Accounting Assignment

49

Cost Classifications 6 C H A P T E R

DISTINCTION BETWEEN DIRECT AND INDIRECT COSTS

Direct costs can be specifically associated with a particular unit or department or patient. The critical distinction for the manager is that the cost is directly attributable. What- ever the manager is responsible for—that is, the unit, the department, or the patient—is known as a cost object.

The somewhat vague definition of a cost object is any unit for which a separate cost measurement is desired. It might help the manager to think of a cost object as a cost ob- jective instead.1 The important thing is that direct costs can be traced. Indirect costs, on the other hand, cannot be specifically associated with a particular cost object. The controller’s office is an example of indirect cost. The controller’s office is essential to the overall organi- zation itself, but its cost is not specifically or directly asso- ciated with providing healthcare services. The critical distinction for the manager is that indirect costs usually cannot be traced, but instead must be allocated or ap- portioned in some manner.2 Figure 6-1 illustrates the direct–indirect cost distinction.

To summarize, it is helpful to recognize that direct costs are incurred for the sole benefit of a particular op- erating unit—a department, for example. As a rule of thumb, if the answer to the following question is “yes,” then the cost is a direct cost: “If the operating unit (such as a department) did not exist, would this cost not be in existence?”

Indirect costs, in contrast, are incurred for the overall operation and not for any one unit. Because they are shared, indirect costs are sometimes called joint costs or

After completing this chapter, you should be able to

1. Distinguish between direct and indirect costs.

2. Understand why the difference is important to management.

3. Understand the composition and purpose of responsibility centers.

4. Distinguish between product and period costs.

P r o g r e s s N o t e s

common costs. As a rule of thumb, if the an- swer to the following question is “yes,” then the cost is an indirect cost: “Must this cost be allocated in order to be assigned to the unit (such as a department)?”

EXAMPLES OF DIRECT COST AND INDIRECT COST

It is important for managers to recognize di- rect and indirect costs and how they are treated on reports. Two sets of examples il- lustrate the reporting of direct and indirect costs. The first example concerns a radiol- ogy department; the second concerns a dial- ysis center.

Table 6-1 represents a report of two line items—direct costs and indirect costs—for a radiology department. The report concerns procedure numbers 557, 558, 559, 560, and 561 and a total. In this report, the manager

can observe the proportionate differences between direct and indirect costs and can also see the differences among the five types of procedures.

Greater detail is provided to the manager in Table 6-2, which presents the method of al- locating indirect costs and the result of such allocation. Managers should notice that the “totals” line carries forward and becomes the “indirect cost” line in Table 6-1. The purpose of the report in Table 6-2 is to reveal details that support the main report in Table 6-1. Thus,

50 CHAPTER 6 Cost Classifications

Cost Object

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to

Are Traced

to

Direct Costs

Indirect Costs

Figure 6–1 Assigning Costs to the Cost Object.

Table 6–1 Example of Radiology Departments Direct and Indirect Cost Totals

Dept: Radiology—Diagnostic Cost Summary—Year to Date November ______

CC #557 CC #558 CC #559 CC #560 CC #561 Indirect Cost Diagnostic Ultra- Nuclear CT Radiation Centers Radiology sound Medicine Scan Therapy Total

Direct costs $1,000,000 $600,000 $1,200,000 $1,800,000 $1,400,000 $6,000,000 Indirect costs* 300,000 195,375 221,500 338,500 211,625 1,267,000 Totals $1,300,000 $795,375 $1,421,500 $2,138,500 $1,611,625 $7,267,000

*See Table 6–2 for cost allocation detail. Source: Adapted from A. Baptist, A General Approach to Costing Procedures in Ancillary Departments, Topics in Health Care Financ- ing, Vol. 13, No. 4, p. 36, © 1987, Aspen Publishers, Inc.

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52 CHAPTER 6 Cost Classifications

this report, showing allocation of indirect costs, is considered a subsidiary report be- cause it is supporting, or subsidiary to, the preceding main report. This use of one or more supporting reports to reveal details be- hind the main report is quite common in managerial reports. The allocation of indi- rect costs subsidiary report contains quite a lot of information. It shows what line items (transporters, receptionists, etc.) are con- tained in the $1,267,000 total. It shows how each line item is allocated across the five separate procedures. And it shows how each line item was allocated; see the “Allocation Basis” column containing codes A, B, C, and D. Then see the box below with the alloca- tion basis set out for type (volumes/ direct costs/number of films) and for the resulting allocation of each across the five procedures. This set of tables is worthy of further study by the manager.

Exhibit 6-1 sets out the direct costs for a freestanding dialysis center. These costs, as direct costs, are what the organization’s

managers believe can be traced to the specific operation of the freestanding center. Exhibit 6-2 sets out the indirect costs for a freestanding dialysis center. These costs are what the or- ganization’s managers believe are not directly attributable to the specific operation of the freestanding center. The decisions about what will and what will not be considered direct or indirect costs will almost always have been made for the manager.3 What is important is that the manager understand two things: first, why this is so, and second, how the relation- ship between the two works. Remember the rule of thumb discussed earlier in this chapter.

If the answer to the following question is “yes,” then the cost is a direct cost: “If the op- erating unit (such as a department) did not exist, would this cost not be in existence?”

RESPONSIBILITY CENTERS

In a previous chapter, we discussed revenue centers, whereby managers are responsible for generating revenue (or volume). We also previously discussed cost centers, whereby managers are responsible for managing and controlling cost. The responsibility center

Exhibit 6–1 Example of Freestanding Dialysis Center Direct Costs

Salaries and fringe benefits $500,000 Salaries—other professional 40,000 Medical director 40,000 Medical supplies 550,000 Pharmacy 1,130,000 Dialysis center equipment

depreciation 80,000 Utilities 80,000 Housekeeping and laundry 20,000 Property taxes 40,000 Other supplies and costs 20,000 Total direct costs $2,500,000

Source: Adapted from D.A. West, T.D. West, and P.J. Malone, Managing Capital and Administrative (Indirect) Costs to Achieve Strategic Objectives: The Dialysis Clinic versus the Outpatient Clinic, Journal of Health Care Finance, Vol. 25, No. 2, p. 24, © 1998, Aspen Publishers, Inc.

Exhibit 6–2 Example of Freestanding Dialysis Center Indirect Costs

Indirect Costs Facility costs $300,000 Administrative costs 300,000

Total indirect costs $600,000

Courtesy of Resource Group, Ltd., Dallas, Texas.

makes a manager responsible for both the revenue/volume (inflow) side and the expense (outflow) side of a department, division, unit, or program. In other words, the manager is responsible for generating revenue/volume and for controlling costs. Another term for re- sponsibility center is profit center.

We will examine the type of information a manager receives about his or her own re- sponsibility center by reviewing the Westside Center operations. Westside Center offers two basic types of services: an ambulatory surgery center and a rehabilitation center. The man- agement of Westside is overseen by Bill, the director. Joe manages the ambulatory surgery center. Bonnie manages the rehabilitation center. Denise, a part-time radiologist, provides radiology services on an as-needed basis. Joe, Bonnie, and Denise, the managers, all report to Bill, the director. Figure 6-2 illustrates the managerial relationships.

To restate the relationships shown in Figure 6-2, Joe manages a responsibility center for am- bulatory surgery services. Bonnie manages a responsibility center for rehabilitation services. These services represent the business of West- side Center. Denise manages the radiology services, but this is not a responsibility center in the Westside organization. Instead, it is a support center. Bill, the director, manages a bigger responsibility center that includes all of the functions just described, plus the gen- eral and administrative support center.

Bill, the director, receives a managerial report, shown in Exhibit 6-3. Bill’s “Direc- tor’s Summary” contains the data for the en- tire Westside operation.

Figure 6-3 illustrates the reports received by each manager at Westside. Joe’s report for the ambulatory surgery center is at the

Responsibility Centers 53

Westside Center

Director

Westside Ambulatory

Surgery Center Responsibility

Center Manager

General & Administrative

Support Center

Radiology Support Center

Manager

Westside Rehab Center Responsibility

Center Manager

Figure 6–2 Lines of Managerial Responsibility at Westside Center. Courtesy of Resource Group, Ltd., Dallas, Texas.

Exhibit 6–3 Director’s Summar y of Westside ASC and Rehab Responsibility Center

ASC R/C Surplus $70,000.00 Rehab R/C Surplus 85,000.00 Less G&A Support Ctr (80,000.00) Less Radiology Support Ctr (20,000.00)

Net Surplus $55,000.00

Courtesy of Resource Group, Ltd., Dallas, Texas.

54 CHAPTER 6 Cost Classifications

top right of Figure 6-3. His report shows the controllable revenues he is responsible for ($225,000), less the controllable expenses he is responsible for ($150,000). The difference is labeled “ASC Responsibility Center Surplus” on his report. The surplus amounts to $70,000 ($225,000 minus $150,000).

Bonnie’s report for the rehabilitation center is the second report on the right of Figure 6-3. Her report shows the controllable revenues she is responsible for ($300,000), less the

Director’s Summary of Westside ASC & Rehab Center

ASC R/C Surplus $70,000.00 Rehab R/C Surplus 85,000.00 Less G&A Suppor t Ctr (80,000.00) Less Radiology Support Ctr (20,000.00) Net Surplus $55,000.00

Westside ASC Responsibility Center

Therapy Manager Controllable revenues:

Patient fees $300,000.00 Controllable expenses:

Wages 120,000.00 Payroll taxes, other fringes 30,000.00 Billable supplies 50,000.00 Medical supplies 10,000.00 Continuing education 3,000.00 Licenses and permits 2,000.00

Total expenses 215,000.00 Rehab R/C surplus $85,000.00

Westside ASC Responsibility Center

Medical/Surgical Manager Controllable revenues:

Patient fees $225,000.00 Controllable expenses:

Wages 100,000.00 Payroll taxes, other fringes 25,000.00 Billable supplies 20,000.00 Medical supplies 10,000.00

Total expenses 155,000.00 ASC R/C surplus $70,000.00

General & Administrative Support Center

Salaries $40,000.00 Payroll taxes, other fringes 10,000.00 Office supplies 1,200.00 Telephone 2,400.00 Rent 10,800.00 Utilities 4,800.00 Insurance 1,200.00 Depreciation 9,600.00 Total expenses $80,000.00

Radiology Support Center Radiology Manager

Salaries $12,000.00 Payroll taxes, other fringes 3,000.00 Radiology supplies 5,000.00 Total expenses $20,000.00

Figure 6–3 Westside Costs by Responsibility Center. Courtesy of Resource Group, Ltd., Dallas, Texas.

Distinction between Product and Period Costs 55

controllable expenses she is responsible for ($215,000). The difference is labeled “Rehab Responsibility Center Surplus” on her report. The surplus amounts to $85,000 ($300,000 minus $215,000).

Denise’s report for radiology services is at the bottom right of Figure 6-3. Her report shows the controllable expenses she is responsible for, which amount to $20,000. Her re- port shows only expenses because it is a support center, not a responsibility center. There- fore, Denise is responsible for expenses but not for revenue/volume.

Bill, the director, receives a report for the general and administrative (G&A) expenses, as shown second from the bottom right of Figure 6-3. This report shows the G&A controllable expenses that Bill himself is responsible for at Westside, which amount to $80,000. The G&A report shows only expenses because it also is a support center, not a responsibility center. Therefore, Bill is responsible for expenses but not for revenue/volume in the case of G&A.

However, Bill is also responsible for the entire Westside operation. That is, the overall Westside operation is his responsibility center. Therefore, Bill’s director’s summary, repro- duced on the left side of Figure 6-3, contains the results of both responsibility centers and both support centers. The surplus figures from Joe and Bonnie’s reports are positive figures of $70,000 and $85,000, respectively. The expense-only figures from Bill’s G&A support cen- ter report and from Denise’s radiology support center report are negative figures of $80,000 and $20,000, respectively. Therefore, to find the result of operations for Bill’s en- tire Westside operation, the $80,000 and the $20,000 expense figures are subtracted from the surplus figures to arrive at a net surplus for Westside of $55,000.

Although the lines of managerial responsibility will vary in other organizations, the rela- tionships between and among responsibility centers, support centers, and overall supervi- sion will remain as shown in this example.

DISTINCTION BETWEEN PRODUCT AND PERIOD COSTS

Product costs is a term that was originally associated with manufacturing rather than with services. The concept of product costs assumes that a product has been manufactured and placed into inventory while waiting to be sold. Then, whenever that product is sold, the product is matched with revenue and recognized as a cost. Thus, cost of sales is the common usage for manufacturing firms. (The concept of matching revenues and expenses has been discussed in a preceding chapter.)

Period costs, in the original manufacturing interpretation, are not connected with the manufacturing process. They are matched with revenue on the basis of the period during which the cost is incurred (thus period costs). The term comes from the span of time in which matching occurs, known as time period.

Service organizations have no manufacturing process as such. The business of health- care service organizations is service delivery, not the manufacturing of products. Although the overall concept of product versus period cost is not as vital to service delivery, the dis- tinction remains important for managers in health care to know.

In healthcare organizations, product cost can be viewed as traceable to the cost object of the department, division, or unit. A period cost is not traceable in this manner. Another way to view this distinction is to think of product costs as those costs necessary to actually deliver the service, whereas period costs are costs necessary to support the existence of the orga- nization itself.

56 CHAPTER 6 Cost Classifications

Finally, medical supply and pharmacy departments do have inventories on hand. In their case, a product is purchased (rather than manufactured) and placed into inventory while waiting to be dispensed. Then, whenever that product is dispensed, the product is matched with revenue and recognized as a cost of providing the service to the patient. Therefore, the product cost concept is important to managers of departments that hold a significant amount of inventory.

INFORMATION CHECKPOINT

What Is Needed? Example of a management report that uses direct/indirect cost.

Where Is It Found? With your supervisor, in administration, or in information services.

How Is It Used? To track operations directly associated with the unit. What Is Needed? Example of a management report that uses responsibility

centers. Where Is It Found? With your supervisor, in administration, or in information

services. How Is It Used? To reflect operations that a manager is specifically respon-

sible for and to measure those operations for planning and control.

KEY TERMS

Cost Object Direct Cost Indirect Cost Joint Cost Responsibility Centers

DISCUSSION QUESTIONS

1. In your own workplace, can you give a good example of a direct cost? An indirect cost?

2. What is the difference? 3. Does your organization use responsibility centers? 4. If not, do you think they should? Why? 5. If so, do you believe the responsibility centers operate properly? Would you make

changes? Why?