examine the topic of ‘cost’ as it applies in the health care setting. Specifically,
we consider what types of costs are encountered in the health care setting, how costs are allocated
among the various departments in a health care entity, and how cost, volume and pricing information
can be used to determine profitability at the service line level.
Cost Terms Used in Managerial Accounting
Management accountants have developed cost classification systems to develop useful cost information
for managers. Some key cost terms include:
• Sunk costs are past costs that are no longer relevant for decision making.
• Direct costs are costs that are easily and directly linked or traced to a cost objective — a product
or service or activity. Examples of direct costs are direct material and direct labor. These are the
material directly linked to the cost objective and the labor directly linked to the cost objective,
respectively.
• Indirect costs are costs that are required in the production process but cannot be directly or
easily linked to a cost objective. These are also called overhead costs.
• Opportunity cost is the cost of a foregone alternative.
• Controllable costs are costs that can be influenced or controlled by a manager. Non-
controllable costs are costs that managers have little or no influence over.
• Variable costs are costs that change (increase or decrease) in total in direct proportion to
changes in the level of business activity. The variable cost per unit remains constant. Examples
are direct material, direct labor and variable overhead.
• Fixed costs are costs that do not change with changes in the level of business activity. Total fixed
costs remain constant, but the fixed cost per unit varies inversely with the changes in the level
of business activity.
• Mixed costs consist of a fixed component and a variable component. The annual expense of
operating a DaVinci robot is a mixed cost. Some of the expenses are fixed, because they do not
change in total as the number of annual usage changes. Think insurance and depreciation. Other
expenses are variable, because they will increase for the year when the usage increases (and will
decrease when usage decreases). Think expendable supplies, medical maintenance service
hours, etc.
• Activity-based costing assigns overhead cost based on activities. The premise is that the activity
(task, operation, or procedure) will cause the cost to be incurred. This system is very
complicated and expensive to implement, but considered by many the most accurate.
• Cost drivers are measures of activity used to develop the rate of overhead cost allocation to
revenue producing departments.
• Cost pools are groupings of costs whose total is to be allocated using an allocation base (cost
driver).
Understanding these and other cost terms are important for health care leaders as they perform their
duties as far as planning, control, and effective decision making.
Cost Allocation
The allocation of a resource’s cost to any segment is, in effect, a charge for the use of that resource.
From a decision-making standpoint, the allocated cost should measure the opportunity cost (what is
given up in order to get something else) of using the resource. However, this is difficult
to operationalize because the opportunity cost may quickly change.
• The first reason for allocation is to reduce frivolous use of a common resource. If there is no cost
for the use of a resource it may be used for frivolous or nonessential purposes. Even frivolous
use may have opportunity costs associated with it. For example, if a work computer is being
used to play games, it cannot be used for essential work.
• A second reason for allocation is to encourage evaluation of the services provided by the
common resource. Again, if there is no charge for services, there is no incentive to evaluate
whether or not the services are needed or their true cost.
• A final reason for cost allocation is to comply with external governance requirements (e.g., the
Securities and Exchange Commission (SEC), the Internal Revenue Service (IRS), Generally
Accepted Accounting Principles (GAAP)) for full costing for external reporting purposes.
Process of Allocation
The first step in cost allocation is the determination of the cost object, i.e., the product, service, or
department that is to receive the allocation.
The second step is to form cost pools. These are groupings of costs whose total is to be allocated using
an allocation base.
• Cost pools may be formed along departmental lines or by major activity, e.g., set ups.
• An overriding concern in forming a cost pool is to ensure that the costs included are similar or
homogeneous.
• The number of cost pools will depend on a health care entity’s need for accurate information
and a cost-benefit analysis for such information.
The third step in the allocation process is selecting a base (cost driver) that has a cause-and-effect
relationship with the costs to be allocated. Many of these bases are volume related, such as direct labor
hours or service hours.
• A problem with such bases is that while they may be equally valid, they may result in
substantially different costs being assigned to the cost objects.
• If the costs to be allocated are fixed, no cause-and-effect relationship need be established.
Other criteria are used:
– Relative benefits. The allocation base should result in more costs being allocated to the cost
objectives that benefit most from incurring the cost.
– Ability to bear. The allocation base should result in more costs being allocated to the cost
objectives that are more profitable.
– Equity. The allocation base should result in allocations that are perceived as fair or
equitable.
Traditional cost systems assign all overhead to one cost pool. Common activity drivers are units
produced, direct labor hours, direct labor cost, and machine hours.
Allocating Service Department Costs
Cost pools are often formed by service departments, and these costs are allocated to production
departments (the cost objectives) via use of one of the following methods:
• The direct method allocates service department costs directly to the production departments,
not to any other service departments. Although simple to implement, this method ignores any
reciprocity of services between service departments.
• The reciprocal method recognizes support department interdependencies (e.g., human
resources, housekeeping, finance, supply / logistics). This method captures all of the
intrasupport department relationships, so no information is ignored and no biases are
introduced into the process. However, this method relies on the relatively complex application
of simultaneous equations to fully implement.
• The step down method represents a compromise between the two prior techniques. It follows a
sequential, stair-step pattern of allocation where one service department’s costs are fully
allocated to the next service department, then the next, and so on. Once all service department
costs are completely allocated to the final service department, costs are then allocated to all
clinical service departments based on a pre-established cost driver. This is the most typical
system currently used in the health care industry based on the fact it is the system prescribed by
CMS to use for Medicare cost reporting (more on this topic in Week 8).
Budgeted costs rather than actual costs should be allocated. This prevents the service departments from
passing their cost inefficiencies on to the producing departments. For additional information on each of
these methods, review the video provided at the site below:
Title: 3 Ways to Allocate Costs to Multiple Support Departments
URL: https://www.youtube.com/watch?v=NKRdmOCgWfQ
Problems with Cost Allocation
A number of problems may occur when indirect costs are allocated.
• Arguably the most significant issue is health care leaders’ performance evaluations should be
based on those revenues and costs that s/he has the ability to influence or control. The
allocation of indirect costs is quite often arbitrary. This results in managers feeling that their
departments receive unjustified allocations. Thus, care must be taken to only allocate those
costs over which a manager has some control (controllable costs). If non-controllable costs
appear on a director’s performance report, they should be clearly labeled as such, and not be
part of the individual’s evaluation.
• A second problem with the allocation process occurs when the allocation makes a fixed cost
appear to behave as if it were a variable cost. This occurs when fixed costs are unitized. The
result may be poor decision-making.
• A third problem with unitizing fixed costs is that the amount allocated to any one department
depends, in part, on what the other departments do. To remedy this problem, fixed cost
allocations should be made in lump-sum amounts based on the long-run needs of the user
departments. These allocations will generally remain the same year after year.
• A fourth problem occurs when only one or two cost pools are used to allocate overhead costs.
While this may greatly simplify product cost determination, it may also seriously distort it. In
general, the more overhead cost pools used, the more accurate the product costs. However,
there is a cost-benefit trade off.
• A final problem with cost allocations occurs when the only bases used are measures of
production volume, e.g., direct labor hours or machine hours. The problem is, that not all
overhead costs vary with volume. The solution may be activity-based costing.
Activity-Based Costing (ABC)
Activity-based costing rests on the premise that products and services consume resources. Managers
are expected to know the activities that are required for making products or providing a service.
Additionally, managers must be aware of the cost related to these activities. Under ABC, the cost of a
product is determined by the product’s “use” of the various activities in the care delivery process.
Traditional costing allocates costs based solely on one activity – usually volume or labor hours. Only one
predetermined overhead rate (cost driver) is normally used in traditional costing. That rate is
determined by estimating the total annual overhead cost and dividing by estimated annual activity.
Activity-based costing (ABC) first assigns costs to activities in the care delivery process, then to the
individual products or services, based on each cost object’s USE of the activities. By focusing attention
on the activities in the production process, ABC helps to identify steps in the process that management
may need to make more efficient, or to change. ABC recognizes that the demand for overhead activities
is driven by various cost pools with several activity cost drivers. In other words, because products
typically move through multiple steps in a production process, multiple cost drivers will ultimately
impact the total allocated cost of a product.
In the ABC approach, organizations identify the major activities that cause overhead costs to be
incurred. The cost of the resources consumed by these activities are grouped into cost pools. Measures
of activity (cost drivers) are then identified and used to develop rates, which are, in turn, used to
allocate overhead costs to the products that use them. This is an improvement over the traditional
approach to overhead allocation that allocates overhead costs in proportion to production volume. The
traditional approach usually results in overcosting high-volume products and undercosting low-volume
products. The reason is that all overhead costs are not proportional to volume (set-up costs, inspection
costs, etc.) Under ABC each activity cost pool has its own rate. Products are assigned costs for only those
activities that they use.
There are five steps to allocate costs using ABC:
• Identify the activities in the production process that consume resources. These are the cost
pools.
• Assign total costs to these activities (or cost pools).
• Identify the cost drivers associated with each activity.
• Compute a rate per cost driver unit for each cost driver.
• Assign costs to the cost object using all applicable cost drivers.
ABC, like any other system, has both benefits and limitations. Some of the benefits of ABC include:
• It is less likely to overcost simple, high-volume products and undercost complex, low-volume
products.
• It may lead to better cost control.
• With a number of activities identified, instead of a single overhead cost pool, it is easier to see
where cost improvements are needed.
Some limitations of ABC include:
• Its major disadvantage is its expense. It is more costly to develop 10 cost pools and assign costs
from them than a single pool.
• In practice it is used to develop the “full cost” of a product or service. Which means that fixed
costs are included in the allocations. This makes it difficult to determine the incremental cost of
producing an item. So, it may not be as conducive to good decision-making as some might hope.
For some insights into how health care costs are being re-examined by thought leaders in the industry
and how activity based costing is being used in the health care environment, review the following sites:
The Big Idea: How to Solve the Cost Crisis in Health Care
URL: https://hbr.org/2011/09/how-to-solve-the-cost-crisis-in-health-care
Title: What Are a Hospital’s Costs? Utah System Is Trying to Learn
URL: https://www.nytimes.com/2015/09/08/health/what-are-a-hospitals-costs-utah-system-is-trying-to-learn.html
Title: How Intermountain Trimmed Health Care Costs
URL: https://www.healthaffairs.org/doi/full/10.1377/hlthaff.2011.0358
Using Costs to Determine Profitability – Cost-Volume-Profit Analysis
Cost-Volume-Profit analysis is a powerful tool used to assist managers in their decision-making process.
It examines the relationship between revenues, costs, and income based on volume of activity. It
answers questions like: What effects on profit can be expected if the Mayo Clinic adds an additional
service line at its Rochester, MN campus? How many patient days must a physician’s office have to
break even for the year? How many medical devices does a manufacturer need to sell to cover all of
their expenses?
Break-Even Point
The first step is to calculate the break-even point. The break-even point is the volume of activity where
revenues equal expenses, meaning no profit or loss is made. The break-even point can be calculated by
using the profit formula approach or the contribution margin approach.
Profit = Selling Price (x) – Variable Costs (x) – Total Fixed Cost, where (x) is the number of units.
When Profit = 0, the Break-Even Point occurs. Therefore,
0 profit (i.e. break-even point) = Selling Price (x) – Variable Costs (x) – Total Fixed Cost
Contribution Margin
Contribution margin is the difference between sales and variable costs. The contribution margin can be
expressed as a total or at the unit level. The unit contribution margin is the difference between unit
sales price and unit variable cost.
Contribution Margin per Unit = Sales Price per Unit – Variable Cost per Unit
Total Contribution Margin = Total Sales – Total Variable Costs
The contribution margin ratio is the contribution margin expressed as a ratio or converted to a
percentage of sales. It can be calculated on a total or per unit basis.
Contribution Margin Ratio = Total Contribution Margin / Total Sales
Contribution Margin Ratio = Contribution Margin per Unit / Sales Price per Unit
We can also use the contribution margin to find the break-even point in the following way:
Break-Even Point = Fixed Costs / Contribution Margin per Unit
In order for Cost-Volume-Profit analysis to work the following assumptions must be followed:
• Revenue is linear, meaning that the sales price will not change as volume changes.
• Expenses are categorized into variable, fixed, and mixed.
• The sales mix remains constant over the relevant range. Relevant range is the normal operating
range for an organization.
Cost-Volume-Profit example chart
Operating Leverage
Operating leverage relates to a company’s cost structure, i.e., the amount of fixed costs in relation to
the amount of variable costs. The level of operating leverage is important because it affects the change
in profit when sales change. Due to fixed costs in the cost structure, when sales increase or decrease by
10%, profit will increase or decrease by more than 10%. The greater the level of fixed costs in relation to
variable costs, the higher the operating leverage. Firms with high operating leverage are more risky
because they have large fluctuations in profits when sales fluctuate. Companies that have relatively
higher fixed costs are said to have higher operating leverage. Thus, a pharmaceutical company with a
large investment in research and development (a fixed cost) would likely have higher operating leverage
compared to an ambulatory surgery company that used little equipment but expensive labor (a variable
cost)
