Ch. 6 Cost Allocation

Question 1

Direct cost: A cost that is tied exclusively to a subunit.

• Salaries of Lab employees
• When the subunit (lab) is eleminated, it’s direct costs disappear

Indirect (Overhead) costs: The subunit uses many shared resources of the hospital as a whole:

• Physical space / Infrastructure
• Utilities
• Medical records
• General Admin

Question 2

Cost Allocation: Pricing process within the organization whereby managers allocate the costs of one department to other departments.

Overhead costs must be allocated to those departments that generate revenues for the organization (i.e. patient services department)

Track and assign costs by individual patient, physician, diagnosis, reimbursement contract etc.

Answer 2

Assigning Costs (basics)

Two elements:

1. Cost pool: A grouping of costs that must be allocated
2. Cost driver: Criterion upon which allocation is made

Ex: Housekeeping

• Cost pool = Housekeping costs
• Cost driver = Number of sq ft occupied by a department

Cost Pool / Cost Driver = Overhead allocation rate

Question 3

Cost pool:

• Consists all of the direct costs of one support department
• If a single support department offers several substantially different services, and the patient services department use those services in different relative amounts, then separate the costs of that support department into multiple pools.
  
  • Ex: Financial services department offering billing / collections and budgeting

Answer 3

Cost Drivers:

Two Characteristics

1. Fairness
2. Cost Control: Does the cost driver chosen create incentives for departments to use less of that overhead service?

Effective cost drivers encourage patient services departments over-head cost reduction actions that do not have negative implication actions or the organization.

Question 4

Allocation Porcess: 4 Steps

1. Determine the Cost Pool
   
   • Ex. Housekeeping costs
2. Identify Effective cost drivers
   
   • Number of hours of house keeping services provided
3. Calculate the allocation rate
4. Make the allocation to each department

Answer 4

Allocation Example:

Cost Pool:

Housekeeping Department: (total budget) $100,000

Cost Driver:

Hours of Housekeeping services 10,000

Allocation Rate: Cost pool / Cost driver $10 / hr

Allocation (PT department)

Expected to use 3,000 hours = 3,000 hrs x $10 = $30,000

Question 5

Three Methods

Direct method

Reciprocal method

Step-down method

Answer 5

Direct Method

Each support departments (ex: human resources and housekeeping) are allocated directly to the patient services department that use the services.

• No intrasupport department allocations are recognized.
• Only the direct cost of support departments are allocated to patient services

Question 6

Reciprocal Method

Recognizes all support department interdependencies

• Difficult to explain
• Costly to implement

Step-down method

• Recognizes some of the intrasupport interdependencies
• Allocation takes place in a specific sequence.
• After each allocation is made, a support department is removed from the process.

Answer 6

Activity Based Costing

All costs stem from activites

Cost Driver: Basic activity that causes costs to be incurred

Identify the activities that are performed to provide a particular service and then aggregate the costs of the activities

• Identify the relevant activities
• Estimate the cost of each activity (Direct & indirect)
• Assign Cost drivers for each activity
• Collect activity data for each service
• Calculate the total cost of the service by aggregating activity costs