Healthcare Finance Cost Allocation

Family Practice Physicians Office (the Group) is a medical practice with four locations in the greater Indianapolis, IN area. The clinical staff consists of 20 physicians, all of whom practice in one or more areas of family medicine, and 46 physician extenders and nurses. The Group is organized into three patient service departments: Adult Medicine, Obstetrics, and Pediatrics. Supporting these patient service depart¬ments are three support departments: Administration, Facilities, and Finance. Figure 1 contains the Group's summary revenue and cost projections by department for the coming year. As part of a much-needed overhaul of the cost allocation process, the Group contracted with a major accounting firm to estimate the amount of services provided by the support departments to each other and to each patient service department. The intent of the study was to provide data that would help the Group develop a better cost allocation system than could the outdated, arbitrary system currently in use. Thus, both senior management and depart¬ment heads at the Group are comfortable with the resulting allocation percentages. The next step in-the cost allocation process improvement initia¬tive is to choose the allocation method. Four allocation methods are under consideration: direct, step-down, double apportionment, and reciprocal. To aid in the decision the Group's CFO has hired Top Block to conduct the following study:

• Make a recommendation regarding the best allocation method
• Determine the overhead cost allocations under each method
• Compare and contrast the results (Sensitivity Analysis)
• Estimate the relative profitability of the patient services departments under the recommended allocation system

Allocation Methods The four methods differ in how intra-support department allocations are handled and, consequently, in complexity.

Direct Method The direct method assumes that support departments provide services only to patient services departments. Thus, no intra-support department services are recognized, even though such services exist. This simplifying assumption makes the direct method the easiest to apply but the weakest conceptually. Step-down Method The step-down method recognizes some intra-support department services, but it does so in a relatively simplistic way. In this method, the support department that provides the most services to the other support departments is allocated first (to support and patient services departments). Then the department is closed, and the process steps down to the support department that provides the next highest amount of services to other support departments. Because support departments are closed out in each step, there is no opportunity to allocate support costs back to the departments that have already closed. Thus, this method is not as complex as the remaining two to implement in practice, but it is superior conceptually to the direct method.

Double Apportionment Method The double apportionment method first recognizes support provided by service departments to all other service departments as well as to the patient services departments. After this step, which is called the first allocation (apportionment), some costs still remain in the support departments. Then, a second apportionment, which uses the step-down method, is used to move all remaining support departments costs to the patient services departments. In this method, service departments support to all other service departments is recognized. In the pure step-down method, on the other-hand, service department support is recognized only to "downstream" service departments. Here's how we assumed that the double apportionment method would be applied to the Group: (This allocation method can be ap¬plied in other ways.)

• First, direct Administration costs would be allocated to the other five departments (two support and three patient services).
• Second, direct Facilities costs would be allocated to all other departments (including Administration and Finance).
• Third, direct Finance costs would be allocated to all other departments (including Administration and Facilities).

After these three allocations are completed, the first apportionment is finished. Some costs still remain in the support departments —the in¬tra-support departments allocations from the first apportionment—so a second apportionment is necessary. The second apportionment is con¬ducted using the step-down method as it is normally applied, except that the application of the first apportionment means that the starting cost pool values are much lower.

Reciprocal Allocation Method Finally, the reciprocal method uses a system of simultaneous equations (or a number of iterations) to allocate overhead costs simultaneously among support and patient services departments. This method is the most complex, but it does the best job of recognizing intra-support department services. Conceptually, the reciprocal method is best. The double apportionment method is next best, followed by the step-down method and, finally, the direct method. Although the direct method is conceptually the weakest, it is the easiest and least costly to implement. As in most situations, greater accuracy comes at a cost—the greater the accuracy of the allocation method, the greater the implementation cost (and the more difficult it is to explain to department heads and other interested parties). The base case allocations and profit forecasts are summarized in the following table. Under base case conditions, as the allocation method moves from the direct method to the reciprocal method, the allocation of indirect costs mostly decreases to Adult Medicine, increases to Obstetrics, and exhibits random fluctuations to Pediatrics. However, as we discuss in the answer to Question 5, changing allocation methods does not materially change the resulting profitability. To help with this analysis, we created a new spreadsheet model, which uses the Group's numbers, to calculate the allocation not only for the reciprocal method but also for the other three methods.

Sensitivity Analysis In this sensitivity analysis, allocation rates are held at their base case values and the cost pool amounts are changed. In the base case, Facilities has by far the largest cost pool.

In Calculation 1, Administration has the largest cost pool, while in Calculation 2, Finance has the largest cost pool. Here are the results: Calculation 1 Calculation 2 In the base case, Facilities has the largest cost pool. In Calculation 1, Administration has the largest cost pool, while in Calculation 2, Finance has the largest. Because Adult Medicine uses the largest amount of Facilities services, its profitability increases substantially when Facilities costs are shifted to Administration. When Facilities costs are shifted to Finance, Adult Medicine’s profitability also increases, but not as much. Conversely, Obstetrics uses the least Facilities services, so its profitability decreases when overhead costs are shifted away from Facilities and into Administration and Finance. The impact of Pediatrics is not as clear-cut: Its profitability lessens when Administration has the largest cost pool, but improves when Finance has the largest. The biggest change here is that the overhead departments are using a much greater proportion of services from one another (50 percent) than in the base case (15 percent).

Here are the results: Calculation 3 This change in allocation rates results in increased profitability to Adult Medicine, which uses the largest amount of overhead services, and decreased profitability to Obstetrics, which uses only a small amount of Facilities services. Shifting overhead amounts from patient services departments to overhead departments benefits the patient services department that uses the most overhead services. Still, the results are not significantly different from those of the base case. The ten iterations in the model are now insufficient to complete the allocation under the reciprocal method, so that method shows $13 less in indirect costs, and hence $13 more in aggregate profit, than do the other methods. Analysis and Insights Assess the sensitivity of patient services department profitability to: a. The allocation method b. The relative sizes of the overhead cost pools c. The allocation rates There are many ways to answer this question. In the matrix below, the changes in profitability from the reciprocal method (which is assumed to be the best) are listed using the base case inputs regarding allocation rates and cost pool values. This provides some feel for the impact of a change in allocation methods on departmental profitability, holding other factors constant. Allocation Method The findings are as we expected—in general the greatest deviation from the reciprocal method occurs in the direct method, while the least deviation occurs with the double apportionment method. As the complexity of the allocation method increases (and the method better allocates intra-overhead department costs), the differences from the reciprocal method results decrease.

The next table examines the differences from the base case profitability under the three alternatives examined in Questions 3 and 4 above. To keep things simple, we have listed only the reciprocal method. Alternative Analysis Here we see that changing the assumptions about the relative sizes of the cost pools and allocation rates can have a significant effect on the resulting profitability. However, this is not a great concern, because these factors are driven by the operating economics of the business, as opposed to arbitrary decisions made by managers regarding which allocation method is used. Over a wide range of assumptions regarding the relative sizes of the cost pools and the allocation rates, we find that Adult Medicine and Obstetrics are profitable, while Pediatrics is not. Thus, the inherent operations of Pediatrics must be examined to see if Westside’s management can take any actions to improve this department’s profitability.

However, at least under the revenue and cost framework used in the managerial accounting system, Pediatrics probably is inherently unprofitable. This does not necessarily mean that department closure should be considered. The department may be vital to the practice’s mission, and the practice therefore may be willing to subsidize the losses with profits from the other two patient services departments.

More probably, the true economic contribution of Pediatrics to the organization is not being adequately measured. For example, Pediatrics may be instrumental in creating patient demand for Obstetrics and Adult Medicine. If Pediatrics were closed and patient demand fell significantly, the loss in aggregate profit from falling volume could exceed the losses realized by Pediatrics. If this is the case, Pediatrics is financially justifiable in spite of the losses it shows on the managerial accounting profit and loss statements. Final Recommendations Without more information about the current cost accounting system, it is impossible to make an informed decision. However, if the reciprocal method can be implemented without an undue increase in accounting costs, it is preferred. If not, the double apportionment method should be considered. If this is not feasible, the step-down method could be implemented without losing over 5 percent of the accuracy inherent in the reciprocal method. Even the direct method introduces only a 6.5 percent inaccuracy. Another consideration is any third-party payer requirements. For example, hospitals are required to use the step-down method for Medicare cost reporting, which drives most hospitals to use that method in their managerial accounting systems. Similar requirements for group practices, if they exist, could influence the final decision.