Variable cost in healthcare finance

In Chapter 4 of Fundamentals of Healthcare Finance, you read about cost and different methods of allocation.

Please download and complete Module 2 Assignment. Submit the completed assignment (worth 5 points) in this drop box by Sunday before midnight EST.

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HSA: Health Care Finance

Module Two Assignment

In Chapter 4 in your book, you learned about cost.Use what you have learned in your readings to complete the following problems.Show all work for full credit.

1.(2 pts) Assuming that your fixed costs for a Rehabilitation Center are $125,000 per year.Your average variable expenses come to $25 per procedure.

a. What are your total fixed costs if you perform 10,000 procedures?

b. What would they be if the volume increased to 20,000 procedures?

2. (2 pts) Assuming that you have two departments in this Rehabilitation Center, PT and OT.The cleaning crew that services the building spends 30% of their time in PT, and 70% in OT due to the square footage that each department uses.

a. What would be the allocation be to PT if the total annual cost of housekeeping is $20,000?

b. What would be the allocation be to OT if the total annual cost of housekeeping is $20,000?

3. (1pt) If you looked at billing for this center, and decided to use the Activity-Based Costing method, what would the allocation of Check-In cost be to PT for 6,000 procedures considering the following information:

ActivityAnnual CostCost DriverTotal Volume of PT and OT

Check-In$20,000Number of Visits10,000

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This is CH.4 -

CHAPTER 4
ESTIMATING COSTS
THEME SET-UP: COST STRUCTURE

As you know from chapter 3, Big Sky Dermatology Specialists is a small group practice located in Jackson, Wyoming. Jen Latimer, a recent health administration graduate and newly hired manager for the group, completed her review of Big Sky's revenue sources. Now she wants to take a closer look at Big Sky's cost structure—that is, the way Big Sky's total costs change as volume changes.

Jen remembers from her healthcare finance courses that a business's costs can be classified in several ways. The major classifications are (1) the relationship of the cost to the amount of services offered (does the cost increase as volume increases?) and (2) the relationship of the cost to the subunit being analyzed (does the cost go away if the subunit is abolished?).

As she thought about these classifications, she breathed a sigh of relief. Big Sky was not formally divided into departments (subunits), so she would not have to develop a system to allocate overhead costs, such as billing expenses, to separate departments in the practice. Still, she had to identify the costs that are unrelated to volume (fixed costs) and the costs that are tied to volume (variable costs). By identifying these two types of costs, Jen would be able to forecast Big Sky's profit potential under different assumptions about volume (number of visits).

By the end of this chapter, you will have an appreciation for the costs inherent to healthcare businesses and how those costs are classified. Then you, like Jen, will be able to apply this knowledge to estimate the cost structure of Big Sky Dermatology Specialists.

LEARNING OBJECTIVES

After studying this chapter, you will be able to do the following:

Discuss the nature and purpose of managerial accounting.
Explain how costs are classified according to their relationship with volume.
Describe how costs are classified according to their relationship with the unit being analyzed.
Explain why proper cost allocation is important to healthcare organizations.
Define the terms cost pool and cost driver, and describe the characteristics of a good cost driver.
List the three primary methods used to allocate overhead costs among revenue-producing (patient services) departments.
Describe three methods used to cost individual services: the cost-to-charge ratio (CCR), relative value units (RVUs), and activity-based costing (ABC).
Articulate the differences between traditional costing and ABC.
4.1 INTRODUCTION

Healthcare managers have many responsibilities. The more important ones include planning for the future, overseeing the day-to-day activities of line employees, and establishing policies that control the operations of the organization.

For example, the practice manager of a primary care practice must estimate future demand (volume) and see to it that the practice has the facilities, staff, and supplies necessary to meet this demand. He does so primarily by creating budgets that use forecasted future volume to estimate the resources needed to meet expected patient demand. As the future unfolds, the practice manager must monitor operations to see if the volume estimates were correct. If not, supplies and staffing requirements must be adjusted to reflect variations from forecasts. Finally, he must constantly review the resources used to ensure that they are being used appropriately and efficiently and are being acquired at the lowest possible costs.

All of these activities require information—a great deal of it. Furthermore, it has to be compiled in a format that facilitates analysis, interpretation, and decision-making. Without timely and relevant information, healthcare managers would be making decisions essentially in the dark. Of course, accurate information does not ensure good decision-making, but without it, the chances of making good decisions are almost nil.

The foundation of a good information system is the manager's ability to estimate costs with confidence. This task is not easy. You may be able to precisely estimate the cost of your college education—just add up the costs of tuition, books and supplies, room and board, and so on—but what about the costs of healthcare organizations? Their overall (total) costs can be measured with some precision, such as the total costs of running a hospital or a medical practice. However, what about the costs of running the emergency department, or the costs associated with Medicare patients, or the costs of treating patients who have had heart attacks? Estimating these costs with confidence is essential to sound management, yet many factors complicate the estimation process.

Although cost estimation comes with a multitude of problems, it is far too important to the financial well-being of healthcare providers to do in a sloppy way. Thus, organizations put a lot of time and effort into doing the best possible job.

4.2 THE BASICS OF MANAGERIAL ACCOUNTING

Cost estimation is an accounting function, so our coverage begins with some accounting basics. Accounting is split into two primary areas: managerial accounting and financial accounting. Whereas financial accounting (discussed in chapters 11 and 12) focuses on the reporting of operational and financial results to outsiders, managerial accounting focuses on the development of information used internally for managerial decision-making (see “Critical Concept: Managerial Accounting”).

Managerial accounting information is used in routine budgeting processes, to allocate managerial bonuses, and to make pricing and service decisions, all of which deal with subunits of an organization. In addition, managers can use managerial accounting data for special purposes, such as assessing alternative modes of delivery or projecting the profitability of a particular reimbursement contract.

Because managers are more concerned with what will happen in the future than with what has happened in the past, managerial accounting is for the most part forward-looking. However, because most of the future is unknown, compiling managerial accounting information requires making many assumptions about future events. For example, as managers create budgets, they often must make assumptions regarding utilization (volume), reimbursement rates, and costs.

A critical part of managerial accounting is the measurement of costs. One issue that makes this task difficult is the fact that no single definition of the term cost exists. Rather, different costs exist for different purposes. As a general rule, for healthcare providers, a cost involves a resource use associated with providing, or supporting, a specific service. However, the cost per service identified for pricing purposes can differ from the cost per service used for management control purposes. Also, the cost per service used for long-range planning purposes may differ from the cost per service defined for short-term purposes. Thus, when dealing with costs, managers have to understand the context so that the correct cost is identified. To complicate matters further, costs do not necessarily reflect actual cash outflows.

Costs are classified in two primary ways: by their relationship to the volume (amount) of services provided and by their relationship to the unit (i.e., department) being analyzed. This chapter focuses on these two cost classifications. In chapter 5, we add revenues to the mix and show how to convert cost estimates into profit estimates.

images CRITICAL CONCEPT
Managerial Accounting
The accounting function in businesses is broken down into two major areas: managerial accounting and financial accounting. Financial accounting, which is covered later in the book, involves the creation of financial statements that report what has occurred at the organization. Managerial accounting concerns the creation and use of data needed to manage an organization's current and future operations. Thus, managerial accounting produces reports used at various levels in an organization, such as department operations, contract negotiations, or specific services delivery, to enhance financial performance.

images SELF-TEST QUESTIONS
What is the primary purpose of managerial accounting information?
What is meant by the term cost?
What are the two primary ways that costs can be classified?
4.3 COST CLASSIFICATION 1: FIXED VERSUS VARIABLE COSTS

One way to classify costs is on the basis of their relationship to the amount of services provided, often referred to as volume or utilization. Future volume—the number of patient days, visits, enrollees, laboratory tests, and so on—is almost always uncertain.

Volume may be forecasted in a number of ways. One way is to review historical trends, say, over the past five to ten years. In many situations, the past is a good predictor of the future. If the manager believes this to be the case, then she can apply statistical analysis (linear regression) to the historical data to predict future volumes. If past data are not available or if significant changes in the operating environment are taking place, then volume forecasting becomes more difficult. In that situation, the manager must evaluate population and disease trends in the service area, actions of competitors, pricing strategies, the impact of new contracts with insurers, and a whole host of additional factors that influence future volume.

If a provider's volume forecast turns out to be inaccurate, the consequences can be severe. First, if the market for any particular service expands more than expected and planned for, the provider will not be able to meet its patients’ needs. Potential patients will go elsewhere, and the provider will lose market share and perhaps miss a major opportunity to maintain or increase its business. On the other hand, if projections are overly optimistic, the provider could end up with excess equipment, supplies, and staff, and hence costs that are higher than necessary.

In spite of the difficulties in forecasting volume with precision, managers typically have some idea of the potential range. For example, the manager of Northside Clinic, a small walk-in clinic, might estimate that the total number of patient visits for next year will likely range from 12,000 to 14,000 or from about 34 to 40 per day. If utilization is not likely to fall outside of these bounds, then the range of 12,000 to 14,000 annual visits defines the clinic's relevant range. Note that the relevant range pertains to a particular period—in this case, next year. For other periods, the relevant range might differ from this estimate.

FIXED COSTS

Some costs, called fixed costs, are more or less known with certainty, regardless of the level of volume in the relevant range. For example, Northside Clinic's labor force would be increased or decreased only under unusual circumstances. Thus, as long as volume falls within the relevant range of 12,000 to 14,000 patient visits, labor costs at the clinic are fixed for the coming year. The actual number of visits might turn out to be 12,352 or 13,877, but labor costs will remain at their forecasted level as long as volume falls in the relevant range (see “For Your Consideration: Cost Structure and Relevant Range”). Other examples of the clinic's fixed costs include expenditures on facilities (e.g., rent, property taxes, utilities), diagnostic equipment, and information systems. After an organization has acquired these assets, it typically is locked into them for some period regardless of volume fluctuations, so these costs are known beforehand.

Of course, no costs are fixed over the long run or over large volume changes. At some level of increasing volume, healthcare businesses must incur additional fixed costs for new facilities and equipment, additional staffing, and so on. Likewise, if volume decreases by a substantial amount, an organization likely would reduce fixed costs by shedding some of its facilities and parts of its equipment and labor base.

images FOR YOUR CONSIDERATION
Cost Structure and Relevant Range
In general, an organization's underlying cost structure is defined for a specified relevant range. For example, assume that Atlanta Clinic's underlying cost structure is given as follows:

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Assume that the expected number of visits next year is 75,000 and the relevant range for this cost structure is 70,000 to 80,000 visits. Now, assume that a new payer makes a proposal to the clinic that would increase next year's volume by 10,000 visits, which would increase the expected number of visits to 85,000. The financial staff presents you, the CEO, with an analysis of the costs under the new proposal that was calculated as follows:

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What is your initial reaction to the analysis? Is it valid or must it be redone? What variable in the underlying cost structure is most likely to change at a volume of 85,000 visits?

VARIABLE COSTS

Whereas some costs are fixed regardless of volume (within the relevant range), other resources are more or less consumed as volume dictates. Costs that are related to (depend on) volume are called variable costs (see “Critical Concept: Fixed Versus Variable Costs”). For example, the costs of the clinical supplies (e.g., rubber gloves, tongue depressors, hypodermics, bandages) used by Northside would be classified as variable costs. Also, some of the clinic's diagnostic equipment is leased on a per-use basis (a fixed payment each time the equipment is used), which converts the cost of the equipment from a fixed cost to a variable cost. Finally, some healthcare organizations pay their employees on the basis of the amount of work performed, which would convert labor costs from fixed to variable. The bottom line is that fixed costs are independent of the volume of services delivered (within the relevant range), while variable costs depend on volume.

images CRITICAL CONCEPT
Fixed Versus Variable Costs
One way to classify costs is by their relationship to volume. Fixed costs are known and predictable regardless of volume (within some relevant range). Conversely, variable costs depend on the volume of services supplied. Consider a clinical laboratory. The costs of the building, equipment, and personnel to run the lab are known with some certainty for the coming year. Furthermore, these costs are independent of the number of tests actually conducted. Such costs are fixed. However, the annual costs of reagents and other test supplies depend on the number (and type) of tests conducted—the greater the number of tests, the greater these costs. Thus, the accounting system would classify these costs as variable.

UNDERLYING COST STRUCTURE

Healthcare managers are vitally interested in how costs are affected by changes in the amount of services supplied. The relationship between costs and volume, called underlying cost structure (or just cost structure), is used by managers in planning, control, and decision-making (see “Critical Concept: Underlying Cost Structure”). The primary reason for defining an organization's cost structure is to provide managers with a tool for forecasting costs (and ultimately profits) at different volume levels.

To illustrate the concept, consider the hypothetical cost data presented in exhibit 4.1 for a hospital's clinical laboratory. The cost structure consists of both fixed and variable costs—that is, some of the costs are expected to be volume sensitive and some are not. This structure of both fixed and variable costs is typical in health services organizations as well as most other businesses (see “Healthcare in Practice: The Cost Structures of Medical Practices”). For illustrative purposes, let us assume the relevant range is from zero to 20,000 tests. (Of course, the actual relevant range might be from 15,000 to 20,000 tests.)

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As noted in exhibit 4.1, the laboratory has $150,000 in fixed costs that consist primarily of labor, facilities, and equipment. (We have purposely kept the numbers unrealistically small for ease of illustration.) These costs will occur even if the laboratory does not perform one test. In addition to the fixed costs, each test, on average, requires $10 in laboratory supplies, such as glass slides, blood test tubes, and reagents.

The per-unit (per test, in this example) variable cost of $10 is defined as the variable cost rate. If laboratory volume doubles—for example, from 500 to 1,000 tests—total variable costs will double from $5,000 to $10,000. However, the variable cost rate of $10 per test remains the same whether the test is the first, the hundredth, or the thousandth. Total variable costs, therefore, increase or decrease proportionately as volume changes, but the variable cost rate remains constant.

Fixed costs, in contrast to total variable costs, remain unchanged as the volume varies. When volume doubles from 500 to 1,000 tests, fixed costs remain at $150,000. Because all costs in this example are either fixed or variable, total costs are merely the sum of the two. For example, at 5,000 tests, total costs are Fixed costs + Total variable costs = $150,000 + (5,000 × $10) = $150,000 + $50,000 = $200,000. Because variable costs are tied to volume, total variable costs, and hence total costs, increase as the volume increases, even though fixed costs remain constant.

The rightmost column in exhibit 4.1 contains average cost per unit of volume, which in this example is average cost per test. It is calculated by dividing total costs by volume. For example, at 5,000 tests, with total costs of $200,000, the average cost per test is $200,000 ÷ 5,000 = $40. Because fixed costs are spread over more tests as volume increases, the average cost per test declines as volume increases. For example, when volume doubles from 5,000 to 10,000 tests, fixed costs remain at $150,000, but fixed cost per test declines from $150,000 ÷ 5,000 = $30 to $150,000 ÷ 10,000 = $15.

With fixed cost per test declining from $30 to $15, the average cost per test goes down from $30 + $10 = $40 to $15 + $10 = $25. The fact that higher volume reduces average fixed cost, and therefore average cost per unit of volume, has important implications for profitability related to volume changes. (In economics, the state of declining average cost as volume increases is called economies of scale.)

The cost behavior presented in exhibit 4.1 in tabular format is presented in graphical format in exhibit 4.2. Here, costs are shown on the vertical (y) axis, and volume (number of tests) is shown on the horizontal (x) axis. Because fixed costs are independent of volume, they are shown as a horizontal dashed line at $150,000. Total variable costs appear as an upward-sloping dotted line that starts at the origin (0 tests, $0 costs) and rises at a rate of $10 for each additional test. When fixed and total variable costs are combined to obtain total costs, the result is the upward-sloping solid line parallel to the total variable costs line but beginning at the y-axis at a value of $150,000 (the fixed costs amount). In effect, the total costs line is nothing more than the total variable costs line shifted upward by the amount of fixed costs.

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Note that exhibit 4.2 is not drawn to scale. Furthermore, the relevant range is unrealistically large. The intent here is to emphasize the general shape of a cost structure graph and not its exact position. Also, note that total variable costs plot as a straight line (linear), because the variable cost rate is assumed to be constant over the relevant range. We assume throughout the book that the variable cost rate is constant, and hence total variable costs are linear, at least within the relevant range. For most healthcare organizations in most situations, such an assumption is not unreasonable.

Before we leave this illustration of underlying cost structure, we should mention that fixed and variable costs represent two ends of the volume classification spectrum. Here, in the relevant range, the costs are either independent of volume (fixed) or directly related to volume (variable). A third classification, semifixed costs, falls between the two extremes. To illustrate, assume that the actual relevant range of volume for the clinical laboratory is 15,000 to 20,000 tests. However, the laboratory's current workforce can only handle up to 17,500 tests per year, so an additional technician, at an annual cost of $35,000, would be required if volume exceeds that level. Now, labor costs are fixed from 15,000 to 17,500 tests and again at a higher level from 17,500 to 20,000 tests, but they are not fixed at the same level throughout the entire relevant range of 15,000 to 20,000 tests. Semifixed costs are fixed within ranges of volume, but multiple ranges of semifixed costs occur within the relevant range. To keep the illustrations manageable, we do not include semifixed costs in our examples in this book.

images CRITICAL CONCEPT
Underlying Cost Structure
The underlying cost structure of a business defines the relationship between volume and costs. To illustrate, assume you plan to sell customized pens to your classmates to make some extra money. To get started, you pay someone $50 to design the logo for the pens. Then, you pay $1.75 for each pen. The cost structure of your pen business consists of $50 in fixed costs and a variable cost rate of $1.75. Thus, the cost structure of the business can be written as:

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If you sell 100 pens, your total costs are $225:

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images HEALTHCARE IN PRACTICE
The Cost Structures of Medical Practices
Different healthcare organizations have different cost structures. Even in the same type of organization, cost structure differences occur. For example, medical practices that are hospital based, such as some radiology groups, tend to have low fixed costs (the hospital pays those). Other practices, such as cardiology, can have a great deal of diagnostic equipment and hence high fixed costs. In addition, the size of a practice influences its underlying cost structure.

Still, by examining the costs associated with a typical practice, we can get some feel for the cost structures involved. We have chosen a primary care practice to represent a typical medical practice. Because the costs involved in the practice are a function of the number of physicians in the practice, most of the data presented here are on a per-physician basis.

In 2011, the most recent data available, the average primary care practice employed roughly five full-time equivalent (adjusted to account for part-time staff) physicians. In addition, each practice, on average, employed two nonphysician providers, such as physician assistants and nurse practitioners, and a support staff of about 20. Thus, if we count the nonphysician providers as support staff for the physicians, each physician had about 4.4 individuals working to support her patient services activities.

The total operating cost to support each physician was about $325,000, not including physician compensation. Of these costs, about $160,000 were labor costs, with the remaining costs devoted to facilities, equipment, malpractice insurance, and supplies. Thus, practice costs (again, excluding physician compensation) were about evenly split between labor and nonlabor components. Taking a closer look at support staff costs, about 47 percent of the labor costs were for clinical staff, 34 percent for front-office staff (e.g., receptionists), and 19 percent for business office staff (e.g., coding, billing, collections).

On average, each primary care physician handled about 2,300 patients, who represented about 5,300 encounters (visits), during which the physician performed about 11,000 procedures. Thus, if we use patient visit as the unit of output (volume), the operating cost per visit averages out to be roughly $325,000 ÷ 5,300 = $61 per visit. The data do not break out fixed versus variable costs.

However, variable costs, which consist mostly of administrative supplies (e.g., forms, letterhead) and medical supplies (e.g., rubber gloves, needles, vaccines, dressings), were relatively small, say, $10 per visit. Thus, the underlying cost structure for an average primary care physician looked something like the following:

Total costs = $272,000 + ($10 × Number of visits),

where the $272,000 represents the fixed costs of the practice (primarily facilities and labor) and the $10 represents the average cost of supplies consumed on each visit.

With this information, the support costs (on a per-physician basis) could be estimated for different volumes. For example, the total cost to support 4,500 visits was $317,000, while the cost to support 5,500 visits was $327,000:

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In the next chapter, we expand this industry practice discussion to include revenues.

Note: This Healthcare in Practice is based on information provided by the Medical Group Management Association, 2011, Performance and Practices of Successful Medical Groups, Englewood, CO: MGMA.

images SELF-TEST QUESTIONS
Define the term relevant range.
Explain the features and provide examples of fixed and variable costs.
How does period affect the definition of fixed costs?
What is meant by underlying cost structure?
Sketch and explain a simple cost structure diagram similar to exhibit 4.2.
What are semifixed costs?
4.4 COST CLASSIFICATION 2: DIRECT VERSUS INDIRECT (OVERHEAD) COSTS

The second major cost classification is by relationship to the unit being analyzed. Some costs—about 50 percent of a large healthcare organization's cost structure—are unique to the reporting subunit and hence usually can be identified with relative certainty. To illustrate, again think in terms of a hospital's clinical laboratory. Certain costs are unique to the laboratory, for example, the salaries and benefits 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 laboratory were closed, are classified as the direct costs of the department.

Direct costs constitute only a portion of the laboratory's total costs. The remaining resources used by the laboratory are not unique to the laboratory; the laboratory shares many resources of the hospital. For example, the laboratory shares the hospital's physical space as well as its infrastructure, which includes information systems, utilities, housekeeping, maintenance, medical records, and general administration. The costs not borne solely by the laboratory but shared by all of the hospital's departments are called indirect (overhead) costs (see “Critical Concept: Direct Versus Indirect [Overhead] Costs”).

Indirect costs, in contrast to direct costs, are more difficult to measure at the department level because they arise from shared resources—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 or indirect classifications have relevance only at the subunit level. When the entire organization is considered, all costs are direct.

The two cost classifications (fixed or variable and direct or indirect) overlay one another. That is, fixed costs typically include both direct and indirect costs, while variable costs generally include only direct costs. For example, the fixed costs of a hospital laboratory include both salaried labor (direct) and facilities (overhead) costs, but the variable costs (reagents and other supplies) are all direct costs. Conversely, direct costs usually include fixed and variable costs, while indirect costs typically include only fixed costs.

Although this mixing of cost classifications can give anyone a headache, the good news is that the classifications typically are used independently of one another.

images CRITICAL CONCEPT
Direct Versus Indirect (Overhead) Costs
In addition to their relationship to volume, costs can be classified by their relationship to the unit being analyzed. Those costs that are unique to a department, and hence would disappear if the department were abolished, are called direct costs. Costs incurred from the use of resources shared across the organization are classified as indirect (overhead) costs. For example, the costs of the supplies used by a hospital's emergency department are direct costs; they would disappear if the department were closed. The costs of facilities (the space used) remain, so they represent overhead costs to the emergency department.

images SELF-TEST QUESTIONS
What is the difference between direct and indirect costs?
Give some examples of each type of cost for an emergency department.
4.5 COST ALLOCATION

A critical part of cost measurement at the department level is the assignment, or allocation, of overhead costs. Cost allocation is a process whereby managers allocate the costs of one department to other departments. Because this process does not occur in a marketplace setting, no observable prices exist for the transferred services. Thus, cost allocation must, to the extent possible, establish prices that mimic those that would be set under market conditions.

What costs in a health services organization must be allocated? Typically, the costs associated with facilities and support personnel, such as land and buildings, administrators, financial staffs, and housekeeping and maintenance personnel, must be allocated to those departments that generate 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 total (full) costs associated with each service, including both direct and overhead costs. Clearly, the proper allocation of overhead costs is essential to good decision-making in healthcare organizations.

The goal of cost allocation is to assign all of the costs of an organization to the activities that cause them to be incurred. Ideally, healthcare managers track and assign costs by individual patient, physician, diagnosis, reimbursement contract, and so on. With complete cost data available in the organization's managerial accounting system, managers can make informed decisions regarding how to control costs, what services to offer, and how to price those services. Of course, the more data needed, the higher the costs of developing, implementing, 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.

COST POOLS

The first step in allocating costs is to identify the cost pools and the cost drivers. Typically, a cost pool consists of all the direct costs of one support department (see “Critical Concept: Cost Pool”). However, if the services of a single support department differ substantially, and if the patient services departments use the different services in varying proportions, the costs of that support department may need to be separated into multiple pools.

To illustrate multiple cost pools, suppose a hospital's Financial Services Department provides two significantly different services: patient billing and managerial budgeting. Furthermore, assume that the Routine Care Department uses proportionally more patient billing services than the Laboratory Department does, but Laboratory proportionally uses more budgeting services than Routine Care does. In this situation, it would be best to create two cost pools for one support department. 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.

images CRITICAL CONCEPT
Cost Pool
A cost pool is a group of overhead costs to be allocated to the patient services departments. Typically, a cost pool consists of all the direct costs of one overhead department. For example, the costs associated with the Housekeeping Department might constitute a cost pool. However, if an overhead department provides different types of support services, the direct costs of that department might be divided into several cost pools, one for each type of service supplied.

COST DRIVERS

One of the most important steps in the cost allocation process is the identification of proper cost drivers (see “Critical Concept: Cost Drivers”). The theoretical basis for identifying cost drivers is the extent to which the costs from a pool actually vary as the value of the driver changes. A good cost driver provides the most accurate cause-and-effect relationship between the use of services and the costs of the department providing those services, so that more costs are allocated to departments that create the greatest need for support department resources. 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 closer the relationship (correlation) between actual overhead resource expenditures at each patient services department and the value of the cost driver, the better the cost driver is and hence the better the resulting cost allocations.

Effective cost drivers possess two primary characteristics. The first is fairness—that is, do the cost drivers chosen result in an allocation that is equitable to the patient services departments? The second, and perhaps more important, characteristic is cost reduction—that is, do the cost drivers chosen create incentives for departments to use fewer overhead services? For example, inpatient department managers can do little to influence overhead cost allocations if the cost driver for administrative support is patient days. In fact, the action needed to reduce the overhead allocation—reduction in patient days—would likely lead to negative financial consequences for the organization. An effective cost driver encourages patient services department managers to take overhead cost reduction actions that do not have negative implications for the organization.

images CRITICAL CONCEPT
Cost Drivers
A cost driver is the basis for allocating a cost pool. For example, if the cost pool consists of the direct costs of the Housekeeping Department, then the cost driver might be the amount of space occupied by each patient services department. The theory is that the greater the amount of square footage occupied by a patient services department, the greater the amount of housekeeping services required. Effective cost drivers have two important attributes: They are perceived by all involved as being fair, and they promote organizational cost reduction. Put another way, effective cost drivers allocate the greatest amount of overhead costs to those patient services departments that use the most overhead services and create incentives for department heads to use fewer overhead services.

THE ALLOCATION PROCESS

Exhibit 4.3 summarizes the steps involved in allocating overhead costs, illustrating how Prairie View Clinic allocated its housekeeping costs for the 2017 budget.

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First, the cost pool must be established. In this case, the clinic is allocating housekeeping costs, so the cost pool is the projected total direct costs of the Housekeeping Department, $100,000.

Second, the most effective cost driver must be identified. After considerable investigation, Prairie View's managers conclude 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 measure most closely related to the actual cost of providing these services. The intent here, as explained earlier, is to pick the cost driver that (1) provides the most accurate cause-and-effect relationship between the use of housekeeping services and the costs of the Housekeeping Department and (2) creates an incentive to use fewer housekeeping services.

Third, the allocation rate must be calculated. For 2017, Prairie View's managers estimate that Housekeeping will provide a total of 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. (Note that different allocation methods can identify different departments as the ones that will receive the allocation. In the example here, the relevant departments [the patient services departments] receive 10,000 hours of housekeeping service. If we had included the Financial Services Department in the allocation, the total amount of service received might be 10,500 hours.)

Fourth, the allocation must be made to each department. To illustrate the allocation, consider the Physical Therapy (PT) Department, one of Prairie View's patient services departments. For 2017, PT is expected to use 3,000 hours of housekeeping services, so the dollar amount of housekeeping overhead allocated is $10 × 3,000 = $30,000.

Other departments in the clinic will also use housekeeping services, and their allocations will be made in a similar manner (see “For Your Consideration: Hospitals and Housekeeping Cost Drivers”). The $10 allocation rate per hour of services used is multiplied by the amount of each department's usage of housekeeping services to obtain the dollar allocation. When all patient services departments are considered, the entire clinic is projected to use 10,000 hours of housekeeping services, so the total amount allocated must be $10 × 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 used.

images FOR YOUR CONSIDERATION
Hospitals and Housekeeping Cost Drivers
Many hospitals use square footage to allocate housekeeping costs. The rationale, of course, is that one patient services department that is twice as big as another will require twice the expenditure of housekeeping resources. The advantage of this cost driver is that it is easy to measure and typically remains constant for a relatively long period (department space allotments do not change very often).

The disadvantage of using square footage as the cost driver is that some patient services departments require more housekeeping support per square foot of occupied space because of the nature of the service that the department provides. For example, emergency departments require more intense housekeeping services than do neonatal care units, and surgical suites require more intense services than do routine care departments.

What do you think? Is a more effective cost driver available for allocating housekeeping costs than square footage? If so, what is it? Describe how the suggested cost driver might work.

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 (primarily patient services departments) that create the need for those costs.

The key differences among the methods are how support services provided by one department are allocated to other support departments. Exhibit 4.4 summarizes the three primary allocation methods as applied to Prairie View Clinic. To simplify the illustration, the clinic has only three support departments (Human Resources, Housekeeping, and Administration) and two patient services departments (PT and Internal Medicine).

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Under the direct method, shown in the top section of exhibit 4.4, each support department's costs are allocated directly to the patient services departments that use the services. In the illustration, both PT 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 none of the costs of providing support services are 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 intra–support department allocations.

As shown in the center section of exhibit 4.4, the reciprocal method recognizes the support department interdependencies among Human Resources, Housekeeping, and Administration, and hence the reciprocal method generally is considered more accurate and objective than the direct method. The reciprocal method derives its name from the fact that it recognizes all services that departments provide to and receive from other departments. The good news is that this method captures all of the intra–support 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 use of intra–support department services. Thus, it is relatively complex, which makes explaining it to department heads difficult and implementing it costly.

The step-down method, which is shown in the lower section of exhibit 4.4, represents a compromise between the simplicity of the direct method and the complexity of the reciprocal method. It recognizes some of the intra–support department effects that the direct method ignores, but it does not recognize the full range of interdependencies. The step-down method derives its name from the sequential, stairstep pattern of the allocation process, which requires that the allocation take place in a specific sequence.

Here is how it works. First, all the direct costs of Human Resources are allocated 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 the direct costs of Housekeeping and indirect costs (the allocation from Human Resources), are allocated to the patient services departments and the remaining support department—Administration. Finally, the direct costs of Administration and the indirect costs (the allocations from Human Resources and Housekeeping) are allocated to the patient services departments. The final allocation includes Human Resources, Housekeeping, and Administration costs because a portion of these support costs has been “stepped down” to Administration.

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.

images SELF-TEST QUESTIONS
What is the goal of cost allocation?
Under what conditions should a single overhead department be divided into multiple cost pools?
On what theoretical basis are cost drivers chosen?
What two characteristics make an effective cost driver?
What are the four steps in the cost allocation process?
What are the three primary methods of cost allocation? How do they differ?
4.6 SERVICE LINE COSTING

While cost measurement at the department level can help managers make decisions about pricing and service offerings, the holy grail of cost estimation is costing at the individual service or patient level. Understanding costs at the microlevel allows managers to focus on cost containment and to make better decisions when negotiating contracts with payers. Several methods are used to estimate costs at the service or patient level. We start this section by discussing two traditional costing methods: cost-to-charge ratio (CCR) and relative value unit (RVU). Next, we discuss a bottom-up method called activity-based costing (ABC).

THE SETTING

To illustrate costing at the service level, consider Tarheel Family Practice (TFP), a large physician group that provides multiple services to its patient population. TFP is organized into five departments, one of which is the Routine Services Department. For ease of discussion, we assume that the department provides only two services: X and Y. Data relevant to our illustrations are summarized in exhibit 4.5.

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The department has 10,000 visits annually, split evenly between the two services (service X and service Y). The department's total annual costs come to $1,027,500. These costs include the following: $300,000 of department overhead (including both TFP overhead allocated to the department through a step-down cost allocation and department overhead that supports both services); $242,500 in direct costs of service X; and $485,000 in direct costs of service Y. The department's charges (based on chargemaster prices) total $2,100,000, while actual revenues (reimbursements) total $1,300,000, split between the two services, as shown in exhibit 4.5. Before we begin discussing the individual costing methods, we want to emphasize that this example is highly simplified. Its purpose is merely to give you a flavor of the alternative methods available for costing individual services.

COST-TO-CHARGE (CCR) METHOD

The cost-to-charge (CCR) method is the most basic of the three methods for costing individual services. The CCR method is based on two assumptions:

The indirect costs allocated to the services constitute a single cost that is proportional across all services provided. In other words, each service consumes indirect costs in the same proportion as the department as a whole.
Charges, or alternatively reimbursement rates, reflect the level of intensity of the service provided and hence the use of shared resources by each service, including both TFP and department overhead.
We will begin by focusing on charges. With indirect (overhead) costs of $300,000 supporting total charges of $2,100,000, the cost-to-charge ratio is CCR = Indirect costs ÷ Total charges = $300,000 ÷ $2,100,000 = 0.143 = 14.3%. Once the CCR has been calculated for the department, it is used to estimate the overhead costs for each individual service:

Service overhead costs = CCR × Service charges.

Thus, the overhead cost allocation for service X is 0.143 × $700,000 = $100,100. Similarly, the overhead cost allocation for service Y is 0.143 × $1,400,000 = $200,200. The total amount of overhead allocated to the two services is $100,100 + $200,200 = $300,300, which, except for a rounding error, equals the $300,000 in total indirect costs for the department.

Finally, to obtain the full costs of each service line, merely add the direct costs to the amounts allocated for overhead:

Full (total) service costs = Direct cost + Indirect cost.

The full costs of service X are $242,500 + $100,100 = $342,600 and the cost per one visit for service X is $342,600 ÷ 5,000 visits = $68.52. The full costs of service Y are $485,000 + $200,200 = $685,200 and the cost per one visit for service Y is $685,200 ÷ 5,000 visits = $137.04. As a check, the full costs of both services total $342,600 + $685,200 = $1,027,800, which once again equals the total costs of the department, except for a rounding error.

Note that revenues can be used as an alternative to charges in the CCR method (see “For Your Consideration: Charges Versus Revenues in the CCR Method”). The procedure is the same as described earlier, but now revenues are used to calculate the CCR. With indirect (overhead) costs of $300,000 supporting total revenues (reimbursements) of $1,300,000, CCR = $300,000 ÷ $1,300,000 = 0.231 = 23.1%. Using this new value for the CCR, and revenues in lieu of charges, the overhead cost allocation for service X is 0.231 × $400,000 = $92,400. The overhead cost allocation for service Y is 0.231 × $900,000 = $207,900. Finally, to obtain the full costs of each service line, allocated overhead costs are added to the direct costs of each service. The resulting full costs of service X are $242,500 + $92,400 = $334,900 and the full costs of service Y are $485,000 + $207,900 = $692,900. As a check, the full costs of both services total $334,900 + $692,900 = $1,027,800, and except for a rounding error, this once again equals the total costs of the department.

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Charges Versus Revenues in the CCR Method
This chapter's illustration of the cost-to-charge ratio (CCR) method of costing at the service level presented two possible approaches: using charges as the basis of the allocation and using revenues (reimbursements) as the basis of the allocation.

Healthcare providers using the CCR method—and many do—must make a choice. (For some Medicare calculations, the use of charges is required. However, for internal use, providers may use either charges or revenues.) In theory, the choice should reflect the metric (charges or revenues) that best mimics the relationship to the amount of overhead resources consumed. Is that metric charges or revenues? Charges supposedly reflect the underlying costs of the service—the higher the charges, the higher the costs. However, much anecdotal evidence indicates that charges are not a good reflection of costs (for example, a charge of $25 for an aspirin administered in the hospital). On the other hand, are revenues a better reflection of costs? Private insurers, Medicare, and Medicaid often have large differences in reimbursement amounts for the same service.

What do you think? Should the CCR method use charges or revenues as the metric? What justification is there to support your answer?

RELATIVE VALUE UNIT (RVU) METHOD

In contrast to the CCR method, which ties overhead resource consumption to charges (or revenues), the relative value unit (RVU) method ties the use of overhead resources to the complexity and time required for each service. In other words, this method uses the intensity of the service provided, as measured by RVUs, as the basis for allocating overhead. As we discussed in chapter 3 (in “Healthcare in Practice: How Medicare Pays Providers”), its use in healthcare pricing and reimbursement was influenced primarily by the resource-based relative value scale system, which uses RVUs to set Medicare payments for physician services.

To begin our illustration of the RVU method, assume that a study by the medical director of Tarheel Family Practice identified the number of RVUs required to perform each service. The result was the assignment of 10 RVUs for service X and 18 RVUs for service Y as shown in

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