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Healthcare Financial Management Lecture Packet 3
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Outline
Types of Costs
Cost Analysis
Cost Allocation
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Types of Costs
Types of Costs
Costs:
Costs are a ‘resource use’ associated with providing or supporting a specific service.
There are several different types of costs: fixed costs, variable costs, direct costs, and indirect costs.
Costs do not necessarily reflect the actual cash outflows.
This occurs because of the use of accrual accounting. We will revisit later.
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Costs can be classified two ways:
Their relationship to the volume (amount of services provided).
E.g. Fixed/ variable costs
Their relationship to the unit (department) being analyzed
E.g. Direct/ indirect costs
We will revisit this topic later.
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Types of Costs
Costs Behavior:
Health services managers are extremely interested in how costs are affected by changes in the organization activity (volume).
The relationship between costs and volume is known as cost behavior, or underlying cost structure.
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The primary reason analyzing an organizations underlying cost structure is to provide healthcare managers with a tool for forecasting costs (and ultimately profits) at different volume levels.
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Types of Costs
Fixed Costs:
Costs that are known with relative certainty.
These costs occur regardless of the level of volume within the relevant range.
e.g. The clinic has a labor force of well trained permanent employees that would be increased or decreased only under certain circumstances.
As long as volume falls within a relevant range, labor costs at the clinic are fixed for the coming year regardless of the number of patient visits.
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Types of Costs
Variable Costs:
Costs that are directly related to the volume of services supplied.
e.g. the costs of the clinical supplies (e.g. rubber gloves , tongue depressors , hypodermics) would be classified as variable costs.
While some costs are fixed regardless of volume (within a relevant range), variable costs are driven by volume.
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| Variable Cost per Test | Fixed Costs per Year | |||
| Clinic Supplies $28.18 | Labor | $1,000,000 | ||
| Other fixed costs | $3,967463 |
Cost Analysis
| ‘Volume | Fixed Costs | Total Variable Costs | ‘Total Costs | ‘Average (Total) Cost Per Tests |
| 0 | $4,967,463 | $0 | $4,967,463 | $ 0 |
| 1 | $4,967,463 | $28 | $4,967,491 | $4,967,491.18 |
| 50 | $4,967,463 | $1,409 | $4,968,872 | $99,377.44 |
| 100 | $4,967,463 | $2,818 | $4,970,281 | $49,702.81 |
| 500 | $4,967,463 | $14,090 | $4,981,553 | $9,963.11 |
| 1,000 | $4,967,463 | $28,180 | $4,995,643 | $4,995.64 |
| 5,000 | $4,967,463 | $140,900 | $5,108,363 | $1,021.67 |
| 10,000 | $4,967,463 | $281,800 | $5,249,263 | $524.93 |
| 15,000 | $4,967,463 | $422,700 | $5,390,163 | $359.34 |
| 20,000 | $4,967,463 | $563,600 | $5,531,063 | $276.55 |
| 70,000 | $4,967,463 | $1,972,600 | $6,940,063 | $99.14 |
| 75,000 | $4,967,463 | $2,113,500 | $7,080,963 | $94.41 |
| 80,000 | $4,967,463 | $2,254,400 | $7,221,863 | $90.27 |
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Cost Analysis
Variable Cost per Test:
The per unit (per test) variable costs of $28.18 for laboratory supplies
The variable cost rate remains the same at $28.18 per test
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Total Variable Costs:
Increases or decreases proportionately as volume changes
If volume doubles from 500 to 1,000 test the total variable costs double from $14,090 to $28,180.
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Fixed Costs:
Remain unchanged as the volume varies
When volume doubles from 500 to 1000 test fixed costs remain at $4,967,463.
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Cost Analysis
Total Costs:
Total costs are the sum of the fixed and total variable costs.
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Average (Total) Cost Per Test:: Total costs/ Volume.
e.g. At 5,000 tests, the total costs is $ 5,108,363 the average cost per test is $ 5,108,363 /5,000= $1,021.61.
As volume increases, the average cost per test declines.
Occurs because the fixed costs are spread over more tests.
Economies of Scale.
The fact that higher volume reduces the average cost per unit of activity has important implications regarding the effect of volume changes on profitability.
We will revisit this concept later.
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$4,967,463
100,000
Total Variables Costs
Cost Behavior Graph
$7,221,863
Fixed Costs
Total Costs
15,000
80,0000
Volume (Number of Tests)
Costs $
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10,000
Cost Analysis
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Cost Analysis
Semi-Fixed Costs
Cost Analysis
Semi-Fixed Costs:
Fixed and variable costs represent two ends of the volume classification spectrum.
Within the relevant range, costs are either independent of volume (fixed costs) or directly related to volume (variable costs).
Semi-fixed costs falls in between the two extremes.
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| Variable Cost per Test | Fixed Costs per Year | |||
| Clinic Supplies $28.18 | Labor | $1,000,000 | ||
| Other fixed costs | $3,967463 |
Cost Analysis
| ‘Volume | Fixed Costs | Total Variable Costs | ‘Total Costs | ‘Average (Total) Cost Per Tests |
| 0 | $4,967,463 | $0 | $4,967,463 | 0 |
| 1 | $4,967,463 | $28 | $4,967,491 | $4,967,491.18 |
| 50 | $4,967,463 | $1,409 | $4,968,872 | $99,377.44 |
| 100 | $4,967,463 | $2,818 | $4,970,281 | $49,702.81 |
| 500 | $4,967,463 | $14,090 | $4,981,553 | $9,963.11 |
| 1,000 | $4,967,463 | $28,180 | $4,995,643 | $4,995.64 |
| 5,000 | $4,967,463 | $140,900 | $5,108,363 | $1,021.67 |
| 10,000 | $4,967,463 | $281,800 | $5,249,263 | $524.93 |
| 15,000 | $4,967,463 | $422,700 | $5,390,163 | $359.34 |
| 20,000 | $5,467,463 | $563,600 | $6,031,063 | $301.55 |
| 70,000 | $5,467,463 | $1,972,600 | $7,440,063 | $106.29 |
| 75,000 | $5,467,463 | $2,113,500 | $7,580,963 | $101.08 |
| 80,000 | $5,467,463 | $2,254,400 | $7,721,863 | $96.52 |
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Cost Analysis
How to handle semi-fixed costs:
Assume that the actual relevant range of volume for the clinic is between 10,000 to 20,000 tests per year.
The clinic's current work force can only handle up to 15,000 tests per year, so an additional tech at an annual cost of $500,000 would be required if volume were to exceeds 15,000 tests per year.
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Labor costs are fixed from 10,000 to 15,000 tests.
Labor costs are then fixed at a higher level from 15,000 to 20,000 tests.
As a result of semi-fixed costs, costs are not at the same level throughout the entire relevant range of 10,000 to 20,000 tests per year.
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Cost Analysis
How to handle semi-fixed costs (continued):
Semi fixed costs are fixed within ranges of volume, but there are multiple ranges of semi-fixed costs within the relevant range.
Also known as step-variable costs (looks like a step when depicted graphically).
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The inclusion of semi fixed costs prevents average fixed costs and average cost per test from continuously declining throughout the relevant range.
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Cost Analysis
How to handle semi-fixed costs (continued):
At a volume above 15,000 tests, the clinic must add an additional staff at a cost of $ 500,000.
This causes an increase in total costs and average cost per test.
If volume continues to show a stable increase, the average fixed costs and average cost per test will again begin to decrease.
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As a result of the negative impact of the sudden increase in total costs, the clinic’s director would probably try to avoid hiring an additional technician when volume exceeds 15,000 tests.
Instead, the director will try to increase worker productivity.
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Cost Analysis
How to handle semi-fixed costs (continued):
This is especially the case if volume is expected to be only slightly above the decision point.
Also a determination has to be made if the increase in business is short term or long term.
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New incentives (?) could be put in place to encourage the current technicians to be more productive.
Such an action could lower costs in general and create a situation in which the average cost per test would decline throughout the relevant range.
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$4,967,463
100,000
Total Variables Costs
Semi-Fixed Costs
Cost Behavior Graph: Semi Fixed Costs
$7,221,863
Fixed Costs
Total Costs
15,000
80,0000
Volume (Number of Tests)
Costs $
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10,000
Cost Analysis
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Cost-Volume Analysis (CVA)
Please see assigned reading titled Economies of Scale : The Obama Administration looks to Private Sector to Discover New Cost Savings
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Cost-Volume Analysis
Cost-Volume Analysis or CVA
Total costs does not provide the clinic's managers with much information regarding potential alternative financial outcomes for a given year.
A detailed breakdown of costs (itemization) gives the clinics managers more insight into prospective financial outcomes.
Please see the next two slides for various cost-volume scenarios.
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Cost-Volume Analysis
Total costs= Fixed costs + Total variable costs
= $4,967, 462 + ($28.18 *number of visits)
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Volume 70,000
= $4,967, 462 + ($28.18 *70,000)
= $4,967, 462 + 1,972,600
Total costs = $6,940,062
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Volume 75,000
= $4,967,462 + ($28.18 * 75,000)
= $4,967, 462 + $2,113,500
Total costs = $7,080,962
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Cost Analysis
Volume 80,000
Total costs= Fixed costs + Total variable costs
= $4,967, 462 + (28.18 * 80,000)
= $4,967, 462 + $2,254, 4000
Total Costs = $7,221, 862
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| Total revenues ($100 * 75,000) | $7,500,000 |
| Total variable costs ($28.18 * 75,000) | 2,113,500 |
| Total contribution margin ($ 71.82 * 75,000) | 5,386,500 |
| Fixed costs | 4,967,462 |
| Profit | 419,038 |
Cost-Volume Analysis
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Cost Allocation * definitions
Cost Allocation:
Intra-organizational process where managers allocate the cost of one department to other departments.
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The allocation of costs from the non-revenue (support) departments to revenue departments are considered to be a rational strategy.
This occurs because without the support departments the revenue departments could not function.
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Cost Allocation definitions
Direct Costs:
Costs that are tied directly to the sub-unit.
These costs are unique to the reporting sub-unit
e.g. salaries (costs) of laboratory employees (sub-unit)
When the subunit is eliminated, the direct costs disappear.
Direct costs constitute only a portion of a sub units cost structure
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Indirect Costs:
Indirect costs are costs that are tied to shared resources rather than an individual subunit.
E.g. Hospitals requires a basic infrastructure to operate, if the lab was closed, indirect costs (e.g. utilities costs) would be reduced but not disappear.
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Indirect costs are more difficult to measure than direct costs.
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Cost Allocation
Cost Allocation Perspective:
The classification of direct/indirect costs depends on perspective.
The direct/indirect classification has relevance only at the sub-unit level; at the organizational level all costs are considered to be direct costs.
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The costs classifications (fixed/variable and direct/indirect) are interrelated to one another.
Fixed costs typically include both direct and indirect costs
Variable costs can include both direct and indirect costs
Direct costs usually include fixed and variable cost
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Cost Allocation *
The goal of cost allocations is to assign all the costs of organization to the activities that cause them to be incurred.
Ideally, health services managers would like to track and assign costs by the true level of costs incurred by the individual patient, physician, diagnosis, etc.
With the true representation of costs are captured and analyzed in a managerial accounting system, managers can make better decisions regarding: cost control, the offering of services, and the pricing of services.
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“To measure is to control”
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Cost Allocation *
The Cost Allocation Trade Off:
The more complex (accurate) the managerial accounting system, the higher the cost of developing, implementing, operating, and explaining the system.
The benefits associated with more accurate cost data must be weighed against the costs required to develop such data (cost-benefit assessment).
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The motivation for more accurate allocation of overhead costs usually come from the recipients of the cost allocation.
e.g. the managers of the revenue centers such as physical therapy, patient care services.
Managers at all levels within health services organizations are under increased pressure to optimize economic performance.
This translates into the desire to reduce cost.
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Cost Allocation
Cost Allocation Basics
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Cost Allocation Basics definitions
To assign cost from one activity to another there needs to be a cost pool and a cost driver.
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Cost Pool:
A cost pool is a group of costs that must be allocated.
e.g. housekeeping costs
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Cost Driver: *
(area of debate)
A cost driver is the standard upon which the allocation is made.
e.g. size of department space
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Total housekeeping costs would be the cost pool, and the number of square feet of occupied space would be a cost driver.
Housekeeping costs/ square foot of department space = dollar cost per square foot of space utilized.
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Cost Allocation Basics *
Cost Pool:
Typically, a cost pool consists of all of the direct costs of one support department.
e.g. housekeeping does one job. There costs are allocated to each department.
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However, depending on the complexity of the department you may have multiple pools.
e.g. hospital's financial services department provides two significantly different services: patient billing and budgeting.
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Cost Allocation Basics
Cost Pools (continued):
Multiple Cost Pools **
Assume that the ambulatory care department uses more patient billing services than the laboratory department, but the laboratory uses more budgeting services than the ambulatory care department.
In this situation, it would be best for the finance department to create two cost pools: one cost pool for billing and the other cost pool for budgeting.
Then, cost drivers must be chosen from each pool and the costs allocated to the various patient services department which uses the service.
The identification of cost drivers is viewed as the most important step in the cost allocation process.
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Cost Allocation
The Cost Allocation Process
The Cost Allocation Process *
Step 1 Establish the cost pool:
In this scenario, the clinic is allocating housekeeping cost, the cost pool is a projected total cost of the housekeeping department ($100,000).
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Step 2: Determine the cost driver:
Cost Driver: Housekeeping labor hours required by the clinics departments (10,000 hours).
This is believed to be the variable that is most closely related to the actual costs of providing these services.
We will revisit later.
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Step 3: Calculate the allocation rate:
$100,000/10,000 hours = $10 per hour of housekeeping services provided.
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The Cost Allocation Process *
Step 4: Determine the allocation amount:
Patient care department or the department receiving the services.
Physical Therapy utilizes 3,000 hours of housekeeping services, so it's allocation of housekeeping department overhead is $10 x 3,000 = $30,000.
Allocation methods would be similar to other revenue generating departments.
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When all departments are considered, the entire clinic is projected to use 10,000 hours of housekeeping services.
The total amount allocated across the entire clinic must = $100,000.
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In addition to determining the allocation amount. The goal is to also analyze the effectiveness of the cost driver.
See example on next slide.
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Cost Allocation Basics *
Cost Allocation Example:
Traditionally, overhead costs were aggregated across all support departments and then divided by a rough measure for organizational output.
e.g. Assume a hospital had 72,000 patient days with total inpatient costs equal to $36 million.
Cost Pool= Total Inpatient Costs ($36 million); Cost Driver: Inpatient Days (72,000)
The overhead allocation rates would be $36 million/72,000 = $500 per patient day (per diem overhead rate).
Regardless of the type of patients treated within it inpatient services department, the $500 per diem allocation rate would be applied the department.
Are inpatient days an appropriate cost driver?
What are the potential problems associated with this cost allocation strategy?
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Cost Allocation
Cost Allocation Methods
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Human Resources
Housekeeping
Administration
Physical Therapy
Internal Medicine
Direct Method
Support Departments
Patient Services Department
Three different types of allocation methods: direct method, reciprocal method, and step-down method.
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Direct method:
Each of the support departments are allocated to the patient services departments.
None of the costs of providing support services is allocated to other support departments.
Only the direct costs of the support departments are allocated to the patient service departments because no indirect costs have been created by intra-support department allocations.
Key feature of this method is that it is easy to apply.
Cost Allocation Methods *
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Support Departments
Patient Services Department
Human Resources
Housekeeping
Administration
Physical Therapy
Internal Medicine
Reciprocal Method
Reciprocal method:
Recognizes the interdependencies between the support departments (e.g. relationship human resources, housekeeping, and administration).
With this method no information is ignored and no biases are introduced into the cost allocation process.
As a result, the reciprocal method is relatively complex, which makes explaining difficult and implementation costly.
Cost Allocation Methods *
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Human Resources
Housekeeping
Administration
Physical Therapy
Internal Medicine
Step Down Method
Step-down method:
A compromise between the simplicity of the direct method and the accuracy/ complexity of the reciprocal method.
It recognizes some of the intra-support departmental effects that the direct method ignores, but it does not recognize the full range of interdependencies.
Support departments are closed out after they are allocated to patient service departments. This does not happen with the reciprocal method.
Support Departments
Patient Services Department
Cost Allocation Methods *
Please see assigned reading titled: Step Up to the Step Down Method
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Healthcare Financial Management Lecture Packet 3
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