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The critical point here is that the clinicā™s total revenues have decreased
signiļ¬cantly from the previous situation in which all visits bring in \$100 in
revenue (see Table 5.4). The clinicā™s cost structure remains the same, however,
because it is handling the same number of visitsā”75,000. The impact of the
discount is strictly on revenues, and the end result of accepting Peachtreeā™s
proposal is a projected loss of \$580,962.
Another way of conļ¬rming the expected loss at 75,000 visits is to
calculate the clinicā™s breakeven point at the new average per visit revenue
of \$86.67. The new breakeven point is 84,928 visits, which conļ¬rms that
the clinic will lose money at 75,000 visits. Because the clinic is projected to
be 84,928 ā” 75,000 = 9,928 visits below breakeven, and the contribution
margin is now \$58.49, the projected loss is 9,928 Ć— \$58.49 = \$580,689,
which is the amount shown in Table 5.8 (except for a rounding difference).
The change in breakeven point that results from accepting Peachtreeā™s
proposal is graphed in Figure 5.4, along with the original breakeven point.
The new total revenues line (the dot-dashed line) is ļ¬‚atter than the original
line, so when it is combined with the existing cost structure, the breakeven
point is pushed to the right to 84,928 visits. However, any cost-control actions
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Chapter 5: Managerial Accounting Basics

FIGURE 5.4
Atlanta Clinic:
Revenues
and Costs
Breakeven Point
(\$)
with Discounted
Old Total
New Total Revenue
Revenues
Revenues

Total Costs

4,967,462
Fixed Costs

0 69,165 84,928 Volume
(Number of Visits)

taken by Atlantaā™s managers would either ļ¬‚atten, if variable costs are lowered,
or lower, if ļ¬xed costs are reduced, the total costs line, and hence push the
breakeven point back to the left.
Nothing much has changed in terms of core economic underpinnings
because of the new discounted-charge environment. The clinic is worse off
economically, but the clinicā™s cost structure, managerial incentives, and solu-
tions to ļ¬nancial problems are essentially the same. To increase proļ¬t, more
services must be provided. In short, the movement from charges to discounted
charges is not that radical in regards to its impact on proļ¬t analysis and man-
agerial decision making. The major difference is that the clinic is now under
greater ļ¬nancial pressure. However, as we discuss in the next major section,
the clinicā™s entire incentive structure will change if it moves to a capitated
environment.

Evaluating the Alternative Strategies
What should Atlantaā™s managers do? If Peachtreeā™s proposal is accepted, the
clinic is expected to lose \$580,962 rather than make a proļ¬t of \$419,038
when no discount was demanded. The difference is a swing of \$1 million in
proļ¬t in the wrong direction, hardly an enticing prospect. What happened to
the āmissingā \$1 million? It is now in the hands of Peachtree HMO, which
is paying \$1 million less to one of its providers (25,000 visits Ć— \$40 savings
= \$1,000,000). This will be reļ¬‚ected as a cost savings on Peachtreeā™s income
142 Healthcare Finance

statement and, if the savings is not passed on to the ultimate payers (typically
employers), will result in a proļ¬t increase.
If market forces in Atlanta Clinicā™s service area suggest that making a
counter offer to Peachtree is not feasibleā”perhaps because the clinic is being
pitted against another providerā”the comparison of a loss of \$580,792 to
a proļ¬t of \$419,038 is irrelevant. The only relevant issue at hand for the
short-term is the comparison of the \$580,792 loss if the clinic accepts the
proposal to the \$1,376,462 loss if the proposal is rejected and Peachtreeā™s
patients are lost to the clinic. Although neither outcome is very appealing, the
acceptance of the discount appears to be the lesser of two evils. In fact, the
acceptance of the discount is better by \$1,376,462 ā’ \$580,792 = \$795,670.
Accepting the discount proposal is Atlantaā™s best short-term strategy because
Peachtreeā™s patients still produce a positive contribution margin of \$60 ā’
\$28.18 = \$31.82 per visit, which would be foregone if the clinic rebuffs
Peachtreeā™s offer. That \$31.82 per visit contribution margin, when multiplied
by the expected 25,000 visits on the contract, puts \$795,500 on the total
contribution margin table that otherwise would be lost.

Marginal Analysis: Short-Term Versus Long-Term Implications
The Atlanta/Peachtree illustration points out how the contribution margin
can be used in managerial decision making. To help see this, the analysis needs
to be viewed from a different perspective. Suppose the clinic is forecasting a
volume of 50,000 visits for 2005, and Peachtree HMO offers to provide the
clinic 25,000 additional visits at \$60 revenue per visit. These 25,000 visits are
called marginal, or incremental, visits, because they add to the exiting base of
visits. Should the clinicā™s managers accept this offer?
Although each marginal visit from the contract brings in only \$60
compared with \$100 on the clinicā™s other contracts, the marginal cost, which
is the cost associated with each additional visit, is the variable cost rate of
\$28.18. The clinicā™s \$4,967,462 in ļ¬xed costs will be incurred whether the
offer is accepted or rejected, so these costs are not relevant to the decision. In
ļ¬nance parlance, the clinicā™s ļ¬xed costs are nonincremental to the decision.
Because the contribution margin of each visit at the margin (the marginal
contribution margin) is a positive \$31.82, each visit contributes positively
to Atlantaā™s recovery of ļ¬xed costs and ultimately to proļ¬ts. Thus, the offer
should be accepted or at least seriously considered.
However, Atlantaā™s managers cannot ignore the long-term implications
associated with accepting the proposal. These are not addressed in detail here,
but clearly the clinic cannot survive this scenario in the long run because the
clinicā™s revenues are not covering the full costs of providing services. In the
meantime, bleeding \$580,962 of losses in 2005 may be better than bleeding
\$1,376,462 until the clinic can adjust to market forces in its service area.
This adjustment may be as simple as merely absorbing the losses while the
clinicā™s competitors, perhaps in poorer ļ¬nancial condition, exit the market as
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Chapter 5: Managerial Accounting Basics

they too face the same difļ¬cult economic choices. Should this happen, a new
equilibrium would be established in the market that would allow the clinic
to raise its prices. If the long-term solution is not that simple, Atlanta Clinic
must reduce its cost structure or perish.
Another problem associated with accepting the discount offer is that
the clinicā™s other payers will undoubtedly learn about the reduced payments
and want to renegotiate their contracts with the same, or even greater, dis-
count. Such a reaction would clearly place the clinic under even more ļ¬nancial
pressure, and a draconian change in either volume or operating costs would
be required for survival.

Self-Test
1. What is the impact of a discount contract on ļ¬xed costs, total variable
Questions
costs, and the breakeven point?
2. What is meant by marginal analysis?
3. What is meant by the following statement: āMarginal analysis is made
more complicated by long-run considerations.ā

Proļ¬t Analysis in a Capitated Environment
As a review of proļ¬t analysis, consider how the analysis is changed when
a provider operates in a capitated environment. In addition to solidifying
concepts presented in previous sections, this section provides insights into
the basic differences between fee-for-service reimbursement and capitation.
To begin, assume that the purchaser of services from Atlanta Clinic is
the Alliance, a local business coalition. As in previous illustrations, assume the
Alliance is paying the clinic \$7,500,000 to provide services for an expected
75,000 visits, but now the amount is capitated. Although projected total
revenues remain the same as the previous base case (see Table 5.4), they are
qualitatively quite different. The \$7,500,000 that the Alliance is paying is not
explicitly related to the amount of services provided by the clinic but to the size
of the covered employee group. In essence, Atlanta Clinic is no longer merely
selling healthcare services as it had in the fee-for-service or discounted fee-for-
service environment. Now, the clinic is taking on the insurance function in that
it is responsible for the health status (utilization) of the covered population
and must bear the attendant risks. If the total costs of services delivered
by the clinic exceed the premium revenue (paid monthly on a per member
basis), the clinic will suffer the ļ¬nancial consequences. However, if the clinic
can efļ¬ciently manage the healthcare of the served population, it will be the
economic beneļ¬ciary.
How might Atlantaā™s managers evaluate whether or not the \$7,500,000
revenue attached to the contract is adequate? To do the analysis, they need
two critical pieces of information: cost information and actuarial (utilization)
information. The clinic already has the cost accounting informationā”the
144 Healthcare Finance

full cost per visit is expected to be \$94.41 (at a volume of 75,000 visits),
with an underlying cost structure of \$28.18 per visit in variable costs and
\$4,967,462 in ļ¬xed costs. For its actuarial information, Atlantaā™s managers
estimate that the Alliance will have a covered population of 18,750 members
with an expected utilization rate of four visits per member per year. Thus, the
total number of visits expected is 18,750 Ć— 4 = 75,000. Although this appears
to be the same 75,000 visits as in the fee-for-service environment, signiļ¬cant
difference exists in the implications of this volume. Because there is no direct
linkage between total revenues and volume, utilization above that expected
will bring increased costs with no corresponding increase in revenues.
The revenues expected from this contract, \$7,500,000, exceed the
expected costs of serving this population, which are 75,000 visits multiplied
by \$94.41 per visit, or \$7,080,750. Thus, this contract is expected to generate
a proļ¬t of \$419,250, which, not surprisingly, is the same as the original base
case fee-for-service result (except for a rounding difference). (See Table 5.4.)

A Graphical View in Terms of Utilization
Figure 5.5 contains a graphical CVP analysis for the capitation contract that
is constructed similar to the fee-for-service graphs shown in Figures 5.3 and
5.4 in that the horizontal axis shows the number of visits, while the vertical
axis shows dollars of revenues and costs. Also shown is the same underlying
cost structure of \$4,967,462 in ļ¬xed costs coupled with a variable cost rate
of \$28.18. One very signiļ¬cant difference exists, however. Instead of being
upward sloping, the total revenues line is horizontal, which shows that total
revenue is \$7,500,000 regardless of volume as measured by the number of
visits.
Several subtle messages are inherent in this ļ¬‚at revenue line. First, it tells
managers that revenue is being driven by something other than the volume of
services provided. Under capitation, revenue is being driven by the insurance
contract (i.e., by the premium payment and the number of covered lives, or
enrollees ). This change in the revenue source is the core of the logic switch
from fee-for-service to capitation; the clinic is being rewarded to manage the
healthcare of the population served rather than to provide services. However,
the clinicā™s costs are still driven by the amount of services provided (the
number of visits).
A second critical point about Figure 5.5 is the difference between the
ļ¬‚at revenue and the ļ¬‚at ļ¬xed-cost base. Atlanta has a spread of \$7,500,000 ā’
\$4,967,462 = \$2,532,538 to work with in the management of the healthcare
of this population for the period of the contract. If total variable costs equal
\$2,532,538, the clinic breaks even; if total variable costs exceed \$2,532,538,
the clinic loses. Thus, to make a proļ¬t, the number of visits must be less than
\$2,532,538 / \$28.18 = 89,870. If everyone in the organization, especially
the managers and clinicians, does not understand the inherent utilization risk
under capitation, the clinic could ļ¬nd itself in serious ļ¬nancial trouble. On
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Chapter 5: Managerial Accounting Basics

FIGURE 5.5
Atlanta Clinic:
Revenues
and Costs Breakeven Point
(\$)
Under
Capitation
Loss
Total Costs
Profit

Total
7,500,000
Revenues

4,967,462
Fixed Costs

0 89,870 Volume
(Number of Visits)

the other hand, if Atlantaā™s managers and clinicians at all levels understand
and manage this utilization risk, a handsome reward may be gained.
A key feature of capitation is the reversal of the proļ¬t and loss portions
of the graph. To see this, compare Figure 5.5 with Figure 5.3. The idea that
proļ¬ts occur at lower volumes under capitation is contrary to the fee-for-
service environment. It is obvious, however, when one recognizes that the
contribution margin, on a per visit basis, is \$0 ā’ \$28.18 = ā’\$28.18. Thus,
revenue. The optimal short-term response to capitation from a purely ļ¬nancial
perspective is to take the money and run (provide no services) because zero
visits allow the clinic to capture the full spread between total revenues and
ļ¬xed costs. Of course, the clinic would have trouble renewing the contract
in subsequent years, but it will have maximized short-term proļ¬t. Obviously,
this course of action is neither appropriate nor feasible. Still, its implications
are at the heart of concerns expressed by critics of managed care about the
incentives to withhold patient care inherent in a capitated environment.

A Graphical View in Terms of Membership
Figure 5.5 is like Alice, of Alice in Wonderland, peering through the looking
glass and ļ¬nding that everything is backwards. The key to this problem is
that the horizontal axis does not measure the volume to which revenues are
relatedā”that is, the horizontal axis in Figure 5.5 has number of visits on the
146 Healthcare Finance

FIGURE 5.6
Atlanta Clinic: Revenues
and Costs
Breakeven Point
(\$)
Under
Total Revenues Profit
Capitation in (\$400 per Member)
Insurance Terms

Loss
Total Costs

4,967,462
Fixed Costs

17,291
0 Volume
(Number of Members)

horizontal axis, just as if Atlanta Clinic were selling healthcare services. It is
not; it is now selling insurance, so the appropriate horizontal axis value is the
number of members (enrollees).
Figure 5.6 recognizes that membership, rather than the amount of
services provided, drives revenues. With the number of members on the
horizontal axis, the total revenues line is no longer ļ¬‚at; revenues only look ļ¬‚at
when they are considered relative to the number of visits. The revenue earned
by the clinic is actually \$7,500,000 / 18,750 = \$400 per member, which could
be broken down to a monthly premium of \$400 / 12 = \$33.33. Thus, the
expected \$7,500,000 revenue shown on Figure 5.5 results from an expected
enrollee population of 18,750 members. The cost structure can easily be
expressed on a membership basis as well. Fixed costs are no problem within
the relevant range; they are inherently volume insensitive, whether volume
is measured by number of visits or members. Thus, Figure 5.6 shows ļ¬xed
costs as the same ļ¬‚at, dashed line as before. However, the variable cost rate
based on number of enrollees is not the same as the variable cost rate based on
number of visits. Per member variable cost must be estimated from two other
factors: the variable cost rate of \$28.18 per visit and the expected utilization
of four visits per year. The combination of the two is 4 Ć— \$28.18 = \$112.72,
which is the clinicā™s expected variable cost per member. Expressed as a per
member basis, the contribution margin is now \$400 ā’ \$112.72 = \$287.28,
as opposed to the ā’\$28.18 when volume is based on number of visits.
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Chapter 5: Managerial Accounting Basics

The analysis based on number of members reveals that there are two
elements to controlling total variable costs under capitation: the underlying
variable cost of the service (\$28.18 per visit) and the number of visits per
member (four). The two-variable nature of the variable cost rate makes cost
control more difļ¬cult under capitation. In a fee-for-service environment, cost
control entails only minimizing per visit expenses. Utilization is not an issue.
If anything, utilization is good because per visit revenue almost always exceeds
the variable cost rate. (In other words, there is a positive contribution margin.)
Capitation requires a change in management thinking about cost control
because utilization is now a component of the variable cost rate and hence total
variable costs. Of course, control of ļ¬xed costs is always ļ¬nancially prudent,
regardless of the type of reimbursement.
Conversely, there is one positive feature of the variable cost structure
under capitation. With two elements to control, the clinic has more opportu-
nity to lower the variable cost rate under capitation than under fee-for-service
reimbursement. The key is the ability of Atlantaā™s managers to control utiliza-
tion. If both utilization and per visit costs can be reduced, the clinic can reap
greater beneļ¬ts (proļ¬ts) than possible under fee-for-service reimbursement.

Projected P&L Statement Analysis
Table 5.9 contains three projected P&L statements in this capitated envi-
ronment. The three volume levels shown are the same as those contained in
Table 5.6 for a fee-for-service environment. To begin, start with the middle
columnā”the one that contains the expected 75,000 patient visits. The bottom
line, \$419,038, is the same as in the fee-for-service analysis, which reinforces
the point that, at least superļ¬cially, the capitated contract is not inherently
better or worse than the fee-for-service contract.
Although the proļ¬t at 75,000 visits is the same, some of the values
in the projected analyses and their economic meanings differ. For example,
although total revenues are \$7,500,000, it is a ļ¬‚at amount in Table 5.9,
while it varies with volume in Table 5.6. The variable cost rate is the same
in both tablesā”\$28.18 per visit. However, because each visit does not result
in additional revenue, the revenue per visit is zero in Table 5.9 and the
contribution margin is ā’\$28.18.
What would happen if the clinic experienced more visits than predicted?
If the number of visits increases by 10 percent, or by 7,500 to 82,500, the
right column in Table 5.9 shows that proļ¬t would decrease by \$419,038
ā’ \$207,688 = \$211,350. This occurs because total revenues stay constant
while costs increase at a rate of \$28.18 for each additional visit. With 7,500
additional visits, the clinicā™s costs increase by 7,500 Ć— \$28.18 = \$211,350.
Obviously this is quite in contrast to the signiļ¬cant increase in proļ¬t at this
volume level that occurs in a fee-for-service environment (see Table 5.6).
Under capitation, a decrease in visits will improve the proļ¬tability of the
clinic. When the number of visits decreases to 69,165, which is the breakeven
148 Healthcare Finance

TABLE 5.9
Number of Visits
Atlanta Clinic:
69,165 75,000 82,500
2005 Projected
P&L Statements
Total revenues \$7,500,000 \$7,500,000 \$7,500,000
(based on
Total variable costs (\$28.18 Ć— volume) 1,949,070 2,113,500 2,324,850
69,165; 75,000;
Total contribution margin \$5,550,930 \$5,386,500 \$5,175,150
and 82,500
Fixed costs 4,967,462 4,967,462 4,967,462
patient visits)
Proļ¬t \$ 583,468 \$ 419,038 \$ 207,688

point in a fee-for-service environment, proļ¬t in a capitated environment in-
creases by \$164,430 to \$583,468. This increase is explained by the decrease in
visits (5,835) multiplied by the contribution margin (ā’\$28.18), which results
in a \$164,430 decrease in costs while revenues remain constant.

The Importance of Utilization
Table 5.9 provides information on the impact of utilization changes on prof-
itability. The center column, the base case, is once again our starting point.
With an assumed utilization of four visits for each of Peachtreeā™s 18,750 mem-
bers, 75,000 visits result in a projected proļ¬t of \$419,038.
However, if Atlantaā™s managers are not able to limit utilization to the
level forecasted (or less), the clinicā™s proļ¬t would fall. Assume that realized
utilization is actually 4.4 visits per member, rather than the 4.0 forecasted.
This higher utilization would result in 4.4 Ć— 18,750 = 82,500 visits, which
produces the proļ¬t of \$207,688 shown in the right column in Table 5.9.
Because revenues are ļ¬xed and total costs are tied to volume, higher utilization
leads to higher costs and lower proļ¬t. With the same 82,500 visits, but total
variable costs of \$2,324,850 at the higher utilization rate, the variable cost
per member increases to \$2,324,850 / 18,750 = \$124.99, which could also
be found by multiplying 4.4 visits per member by the variable cost rate of
\$28.18.
The left column of Table 5.9 shows that the clinicā™s proļ¬tability would
increase to \$583,468 if utilization was reduced to 3.69 visits per member,
producing about 69,165 total visits. With lower utilization, total variable
costs are reduced and proļ¬t increases. The key point is that the ability of a
provider to control utilization is the primary key to proļ¬tability in a capitated
environment. Less utilization means lower total costs, and lower total costs
mean greater proļ¬t.
In our initial discussion of proļ¬t analysis, we introduced the concept of
operating leverage, which is related to the cost structure of the organizationā”
the higher the proportion of ļ¬xed costs, the greater the operating leverage. In
a fee-for-service environment, high operating leverage means a low variable
cost rate and a high per visit contribution margin, and hence high risk in that
149
Chapter 5: Managerial Accounting Basics

small volume decreases lead to large reductions in proļ¬tability. On the other
hand, small volume increases can have a signiļ¬cant positive impact on the
bottom line.
Under capitation, the situation is reversed because the per visit contri-
bution margin is negative. Whereas a higher proportion of ļ¬xed costs drives
the positive per visit contribution margin even higher under fee-for-service
reimbursement, it drives the negative per visit contribution margin toward
zero under capitation. In fact, if all of Atlanta Clinicā™s costs were ļ¬xed, its
contribution margin would be zero, and the clinicā™s proļ¬t would be assured
regardless of the number of visits, assuming that they fall within the relevant
range. Thus, a higher ļ¬xed cost structure leads to lower risk in a capitated
environment, while a higher variable cost (lower ļ¬xed cost) structure leads
to lower risk in a fee-for-service environment. Of course, the reduction in
risk also limits the rewards that an organization can attain from utilization
management.

The Importance of the Number of Members
Table 5.10 contains the projected P&L statements under capitation, recast to
focus on the number of members. Assuming a per member utilization of four
visits per year, a 10 percent membership increase to 20,625 members increases
the projected proļ¬t by about 128 percent. However, if membership declines
to 17,291, the clinic just breaks even.
We can use the breakeven equation to verify the breakeven point:

Total revenues ā’ Total variable costs ā’ Fixed costs = Proļ¬t
(\$400 Ć— Members) ā’ (\$112.72 Ć— Members) ā’ \$4,967,462 = \$0
\$287.28 Ć— Members = \$4,967,462
Members = 17,291.
Thus, breakeven analysis reafļ¬rms that the clinic needs 17,291 members in
its contract with the Alliance to break even, given the assumed cost structure,
which in turn assumes utilization of four visits per member and a variable cost
rate of \$28.18 per visit.

TABLE 5.10
Number of Members
Atlanta Clinic:
17,291 18,750 20,625 2005 Projected
P&L Statements
Total revenues (\$400 Ć— number of members) \$ 6,916,400 \$7,500,000 \$8,250,000 (based on
Total variable costs (\$112.72 Ć— members) 1,949,042 2,113,500 2,324,850
17,291; 18,750;
Total contribution margin \$4,967,358 \$5,386,500 \$ 5,925,150
and 20,625
Fixed costs 4,967,462 4,967,462 4,967,462
members)
Proļ¬t (\$ 104) \$ 419,038 \$ 957,688
150 Healthcare Finance

Assuming constant per member utilization, more members increases
presumably exceed their incremental (variable) costs. Indeed, the degree of
operating leverage concept can be applied here. As shown in Table 5.10,
a 10 percent increase to 20,625 members from a base case membership of
18,750 results in a (roughly) 128.5 percent increase in proļ¬t (from \$419,038
to \$957,688, or by \$538,650). Thus, each 1-percent increase in membership
increases proļ¬tability by 12.85 percent. Similarly, if membership decreases to
the breakeven point of 17,291, a decrease of 7.8 percent, proļ¬tability falls by
7.8% Ć— 12.85 ā 100%, which leads to a proļ¬t of zero.

Self-Test 1. Under capitation, what is the difference between a CVP graph with the
Questions number of visits on the X axis versus one with the number of members
on the X axis?
2. What is unique about the contribution margin under capitation?
3. Why is utilization management so important in a capitated environment?
4. Why is the number of members so important in a capitated environment?

The Impact of Cost Structure on Financial Risk
The ļ¬nancial risk of a healthcare provider, at least in theory, is minimized
by having a cost structure that āmatchesā its revenue structure. To illustrate,
consider a clinic with all revenues (reimbursement) tied to volume. For this
clinic, each visit adds to the businessā™s revenues. If the clinicā™s cost structure
consisted of all variable costs (no ļ¬xed costs), then each visit would incur
costs, but at the same time create revenues. Assuming that per visit revenue
exceeds per visit costs, the clinic would ālock inā a proļ¬t on each visit. The
total proļ¬tability of the clinic would be uncertain, as it is tied to volume, but
the ability of the clinic to generate a proļ¬t would be a sure thing.
On the other extreme, consider a hospital with all patient reimburse-
ment being capitated. In this situation, assuming a ļ¬xed number of covered
lives, the hospitalā™s revenue stream is ļ¬xed regardless of volume. Now, to
match the revenue and cost structures, the hospital must have all ļ¬xed (no
variable) costs. Now, assuming that annual ļ¬xed revenue exceeds annual ļ¬xed
costs, the hospital has a āguaranteedā proļ¬t at the end of the year.
Note that in both illustrations, the key to minimizing risk (assuring a
proļ¬t) is to create a cost structure that matches the revenue structure: variable
costs for fee-for-service revenues and ļ¬xed costs for capitated revenues. Of
course, āreal worldā problems occur when a provider tries to implement a
cost structure that matches its revenue structure. First, very few providers are
reimbursed solely on a fee for service or capitated basis. Most providers face a
mix of reimbursement methods. Still, most providers are either predominantly
fee for service or predominantly capitated.
151
Chapter 5: Managerial Accounting Basics

Second, providers do not have complete control over their cost struc-
tures. It is impossible for providers to create cost structures with all variable or
all ļ¬xed costs. Nevertheless, managers can take actions to change their exist-
ing cost structures to one that is more compatible with the revenue structure
(has less risk). For example, assume a medical group practice is reimbursed
almost exclusively on a per procedure basis. To minimize ļ¬nancial risk, the
practice can take such actions as pay physicians on a per procedure basis and
use per procedure leases for diagnostic equipment. The greater the proportion
of variable costs in the practiceā™s cost structure, the lower its ļ¬nancial risk.

Self-Test
1. Explain this statement: To minimize ļ¬nancial risk, match the cost
Questions
structure to the revenue structure.
2. What cost structure would minimize risk if a provider had all fee-for-
service reimbursement?
3. What cost structure would minimize risk if a provider were entirely
capitated?
4. What are the real world constraints on creating matching cost struc-
tures?

Key Concepts
Managers rely on managerial accounting information to plan for and control
a businessā™s operations. A critical part of managerial accounting information
is the measurement of costs and the use of this information in proļ¬t analysis.
The key concepts of this chapter are:
ā¢ Costs can be classiļ¬ed by their relationship to the amount of services
provided.
ā¢ Variable costs are those costs that are expected to increase and decrease
with volume (patient days, number of visits, and so on), while ļ¬xed costs
are the costs that are expected to remain constant regardless of volume
within some relevant range. Semi-ļ¬xed costs are those that are ļ¬xed within
ranges that are less than the relevant range.
ā¢ The relationship between cost and activity (volume) is called cost behavior
or underlying cost structure.
ā¢ Proļ¬t analysis, often called cost-volume-proļ¬t (CVP) analysis, is an
analytical technique that typically is used to analyze the effects of volume
changes on revenues, costs, and proļ¬t.
ā¢ A projected proļ¬t and loss (P&L) statement is a proļ¬t projection that, in a
proļ¬t analysis context, uses assumed values for volume, price, and costs.
ā¢ Breakeven analysis is used to estimate the volume needed (or the value of
some other variable) for the organization to break even in proļ¬tability.
ā¢ Contribution margin is the difference between unit price and the variable
cost rate, or per unit revenue minus per unit variable cost. Hence,
152 Healthcare Finance

contribution margin is the per unit dollar amount available to ļ¬rst cover
an organizationā™s ļ¬xed costs and then to contribute to proļ¬ts.
ā¢ Operating leverage reļ¬‚ects the extent to which an organizationā™s costs are
ļ¬xed. It is measured by the degree of operating leverage (DOL). Assuming
fee-for-service reimbursement, a business with a high DOL has more risk
than a business with a low DOL because DOL measures the impact of
utilization changes on proļ¬ts. Thus, in a fee-for-service environment,
high-DOL businesses beneļ¬t most from increases in utilization.
Conversely, high-DOL businesses are hurt the most when utilization falls.
ā¢ In marginal analysis, the focus is on the incremental (marginal)
proļ¬tability associated with increasing or decreasing volume.
ā¢ A capitated environment dramatically changes the situation for providers
vis-a-vis a fee-for-service environment. In essence, a capitated provider
takes on the insurance function.
ā¢ Under capitation, the revenue per unit of volume, when measured
traditionally, is zero. Thus, provider risk is minimized with a high DOL
(high ļ¬xed costs), which results in a low variable cost rate and a small, but
negative, contribution margin.
ā¢ The keys to success in a capitated environment are to (1) manage (reduce)
utilization and (2) increase the number of members covered.
ā¢ To miximize ļ¬nancial risk, providers should create a cost structure that
matches its revenue structure.

In Chapter 6, the discussion of managerial accounting continues with an
examination of the second major classiļ¬cation of costs, which is based on the
relationship of costs to the sub-unit being analyzed.

Questions
5.1 Explain the differences between ļ¬xed costs, semi-ļ¬xed costs, and
variable costs?
5.2 Total costs are made up of what components?
5.3 a. What is cost-volume-proļ¬t (CVP) analysis?
b. Why is it so useful to health services managers?
5.4 a. Deļ¬ne contribution margin.
b. What is its economic meaning?
5.5 a. Write out and explain the equation for volume breakeven.
b. What role does contribution margin play in this equation?
5.6 a. What is operating leverage?
b. How is it measured?
5.7 What elements of proļ¬t analysis change when a provider moves from a
fee-for-service to a discounted fee-for-service environment?
5.8 What are the critical differences in proļ¬t analysis when conducted in a
capitated environment versus a fee-for-service environment?
153
Chapter 5: Managerial Accounting Basics

5.9 How do provider incentives differ when it moves from a fee-for-service
to a capitated environment?
5.10 a. What cost structure is best when a provider is capitated? Explain.
b. What cost structure is best when a provider is reimbursed mostly by
fee for service. Explain.

Problems
5.1 Consider the CVP graphs below for two providers operating in a
fee-for-service environment:
a. Assuming the graphs are drawn to the same scale, which provider has
the greater ļ¬xed costs? The greater variable cost rate? The greater per
unit revenue?
b. Which provider has the greater contribution margin?
c. Which provider needs the higher volume to break even?
d. How would the graphs above change if the providers were operating in
a discounted fee-for-service environment? In a capitated environment?

5.2 Consider the data in the table below for three independent health
services organizations:

Total Fixed Total
Sales Variable Costs Costs Costs Proļ¬t
a. \$2,000 \$1,400 ? \$2,000 ?
b. ? 1,000 ? 1,600 \$2,400
c. 4,000 ? \$600 ? 400

Fill in the missing data indicated by question marks.
5.3 Assume that a radiologist group practice has the following cost structure:
Fixed costs \$500,000
Variable cost per procedure \$25
Charge (revenue) per procedure \$100
154 Healthcare Finance

Furthermore, assume that the group expects to perform 7,500
procedures in the coming year.
a. Construct the groupā™s base case projected proļ¬t and loss statement.
b. What is the groupā™s contribution margin? What is its breakeven point?
c. What volume is required to provide a pre-tax proļ¬t of \$100,000? A
pre-tax proļ¬t of \$200,000?
d. Sketch out a CVP analysis graph depicting the base case situation.
e. Now, assume that the practice contracts with one HMO, and the plan
proposes a 20 percent discount from charges. Redo questions a, b, c,
and d under these conditions.
5.4 General Hospital, a not-for-proļ¬t acute care facility, has the following
cost structure for its inpatient services:
Fixed costs \$10,000,000
Variable cost per inpatient day \$200
Charge (revenue) per inpatient day \$1,000
The hospital expects to have a patient load of 15,000 inpatient days next
year.
a. Construct the hospitalā™s base case projected P&L statement.
b. What is the hospitalā™s breakeven point?
c. What volume is required to provide a proļ¬t of \$1,000,000? A proļ¬t
of \$500,000?
d. Now, assume that 20 percent of the hospitalā™s inpatients come from
a managed care plan that wants a 25 percent discount from charges.
Should the hospital agree to the discount proposal?
5.5 You are considering starting a walk-in clinic. Your ļ¬nancial projections
for the ļ¬rst year of operations are as follows:
Revenues (10,000 visits) \$400,000
Wages and beneļ¬ts 220,000
Rent 5,000
Depreciation 30,000
Utilities 2,500
Medical supplies 50,000
Assume that all costs are ļ¬xed except supply costs, which are variable.
Furthermore, assume that the clinic must pay taxes at a 30 percent rate.
a. Construct the clinicā™s projected P&L statement.
b. What number of visits is required to break even?
c. What number of visits is required to provide you with an after-tax
proļ¬t of \$100,000?
5.6 Review the walk-in clinic data presented in Problem 5.5. Construct
projected proļ¬t and loss statements at volume levels of 8,000, 9,000,
10,000, 11,000, and 12,000 visits.
a. Assume that the base case forecast is 10,000 visits. What is the clinicā™s
degree of operating leverage (DOL) at this volume level? Conļ¬rm
155
Chapter 5: Managerial Accounting Basics

the net incomes at the other volume levels using the DOL combined
with the percent changes in volume.
b. Now, assume that the base case volume is 9,000 visits. What is the
DOL at this volume?
5.7 Grandview Clinic has ļ¬xed costs of \$2 million and an average variable
cost rate of \$15 per visit. Its sole payer, an HMO, has proposed an
annual capitation payment of \$150 for each of its 20,000 members. Past
experience indicates the population served will average two visits per
year.
a. Construct the base case projected proļ¬t and loss statement on the
contract.
b. Sketch two CVP analysis graphs for the clinicā”one with number of
visits on the X axis, and one with number of members on the X axis.
Compare and contrast these graphs with the one in Problem 5.3.d.
c. What is the clinicā™s contribution margin on the contract? How does
this value compare with the value in Problem 5.3.b?
d. What proļ¬t gain can be realized if the clinic can lower per member
utilization to 1.8 visits?

Note
1. The term management accounting is sometimes used in place of managerial
accounting. Although some accountants differentiate between managerial and
management accounting, the differences are small and beyond the scope of this
book. Thus, for purposes here, managerial and management accounting are the
same.

References
For a more in-depth treatment of cost measurement in health services organizations, see
Baker, J. 1999. Cost Accounting for Healthcare. Chicago: McGraw-Hill/HFMA.
Finkler, S. A., and D. M. Ward. 1999. Essentials of Cost Accounting for Health Care
Organizations. Gaithersburg, MD: Aspen.
Newmann, B. R., and K. E. Boles. 1998. Management Accounting for Healthcare
Organizations. Chicago: Precept Press.
Suver, J. D., B. R. Neumann, and K. E. Boles. 1992. Management Accounting for
Healthcare Organizations. Chicago: HFMA/Pluribus Press.
Young, D. W. 2003. Management Accounting in Health Care Organizations. New
York: Jossey-Bass.

Barnett, P., and A. Hendricks (eds). 1999. āDevelopments in Cost Methodology:
Lessons from VA Research.ā Medical Care (April).
Boles, K. E., and S. T. Fleming. 1996. āBreakeven Under Capitation.ā Health Care
Management Review (Winter): 38ā“47.
156 Healthcare Finance

Davis, K., R. Otwell, and J. Barber. 2004. āManaging Costs Through Clinical Quality
Improvement.ā Healthcare Financial Management (July): 52ā“58.
Kilgore, M. L., S. J. Steindel, and J. A. Smith. 1999. āCost Analysis for Decision
Support: The Case of Comparing Centralized Versus Distributed Methods for
Blood Gas Testing.ā Journal of Healthcare Management (May/June): 207ā“
215.
Shackelford, L. 1999. āMeasuring Productivity Using RBRVS Cost Accounting.ā
Healthcare Financial Management (January): 67ā“69.
Smith, B., and R. B. Hardaway. 2004. āMaking the Tough Choices for Cost Control.ā
Healthcare Financial Management (July): 76ā“84.
CHAP TER

6
COST ALLOCATION

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

ā¢ Explain why proper cost allocation is important to health services
organizations.
ā¢ Deļ¬ne a cost driver and explain the characteristics of a good driver
as opposed to a poor one.
ā¢ Describe the three primary methods used to allocate overhead costs
among revenue producing departments.
ā¢ Apply cost-allocation principles across a wide range of situations
within health services organizations.

Introduction
In Chapter 5, we discussed the classiļ¬cation of costs according to their rela-
tionship to volume. In this chapter, we introduce the second primary classi-
ļ¬cation of costsā”the relationship between costs and the sub-unit being ana-
lyzed (e.g., a department, service, or third-party payer contract). In essence,
we will see that some costs are unique to the sub-unit being analyzed, while
some 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
speciļ¬c to a sub-unit, it becomes necessary to create a system that allocates
organizational costs to sub-units. Although some of this chapterā™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.

Some costsā”about 50 percent of a health services organizationā™s cost struc-
tureā”are unique to the reporting sub-unit and hence usually can be identiļ¬ed
with relative certainty. To illustrate, consider a hospitalā™s clinical laboratory.
Certain costs are unique to the laboratory: for example, the salaries and ben-
eļ¬ts for the 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
157
laboratory were closed, are classiļ¬ed as the direct costs of the department.
158 Healthcare Finance

Unfortunately, direct costs constitute only a portion of the laboratoryā™s
entire cost structure. The remaining resources utilized by the laboratory are
not unique to the laboratory; the laboratory utilizes many shared resources of
the hospital as a whole. For example, the laboratory shares the organizationā™s
physical space as well as its infrastructure, which includes information systems,
utilities, housekeeping, maintenance, medical records, and general administra-
tion. The costs that are not borne solely by the laboratory are called indirect,
Indirect costs, in contrast to direct costs, are much more difļ¬cult to
measure at the sub-unit level for the precise reason that they arise from shared
resourcesā”that is, if the laboratory were closed, the indirect costs would not
disappear. Perhaps some indirect costs could be reduced, but the hospital still
requires a basic infrastructure to operate its remaining departments. Note that
the direct/indirect classiļ¬cation has relevance only at the sub-unit level; if the
unit of analysis is the entire organization, all costs are direct by deļ¬nition.

Self-Test 1. What is the difference between direct and indirect costs?
Questions 2. Give some examples of each type of cost for an emergency services
department.

Introduction to Cost Allocation
A critical part of cost measurement at the sub-unit 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 depart-
ment to other departments. Because this pricing process does not occur in a
market setting, no objective standard exists that establishes the price for the
transferred services. Thus, cost allocation within a business must, to the ex-
tent possible, establish prices that proxy those that would be set under market
conditions.
What costs within a health services organization must be allocated?
istrators, facilities management personnel, ļ¬nancial 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 support costs to patient services departments is necessary
because there would be no need for support costs 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.
159
Chapter 6: Cost Allocation

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. Ideally, health services
managers would like to track and assign costs by individual patient, physi-
cian, diagnosis, reimbursement contract, and so on. With complete cost data
accessible in the organizationā™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 beneļ¬ts 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 coming under increased pressure to
optimize economic performance, which translates into reducing costs. Indeed,
many department heads are being evaluated, and hence compensated and pro-
moted, primarily on the basis of economic results, assuming that performance
along other dimensions is satisfactory. For such a performance-evaluation sys-
tem to work, all parties must perceive the cost allocation process to be accurate
and fair because managers are being held accountable for both direct and in-
direct (full) costs.

Self-Test
1. What is meant by the term cost allocation?
Questions
2. What is the goal of cost allocation?
3. Why is cost allocation important to health services managers?

Cost Allocation Basics
To assign costs from one activity to another, two important elements must be
identiļ¬ed: a cost pool and a cost driver. A cost pool is a grouping of costs that
must be allocated, while a cost driver is the criterion upon which the allocation
is made. To illustrate, a hospital may allocate housekeeping costs to its other
departments on the basis of the size of each departmentā™s physical space. The
logic here is that the amount of housekeeping 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 is divided by the cost driver, the result is the
overhead allocation rate. Thus, in the housekeeping illustration, the allocation
rate is total housekeeping costs of the organization 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
160 Healthcare Finance

foot of space utilized. In the patient services departments, total costs would
include not only the direct costs of each department but also an allocation
for the cost of providing housekeeping services made on the basis of the
amount of occupied space. Clearly, the development of meaningful allocation
rates enhances the ability of managers to make judgments concerning price
negotiations, service proļ¬tability, and cost reduction.

Cost Drivers
Perhaps the most important step in the cost allocation process is the identi-
across all support departments and then divided by a rough measure of or-
ganizational output, resulting in an allocation rate of some dollar amount of
generic overhead per unit of output. For example, the total inpatient over-
head costs of a hospital might be divided by total inpatient days, giving an
allocation rate of so many dollars per patient day, which was called the per
diem overhead rate. If a hospital had 72,000 patient days in 2004, and total
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 indirect cost
allocation for that department.
However, it is clear that not all overhead costs are tied to the num-
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 identiļ¬ed.
The 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 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 sub-unit and the cost driver, the better the cost driver and hence the
better the resulting cost allocations.
Good cost drivers exhibit two characteristics. First, and perhaps the less
important of the two, is fairness ā”that is, do the cost drivers chosen result in an
allocation that is fair to the patient services departments? The second, and per-
haps more important, characteristic is cost control ā”that is, do the cost drivers
chosen create incentives for departments to utilize less overhead services? For
example, there is little that patient services department managers can do to
161
Chapter 6: Cost Allocation

TABLE 6.1
Step One: Determine the Cost Pool
Prairie View
The departmental costs to be allocated are for the Housekeeping department,
Clinic:
which has total budgeted costs for 2005 of \$100,000.
Allocation of
Step Two: Determine the Cost Driver
Housekeeping
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
Physical Therapy
provided in 2005 to those departments that will receive the allocation.
Department
Step Three: Calculate the Allocation Rate
\$100,000 / 10,000 hours = \$10 per hour of housekeeping services provided.
Step Four: Determine the Allocation Amount
Physical Therapy utilizes 3,000 hours of housekeeping services, so its
allocation of Housekeeping department overhead is \$10 Ć— 3,000 = \$30,000.

inļ¬‚uence overhead cost allocations if the cost driver is patient days. In fact,
the action needed to reduce the overhead allocation, reduction in patient days,
would likely lead to negative ļ¬nancial consequences for the organization. A
good 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
good cost drivers, including several illustrations that distinguish good drivers
from poor ones.

The Allocation Process
The steps involved in allocating overhead costs are summarized in Table 6.1,
which illustrates how Prairie View Clinic allocated its housekeeping costs for
2005.1 First, the cost pool must be established. 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 best cost driver must be identiļ¬ed. After considerable investi-
gation, Prairie Viewā™s managers concluded that the best cost driver for house-
keeping costs is labor hoursā”that is, the number of hours of housekeeping
services required by the clinicā™s departments is the variable most closely re-
lated 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 department. For 2005, Prairie Viewā™s managers estimate that
the Housekeeping 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 deļ¬ned 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.
162 Healthcare Finance

The ļ¬nal step in the process is to make the allocation to each depart-
ment. To illustrate the allocation, consider Physical Therapy (PT)ā”one of
Prairie Viewā™s patient services departments. For 2005, PT is expected to utilize
3,000 hours of housekeeping services, so the dollar amount of housekeeping
overhead allocated to PT is \$10 Ć— 3,000 = \$30,000. Other departments
within the clinic will also utilize housekeeping services, and their allocations
would be made in a similar manner. The \$10 allocation rate per hour of ser-
vices utilized is multiplied by the amount of each departmentā™s utilization of
housekeeping services to obtain the dollar allocation. When all departments
are considered, the entire clinic is projected to use 10,000 hours of house-
keeping services, so the total amount allocated across the entire clinic must
be \$10 Ć— 10,000 = \$100,000, which is the amount in the cost pool. For any
department, the amount allocated depends on both the allocation rate and
the amount of overhead services utilized.

Self-Test 1. What are the deļ¬nitions of a cost pool, a cost driver, and an allocation
Questions rate?
2. On what basis are cost drivers chosen?
3. What two characteristics make a good cost driver?
4. What are the four steps in the cost allocation process?

Cost Allocation Methods
Mechanically, 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
(primarily, patient services departments) that create the need for the overhead
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; 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 allocated
from support departments to the departments that generate revenues for the
organization and hence create the need for the support services.
Figure 6.1 summarizes the three allocation methods. Prairie View
Clinic, which is used in the illustration, has three support departments (Hu-
man Resources, Housekeeping, and Administration) and two patient services
departments (Physical Therapy and Internal Medicine).
163
Chapter 6: Cost Allocation

FIGURE 6.1
Prairie View
Support Departments Patient Services Departments
Clinic:
Direct Method
Alternative Cost
Human Resources
Allocation
Physical Therapy
Methods
Housekeeping
Internal Medicine

Reciprocal Method

Human Resources
Physical Therapy
Housekeeping
Internal Medicine

Step-Down Method

Human Resources
Physical Therapy
Housekeeping
Internal Medicine

Under the direct method, shown in the top section of Figure 6.1, each
support departmentā™s costs are allocated directly to the patient services depart-
ments that utilize the services. 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 de-
partments. The key feature of the direct method, and the feature that makes
it relatively simple to apply, is that none of the costs of providing support
services is allocated to other support departments. In effect, 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 Figure 6.1, the reciprocal method
recognizes the support department interdependencies between Human Re-
sources, Housekeeping, and Administration, and hence it generally is consid-
ered to be more accurate and objective than the direct method. The reciprocal
method derives its name from the fact that it recognizes all services that de-
partments provide to and receive from other departments. The good news
is that this method captures all of the intrasupport department relationships,
164 Healthcare Finance

so no information is ignored and no biases are introduced into the cost al-
location 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 difļ¬cult to explain to general managers and more costly to implement.
The step-down method, which is shown in the lower section of Figure
6.1, represents a compromise between the simplicity of the direct method
and the complexity of the reciprocal method. It recognizes some of the in-
trasupport 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 pat-
tern of the allocation process, which requires that the allocation takes place
in a speciļ¬c sequence. First, all the direct costs of Human Resources are al-
located to both the patient services departments and the other two support
departments. Human Resources is then closed out because all 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 departmentā”
allocated to the patient services departments. The ļ¬nal allocation includes
Human Resources, Housekeeping, and Administration costs because a por-
tion of these support costs have been āstepped downā to the Administration
department.
The critical difference between the step-down and reciprocal methods
is that after each allocation is made in the step-down method, a support
department is removed from the process. Even though Housekeeping and
Administration provide support services back to Human Resources, these
indirect costs are not recognized because Human Resources is removed from
the allocation process after the initial allocation. Such costs are recognized in
the reciprocal method.

Self-Test 1. What are the three primary methods of cost allocation?
Questions 2. Explain how they differ?

Direct Method Illustration
The best way to gain a more in-depth understanding of cost allocation basics is
to work through several allocation illustrations. We will begin with the direct
method. As shown in Table 6.2, Kensington Hospital has three revenue-
producing patient services departments, or revenue centers : Routine Care,
Laboratory, and Radiology. Hospital costs are divided into those attributable
to the revenue centers (direct costs) and those attributable to the support
165
Chapter 6: Cost Allocation

TABLE 6.2
Projected Revenues by Patient Services Department
Kensington
Routine Care \$ 16,000,000
Hospital:
Laboratory 5,000,000
and Cost
Total revenues \$27,000,000
Projections
Projected Costs for All Departments
Patient Services Departments (Direct Costs):
Routine Care \$ 5,500,000
Laboratory 3,300,000
Total costs \$ 11,600,000

Financial Services \$ 1,500,000
Facilities 3,800,000
Housekeeping 1,600,000
Personnel 2,550,000
Total costs \$ 13,850,000

Total costs of both patient and support services \$25,450,000

Projected proļ¬t \$ 1,550,000

to the support departments, but when they are allocated these direct costs
become indirect costs to the revenue centers (patient services departments).
The data show that the revenues for each of the patient services depart-
ments are much greater than their direct costs. Furthermore, Kensingtonā™s
projected total revenues of \$27,000,000 exceed the hospitalā™s projected total
costs of \$25,450,000. However, the aggregate revenue and cost amounts pro-
vide no information to Kensingtonā™s managers concerning the proļ¬tability of
each patient services department. To determine true proļ¬tability by revenue
center, the full costs of providing patient services, including both direct and
indirect costs, must be measured. Only then can the hospitalā™s managers de-
velop rational pricing and cost control strategies.
As previously discussed, there are two decisions required when allocat-
ing costs: choosing the cost driver and choosing the method of allocation.2
This illustration sticks to the basics, so the assumption is that Kensington
Hospital uses the direct method of cost allocation. The step-down method
is discussed in a later illustration.
The cost pools (total costs) for the support services departments are
given in the lower section of Table 6.2. Financial Services costs are \$1,500,000;
166 Healthcare Finance

Facilities costs equal \$3,800,000; Housekeeping costs are \$1,600,000; Ad-
ministration costs total \$4,400,000; and Personnel costs equal \$2,550,000.
Thus, total overhead costs at the hospital are \$13,850,000. The allocation
process must allocate these overhead costs to the hospitalā™s three patient ser-
vices departments.
The most important step in the allocation process is to identity the
best cost drivers for each category of overhead costs (each cost pool). Table
6.3 provides a summary of the support departments and their assigned cost
drivers. Unfortunately, the selection of cost drivers is not an easy process and,
to a large extent, the usefulness of the entire cost allocation process depends
on choosing the most appropriate drivers. As discussed later, Kensingtonā™s
selection of cost drivers, like many selections made in real-world situations, is
somewhat of a compromise between the effectiveness and ease of the alloca-
tion process.
The cost driver for Financial Services is patient services revenue. Fi-
nancial Services provides a full range of ļ¬nancial support to the hospital. The
bulk of its efforts are devoted to patient accounts, but it is also involved in
ļ¬nancial and managerial accounting, budgeting and report preparation, and a
host of other ļ¬nancial tasks. Tying the allocation of this support department to
the amount of patient services revenues assumes a strong positive relationship
between the amount of ļ¬nancial services provided to each patient services de-
partment and revenues generated by that department. Clearly, patient services
revenue is a relatively rough cost driver, and hence the resulting cost allocation
has limited economic meaning. In the next section, we discuss the beneļ¬ts of
moving from a rough cost driver to a more precise one.
The amount of space utilized (square footage) is the basis for allocating
the costs of Facilities. This cost driver is often used by health services organi-
zations to allocate the initial costs of land, buildings, and equipment as well as
the costs of maintenance and other facilities services. The logic applied here is
that the patient services departments with the most space require the most fa-
cilities and facilities support. Of course, this assumption does not always hold.
For example, in any year, Facilities may be required to support a special large
project for one of the patient services departments that results in costs that far
exceed that departmentā™s proportional space utilization. Nevertheless, over
the long run at Kensington Hospital, the relative costs of Facilities utilization
by the patient services departments track closely with the space occupied by
those departments.
Two of the support departments, Administration and Personnel, also
use a fairly rough cost driver, salary dollars of the patient services departments,
instead of a more precise one. For example, if Radiology has payroll costs
that are ļ¬ve times larger than those of Laboratory, Radiology will be charged
(allocated) ļ¬ve times as much of the costs incurred by Administration and
Personnel. This cost driver is often used, but in reality, it is not very precise
167
Chapter 6: Cost Allocation

TABLE 6.3
Support Services Department Cost Driver
Kensington
Hospital:
Financial Services Patient services revenue Assigned Cost
Facilities Space utilization (square footage)
Drivers
Housekeeping Labor hours
Personnel Salary dollars

or meaningful. Thus, the allocated costs probably do not truly represent the
relative amounts of utilization of these overhead services.
Housekeeping, perhaps, has chosen the best cost driverā”namely, the
number of labor hours of housekeeping services consumed. In many organi-
zations, housekeeping costs are allocated on the basis of square footage, which
uses the logic that the amount of space occupied by a department accurately
reļ¬‚ects housekeeping efforts and hence costs. This assumption may or may not
be valid, however. In effect, large space departments may be subsidizing small
space departments, such as emergency services, where space may be limited
but the intensity of work requires a signiļ¬cant amount of housekeeping ser-
vices. To account for such situations at Kensington Hospital, Housekeeping
is using a better cost driverā”one that is more closely aligned to the actual
resources expended in providing services to the patient services departments.
Similar to most situations, the development and use of the best cost
driver is a cost-beneļ¬t issue. Housekeeping must now devote resources to
track where their workers spend their time, an effort that would not be
required if the cost driver were square footage. The beneļ¬t, of course, is
a cost driver that makes it easier for Kensingtonā™s senior managers to hold
department heads responsible for both direct and indirect costs. Now, if the
head of Radiology does not like the amount of housekeeping costs that are
being charged to the department, he or she can do something about it: use less
Housekeeping services. Under an inferior cost driver, such as square footage,
there is little that patient services department heads can do if they do not like
the Housekeeping allocation. In most cases, reduction of square footage is
not a very practical way to deal with excessive housekeeping costs.
However, with labor hours consumed as the cost driver, the cost con-
trol solution for patient services department heads is to reduce the amount
of Housekeeping services utilized. If all patient services department heads are
made to think this way by having the right incentive system in place, ultimately,
the hospital will discover it is as efļ¬cient as possible in utilizing housekeeping
services. In the long run, the direct costs of the Housekeeping Department,
currently \$1,600,000, will fall as these services are more efļ¬ciently utilized.
In reality, the secondary beneļ¬t of moving from a rough cost driver, such as
168 Healthcare Finance

TABLE 6.4
Patient
Kensington
Services Square Housekeeping Salary
Hospital: Department Revenues Feet Labor Hours Dollars
Patient Services
Departmental
Routine Care \$16,000,000 199,800 76,000 \$ 5,709,000
Summary Data Laboratory 5,000,000 39,600 6,000 2,035,000
Total \$27,000,000 300,600 91,000 \$10,183,000

square footage, to a more precise cost driver, such as labor hours, is a more
equitable allocation. The primary beneļ¬t is that a more meaningful cost driver
creates an incentive to use less of a support service, which ultimately leads to
lower overall costs for the organization.
Table 6.4 contains the initial data necessary for Kensingtonā™s managers
to allocate overhead costs to the patient services departments. The ļ¬rst col-
umn of Table 6.4 lists the patient services departments. The amounts of the
chosen cost drivers consumed by each patient services department are listed
after that: patient services revenue used for allocating Financial Services costs,
square footage used for Facilities allocations, housekeeping labor hours used
for Housekeeping allocations, and departmental salary dollars used both for
If Kensington were using the step-down or reciprocal allocation meth-
ods, the information shown in Table 6.4 would have included the support
departments because the data would be needed for intrasupport department
allocations. By using the direct method, the hospital ignores intrasupport de-
partment dependencies, so the totals indicated at the bottom of each column
reļ¬‚ect only the utilization of support services by the patient services depart-
ments, which are allocated all of the support costs.
Table 6.5 combines the dollar amount of each cost pool with the total
amount of each cost driver to derive the allocation rates. For example, the
cost pool (direct costs) for Financial Services totals \$1,500,000, which will be
allocated as indirect costs to the patient services departments that have a total
of \$27,000,000 in patient services revenues. The allocation rate for Financial
Services, therefore, is \$1,500,000 / \$27,000,000 = \$0.05556 per dollar of
patient services revenue.
As previously mentioned, the allocation of indirect costs can be viewed
as an internal pricing mechanism. Thus, the revenue producing department
heads can look at Table 6.5 and see the rate that they are being charged for
support services, which amounts to:
169
Chapter 6: Cost Allocation

ā¢ \$0.05556 for each dollar of patient services revenue generated for
Financial Services support.
ā¢ \$12.64 per square foot of space utilized for Facilities support.
ā¢ \$17.58 per labor hour consumed for Housekeeping support.
ā¢ \$0.432 per salary dollar paid to department employees for