Centers of Responsibility
Medical care institutions are divided into responsibility centers. These function as organizational units headed by a manager who is accountable for evaluating the unit’s performance and its operations. For instance, a Nurse Manager could account for an inpatient pediatric unit, a house keeping manager is in charge of cleanliness in that facility, while a home care Manager is accountable to all delivered home care services. Every department and program in a hospital is usually categorized as a responsibility center. The information that a manager employs in managing a responsibility center emanates from responsibility accounting. Responsibility accounting is the categorization of statistical and financial data in accordance with organizational units that generates the revenue and incurs the costs (Jacobs & Noseworthy, 2010).
Reasons for Using Allocation Methods
Cost allocation is also referred to as cost finding. It refers to a method in which the complete cost of operating a profitable center is determined. The main reason that makes healthcare institutions to use this method is that it permeates them to allocate their hospital costs per cost center. For instance, healthcare practitioners at Maple Street Hospital can allocate overhead departments in their hospital, which do not realize revenues but spend a lot to coordinate the profit centers that generate revenues even though they also incur costs (Janowitz and Bratt, 2012).
Cost allocation is very critical for health practitioners and stakeholders, in general, to be informed of the entire cost involved in generating the services provided to patients. If a health care organization is made aware of the entire costs of generating patients’ services, it will be in a position to gauge if the patients’ payment for the services rendered is appropriate (Jolly & Gerbaud, 2007). Cost Allocation is made up of the following basics:
i) The Cost Pool
The Cost Pool is a group of costs that stems from an overhead department that is to be apportioned. The cost pool here entails costs from both the direct and indirect costs. The allocation rate is the amount of cost pool apportioned to a profit center by an overhead department. Allocation amount is the amount of money in terms of the overhead departmental cost allocated to the departments of patient services.
ii) Cost Drivers
The cost driver is the principle employed in the allocation of each overhead departmental cost to a patient’s service department cost pool. The classification of important cost drivers is a critical step in the development of a sound cost, allocation system. The cost driver must mirror the range by which an overhead departmental cost is employed by every particular profit center. A department which doubles the space occupied by other relevant departments should be apportioned twice the cost that is allocated to other departments (Mills, et al, 2009).
The Differences in the Three Allocation Methods Discussed in this Case
Cost allocation can be determined in hospitals in several ways. However, good allocation methods should have certain defined characteristics. First, the objective of any good allocation paradigm is to assign overhead costs to the actions that generate the need for these costs. Second, it should be fair enough for the profit center managers of the hospital to deem the figures provided as a true reflection of the total amount of overhead services required by their departments. Finally, the allocation mechanism should be in a position to promote a cost diminution mindset within the hospital (Newbrander, et al, 2008).
The following elaboration on the Direct, Step-Down, and Double Apportionment allocation methods provides better insight on the application at Maple Street Hospital.
Direct Cost Allocation Method
This implies a top-down paradigm of cost allocation that starts with the overhead department costs and apportions any indirect costs to the respective profit centers. The INPUT DATA table in the attached spreadsheet indicates that Maple Street Hospital has six patient department services, Medical services, Administration, housekeeping and business offices, as well as Obstetrics and Emergency departments (Rannan, 2008). Three of these departments are categorized as profit centers; namely, the medical services, Obstetrics and Emergency department. They generate $ 69,000 in accrued revenues. The table also indicates the costs for six department where direct costs are incurred by three departments including the medical services $12,000 (row 8), Obstetrics $6000 (row 9), Emergency department $19,000 (row 10). Three support departments incur overhead or indirect costs that include Administration $500 (row 13), Housekeeping $13,500 (row 14), and Business office $8,000 (row 15).
From the cost accounting perspective, Maple Street Hospital has six responsibility centers of which three are profit centers (the medical services, Obstetrics and Emergency department) and the other three are the cost centers (Administration, Housekeeping and Business office). Profit center managers are accountable for both expenses and profits while their counterparts in the cost centers are only responsible for the incurred expenses (Newbrander, et al, 2008). The sum total of expenses for the three cost centers is $37,000 (row 11), while the total of indirect costs is $ 27,000 (row 16). The total costs for Maple Street Hospital are $64, 000 (row 12).
The objective of cost allocations is to apportion the three overhead departments’ indirect costs to the three profit centers of the patient services departments. In so doing, the overhead departments’ costs are apportioned to the patient services departments to establish the entire cost of providing medical care.
Step Down Method
It has been popularly used for cost allocation in Medicare since 1966. In contrast to the direct method, the step down method provides for the apportionment of the costs of a service department to other service departments and even to operating departments. This method is chronological in nature. Its objective is to apportion all the costs in a service department. The order in which the allocation is done eventually affects the amount apportioned to the revenue departments. The sequence characteristically starts with the department that provides the highest amount of service to other service departments (Mills, et al, 2009).
After the allocation of its costs, the process progresses and terminates with the department that provides the least number of services to other service departments. Upon the closure of a department, it cannot receive costs from other service departments on its own in a left to right allocation. For instance, under KEY OUT PUT in the step down method highlighted in the attached spreadsheet, there are two steps or allocations. In the initial step, the Medical services costs (First column) are allocated to the Obstetrics department (second column) as well as to the emergency department (third column). As a stuck contrast to the direct method, the medical services allocation base now includes obstetrics and emergency department employee hours. Despite this fact, the allocation does not include any direct provision for the medical services itself. In both the step down and direct methods, the amount of allocation base that is attributed to a service department that has its cost being apportioned is always ignored (Jolly & Gerbaud, 2007).
It can be noted that in the second step, the cost of obstetrics is allocated to the emergency department (Column 3), but none of it is allocated to the medical services department. This is in spite of the fact that the medical services department is also located in the same building. In the step down method, any allocation base amount attributable to a department whose cost has already been apportioned is ignored. Apart from that, upon allocating the costs of a service department, it is not possible to reallocate other departments’ costs back to the original one. It is important to note that the costs of Obstetrics $12, 519 (second column, fifth row) includes the medical services costs that were allocated to it during the first step (Janowitz and Bratt, 2012).
Double Apportionment Allocation
This method acknowledges services offered by one service departments to the other service departments during the initial apportioning. Upon completing the first apportioning round, some costs still remain in the service departments. A second allocation, referred to as step down, apportions the residual service departmental costs to the revenue departments and service departments that are not yet closed. The order in which the departments are closed impacts the amounts apportioned to the revenue departments (Jacobs & Noseworthy, 2010).
This paradigm is more complex than the step down paradigm and the biased acknowledgement of departmental services being apportioned to other departments in the second allocation is likely to generate vague results. The basis upon which apportioning is done amends the percentage of services so that all generated services are circulated to the revenue departments and the service departments that are not yet closed. Adjustment is responsible to the overall service departments costs. There is thus a necessity to readjust the cost statistics to be 100% so that all costs are distributed to these departments (Janowitz and Bratt, 2012).
The Allocations to Each Patient Services Department, And Resulting Profitability, For Each Allocation Method
The three methods tend to come up with the same amount of service departments costs that are in the end apportioned to revenue departments since any of these methods can be utilized. Health practitioners have the tendency of using the method that they have previously handled and know how it works. However, the results produced by these methods tend to differ. For instance, Marble Street Hospital has three service departments (medical services, obstetric and emergency departments) offering services to other departments. Medical records, Laundry, patient care support, and food services offer their services to only one department; namely, the revenue department. Patient care, support departments entail patient accounting, nursing administration, and general administration (Rannan-Eliya & Berman, 2008).
The step down gave in to two departments whose total cost difference was more than 4%. One department had disparities of 1 to 3% and three departments with disparities of less than 1%. These disparities are quite small in comparison to these generated by the direct method. However, the 9% disparity in the Obstetric department and the 8% disparity in the emergency department are significant and would be of use to Maple Street Hospital. In the double apportion paradigm, all disparities are below 1%.
Indication of the Analysis about Profitability of Each Patient Services Department with or Without Allocation
At Maple Street Hospital, the step down and direct methods can be said to be the less perfect paradigms given that they have disparities of more than 4% in the accrued costs of revenue department. The data found in the attached spreadsheet indicates that these paradigms resulted in several amounts of costs of services being apportioned to this hospital’s revenue department. The step down and the direct methods are user friendly in comparison to the double apportionment allocation method. The indication of the analysis about profitability of each patient service department with or without allocation is that these departments are profitable to Maple Street Hospital (Mills, et al, 2009).
Recommendation Regarding the Appropriate Cost Allocation Method for the Practice
In the future, Maple Street Hospital will have to accommodate two costing paradigms. One that is capable of satisfying Medicaid payment and Medicare. Apart from that, it is advisable that Maple Street Hospital should come up with a more developed accounting system and avoid using the obsolete step down method that has been in use since 1967. This is because employing spreadsheet programs such as Excel, Lotus 123, and Quattro Pro will enable Maple Street Hospital to augment its cost accounting system that incorporates the more complicated reciprocal method at minimal costs (Newbrander, et al, 2008).
The allocation of healthcare costs has drastically changed in the last four decades. As much as government regulations have insisted on the step down method to be employed in the determination of Medicare payments, this paradigm is limited in the manner in which it can generate appropriate cost data necessary for decision making by hospital managers and effective negotiation by the rate negotiation of managed care contract. Maple Street Hospital should employ the double-apportionment method since it is the most advanced of the three methods and could offer the most perfect cost representation.
Jacobs P., and Noseworthy W.T. (2010) “National Estimates of Intensive Care Utilization and Costs: Canada and the United States.” Critical Care Medicine, Vol. 18, No. 11.
Janowitz, B., and Bratt J.H. (2012). “Methods for Costing Family Planning Services.” United Nations Population Fund.
Jolly, D, and Gerbaud I. (2007). “The Hospital for Tomorrow. Division of Strengthening of Health Services.” Report Number 5. Geneva: World Health Organization.
Mills, A. J., Kapalamula J., and Chisimbi S. (2009). “The Cost of the District Hospital: A Case Study in Malawi.” WHO Bulletin OMS. Vol 71.
Newbrander, W., Barnum H., J. and Kutzin. (2008). Hospital Economics and Financing in Developing Countries. Division of Strengthening of Health Services. NHP/92.2. Geneva, Switzerland: World Health Organization.
Rannan-Eliya, R.P., and Berman P. (2008). .National Health Accounts for Egypt. DDM Publication No. 25. Boston MA: Harvard School of Public Health.
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