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CHAPTER

201

DEPARTMENTAL COSTING AND COST ALLOCATION

Introduction

In Chapter 5 we discussed organizational costing, which requires the classification of costs according to their relationship to volume. In this chapter we introduce departmental costing, which requires an additional classification of costs—the relationship between costs and the department being analyzed. In essence, we will see that some costs are unique to the department, while other costs stem from resources that belong to the organization as a whole. Once it is recognized that some costs are organizational in nature rather than department specific, it becomes necessary to create a system that allocates organizational costs to indi- vidual departments. For now, we will focus on costing at the department level. In the next chapter, we will discuss costing (and pricing) of individual service lines. Although some of this chapter’s material is conceptual in nature, much of it involves the application of various allocation techniques. Thus, a considerable portion of the chapter is devoted to examples of cost allocation in different settings.

Direct Versus Indirect (Overhead) Costs

Some costs—about 50 percent of a health services organization’s cost struc- ture—are unique to the reporting subunit and hence usually can be identified

6 Learning Objectives After studying this chapter, readers will be able to

• Differentiate between direct and indirect (overhead) costs. • Explain why proper cost allocation is important to health services

organizations. • Define a cost driver and explain the characteristics of a good driver

as opposed to a poor one. • Describe the three primary methods used to allocate overhead

costs among revenue-producing departments. • Apply cost allocation principles across a wide range of situations

within health services organizations.

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H e a l t h c a r e F i n a n c e202

with relative certainty. To illustrate, consider a hospital’s clinical laboratory department. Certain costs are unique to the department: for example, the salaries and benefits for the managers and technicians who work there and the costs of the equipment and supplies used to conduct the tests. These costs, which would not occur if the laboratory were closed, are classified as the direct costs of the department.

Unfortunately, direct costs constitute only a portion of the depart- ment’s entire cost structure. The remaining resources used by the laboratory are not unique to the laboratory; the department uses many shared resources of the hospital as a whole. For example, the laboratory shares the organiza- tion’s physical space (facilities) as well as its infrastructure, which includes information systems, utilities, housekeeping, maintenance, medical records, and general administration. The costs that are not borne exclusively by the laboratory department are called indirect costs, or overhead costs.

Indirect costs, in contrast to direct costs, are much more difficult to measure at the department level for the precise reason that they arise from shared resources—that is, if the laboratory department were closed, the indirect costs would not disappear. Perhaps some indirect costs could be reduced, but the hospital would still require a basic infrastructure to operate its remaining departments. The direct/indirect classification has relevance only at the sub- unit level; if the unit of analysis is the entire organization, all costs are direct by definition. Thus, in our Chapter 5 discussion of organizational costing, we did not have to introduce the concept of direct versus indirect costs.

Note that the two cost classifications (fixed/variable and direct/indirect) overlay one another. That is, fixed costs typically include both direct and indirect costs, while variable costs, in most cases, contain only direct costs (although they can include both direct and indirect costs). Conversely, direct costs usually include fixed and variable costs, while indirect costs typically include only fixed costs.

Introduction to Cost Allocation

A critical part of cost measurement at the department level is the assignment, or allocation, of indirect costs. Cost allocation is essentially a pricing process within the organization whereby managers allocate the costs of one department to other departments. Because this pricing process does not occur in a market

Direct cost A cost that is tied exclusively to a subunit, such as the salaries of laboratory department employees. When a subunit is eliminated, its direct costs disappear.

Indirect (overhead) cost A cost that is tied to shared resources rather than to an individual subunit of an organization; for example, facilities costs.

1. What is the difference between direct and indirect costs? 2. Give some examples of each type of cost for a hospital’s emergency

services department.

SELF-TEST QUESTIONS

Cost allocation The process by which overhead costs are assigned (allocated) to individual departments.

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setting, no objective standard exists that establishes the price for the transferred services. Thus, cost allocation within a business must, to the extent possible, establish prices that proxy those that would be set under market conditions.

What costs within a health services organization must be allocated? Typically, the overhead costs of the business, such as those incurred by admin- istrators, facilities management personnel, financial staffs, and housekeeping and maintenance personnel, must be allocated to those departments that gen- erate revenues for the organization (generally patient services departments). The allocation of overhead costs to patient services departments is necessary because there would be no need for such costs in the first place if there were no patient services departments. Thus, decisions regarding pricing and service offerings by the patient services departments must be based on the full costs associated with each service, including both direct and overhead (indirect) costs. Clearly, the proper allocation of overhead costs is essential to good decision making within health services organizations.

The goal of cost allocation is to assign all of the costs of an organiza- tion to the activities that cause them to be incurred. With complete cost data accessible in the organization’s managerial accounting system, managers can make better decisions regarding cost control, what services should be offered, and how these services should be priced. Of course, the more complex the managerial accounting system, the higher the costs of developing, implement- ing, and operating the system. As in all situations, the benefits associated with more accurate cost data must be weighed against the costs required to develop such data.

Interestingly, much of the motivation for more accurate cost allocation systems comes from the recipients of overhead services. Managers at all levels within health services organizations are under pressure to optimize financial performance, which translates to reducing costs. Indeed, many department heads are evaluated, and hence compensated and promoted, primarily on the basis of profitability, assuming that performance along other dimensions is satisfactory. For such a performance evaluation system to work, all parties must perceive the cost allocation process to be accurate and fair because man- agers are held accountable for both the direct and the indirect costs of their departments. In other words, department heads are held accountable for the full costs associated with services performed by their departments.

1. What is meant by the term cost allocation? By the term full costs? 2. What is the goal of cost allocation? 3. Why is cost allocation important to health services managers?

SELF-TEST QUESTIONS

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Cost Allocation Basics

To assign costs from one activity to another, two important elements must be identified: a cost pool and a cost driver. A cost pool is a grouping of similar costs to be allocated, while a cost driver is the basis upon which the alloca- tion is made. To illustrate, the costs of a hospital’s housekeeping department might be allocated to the other departments on the basis of the size of each department’s physical space. The logic here is that the amount of housekeep- ing resources expended in each department is directly related to the physical size of that department. In this situation, total housekeeping costs would be the cost pool, and the number of square feet of occupied space would be the cost driver.

When the cost pool amount is divided by the total amount of the cost driver, the result is the overhead allocation rate. Thus, in the housekeeping illustration, the allocation rate is the total housekeeping costs of the organiza- tion divided by the total space (square footage) occupied by the departments receiving the allocation. This procedure results in an allocation rate measured in dollar cost per square foot of space used. In the patient services depart- ments, full (total) costs would include the direct costs of each department and an allocation for housekeeping services, made on the basis of the amount of occupied space.

Cost Pools Typically, a cost pool consists of all of the direct costs of one support depart- ment. However, if a single support department offers several substantially different services, and the patient services departments use those services in different relative amounts, it may be beneficial to separate the costs of that support department into multiple pools.

For example, suppose a hospital’s financial services department provides two significantly different services: patient billing/collections and budgeting. Furthermore, assume that the routine care department uses proportionally more patient billing/collections services than does the laboratory department, but the laboratory department uses proportionally more budgeting services than does the routine care department. In this situation, it would be best to create two cost pools for one support department. To do this, the total costs of financial services would be divided into a billing pool and a budgeting pool. Then, cost drivers would be chosen for each pool and the costs allocated to the patient services departments as described in the following sections.

Cost Drivers Perhaps the most important step in the cost allocation process is the identi- fication of proper cost drivers. Traditionally, overhead costs were aggregated

Cost pool A group of overhead costs to be allocated; for example, facilities costs or marketing costs.

Cost driver The basis on which a cost pool is allocated; for example, square footage for facilities costs.

Allocation rate The numerical value used to allocate overhead costs; for example, $10 per square foot of occupied space for facilities costs.

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across all support departments and then divided by a rough measure of orga- nizational volume, resulting in an allocation rate of some dollar amount of generic overhead per unit of volume.

For example, the total inpatient overhead costs of a hospital might be divided by total inpatient days, giving an allocation rate of so many dollars per patient day, which is called the per diem overhead rate. If a hospital had 72,000 patient days in 2015 and its total inpatient overhead costs were $36 million, the overhead allocation rate would be $36,000,000 ÷ 72,000 = $500 per patient day (per diem). Regardless of the type of patients treated within an inpatient services department (adult versus child, trauma versus illness, acute versus critical care, and so on), the $500 per diem allocation rate would be applied to determine the total indirect cost allocation for that department.

However, it is clear that not all overhead costs are tied to the num- ber of patient days. For example, overhead costs associated with admission, discharge, and billing are typically not related to the number of patient days but to the number of admissions. Thus, tying all overhead costs to a single cost driver improperly allocates such costs, which distorts reported costs for patient services and hence raises concerns about the effectiveness of decisions based on such costs. In state-of-the-art cost management systems, the various types of overhead costs are separated into different cost pools, and the most appropriate cost driver for each pool is identified.

The theoretical basis for identifying cost drivers is the extent to which costs from a pool actually vary as the value of the driver changes. For example, does a patient services department with 10,000 square feet of space use twice the amount of housekeeping services as a department with only 5,000 square feet of space? The better the relationship (correlation) between actual resource expenditures at each subunit and the cost driver, the better the cost driver and the better the resulting cost allocations.

Effective cost drivers possess two important characteristics. First, and perhaps the less important of the two, is fairness—that is, does the cost driver chosen result in an allocation that is fair to the patient services departments? The second, and perhaps more important, characteristic is cost control—that is, does the cost driver chosen create incentives for departments to use less of that overhead service?

For example, there is little that a patient services department manager can do to influence overhead cost allocations if the cost driver is patient days. In fact, the action needed to reduce patient days might lead to negative finan- cial consequences for the organization. An effective cost driver will encourage patient services department managers to take overhead cost reduction actions that do not have negative implications for the organization. The remainder of this chapter emphasizes the importance of effective cost drivers, including several illustrations that distinguish good drivers from poor ones.

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The Allocation Process The steps involved in allocating overhead costs are summarized in Exhibit 6.1, which illustrates how Prairie View Clinic allocated its housekeeping costs for 2016. Cost alloca- tion takes place both for historical purposes, in which realized costs over the past year are allocated, and for planning purposes, in which estimated future costs are allocated to aid in pricing and other decisions. The examples in this chapter generally assume that the purpose of the allocation is for financial planning and budgeting, so the data presented are estimated for the com- ing year—2016.

The first step in the allocation process is to establish the cost pool. In this case, the clinic is allocating housekeeping costs, so the cost pool is the projected total costs of the housekeeping department—$100,000. Next, the most effective cost driver must be identified. After considerable investigation,

Prairie View’s managers concluded that the best cost driver for housekeeping costs is labor hours—that is, the number of hours of housekeeping services required by the clinic’s departments is the variable most closely related to the actual cost of providing these services. The intent here, of course, is to pick the cost driver that provides the most accurate cause-and-effect relationship between the use of housekeeping services and the costs of the housekeeping

Industry Practice Hospitals and Housekeeping Cost Drivers

Most hospitals use square footage to allocate housekeeping costs. The rationale, of course, is that a patient services department that is twice as big as another will require twice the expendi- ture of housekeeping resources. The advantage of this cost driver is that it is easy to measure and does not change very often.

The disadvantage of using square footage as the cost driver is that some patient services departments require more housekeeping support because of the nature of the service, even when similar-sized spaces are occupied. For example, emergency departments require more intense housekeeping services than do neonatal care units.

Is there a better cost driver available for allocating housekeeping costs? If so, what is it? Describe how the “new and improved” cost driver would work.

Step One: Determine the Cost Pool The departmental costs to be allocated are for the housekeeping

department, which has total budgeted costs for 2016 of $100,000. Step Two: Determine the Cost Driver The best cost driver was judged to be the number of hours of housekeeping

services provided. An expected total of 10,000 hours of such services will be provided in 2016 to those departments that will receive the allocation.

Step Three: Calculate the Allocation Rate $100,000÷10,000 hours = $10 per hour of housekeeping services provided. Step Four: Determine the Allocation Amount The physical therapy department uses 3,000 hours of housekeeping

services, so its allocation of housekeeping department overhead is $10×3,000 = $30,000.

EXHIBIT 6.1 Prairie View

Clinic: Allocation of

Housekeeping Overhead to the Physical

Therapy Department

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department. For 2016, Prairie View’s managers estimate that the housekeep- ing department will provide 10,000 hours of service to the departments that will receive the allocation.

Now that the cost pool and cost driver have been defined and measured, the allocation rate is established by dividing the expected total overhead cost (the cost pool) by the expected total volume of the cost driver: $100,000 ÷ 10,000 hours = $10 per hour of services provided.

The final step in the process is to make the allocation to each depart- ment. To illustrate the allocation, consider the physical therapy (PT) depart- ment—one of Prairie View’s patient services departments. For 2016, PT is expected to use 3,000 hours of housekeeping services, so the dollar amount of housekeeping overhead allocated to PT is $10 × 3,000 = $30,000. Other departments within the clinic will also use housekeeping services, and their allocations would be made in a similar manner—the $10 allocation rate per hour of services used is multiplied by the amount of each department’s hourly utilization of housekeeping services. When all departments are considered, the 10,000 hours of housekeeping services is fully distributed among the using departments. For any one department, the amount allocated depends on both the allocation rate and the amount of housekeeping services used.

Key Equation: Allocation Rate

The allocation rate is the rate used to calculate each user department’s allocation of an overhead cost pool. To illustrate, assume the financial services department has $1,000,000 in total costs (the cost pool) and the patient services departments in total generate 500,000 bills (the cost driver). Then, the allocation rate is $2 per bill:

Allocation rate = Cost pool amount ÷ Cost driver volume = $1,000,000 ÷ 500,000 bills = $2 per bill.

1. What are the definitions of a cost pool, a cost driver, and an allocation rate?

2. Under what conditions should a single overhead department be divided into multiple cost pools?

3. On what theoretical basis are cost drivers chosen? 4. What two characteristics make an effective cost driver? 5. What are the four steps in the cost allocation process?

SELF-TEST QUESTIONS

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Cost Allocation Methods

Mathematically, cost allocation can be accomplished in a variety of ways, and the method used is somewhat discretionary. No matter what method is chosen, all support department costs eventually must be allocated to the departments (generally patient services departments) that create the need for those costs.

The key differences among the methods are how support services pro- vided by one department are allocated to other support departments. The direct method totally ignores services provided by one support department to another. Two other allocation methods address intrasupport department allo- cations. The reciprocal method recognizes all of the intrasupport department services, and the step-down method represents a compromise that recognizes some, but not all, of the intrasupport department services. Regardless of the method, all of the support costs within an organization ultimately are allo- cated from support departments to the departments that generate revenues for the organization.

Exhibit 6.2 summarizes the three allocation methods. Prairie View Clinic, which is used in the illustration, has three support departments (human

Human Resources

Support Departments

Direct Method

Reciprocal Method

Step-Down Method

Patient Services Departments

Housekeeping

Physical Therapy

Administration

Internal Medicine

EXHIBIT 6.2 Prairie View

Clinic: Alternative

Cost Allocation Methods

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resources, housekeeping, and administration) and two patient services depart- ments (physical therapy and internal medicine).

Under the direct method, shown in the top section of Exhibit 6.2, each support department’s costs are allocated directly to the patient services departments that use the services. Thus, none of the support services costs are allocated to other support departments. In the illustration, both physical therapy and internal medicine use the services of all three support departments, so the costs of each support department are allocated to both patient services departments. The key feature of the direct method—and the feature that makes it relatively simple to apply—is that no intrasupport department allocations are recognized. Thus, under the direct method, only the direct costs of the support departments are allocated to the patient services departments because no indirect costs have been created by intrasupport department allocations.

As shown in the center section of Exhibit 6.2, the reciprocal method recognizes the support department interdependencies among human resources, housekeeping, and administration, and hence it generally is considered to be more accurate and objective than the direct method. The reciprocal method derives its name from the fact that it recognizes all of the services that depart- ments provide to and receive from other departments. The good news is that this method captures all of the intrasupport department relationships, so no information is ignored and no biases are introduced into the cost allocation process. The bad news is that the reciprocal method relies on the simultaneous solution of a series of equations representing the utilization of intrasupport department services. Thus, it is relatively complex, which makes it difficult to explain to department heads and typically more costly to implement.

The step-down method, which is shown in the lower section of Exhibit 6.2, represents a compromise between the simplicity of the direct method and the complexity of the reciprocal method. It recognizes some of the intrasupport department effects that the direct method ignores, but it does not recognize the full range of interdependencies as does the reciprocal method. The step- down method derives its name from the sequential, stair-step pattern of the allocation process, which requires that the allocation take place in a specific sequence. As shown in the exhibit, all the direct costs of human resources first are allocated to both the patient services departments and the other two sup- port departments. Human resources is then closed out because all of its costs have been allocated. Next, housekeeping costs, which now consist of both direct and indirect costs (the allocation from human resources), are allocated to the patient services departments and the remaining support department— administration. Finally, the direct and indirect costs of administration are allo- cated to the patient services departments. The final allocation from administra- tion includes human resources and housekeeping costs because a portion of these support costs has been allocated or “stepped down” to administration.

Direct method A cost allocation method in which all overhead costs are allocated directly from the overhead departments to the patient services departments with no recognition that overhead services are provided to other support departments.

Reciprocal method A cost allocation method that recognizes all of the overhead services provided by one support department to another.

Step-down method A cost allocation method that recognizes some of the overhead services provided by one support department to another.

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The critical difference between the step-down and reciprocal methods is that after each allocation is made in the step-down method, a support depart- ment is removed from the process. Even though housekeeping and administra- tion provide support services back to human resources, these indirect costs are not recognized because human resources is removed from the allocation process after the initial allocation. Such costs are recognized in the reciprocal method.

Direct Method Illustration

The best way to gain a more in-depth understanding of cost allocation is to work through several allocation illustrations. We begin with the direct method. As shown in Exhibit 6.3, Kensington Hospital has three revenue-producing patient services departments: routine care, laboratory, and radiology. Accoun- tants often call the patient services departments profit centers, because they not only incur costs but also create revenues. Conversely, overhead depart- ments are called cost centers in that they incur costs but create no revenues.

Hospital costs are divided into those costs attributable to the profit centers (direct costs) and those costs attributable to the support departments (overhead costs). Of course, the overhead costs are direct costs to the support departments, but when they are allocated to the patient services departments, these direct costs become indirect (overhead) costs.

The data show that the revenues for each of the patient services depart- ments are much greater than their direct costs. Furthermore, Kensington’s projected total revenues of $27,000,000 exceed the hospital’s projected total costs of $25,450,000. However, the aggregate revenue and cost amounts provide no information to Kensington’s managers concerning the true profit- ability of each patient services department. To determine true profitability by profit center, the full costs of providing patient services, including both direct and indirect costs, must be measured. Only then can the hospital’s managers develop rational pricing and cost control strategies.

As previously discussed, three decisions are required when allocating costs: how to define the cost pools, what the cost drivers are, and which method of allocation to use. We begin by illustrating the direct method of cost allocation. The step-down method is discussed in the Chapter 6 Supplement.

The cost pools (total costs) for the support departments are given in the lower section of Exhibit 6.3. Financial services costs are $1,500,000;

1. What are the three primary methods of cost allocation? 2. Explain how they differ. 3. Which one do you think is best? Which is the worst?

SELF-TEST QUESTIONS

Profit center A business unit (in our examples, typically a department) that generates revenues as well as costs, and hence its profitability can be measured.

Cost center A business unit that does not generate revenues, and hence only its costs can be measured.

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facilities costs equal $3,800,000; housekeeping costs are $1,600,000; gen- eral administration costs total $4,400,000; and human resources costs equal $2,550,000. Thus, overhead costs at the hospital total $13,850,000, which ultimately must be allocated to the hospital’s three patient services depart- ments. Kensington’s managers believe that little is to be gained by dividing any of the support departments into multiple cost pools, so each support department constitutes one cost pool.

The next step in the allocation process is to identify the best cost drivers for each cost pool. Exhibit 6.4 provides a summary of the support departments and their assigned cost drivers. Unfortunately, the selection of cost drivers is not an easy process, and to a large extent the usefulness of the entire cost allocation process depends on choosing the most effective drivers. As discussed later, Kensington’s selection of cost drivers, like many selections made in real-world situations, is somewhat of a compromise between effec- tiveness and simplicity.

EXHIBIT 6.3 Kensington Hospital: 2016 Revenue and Cost Projections

Projected Revenues by Patient Services Department Routine Care $16,000,000 Laboratory 5,000,000 Radiology 6,000,000 Total revenues $27,000,000

Projected Costs for All Departments Patient Services Departments (Direct Costs): Routine Care $ 5,500,000 Laboratory 3,300,000 Radiology 2,800,000 Total costs $ 11,600,000

Support Services Departments (Overhead Costs): Financial Services $ 1,500,000 Facilities 3,800,000 Housekeeping 1,600,000 General Administration 4,400,000 Human Resources 2,550,000 Total overhead costs $ 13,850,000

Total costs of both patient and support services $25,450,000

Projected profit $ 1,550,000

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The cost driver chosen for financial services is patient services revenue. Financial services provides a full range of financial support to the hospital. The bulk of its efforts are devoted to patient billing and collections, but it is also involved in financial and managerial accounting, budgeting and report preparation, and a host of other financial tasks. Tying the allocation of this support department to the amount of patient services revenues assumes a strong positive relationship between the amount of financial services provided to each patient services department and revenues generated by that depart- ment. Clearly, patient services revenue is a relatively inaccurate cost driver, and hence the resulting cost allocation has limitations. In the next section, we discuss the benefits of moving from a poor cost driver to a better one.

The amount of space used (square footage) is the basis for allocating the costs of facilities. This cost driver is often used by health services organiza- tions to allocate the initial costs of land, buildings, and equipment as well as the costs of maintenance and other facilities services. The logic applied here is that the patient services departments with the most space require the most facilities and hence the most facilities support. Of course, this assumption does not always hold. For example, in any year, facilities may be required to support a special large project for one of the patient services departments, resulting in costs that far exceed that department’s proportional space utili- zation. Nevertheless, over the long run at Kensington Hospital, the relative costs of facilities utilization by the patient services departments track closely with the space occupied by those departments.

Two of the remaining support departments, general administration and human resources, also use a relatively poor cost driver, salary dollars. If radiology has payroll costs that are five times larger than those of laboratory, radiology will be charged (allocated) five times as much of the costs incurred by administration and personnel. This cost driver is often used, but in real- ity it is not very good. Thus, the allocated costs from general administration and human resources probably do not truly represent the relative amounts of utilization of these overhead services.

Housekeeping has chosen perhaps the best cost driver—namely, the num- ber of labor hours of housekeeping services consumed. In many organizations,

Support Services Department Cost Driver

Financial Services Patient services revenue Facilities Space utilization (square footage) Housekeeping Labor hours General Administration Salary dollars Human Resources Salary dollars

EXHIBIT 6.4 Kensington

Hospital: Assigned Cost

Drivers

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 213

housekeeping costs are allocated on the basis of square footage, using the logic that the amount of space occupied by a department accurately reflects housekeeping efforts and hence costs. This assumption may or may not be valid, however. In effect, large-space departments may be subsidizing small- space departments, such as emergency services, where space may be limited but the intensity of work requires a significant amount of housekeeping ser- vices. To account for such situations at Kensington Hospital, housekeeping is using a better cost driver—one that more closely aligns to the actual resources expended in providing support to the patient services departments.

The development and use of the best cost driver is a cost–benefit issue. Housekeeping must devote resources to tracking where their workers spend their time, an effort that would not be required if the cost driver were square footage. The benefit, of course, is a cost driver that makes it easier for Kens- ington’s senior managers to hold department heads responsible for both direct and indirect costs. If the head of the radiology department does not like the amount of housekeeping costs that are being charged to the department, she can do something about it: use fewer housekeeping services. With an inferior cost driver, such as square footage, there is little that patient services depart- ment heads can do if they do not like the housekeeping allocation. In most cases, reduction of square footage is not a practical way to deal with excessive housekeeping costs.

With labor hours consumed as the cost driver, the cost control solution for patient services department heads is to reduce the amount of housekeep- ing services used. If all patient services department heads are made to think this way by having the right incentive system in place, ultimately the hospital will discover it is as efficient as possible in using housekeeping services. In the long run, the direct costs of the housekeeping department—currently $1,600,000—will fall as these services are more efficiently used. In reality, the secondary benefit of choosing a more effective cost driver is a more equitable allocation. The primary benefit is that a good cost driver creates an incentive to use less of the support service, which ultimately leads to lower overhead costs for the organization.

Exhibit 6.5 contains the initial data necessary for the allocation. The first column of the exhibit lists the patient services departments. The amounts of the chosen cost drivers consumed by each patient services department are listed after that: patient services revenue used for allocating financial services costs, square footage used for facilities allocations, housekeeping labor hours used for housekeeping allocations, and departmental salary dollars used for both general administration and human resources allocations.

If Kensington were using the step-down or reciprocal allocation meth- ods, the information shown in Exhibit 6.5 would have to include the support departments because the data would be needed for intrasupport department

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H e a l t h c a r e F i n a n c e214

allocations. By using the direct method, the hospital ignores intrasupport department dependencies, so the totals indicated at the bottom of each column reflect only the use of support services by the patient services departments, to which are allocated all of the support costs.

Exhibit 6.6 divides the dollar amount of each cost pool by the total amount of each cost driver to derive the allocation rates. For example, the cost pool (direct costs) for financial services totals $1,500,000, which will be allocated as indirect (overhead) costs to the patient services departments that have a total of $27,000,000 in patient services revenues. The allocation rate for financial services, therefore, is $1,500,000 ÷ $27,000,000 = $0.05556 per dollar of patient services revenue.

As previously mentioned, the allocation of indirect costs can be viewed as an internal pricing mechanism. Thus, the heads of the revenue-producing departments can look at Exhibit 6.6 and see the rate that they are being charged for support services, which amounts to the following:

• $0.05556 for each dollar of patient services revenue generated for financial services support.

• $12.64 per square foot of space used for facilities support.

Patient Services Square Housekeeping Salary Department Revenues Feet Labor Hours Dollars

Routine Care $16,000,000 199,800 76,000 $ 5,709,000 Laboratory 5,000,000 39,600 6,000 2,035,000 Radiology 6,000,000 61,200 9,000 2,439,000 Total $27,000,000 300,600 91,000 $10,183,000

EXHIBIT 6.5 Kensington

Hospital: Patient Services

Departmental Summary Data

Cost Pool Total Allocation Department (total costs) Cost Driver Utilization Ratea

Financial Services $1,500,000 Patient revenue $27,000,000 $0.05556 Facilities 3,800,000 Square feet 300,600 12.64 Housekeeping 1,600,000 Labor hours 91,000 17.58 General 4,400,000 Salary dollars $10,183,000 0.432 Administration Human Resources 2,550,000 Salary dollars $10,183,000 0.250

EXHIBIT 6.6 Kensington

Hospital: Overhead Allocation

Rates

a $ per unit of the cost driver

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C h a p t e r 6 : D e p a r t m e n t a l C o s t i n g a n d C o s t A l l o c a t i o n 215

• $17.58 per labor hour consumed for housekeeping support. • $0.432 per salary dollar paid to department employees for general

administrative overhead. • $0.250 per salary dollar for human resources support.

If radiology pays a technician $10 an hour in direct labor costs for each hour the technician works, the department will also be charged 0.432 × $10.00 = $4.32 for general administrative overhead and 0.250 × $10.00 = $2.50 for human resources overhead, plus additional allocations for financial services, facilities, and housekeeping support. Having two cost pools, in this case the general administration and human resources departments, that use the same cost driver (salary dollars) is not unusual. However, the allocation rate is different for the two support departments because they have different cost pool amounts.

The final step in the allocation process is to calculate the actual dol- lar allocation to each of the patient services departments, which is shown in Exhibit 6.7. The support departments are listed in the first column, along with the applicable allocation rate, while the patient services departments are listed across the top. To illustrate the calculations, consider the routine care department. It produces $16,000,000 in patient services revenue, and the overhead allocation rate for financial services is $0.05556 per dollar of patient services revenue, so the allocation for such support is 0.05556 × $16,000,000 = $888,960. Furthermore, routine care has 199,800 square feet of space; with a facilities rate of $12.64 per square foot, its allocation for facilities support is $12.64 × 199,800 = $2,525,472.

The allocations to the routine care department for housekeeping, general administration, and human resources support shown in Exhibit 6.7 were calculated similarly. The end result is that $8,644,050 out of a total of $13,850,000 of the indirect (overhead) costs of Kensington Hospital are allocated to routine care. Routine care also has direct costs of $5,500,000, so the full (total) costs of the department, including both direct and indirect, are $8,644,050 + $5,500,000 = $14,144,050. The cost allocations and total cost calculations for the laboratory and radiology departments shown in Exhibit 6.7 were done in a similar manner.

For general management purposes, understanding the mechanics of the allocation is less important than recognizing the value of choosing effective cost drivers. The cost driver for housekeeping services (i.e., the number of service hours provided) is good in the sense that it reflects the true level of effort expended by this department in support of the patient services departments. The patient services department heads are being fairly charged for these services, and more important, patient services department heads can take actions to lower the allocated amounts by reducing the amount of housekeeping services used.

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H e a l t h c a r e F i n a n c e216

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