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Cases in Healthcare Finance

Case Questions

CASE 4 QUESTIONS

APPLE VALLEY FAMILY PRACTICE

Cost Allocation Methods
1. Briefly describe the differences in the four allocation methods discussed in the case. (Hint: Dont discuss the mathematics of the schemes, but rather how they differ conceptually.) Which of the four methods is conceptually the most reasonable? 2. What are the allocations to each patient services department, and resulting profitability, under the four allocation methods using the base case cost amounts (Exhibit 4.1) and allocation rates (Exhibit 4.2)? 3. Now consider the sensitivity of the results to changes in the values of the overhead cost pools. Repeat Question 2, but now use the overhead cost pool amounts from the first section of Exhibit 4.3 along with the base case allocation percentages contained in Exhibit 4.2. (Note the two different overhead cost pool amounts: Calculation 1 and Calculation 2.) 4. Now consider the sensitivity of the results to changes in the allocation percentages. Repeat Question 2, but now use the percentages from Exhibit 4.3 along with the base case overhead cost pool amounts given in Exhibit 4.1. 5. Assess the sensitivity of patient services department profitability to: a. The allocation method b. The relative sizes of the overhead cost pools c. The allocation rates 6. What does the analysis indicate about the true (but not really observable) profitability of each patient services department? 7. What is your recommendation regarding the appropriate cost allocation method for the practice?

Health Administration Press, 2010. Reproduction without permission is prohibited.

Cases in Healthcare Finance Case 4 Solution

CASE 4 SOLUTION (8/26/09) Copyright 2010 by FACHE

APPLE VALLEY FAMILY PRACTICE

Cost Allocation Methods

Case Information
Type
This case is nondirected, in that it does not contain a specific list of questions that students must answer. Rather, it contains general guidance or concerns expressed by various parties that students should consider when developing their solutions. If you, as the instructor, want to convert this case to a directed case, you may provide your students with the applicable questions for this case in the Case Questions section of the online material for instructors.

Purpose
This case requires students to apply four different allocation methods (direct, step-down, double apportionment, and reciprocal) to the situation at a large group practice. The purpose is to give students some feel for how much variation in final allocation amounts is due to methodological differences. Of course, the results depend on the assumptions of the case, so there is no guarantee that the conclusions reached here are applicable to all situations.

Complexity
This case is relatively straightforward, but the calculations are complex and time consuming if the case is attempted without the accompanying model.

Model Description
The model takes much of the busywork out of the case, enabling students to spend more time on interpretation and evaluation. Like most case models, the student and instructor versions differ only in regard to the input data. The instructors version contains the complete base case inputs, while these inputs are zeroed out in the student version of the model. The model for this case takes the input data (cost pool values and allocation rates) and allocates overhead costs from the three overhead departments to the three patient services departments using all four allocation methods. Additionally, the model calculates the profitability of each patient services department under each allocation method. The models (instructors version) Input Data and Key Output sections are as follows:

Copyright 2010 Health Administration Press Case 4 - 1

Case 4 Solution Cases in Healthcare Finance

INPUT DATA: Revenues: Adult Medicine Obstetrics Pediatrics Total revenues Direct Costs: Patient Services Departments: Adult Medicine Obstetrics Pediatrics Subtotal Support Departments: Administration Facilities Finance Subtotal Total costs Allocation Matrix: Services Provided to Administration Facilities Finance Adult Medicine Obstetrics Pediatriacs Total Percentage of Services Provided by Administration Facilities Finance 5% 10% 10% 35% 20% 25% 100% 10% 55% 10% 20% 100% 5% 5% 50% 25% 15% 100% $ 12,000,000 6,000,000 2,000,000 $ 20,000,000

KEY OUTPUT: Profit and Loss Statements: Direct Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit 6,000,000 3,600,000 1,200,000 $ 10,800,000 1,000,000 4,400,000 1,800,000 $ 7,200,000 $ 18,000,000 $ Step-Down Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit A. Medicine $ 12,000,000 $ 6,000,000 4,273,977 $ 10,273,977 $ 1,726,023 $ $ $ $ Obstetrics 6,000,000 3,600,000 1,333,041 4,933,041 1,066,959 $ $ $ $ Pediatrics 2,000,000 1,200,000 1,592,982 2,792,982 (792,982) Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000 A. Medicine $ 12,000,000 $ $ 6,000,000 $ 4,284,559 $ 10,284,559 $ 1,715,441 $ $ Obstetrics 6,000,000 $ 3,600,000 $ 1,267,647 4,867,647 1,132,353 $ $ Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,647,794 7,200,000 2,847,794 $ 18,000,000 (847,794) $ 2,000,000

Double Apportionment Method: A. Medicine Revenues Direct costs Indirect costs Total costs Pre-tax profit Reciprocal Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit A. Medicine $ 12,000,000 $ 6,000,000 4,234,315 $ 10,234,315 $ 1,765,685 $ $ $ $ $ 12,000,000 $ 6,000,000 4,236,594 $ 10,236,594 $ 1,763,406 $ $ $ $

Obstetrics 6,000,000 3,600,000 1,340,336 4,940,336 1,059,664 $ $ $ $

Pediatrics 2,000,000 1,200,000 1,623,070 2,823,070 (823,070)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Obstetrics 6,000,000 3,600,000 1,336,297 4,936,297 1,063,703

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,629,388 2,829,388 (829,388)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Case Solution
Because the case is nondirected, students have ample opportunity to be creative in their solution approaches. Thus, it is impossible to provide a single solution here that applies to every students work. As a starting point in evaluating students solutions, we provide a solution based on the questions in the online Case Questions section. However, this solution is merely a starting point, and student work should be graded at least as much on thought processes, assumptions used, creativity, and the ability to express ideas coherently as on the resulting numerical answers. Also, some questions address conceptual issues that most students understand but typically would not include in a case presentation/write-up. Such questions are ideal for instructors to use to extend the case discussion when students are working with the nondirected versions. These questions may be directed to the presenting team, if team presentations are used, or offered to the class in general. 1. Briefly describe the differences in the four allocation methods discussed in the case. (Hint: Dont discuss the mathematics of the schemes, but rather how they differ conceptually.) Which of the four methods is conceptually the most reasonable? Copyright 2010 Health Administration Press Case 4 - 2

Cases in Healthcare Finance Case 4 Solution

The four methods differ in how intra-support department allocations are handled and, consequently, in complexity. The direct method assumes that support departments provide services only to patient services departments. Thus, no intra-support department services are recognized, even though such services exist. This simplifying assumption makes the direct method the easiest to apply but the weakest conceptually. The step-down method recognizes some intra-support department services, but it does so in a relatively simplistic way. In this method, the support department that provides the most services to the other support departments is allocated first (to support and patient services departments). Then the department is closed, and the process steps down to the support department that provides the next highest amount of services to other support departments. Because support departments are closed out in each step, there is no opportunity to allocate support costs back to the departments that have already closed. Thus, this method is not as complex as the remaining two to implement in practice, but it is superior conceptually to the direct method. The double apportionment method first allocates each support department to all other departments, so each support department receives an allocation from all other support departments. After the initial allocation (the first apportionment), the step-down method is used to allocate the costs that remain in the support departments after the first apportionment, which for all support departments consists of direct costs and allocations from other support departments. This method better recognizes intra-support department relationships than do the first two, but it adds complexity. Finally, the reciprocal method uses a system of simultaneous equations (or a number of iterations) to allocate overhead costs simultaneously among support and patient services departments. This method is the most complex, but it does the best job of recognizing intra-support department services. Conceptually, the reciprocal method is best. The double apportionment method is next best, followed by the step-down method and, finally, the direct method. Although the direct method is conceptually the weakest, it is the easiest and least costly to implement. As in most situations, greater accuracy comes at a costthe greater the accuracy of the allocation method, the greater the implementation cost (and the more difficult it is to explain to department heads and other interested parties). 2. What are the allocations to each patient services department, and resulting profitability, under the four allocation methods using the base case cost amounts (Exhibit 4.1) and allocation rates (Exhibit 4.2)? The base case allocations and profit forecasts are summarized in the following table.

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Case 4 Solution Cases in Healthcare Finance

Direct Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit Step-Down Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit A. Medicine $ 12,000,000 $ $ 6,000,000 $ 4,273,977 $ 10,273,977 $ $ 1,726,023 $ Obstetrics 6,000,000 $ 3,600,000 $ 1,333,041 4,933,041 $ 1,066,959 $ Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,592,982 7,200,000 2,792,982 $ 18,000,000 (792,982) $ 2,000,000 A. Medicine $ 12,000,000 $ $ 6,000,000 $ 4,284,559 $ 10,284,559 $ 1,715,441 $ $ Obstetrics 6,000,000 $ 3,600,000 $ 1,267,647 4,867,647 1,132,353 $ $ Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,647,794 7,200,000 2,847,794 $ 18,000,000 (847,794) $ 2,000,000

Double Apportionment Method: A. Medicine Revenues $ 12,000,000 Direct costs $ 6,000,000 Indirect costs 4,236,594 Total costs $ 10,236,594 Pre-tax profit $ 1,763,406 Reciprocal Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit

$ $ $ $

Obstetrics 6,000,000 3,600,000 1,340,336 4,940,336 1,059,664

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,623,070 2,823,070 (823,070)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

A. Medicine $ 12,000,000 $ $ 6,000,000 4,234,315 $ 10,234,315 $ 1,765,685 $ $ $

Obstetrics 6,000,000 $ 3,600,000 1,336,297 4,936,297 1,063,703 $ $ $

Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,629,388 7,200,000 2,829,388 $ 18,000,000 (829,388) $ 2,000,000

Under base case conditions, as the allocation method moves from the direct method to the reciprocal method, the allocation of indirect costs mostly decreases to Adult Medicine, increases to Obstetrics, and exhibits random fluctuations to Pediatrics. However, as we discuss in the answer to Question 5, changing allocation methods does not materially change the resulting profitability.

3. Now consider the sensitivity of the results to changes in the values of the overhead cost pools. Repeat Question 2, but now use the overhead cost pool amounts from the first section of Exhibit 4.3 along with the base case allocation percentages contained in Exhibit 4.2. (Note that there are two different overhead cost pool amounts: Calculation 1 and Calculation 2.)

In this sensitivity analysis, allocation rates are held at their base case values and the cost pool amounts are changed. In the base case, Facilities has by far the largest cost pool. In Calculation 1, Copyright 2010 Health Administration Press Case 4 - 4

Cases in Healthcare Finance Case 4 Solution

Administration has the largest cost pool, while in Calculation 2, Finance has the largest cost pool. Here are the results: Calculation 1:
Direct Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit Step-Down Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 3,702,339 9,702,339 2,297,661 $ $ $ $ Obstetrics 6,000,000 3,600,000 1,695,906 5,295,906 704,094 $ $ $ $ Pediatrics 2,000,000 1,200,000 1,801,754 3,001,754 (1,001,754) Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000 A. Medicine $ 12,000,000 $ $ 6,000,000 $ $ $ 3,572,059 9,572,059 2,427,941 $ $ Obstetrics 6,000,000 $ 3,600,000 $ 1,717,647 5,317,647 682,353 Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000

1,910,294 7,200,000 $ 3,110,294 $ 18,000,000 $ (1,110,294) $ 2,000,000

Double Apportionment Method: A. Medicine Revenues Direct costs Indirect costs Total costs Pre-tax profit Reciprocal Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 3,688,519 9,688,519 2,311,481 $ $ $ $ $ 12,000,000 $ 6,000,000 3,693,538 $ 9,693,538 $ 2,306,462 $ $ $ $

Obstetrics 6,000,000 3,600,000 1,685,058 5,285,058 714,942 $ $

Pediatrics 2,000,000 1,200,000 1,821,404 $ 3,021,404 $ (1,021,404)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Obstetrics 6,000,000 3,600,000 1,682,601 5,282,601 717,399

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,828,880 3,028,880 (1,028,880)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Calculation 2

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Case 4 Solution Cases in Healthcare Finance

Direct Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit Step-Down Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 4,061,111 10,061,111 1,938,889 $ $ $ $ Obstetrics 6,000,000 3,600,000 1,705,556 5,305,556 694,444 $ $ $ $ Pediatrics 2,000,000 1,200,000 1,433,333 2,633,333 (633,333) Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000 A. Medicine $ 12,000,000 $ $ 6,000,000 $ 4,046,650 $ 10,046,650 $ 1,953,350 $ $ Obstetrics 6,000,000 $ 3,600,000 $ 1,683,987 5,283,987 716,013 $ $ Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,469,363 7,200,000 2,669,363 $ 18,000,000 (669,363) $ 2,000,000

Double Apportionment Method: A. Medicine Revenues Direct costs Indirect costs Total costs Pre-tax profit Reciprocal Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 4,041,808 10,041,808 1,958,192 $ $ $ $ $ 12,000,000 $ 6,000,000 4,045,015 $ 10,045,015 $ 1,954,985 $ $ $ $

Obstetrics 6,000,000 3,600,000 1,675,599 5,275,599 724,401 $ $ $ $

Pediatrics 2,000,000 1,200,000 1,479,386 2,679,386 (679,386)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Obstetrics 6,000,000 3,600,000 1,674,422 5,274,422 725,578

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,483,769 2,683,769 (683,769)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

In the base case, Facilities has the largest cost pool. In Calculation 1, Administration has the largest cost pool, while in Calculation 2, Finance has the largest. Because Adult Medicine uses the largest amount of Facilities services, its profitability increases substantially when Facilities costs are shifted to Administration. When Facilities costs are shifted to Finance, Adult Medicines profitability also increases, but not as much. Conversely, Obstetrics uses the least Facilities services, so its profitability decreases when overhead costs are shifted away from Facilities and into Administration and Finance. The impact of Pediatrics is not as clear-cut: Its profitability lessens when Administration has the largest cost pool, but improves when Finance has the largest.

4.

Now consider the sensitivity of the results to changes in the allocation percentages. Repeat Question 2, but now use the percentages from Exhibit 4.3 along with the base case overhead cost pool amounts given in Exhibit 4.1.

Copyright 2010 Health Administration Press Case 4 - 6

Cases in Healthcare Finance Case 4 Solution

The biggest change here is that the overhead departments are using a much greater proportion of services from one another (50 percent) than in the base case (15 percent). Here are the results: Calculation 3 Direct Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit Step-Down Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 4,202,000 10,202,000 1,798,000 $ $ $ $ Obstetrics 6,000,000 3,600,000 1,514,889 5,114,889 885,111 $ $ $ $ Pediatrics 2,000,000 1,200,000 1,483,111 2,683,111 (683,111) Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000 A. Medicine $ 12,000,000 $ $ 6,000,000 $ 4,256,000 $ 10,256,000 $ 1,744,000 $ $ Obstetrics 6,000,000 $ 3,600,000 $ 1,288,000 4,888,000 1,112,000 $ $ Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,656,000 7,200,000 2,856,000 $ 18,000,000 (856,000) $ 2,000,000

Double Apportionment Method: A. Medicine Revenues Direct costs Indirect costs Total costs Pre-tax profit Reciprocal Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 4,105,955 10,105,955 1,894,045 $ $ $ $ $ 12,000,000 $ 6,000,000 4,125,480 $ 10,125,480 $ 1,874,520 $ $ $ $

Obstetrics 6,000,000 3,600,000 1,528,307 5,128,307 871,693 $ $ $ $

Pediatrics 2,000,000 1,200,000 1,546,213 2,746,213 (746,213)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Obstetrics 6,000,000 3,600,000 1,477,373 5,077,373 922,627

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,616,659 2,816,659 (816,659)

Aggregate $ 20,000,000 $ 10,800,000 7,199,987 $ 17,999,987 $ 2,000,013

This change in allocation rates results in increased profitability to Adult Medicine, which uses the largest amount of overhead services, and decreased profitability to Obstetrics, which uses only a small amount of Facilities services. Shifting overhead amounts from patient services departments to overhead departments benefits the patient services department that uses the most overhead services. Still, the results are not significantly different from those of the base case. The ten iterations in the model are now insufficient to complete the allocation under the reciprocal method, so that method shows $13 less in indirect costs, and hence $13 more in aggregate profit, than do the other methods.

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Case 4 Solution Cases in Healthcare Finance

5. Assess the sensitivity of patient services department profitability to: a. The allocation method b. The relative sizes of the overhead cost pools c. The allocation rates

There are many ways to answer this question. In the matrix below, the changes in profitability from the reciprocal method (which is assumed to be the best) are listed using the base case inputs regarding allocation rates and cost pool values. This provides some feel for the impact of a change in allocation methods on departmental profitability, holding other factors constant. Allocation Method Step-Down Double Apportionment 2.2% 0.3 4.4 0.1% -0.4 0.8

Department Adult Medicine Obstetrics Pediatrics

Direct 2.8% 6.5 2.2

The findings are as we expectedin general the greatest deviation from the reciprocal method occurs in the direct method, while the least deviation occurs with the double apportionment method. As the complexity of the allocation method increases (and the method better allocates intraoverhead department costs), the differences from the reciprocal method results decrease. The next table examines the differences from the base case profitability under the three alternatives examined in Questions 3 and 4 above. To keep things simple, we have listed only the reciprocal method.

Department Adult Medicine Obstetrics Pediatrics

Calculation1 8.7% -32.6 -24.1

Alternative Analysis Calculation 2 Calculation 3 10.9% 31.8 17.6 7.3% -13.3 1.5

Here we see that changing the assumptions about the relative sizes of the cost pools and allocation rates can have a significant effect on the resulting profitability. However, this is not a great concern, because these factors are driven by the operating economics of the business, as opposed to arbitrary decisions made by managers regarding which allocation method is used.

6. What does the analysis indicate about the true (but not really observable) profitability of each patient services department?

Over a wide range of assumptions regarding the relative sizes of the cost pools and the allocation rates, we find that Adult Medicine and Obstetrics are profitable, while Pediatrics is not. Thus, the inherent operations of Pediatrics must be examined to see if Westsides management can take any actions to improve this departments profitability. However, at least under the revenue and cost framework used in the managerial accounting system, Pediatrics probably is inherently unprofitable. This does not necessarily mean that department closure should be considered. The department may be vital to the practices mission, and the practice therefore may be willing to subsidize the losses with profits from the Copyright 2010 Health Administration Press Case 4 - 8

Cases in Healthcare Finance Case 4 Solution

other two patient services departments. More probably, the true economic contribution of Pediatrics to the organization is not being adequately measured. For example, Pediatrics may be instrumental in creating patient demand for Obstetrics and Adult Medicine. If Pediatrics were closed and patient demand fell significantly, the loss in aggregate profit from falling volume could exceed the losses realized by Pediatrics. If this is the case, Pediatrics is financially justifiable in spite of the losses it shows on the managerial accounting profit and loss statements.

7. What is your recommendation regarding the appropriate cost allocation method for the practice?

Without more information about the current cost accounting system, it is impossible to make an informed decision. However, if the reciprocal method can be implemented without an undue increase in accounting costs, it is preferred. If not, the double apportionment method should be considered. If this is not feasible, the step-down method could be implemented without losing over 5 percent of the accuracy inherent in the reciprocal method. Even the direct method introduces only a 6.5 percent inaccuracy. Another consideration is any third-party payer requirements. For example, hospitals are required to use the step-down method for Medicare cost reporting, which drives most hospitals to use that method in their managerial accounting systems. Similar requirements for group practices, if they exist, could influence the final decision.

Copyright 2010 Health Administration Press Case 4 - 9

CASE 4 8/18/09

Instructor Version APPLE VALLEY FAMILY PRACTICE Cost Allocation Methods

Copyright 201 by FACHE

This case illustrates the use of four cost allocation methods: direct, step-down, double apportionment, and reciprocal. The model calculates the overhead allocations for all four methods on the basis of cost pool and resource use data that is entered as input. In addition, the model calculates pro forma profit and loss statements for the three patient services departments. The model consists of a complete base case analysis--no changes need to be made to the existing MODEL-GENERATED DATA section. However, in the student version all values in the INPUT DATA section have been replaced with zeros. Thus, students must enter the appropriate input values into the red cells that currently contain a zero or hyphen. When this is done, any error cells will be corrected and the base case solution will appear. Note that the model does not contain any uncertainty analyses, so students will have to create their own if required by the case. Furthermore, students must create their own graphics ouput (charts) as needed to present their results.

INPUT DATA: Revenues: Adult Medicine Obstetrics Pediatrics Total revenues Direct Costs: Patient Services Departments: Adult Medicine Obstetrics Pediatrics Subtotal Support Departments: Administration Facilities Finance Subtotal Total costs Allocation Matrix: $ 12,000,000 6,000,000 2,000,000 $ 20,000,000

KEY OUTPUT: Profit and Loss Statements: Direct Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit 6,000,000 3,600,000 1,200,000 $ 10,800,000 1,000,000 4,400,000 1,800,000 $ 7,200,000 $ 18,000,000 $ Step-Down Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit $ $ $ $ A. Medicine 12,000,000 6,000,000 4,273,977 10,273,977 1,726,023 A. Medicine $ 12,000,000 $ 6,000,000 4,284,559 $ 10,284,559 $ 1,715,441

Double Apportionment Method: A. Medicine Revenues Direct costs $ 12,000,000 $ 6,000,000

Services Provided to Administration Facilities Finance Adult Medicine Obstetrics Pediatriacs Total

Percentage of Services Provided by Administration Facilities Finance 5% 10% 10% 35% 20% 25% 100% 10% 55% 10% 20% 100% 5% 5% 50% 25% 15% 100%

Indirect costs Total costs Pre-tax profit Reciprocal Method: Revenues Direct costs Indirect costs Total costs Pre-tax profit

4,236,594 $ 10,236,594 $ 1,763,406

A. Medicine $ 12,000,000 $ 6,000,000 4,234,315 $ 10,234,315 $ 1,765,685

MODEL-GENERATED DATA: DIRECT METHOD: Administration allocation Facilities allocation Finance allocation Total Adult Medicine $ 437,500 $ 2,847,059 1,000,000 $ 4,284,559 $ Obstetrics 250,000 $ 517,647 500,000 1,267,647 $ Pediatrics 312,500 $ 1,035,294 300,000 1,647,794 $ PS Total 1,000,000 4,400,000 1,800,000 7,200,000

STEP-DOWN METHOD: Administration Administration allocation Facilities allocation Finance allocation Total $ Facilities Finance Adult Medicine Obstetrics 100,000 $ 100,000 $ 350,000 $ 200,000 473,684 2,605,263 473,684 1,318,713 659,357 $ 4,273,977 $ 1,333,041

DOUBLE APPORTIONMENT METHOD: First Apportionment: Administration Administration allocation $ Facilities allocation 220,000 Finance allocation 90,000 Total $ 310,000 $ Second Apportionment: Administration Administration allocation Facilities allocation Finance allocation $

Facilities Finance Adult Medicine Obstetrics 100,000 $ 100,000 $ 350,000 $ 200,000 440,000 2,420,000 440,000 90,000 900,000 450,000 190,000 $ 540,000 $ 3,670,000 $ 1,090,000

Facilities Finance Adult Medicine Obstetrics 31,000 $ 31,000 $ 108,500 $ 62,000 23,263 127,947 23,263 330,146 165,073

Carry-over from 1st Appor. Total

3,670,000 4,236,594

1,090,000 1,340,336

RECIPROCAL METHOD: Administration First Allocation: Direct costs Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Second Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Third Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Fourth Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation $ $ $ 242 $ (242) $ 5 5 $ 2 68 $ 24 92 $ (92) $ 2 $ 4,234,160 85 4,234,244 51 4,234,295 17 $ $ $ 1,336,229 48 1,336,277 9 1,336,287 8 $ $ $ $ 10,059 (10,059) 174 174 68 242 $ $ $ $ 2,471 1,006 3,477 (3,477) 68 68 $ $ $ $ 1,006 1,006 348 1,354 (1,354) $ $ $ $ 4,228,050 3,521 4,231,571 1,912 4,233,483 677 4,234,160 $ $ $ $ 1,333,531 2,012 1,335,543 348 1,335,891 338 1,336,229 $ $ $ $ 342,500 (342,500) 7,588 7,588 2,471 10,059 $ $ $ $ 117,500 34,250 151,750 (151,750) 2,471 2,471 $ $ $ $ 34,250 34,250 15,175 49,425 (49,425) $ $ $ $ 4,000,000 119,875 4,119,875 83,463 4,203,338 24,713 4,228,050 $ $ $ $ 1,237,500 68,500 1,306,000 15,175 1,321,175 12,356 1,333,531 $ 1,000,000 (1,000,000) $ 225,000 $ 225,000 117,500 $ 342,500 $ 4,400,000 100,000 $ 4,500,000 (4,500,000) $ 117,500 $ 117,500 $ 1,800,000 100,000 $ 1,900,000 450,000 $ 2,350,000 (2,350,000) $ $ $ $ $ 350,000 350,000 2,475,000 2,825,000 1,175,000 4,000,000 $ $ $ $ 200,000 200,000 450,000 650,000 587,500 1,237,500 Facilities Finance Adult Medicine Obstetrics

24 24 $ 9 33 $ (33)

Total Fifth Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Sixth Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Seventh Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Eighth Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Ninth Allocation: Costs brought forward

4,234,311

1,336,295

$ $ $ $

6 $ (6) $ 0 0 $ 0 0 $

2 $ 1 2 $ (2) $ 0 0 $

1 1 $ 0 1 $ (1) $

4,234,311 2 4,234,314 1 4,234,315 0 4,234,315

$ $ $ $

1,336,295 1 1,336,296 0 1,336,296 0 1,336,297

$ $ $ $

0 $ (0) $ 0 0 $ 0 0 $

0 $ 0 0 $ (0) $ 0 0 $

0 0 $ 0 0 $ (0) $

4,234,315 0 4,234,315 0 4,234,315 0 4,234,315

$ $ $ $

1,336,297 0 1,336,297 0 1,336,297 0 1,336,297

$ $ $ $

0 $ (0) $ 0 0 $ 0 0 $

0 $ 0 0 $ (0) $ 0 0 $

$ 0 0 $ 0 0 $ (0) $

4,234,315 0 4,234,315 0 4,234,315 0 4,234,315

$ $ $ $

1,336,297 0 1,336,297 0 1,336,297 0 1,336,297

$ $ $ $

0 $ (0) $ 0 0 $ 0 0 $

0 $ 0 0 $ (0) $ 0 0 $

0 0 $ 0 0 $ (0) $

4,234,315 0 4,234,315 0 4,234,315 0 4,234,315

$ $ $ $

1,336,297 0 1,336,297 0 1,336,297 0 1,336,297

4,234,315

1,336,297

Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total Tenth Allocation: Costs brought forward Administration allocation Subtotal Facilities allocation Subtotal Finance allocation Total

(0) $ $ $ 0 0 0 0 $ $ $

0 0 $ (0) $ 0 0 $

0 0 $ 0 0 $ (0) $

0 4,234,315 0 4,234,315 0 4,234,315

$ $ $

0 1,336,297 0 1,336,297 0 1,336,297

$ $ $ $

0 $ (0) $ 0 0 $ 0 0 $

0 $ 0 0 $ (0) $ 0 0 $

0 0 $ 0 0 $ (0) $

4,234,315 0 4,234,315 0 4,234,315 0 4,234,315

$ $ $ $

1,336,297 0 1,336,297 0 1,336,297 0 1,336,297

10

$ $ $ $

Obstetrics 6,000,000 $ 3,600,000 $ 1,267,647 4,867,647 1,132,353 $ $

Pediatrics Aggregate 2,000,000 $ 20,000,000 1,200,000 $ 10,800,000 1,647,794 7,200,000 2,847,794 $ 18,000,000 (847,794) $ 2,000,000

$ $ $ $

Obstetrics 6,000,000 3,600,000 1,333,041 4,933,041 1,066,959

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,592,982 2,792,982 (792,982)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Obstetrics $ $ 6,000,000 3,600,000 $ $

Pediatrics 2,000,000 1,200,000

Aggregate $ 20,000,000 $ 10,800,000

$ $

1,340,336 4,940,336 1,059,664

$ $

1,623,070 7,200,000 2,823,070 $ 18,000,000 (823,070) $ 2,000,000

$ $ $ $

Obstetrics 6,000,000 3,600,000 1,336,297 4,936,297 1,063,703

$ $ $ $

Pediatrics 2,000,000 1,200,000 1,629,388 2,829,388 (829,388)

Aggregate $ 20,000,000 $ 10,800,000 7,200,000 $ 18,000,000 $ 2,000,000

Pediatrics 250,000 947,368 395,614 $ 1,592,982

PS Total 800,000 4,026,316 2,373,684 $ 7,200,000

Pediatrics $ 250,000 880,000 270,000 $ 1,400,000

PS Total $ 1,000,000 4,400,000 1,800,000 $ 7,200,000

Pediatrics $ 77,500 46,526 99,044

PS Total $ 248,000 197,737 594,263

1,400,000 1,623,070

6,160,000 7,200,000

Pediatrics

Total

$ $ $ $

250,000 250,000 900,000 1,150,000 352,500 1,502,500

$ $

6,740,000 460,000

Unallocated =

$ $ $ $

1,502,500 85,625 1,588,125 30,350 1,618,475 7,414 1,625,889

$ $

7,187,470 12,530

Unallocated =

$ $ $ $

1,625,889 2,515 1,628,403 695 1,629,099 203 1,629,302

$ $

7,199,691 309

Unallocated =

$ $ $

1,629,302 60 1,629,362 18 1,629,381 5

1,629,386

$ $

7,199,992 8

Unallocated =

$ $ $ $

1,629,386 2 1,629,387 0 1,629,388 0 1,629,388

$ $

7,200,000 0

Unallocated =

$ $ $ $

1,629,388 0 1,629,388 0 1,629,388 0 1,629,388

$ $

7,200,000 0

Unallocated =

$ $ $ $

1,629,388 0 1,629,388 0 1,629,388 0 1,629,388

$ $

7,200,000 0

Unallocated =

$ $ $ $

1,629,388 0 1,629,388 0 1,629,388 0 1,629,388

$ $

7,200,000 0

Unallocated =

1,629,388

$ $ $

0 1,629,388 0 1,629,388 0 1,629,388

$ $

7,200,000 0

Unallocated =

$ $ $ $

1,629,388 0 1,629,388 0 1,629,388 0 1,629,388

$ $

7,200,000 0

Unallocated =

END

4-1

CASE 4
APPLE VALLEY FAMILY PRACTICE (Cost Allocation Methods) Introduction

Copyright 2010 by the Foundation of the American College of Healthcare Executives 7/09

4-2

Introduction This case illustrates the application of four different cost allocation methods in a large group practice. The primary goal of this case is to give you the opportunity to
learn more about alternative allocation methods, and assess the impact of each allocation method on allocation amounts and, hence, sub-unit (department) profitability.

4-3

Spreadsheet Model The case has a complex spreadsheet model. It allocates overhead costs from three overhead departments to three patient service departments using four allocation methods:
Direct Step-down Double apportionment Reciprocal

4-4

Cost Allocation Basics In general, healthcare organizations costs can be classified as

direct, which are costs unique and exclusive to a sub-unit, or indirect, or overhead, which are costs associated with shared resources used by the entire organization.

? What are some examples, say, for a

hospital clinical laboratory?

4-5

Cost Allocation The purpose of cost allocation is to allocate all overhead costs to the departments that create the need for such costs, typically the patient service departments. There are three primary allocation methods:
Direct method Step-down method Reciprocal method

4-6

Allocation Methods In the direct method, the costs of each support department are allocated directly to, and only to, the patient service departments. In the step-down method, some (but not all) of the intra-support department relationships are recognized. This method is more complex than the direct method but still manageable.

4-7

Allocation Methods (cont.)

The reciprocal method recognizes all of the intra-support department relationships, but it requires simultaneous equations or a relatively complex set of iterative calculations. In addition, the case introduces the double-apportionment method, which is a more complex version of the stepdown method.

? Which method is used most commonly

by healthcare providers?

4-8

Cost Pools
A cost pool is the overhead amount to be allocated. In general, a cost pool consists of the direct costs of one overhead department. However, if the costs of one overhead department differ substantially in nature, the department may be divided into multiple cost pools. For example, Financial Services might be divided into two pools:
Billing and collections Budgeting

4-9

Cost Drivers A cost driver is the basis on which the cost pool will be allocated. For example, the cost driver for facilities overhead (e.g., depreciation, utilities) might be the amount of space used by each patient service department.

4 - 10

Cost Drivers (cont.) The selection of cost drivers is critical to the cost allocation process. To create the best possible cost allocation system, the cost drivers should have two attributes:
They should be perceived as fair. They should promote organizational cost reduction.

4 - 11

Discussion Items Overhead cost allocation is a pain. Why is it necessary? Suppose a hospital uses amount of space occupied (square footage) as the cost driver for the allocation of Housekeeping Services. Does this driver meet the criteria for a good driver?

4 - 12

Direct Method Illustration (situation) Consider the direct cost allocation system used at Mercy Hospital. To simplify the illustration, we have reduced the number of departments to four:
Overhead departments
Facilities Services General Administration

Patient service departments

Routine Care Critical Care

4 - 13

Direct Method Illustration (situation cont.) Mercy uses the following cost drivers:
The cost driver for the Facilities Services cost pool is the amount of space used by each patient service department. The cost driver for the General Administration cost pool is the amount of revenue generated by each patient service department.

4 - 14

Direct Method Illustration (data)

Projected revenues by patient service department: Routine Care Critical Care Total revenues $22,000,000 5,000,000 $27,000,000

Projected costs for all departments: Patient Service Departments (Direct Costs) Routine Care Critical Care Total direct costs $ 8,300,000 3,300,000 $11,600,000

4 - 15

Direct Method Illustration (data)

Projected costs for all departments (cont.): Support Service Departments (overhead costs) Facilities Services General Administration Total overhead costs Total costs of both patient and support services Projected overall profit $ 8,600,000 5,250,000 $13,850,000

$25,450,000 $ 1,550,000

4 - 16

Direct Method Illustration (data)

Selected patient service department data: Square Feet Routine Care Critical Care Total 261,000 39,600 300,600 Revenue $22,000,000 5,000,000 $27,000,000

? Why arent the support departments

listed here?

4 - 17

DM Illustration (allocation rates) Facilities Services $8,600,000 in overhead costs to be allocated across 300,600 square feet: $8,600,000 300,600 $28.61 per sq. ft. This is the allocation rate. General Administration $5,250,000 in overhead costs to be allocated across $27,000,000 in revenue dollars: $5,250,000 $27,000,000 $0.194 per revenue dollar.

4 - 18

DM Illustration (allocation amounts) From Facilities Services: To Routine Care $28.61 261,000 To Critical Care $28.61 39,600 = $1,132,934 $8,600,000 = $7,467,066

4 - 19

DM Illustration (allocation amounts) From General Administration: To Routine Care $0.194 22,000,000 = $4,277,778 To Critical Care $0.194 5,000,000 = $ 972,222 $5,250,000

4 - 20

DM Illustration (P&L statements)

Routine Care Revenues Direct costs Profit on direct costs Indirect costs: Facilities Services General Administration Profit on total(full)costs Critical Care Revenues Direct costs Profit on direct costs Indirect costs: Facilities Services General Administration Profit on total(full)costs $ 5,000,000 3,300,000 $ 1,700,000 1,132,934 972,222 $ 405,156 $22,000,000 8,300,000 $13,700,000 7,467,066 4,277,778 $ 1,955,156 Margin

62.3%

8.8%

34.0%

8.1%

4 - 21

Discussion Item Suppose you are the Critical Care department head at Mercy Hospital. Your bonus depends on good financial performance. What would be your reaction to the allocation results? What would be your first line of defense? (Hint: Think in terms of direct versus full costs.) What are some other lines of defense?

4 - 22

Conclusion This concludes our introduction of Case 4. Note that this review did not cover all topics needed to work the case. A good starting point to begin your work is to review the applicable chapter in your reference text:
Healthcare Finance, 4th edition: Chapter 6

? Do you have any questions?