format) detailing answers to the following:
    • Interpret the hospital's statements of cash flows.
    • Present an overview of the hospital's financial position using the Du Pont equation as a guide.
    • Use ratio analysis to identify the hospital's specific financial strengths and weaknesses. Note: The board is not going to appreciate a lengthy dialogue with too many individual ratios. Focus on key findings and one or two ratios per category – don't put them to sleep! Also, use graphs or other techniques to summarize the data.
    • Use operating indicator analysis to identify the operational factors that explain the hospital's current financial condition.
    • Summarize your evaluation of the hospital's financial condition. However, don't just rehash the numbers; rather, present your views on the potential underlying economic and managerial factors that might have caused any problems that surfaced in the financial and operating analysis.
    • Make any recommendations that you believe the hospital should follow to ensure future financial soundness.
  4. Prepare your assignment for submission:
    • Follow all applicable APA Guidelines (Links to an external site.) regarding in-text citations, list of cited references, and document formatting for this paper. Failure to properly cite and reference sources constitutes plagiarism.
    • The title page and reference list are not included in the page count for this paper.
    • Proofread your assignment carefully. Improper English grammar, sentence structure, punctuation, or spelling will result in significant point deductions.

Reference:

For Book Chapters: 

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Louis Gapenski. (2016). Healthcare Finance: An Introduction to Accounting and Financial Management, Sixth Edition: Vol. Sixth edition. Health Administration Press. 

For Pages 159-160 documents:

G. Pink, and P. Song (2018). Gapenski's cases in healthcare finance, sixth edition: Sixth edition. Health Administration Press.

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CHAPTER

201

DEPARTMENTAL COSTING AND COST ALLOCATION

Introduction

In Chapter 5 we discussed organizational costing, which requires the classification of costs according to their relationship to volume. In this chapter we introduce departmental costing, which requires an additional classification of costs—the relationship between costs and the department being analyzed. In essence, we will see that some costs are unique to the department, while other costs stem from resources that belong to the organization as a whole. Once it is recognized that some costs are organizational in nature rather than department specific, it becomes necessary to create a system that allocates organizational costs to indi- vidual departments. For now, we will focus on costing at the department level. In the next chapter, we will discuss costing (and pricing) of individual service lines. Although some of this chapter’s material is conceptual in nature, much of it involves the application of various allocation techniques. Thus, a considerable portion of the chapter is devoted to examples of cost allocation in different settings.

Direct Versus Indirect (Overhead) Costs

Some costs—about 50 percent of a health services organization’s cost struc- ture—are unique to the reporting subunit and hence usually can be identified

6 Learning Objectives After studying this chapter, readers will be able to

• Differentiate between direct and indirect (overhead) costs. • Explain why proper cost allocation is important to health services

organizations. • Define a cost driver and explain the characteristics of a good driver

as opposed to a poor one. • Describe the three primary methods used to allocate overhead

costs among revenue-producing departments. • Apply cost allocation principles across a wide range of situations

within health services organizations.

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H e a l t h c a r e F i n a n c e202

with relative certainty. To illustrate, consider a hospital’s clinical laboratory department. Certain costs are unique to the department: for example, the salaries and benefits for the managers and technicians who work there and the costs of the equipment and supplies used to conduct the tests. These costs, which would not occur if the laboratory were closed, are classified as the direct costs of the department.

Unfortunately, direct costs constitute only a portion of the depart- ment’s entire cost structure. The remaining resources used by the laboratory are not unique to the laboratory; the department uses many shared resources of the hospital as a whole. For example, the laboratory shares the organiza- tion’s physical space (facilities) as well as its infrastructure, which includes information systems, utilities, housekeeping, maintenance, medical records, and general administration. The costs that are not borne exclusively by the laboratory department are called indirect costs, or overhead costs.

Indirect costs, in contrast to direct costs, are much more difficult to measure at the department level for the precise reason that they arise from shared resources—that is, if the laboratory department were closed, the indirect costs would not disappear. Perhaps some indirect costs could be reduced, but the hospital would still require a basic infrastructure to operate its remaining departments. The direct/indirect classification has relevance only at the sub- unit level; if the unit of analysis is the entire organization, all costs are direct by definition. Thus, in our Chapter 5 discussion of organizational costing, we did not have to introduce the concept of direct versus indirect costs.

Note that the two cost classifications (fixed/variable and direct/indirect) overlay one another. That is, fixed costs typically include both direct and indirect costs, while variable costs, in most cases, contain only direct costs (although they can include both direct and indirect costs). Conversely, direct costs usually include fixed and variable costs, while indirect costs typically include only fixed costs.

Introduction to Cost Allocation

A critical part of cost measurement at the department level is the assignment, or allocation, of indirect costs. Cost allocation is essentially a pricing process within the organization whereby managers allocate the costs of one department to other departments. Because this pricing process does not occur in a market

Direct cost A cost that is tied exclusively to a subunit, such as the salaries of laboratory department employees. When a subunit is eliminated, its direct costs disappear.

Indirect (overhead) cost A cost that is tied to shared resources rather than to an individual subunit of an organization; for example, facilities costs.

1. What is the difference between direct and indirect costs? 2. Give some examples of each type of cost for a hospital’s emergency

services department.

SELF-TEST QUESTIONS

Cost allocation The process by which overhead costs are assigned (allocated) to individual departments.

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 203

setting, no objective standard exists that establishes the price for the transferred services. Thus, cost allocation within a business must, to the extent possible, establish prices that proxy those that would be set under market conditions.

What costs within a health services organization must be allocated? Typically, the overhead costs of the business, such as those incurred by admin- istrators, facilities management personnel, financial staffs, and housekeeping and maintenance personnel, must be allocated to those departments that gen- erate revenues for the organization (generally patient services departments). The allocation of overhead costs to patient services departments is necessary because there would be no need for such costs in the first place if there were no patient services departments. Thus, decisions regarding pricing and service offerings by the patient services departments must be based on the full costs associated with each service, including both direct and overhead (indirect) costs. Clearly, the proper allocation of overhead costs is essential to good decision making within health services organizations.

The goal of cost allocation is to assign all of the costs of an organiza- tion to the activities that cause them to be incurred. With complete cost data accessible in the organization’s managerial accounting system, managers can make better decisions regarding cost control, what services should be offered, and how these services should be priced. Of course, the more complex the managerial accounting system, the higher the costs of developing, implement- ing, and operating the system. As in all situations, the benefits associated with more accurate cost data must be weighed against the costs required to develop such data.

Interestingly, much of the motivation for more accurate cost allocation systems comes from the recipients of overhead services. Managers at all levels within health services organizations are under pressure to optimize financial performance, which translates to reducing costs. Indeed, many department heads are evaluated, and hence compensated and promoted, primarily on the basis of profitability, assuming that performance along other dimensions is satisfactory. For such a performance evaluation system to work, all parties must perceive the cost allocation process to be accurate and fair because man- agers are held accountable for both the direct and the indirect costs of their departments. In other words, department heads are held accountable for the full costs associated with services performed by their departments.

1. What is meant by the term cost allocation? By the term full costs? 2. What is the goal of cost allocation? 3. Why is cost allocation important to health services managers?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e204

Cost Allocation Basics

To assign costs from one activity to another, two important elements must be identified: a cost pool and a cost driver. A cost pool is a grouping of similar costs to be allocated, while a cost driver is the basis upon which the alloca- tion is made. To illustrate, the costs of a hospital’s housekeeping department might be allocated to the other departments on the basis of the size of each department’s physical space. The logic here is that the amount of housekeep- ing resources expended in each department is directly related to the physical size of that department. In this situation, total housekeeping costs would be the cost pool, and the number of square feet of occupied space would be the cost driver.

When the cost pool amount is divided by the total amount of the cost driver, the result is the overhead allocation rate. Thus, in the housekeeping illustration, the allocation rate is the total housekeeping costs of the organiza- tion divided by the total space (square footage) occupied by the departments receiving the allocation. This procedure results in an allocation rate measured in dollar cost per square foot of space used. In the patient services depart- ments, full (total) costs would include the direct costs of each department and an allocation for housekeeping services, made on the basis of the amount of occupied space.

Cost Pools Typically, a cost pool consists of all of the direct costs of one support depart- ment. However, if a single support department offers several substantially different services, and the patient services departments use those services in different relative amounts, it may be beneficial to separate the costs of that support department into multiple pools.

For example, suppose a hospital’s financial services department provides two significantly different services: patient billing/collections and budgeting. Furthermore, assume that the routine care department uses proportionally more patient billing/collections services than does the laboratory department, but the laboratory department uses proportionally more budgeting services than does the routine care department. In this situation, it would be best to create two cost pools for one support department. To do this, the total costs of financial services would be divided into a billing pool and a budgeting pool. Then, cost drivers would be chosen for each pool and the costs allocated to the patient services departments as described in the following sections.

Cost Drivers Perhaps the most important step in the cost allocation process is the identi- fication of proper cost drivers. Traditionally, overhead costs were aggregated

Cost pool A group of overhead costs to be allocated; for example, facilities costs or marketing costs.

Cost driver The basis on which a cost pool is allocated; for example, square footage for facilities costs.

Allocation rate The numerical value used to allocate overhead costs; for example, $10 per square foot of occupied space for facilities costs.

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across all support departments and then divided by a rough measure of orga- nizational volume, resulting in an allocation rate of some dollar amount of generic overhead per unit of volume.

For example, the total inpatient overhead costs of a hospital might be divided by total inpatient days, giving an allocation rate of so many dollars per patient day, which is called the per diem overhead rate. If a hospital had 72,000 patient days in 2015 and its total inpatient overhead costs were $36 million, the overhead allocation rate would be $36,000,000 ÷ 72,000 = $500 per patient day (per diem). Regardless of the type of patients treated within an inpatient services department (adult versus child, trauma versus illness, acute versus critical care, and so on), the $500 per diem allocation rate would be applied to determine the total indirect cost allocation for that department.

However, it is clear that not all overhead costs are tied to the num- ber of patient days. For example, overhead costs associated with admission, discharge, and billing are typically not related to the number of patient days but to the number of admissions. Thus, tying all overhead costs to a single cost driver improperly allocates such costs, which distorts reported costs for patient services and hence raises concerns about the effectiveness of decisions based on such costs. In state-of-the-art cost management systems, the various types of overhead costs are separated into different cost pools, and the most appropriate cost driver for each pool is identified.

The theoretical basis for identifying cost drivers is the extent to which costs from a pool actually vary as the value of the driver changes. For example, does a patient services department with 10,000 square feet of space use twice the amount of housekeeping services as a department with only 5,000 square feet of space? The better the relationship (correlation) between actual resource expenditures at each subunit and the cost driver, the better the cost driver and the better the resulting cost allocations.

Effective cost drivers possess two important characteristics. First, and perhaps the less important of the two, is fairness—that is, does the cost driver chosen result in an allocation that is fair to the patient services departments? The second, and perhaps more important, characteristic is cost control—that is, does the cost driver chosen create incentives for departments to use less of that overhead service?

For example, there is little that a patient services department manager can do to influence overhead cost allocations if the cost driver is patient days. In fact, the action needed to reduce patient days might lead to negative finan- cial consequences for the organization. An effective cost driver will encourage patient services department managers to take overhead cost reduction actions that do not have negative implications for the organization. The remainder of this chapter emphasizes the importance of effective cost drivers, including several illustrations that distinguish good drivers from poor ones.

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H e a l t h c a r e F i n a n c e206

The Allocation Process The steps involved in allocating overhead costs are summarized in Exhibit 6.1, which illustrates how Prairie View Clinic allocated its housekeeping costs for 2016. Cost alloca- tion takes place both for historical purposes, in which realized costs over the past year are allocated, and for planning purposes, in which estimated future costs are allocated to aid in pricing and other decisions. The examples in this chapter generally assume that the purpose of the allocation is for financial planning and budgeting, so the data presented are estimated for the com- ing year—2016.

The first step in the allocation process is to establish the cost pool. In this case, the clinic is allocating housekeeping costs, so the cost pool is the projected total costs of the housekeeping department—$100,000. Next, the most effective cost driver must be identified. After considerable investigation,

Prairie View’s managers concluded that the best cost driver for housekeeping costs is labor hours—that is, the number of hours of housekeeping services required by the clinic’s departments is the variable most closely related to the actual cost of providing these services. The intent here, of course, is to pick the cost driver that provides the most accurate cause-and-effect relationship between the use of housekeeping services and the costs of the housekeeping

Industry Practice Hospitals and Housekeeping Cost Drivers

Most hospitals use square footage to allocate housekeeping costs. The rationale, of course, is that a patient services department that is twice as big as another will require twice the expendi- ture of housekeeping resources. The advantage of this cost driver is that it is easy to measure and does not change very often.

The disadvantage of using square footage as the cost driver is that some patient services departments require more housekeeping support because of the nature of the service, even when similar-sized spaces are occupied. For example, emergency departments require more intense housekeeping services than do neonatal care units.

Is there a better cost driver available for allocating housekeeping costs? If so, what is it? Describe how the “new and improved” cost driver would work.

Step One: Determine the Cost Pool The departmental costs to be allocated are for the housekeeping

department, which has total budgeted costs for 2016 of $100,000. Step Two: Determine the Cost Driver The best cost driver was judged to be the number of hours of housekeeping

services provided. An expected total of 10,000 hours of such services will be provided in 2016 to those departments that will receive the allocation.

Step Three: Calculate the Allocation Rate $100,000÷10,000 hours = $10 per hour of housekeeping services provided. Step Four: Determine the Allocation Amount The physical therapy department uses 3,000 hours of housekeeping

services, so its allocation of housekeeping department overhead is $10×3,000 = $30,000.

EXHIBIT 6.1 Prairie View

Clinic: Allocation of

Housekeeping Overhead to the Physical

Therapy Department

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department. For 2016, Prairie View’s managers estimate that the housekeep- ing department will provide 10,000 hours of service to the departments that will receive the allocation.

Now that the cost pool and cost driver have been defined and measured, the allocation rate is established by dividing the expected total overhead cost (the cost pool) by the expected total volume of the cost driver: $100,000 ÷ 10,000 hours = $10 per hour of services provided.

The final step in the process is to make the allocation to each depart- ment. To illustrate the allocation, consider the physical therapy (PT) depart- ment—one of Prairie View’s patient services departments. For 2016, PT is expected to use 3,000 hours of housekeeping services, so the dollar amount of housekeeping overhead allocated to PT is $10 × 3,000 = $30,000. Other departments within the clinic will also use housekeeping services, and their allocations would be made in a similar manner—the $10 allocation rate per hour of services used is multiplied by the amount of each department’s hourly utilization of housekeeping services. When all departments are considered, the 10,000 hours of housekeeping services is fully distributed among the using departments. For any one department, the amount allocated depends on both the allocation rate and the amount of housekeeping services used.

Key Equation: Allocation Rate

The allocation rate is the rate used to calculate each user department’s allocation of an overhead cost pool. To illustrate, assume the financial services department has $1,000,000 in total costs (the cost pool) and the patient services departments in total generate 500,000 bills (the cost driver). Then, the allocation rate is $2 per bill:

Allocation rate = Cost pool amount ÷ Cost driver volume = $1,000,000 ÷ 500,000 bills = $2 per bill.

1. What are the definitions of a cost pool, a cost driver, and an allocation rate?

2. Under what conditions should a single overhead department be divided into multiple cost pools?

3. On what theoretical basis are cost drivers chosen? 4. What two characteristics make an effective cost driver? 5. What are the four steps in the cost allocation process?

SELF-TEST QUESTIONS

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H e a l t h c a r e F i n a n c e208

Cost Allocation Methods

Mathematically, cost allocation can be accomplished in a variety of ways, and the method used is somewhat discretionary. No matter what method is chosen, all support department costs eventually must be allocated to the departments (generally patient services departments) that create the need for those costs.

The key differences among the methods are how support services pro- vided by one department are allocated to other support departments. The direct method totally ignores services provided by one support department to another. Two other allocation methods address intrasupport department allo- cations. The reciprocal method recognizes all of the intrasupport department services, and the step-down method represents a compromise that recognizes some, but not all, of the intrasupport department services. Regardless of the method, all of the support costs within an organization ultimately are allo- cated from support departments to the departments that generate revenues for the organization.

Exhibit 6.2 summarizes the three allocation methods. Prairie View Clinic, which is used in the illustration, has three support departments (human

Human Resources

Human Resources

Human Resources

Support Departments

Direct Method

Reciprocal Method

Step-Down Method

Patient Services Departments

Housekeeping

Housekeeping

Housekeeping

Physical Therapy

Physical Therapy

Physical Therapy

Administration

Administration

Administration

Internal Medicine

Internal Medicine

Internal Medicine

EXHIBIT 6.2 Prairie View

Clinic: Alternative

Cost Allocation Methods

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resources, housekeeping, and administration) and two patient services depart- ments (physical therapy and internal medicine).

Under the direct method, shown in the top section of Exhibit 6.2, each support department’s costs are allocated directly to the patient services departments that use the services. Thus, none of the support services costs are allocated to other support departments. In the illustration, both physical therapy and internal medicine use the services of all three support departments, so the costs of each support department are allocated to both patient services departments. The key feature of the direct method—and the feature that makes it relatively simple to apply—is that no intrasupport department allocations are recognized. Thus, under the direct method, only the direct costs of the support departments are allocated to the patient services departments because no indirect costs have been created by intrasupport department allocations.

As shown in the center section of Exhibit 6.2, the reciprocal method recognizes the support department interdependencies among human resources, housekeeping, and administration, and hence it generally is considered to be more accurate and objective than the direct method. The reciprocal method derives its name from the fact that it recognizes all of the services that depart- ments provide to and receive from other departments. The good news is that this method captures all of the intrasupport department relationships, so no information is ignored and no biases are introduced into the cost allocation process. The bad news is that the reciprocal method relies on the simultaneous solution of a series of equations representing the utilization of intrasupport department services. Thus, it is relatively complex, which makes it difficult to explain to department heads and typically more costly to implement.

The step-down method, which is shown in the lower section of Exhibit 6.2, represents a compromise between the simplicity of the direct method and the complexity of the reciprocal method. It recognizes some of the intrasupport department effects that the direct method ignores, but it does not recognize the full range of interdependencies as does the reciprocal method. The step- down method derives its name from the sequential, stair-step pattern of the allocation process, which requires that the allocation take place in a specific sequence. As shown in the exhibit, all the direct costs of human resources first are allocated to both the patient services departments and the other two sup- port departments. Human resources is then closed out because all of its costs have been allocated. Next, housekeeping costs, which now consist of both direct and indirect costs (the allocation from human resources), are allocated to the patient services departments and the remaining support department— administration. Finally, the direct and indirect costs of administration are allo- cated to the patient services departments. The final allocation from administra- tion includes human resources and housekeeping costs because a portion of these support costs has been alloca

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