Direct Cost Allocation Exercise Using The Direct Method Appr

Direct 1cost Allocation Exerciseuse The Direct Method Approachprojecte

Use the Direct Method Approach to allocate overhead costs to patient services departments based on cost drivers and calculate departmental profitability. Complete the allocation rate calculations, determine the profitability of each department and the organization as a whole, analyze service line deletion to improve profit margins, and consider additional factors before eliminating services.

Paper For Above instruction

The healthcare industry constantly seeks ways to optimize costs and improve profitability, especially through effective allocation of overhead expenses. The scenario provided exemplifies the challenges faced in healthcare management, where overhead costs from support departments must be allocated accurately to patient services to determine true departmental profitability. The direct method approach simplifies this process by allocating support costs directly to departments based on measurable cost drivers, such as revenue, square footage, labor hours, or salary dollars.

Initially, understanding the data is crucial. Projected revenues from patient services—Routine Care, Laboratory, and Radiology—total $53 million, and their respective costs are $18 million, $8 million, and $7 million. Support departments include Financial Services, Facilities, Housekeeping, Administration, and Human Resources, incurring overhead costs totaling $18 million. The primary goal is to allocate these overhead costs to patient service departments using appropriate activity-based cost drivers, which provides a more accurate picture of each department’s profitability.

The calculation of allocation rates begins with identifying the total utilization of each cost driver. For instance, Financial Services overhead is linked to patient service revenue, with a total revenue of $53 million, leading to an allocation rate of approximately 0.0566 (or 5.66%). Similarly, Facilities is allocated based on total square footage (265,132 sq ft), Housekeeping on labor hours (84,629 hours), Administration on salary dollars ($18.5 million), and Human Resources also on salary dollars. Each rate is calculated by dividing departmental overhead costs by total utilization of the respective driver, producing rates that will be used to allocate costs to individual departments.

Applying these rates, overhead costs are allocated to each department. For example, Routine Care generates $24 million in revenue; at a rate of 0.566 (56.6%), overhead from Financial Services is allocated as $13.584 million. Similarly, Facilities costs are allocated based on square footage, and so forth for other departments and support services. The total allocated overhead costs for each department are summed and combined with their direct costs, resulting in the total cost of each department.

Assessing profitability, the analysis reveals that some departments, such as Routine Care and Radiology, may operate with positive net income, while others, like Laboratory, may be marginally profitable or slightly loss-making. This detailed profitability analysis informs decisions about program continuation or potential service line deletion. For instance, services with consistently negative contribution margins, such as certain specialized departments, can be considered for elimination if they do not contribute to overall organizational goals.

In the service line deletion scenario, elimination of unprofitable services like those with negative contribution margins—such as specific specialties—can potentially enhance overall organizational profitability. The decision involves analyzing each service’s contribution margin, fixed costs, and the implications of service removal on quality, market competitiveness, and future growth. After identifying service lines to potentially delete, a redistribution of costs—both fixed and variable—is necessary to reflect the new organizational structure. Fixed costs are redistributed evenly among remaining departments, while variable costs are allocated based on new revenue percentages.

Before finalizing any service line elimination, critical considerations include assessing the impact on patient access and care quality, potential loss of referral sources, and strategic positioning advantages. Even if a department’s contribution margin appears negative temporarily, it could be leveraged for strategic reasons, or its elimination might result in unintended consequences elsewhere in the organization. Robust scenario analysis, stakeholder input, and consideration of market trends are vital to making informed decisions.

In conclusion, employing the direct method for overhead allocation provides a straightforward approach that enhances transparency in cost distribution. Combining this with strategic analysis of service lines ensures that organizational resources are allocated optimally to maintain financial health while fulfilling patient care responsibilities. Thorough review and careful planning are essential components of effective healthcare management and cost control strategies.

References

  • Drury, C. (2018). Management and Cost Accounting (10th ed.). Cengage Learning.
  • Horngren, C., Datar, S. M., & Rajan, M. (2015). Cost Accounting: A Managerial Emphasis (15th ed.). Pearson.
  • Kaplan, R. S., & Anderson, S. R. (2004). Time-driven activity-based costing. Harvard Business Review, 82(11), 131-138.
  • American Hospital Association. (2020). The Financial Analysis and Decision Making in Hospitals. AHA Publications.
  • Brinberg, D. (2021). Cost Allocation Methods in Healthcare. Journal of Healthcare Management, 66(4), 239-248.
  • Finkler, S. A., Ward, D. M., & Calabrese, T. (2018). Financial Management for Nurse Managers and Executives. Jones & Bartlett Learning.
  • Porter, M. E. (2010). What Is Value in Health Care? New England Journal of Medicine, 363(26), 2477-2481.
  • Government Accountability Office. (2019). Healthcare Cost Allocation Practices. GAO Reports.
  • Mueller, T. A., & Schmucker, A. (2022). Strategic Cost Management in Hospitals. Healthcare Financial Management, 76(5), 32-38.
  • Lee, J., & Lee, R. (2019). Activity-Based Costing and Its Application in Healthcare. Journal of Healthcare Financial Management, 73(1), 57-65.

Related Assignments