Readings/sources: Lesson 3 Lecture Notes Gapenski Text: Chapters 5 and 6 Shea
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Lesson 3 Lecture Notes
Gapenski Text: Chapters 5 and 6
Shea, B. (2012). Five key trends reshaping the future of healthcare. Cognizant 20-20 Insights.
Gershman, B. (May 25, 2010). NOVAaccess ACC 211 – Chapter 11| Episode 1 – Payroll Liabilities (Part 1). Northern Virginia Community College.
Cost Behavior and Allocation
Lesson 3 Lecture Notes
We began this course by saying that health care financial management is based on two separate disciplines:
We have created a foundation of knowledge built on financial accounting. You learned about the basic financial statements and how they are created and used, as well as some of the tools used in analysis of those statements. Now, we are going to venture into the realm of managerial accounting. We will discuss how managers utilize financial data to make both organizational and departmental decisions.
We will begin with the costs of providing services to our customers, as those costs play such a large role in the decisions made. The term “cost” seems simple enough, but as you begin to use it in managerial decision making, you will find that it has many different uses and meanings. Those different meanings usually come from the adjective connected to the term. For example, costs may be:
direct or indirect
fixed or variable
budgeted or actual
non-controllable or controllable
The definitive adjective identifies how the cost is used. We will highlight some of those categories here, to supplement the discussion in the text and to provide you with additional examples.
Direct vs. Indirect Costs
Costs are designated Direct or Indirect based on whether they can be traced to, or identified with, a specific department, cost center, or activity. Those that can be so identified are classified as Direct Costs. Those that cannot are classified as Indirect Costs. You may think of this in terms of the question: “If the operating unit (such as a department) did not exist, would this cost be in existence?” If the cost would not exist without the department, it is a direct cost. If it would be there anyway, it is an indirect cost, and is generated by other factors.
Some examples of Direct Costs might include salaries of staff employed in that department or unit, supplies, or utilities (e.g., electric and telephone service) that would not be needed if the department or unit disappeared. Indirect Costs could include items such as the salaries of managers with organization-wide responsibility, housekeeping, and maintenance of the physical plant, since these costs would exist even if the specific function were discontinued. Note that they might be reduced a bit in some cases, but would not go away.
Fixed vs. Variable Costs
Costs may also be classified as either Fixed or Variable, depending on the volume of services provided. Fixed costs will exist at the same price regardless of the level of activity, or how many patients are involved. If the costs change with the level of activity, they are variable. For instance, fire insurance will be the same no matter how many patients there are, thus it is a fixed cost. The number of nursing staff on the shift may depend on the number and type of patients on the floor. Therefore, that is a variable cost. Supplies purchased subject to a volume discount would be variable, since the volume of supplies purchased and used would depend on the volume of services provided. Some costs are semi-variable, a combination of fixed and variable. For example, the electric bill will have a lower limit. That’s the fixed part. The rate for any electricity used above that will change with the amount that is used. It is variable.
Keep in mind that: Total Costs = Fixed Costs + Variable Costs.
Budgeted vs. Actual Costs
One of the cost classification categories most familiar to health care workers not directly involved with finance is the designation of costs as Budgeted or Actual. Most health care managers, and many others, are responsible for the budgets for their departments or work units. The primary way in which that responsibility is measured is by comparing budgeted costs against actual costs. The budgeted costs are what have been projected and are expected. The actual costs are just what the name suggests – the expenses that have actually been incurred. It is expected that actual costs will
be less than budgeted or the manager will need to explain why they are not. We will look at budgeted and actual costs in more detail in Lesson 6.
Short-Term Routine Decision Making
Managers in health care settings are required to make many decisions that can best be classified as short-term routine. By short-term, we mean decisions lasting a year or less and not involving any new long-term assets. By routine, we mean that they are a part of the organization’s everyday operations. Those decisions often involve the classification of costs that we discussed above. We will look at some of the decision-making processes.
The Cost-Volume-Profit Analysis, also called the Break Even Analysis, helps managers to determine costs and volumes needed to break even. In its simplest form, the equation for breaking even is:
Total Revenues = Total Costs
As we noted earlier:
Total Costs = Total Fixed Costs + Total Variable Costs
Thus, the formula can be used to determine the amount of revenue needed to cover both fixed and variable costs. Or, since the amount of total fixed costs cannot be changed, it can show the maximum variable costs allowable given a certain revenue level.
In determining the break-even point, it is useful to separate variable costs into Variable Cost per Unit and Quantity (number of units). Keeping it very simple, if you know how much it costs per hour to provide physical therapy services (variable cost per unit), you can determine how many units (quantity) can be delivered while staying within a given total variable cost figure.
The formula would be:
Total Revenues = Total Fixed Costs + (Variable Cost Per Unit x Quantity)
Using a similar formula, Total Revenues can be broken down into Revenue Per Unit and Quantity. That expands the break-even equation to the following:
Revenue Per Unit x Quantity = Total Fixed Costs + (Variable Cost Per Unit x Quantity)
That equation can be used in a number of ways. You can see what effect changing any one of the components would have on the others. For example, you could determine what price (Revenue Per Unit) you would need to cover different levels of volume (Quantity). You could see what volume (Quantity) you would need at different prices (Revenue Per Unit) to cover the costs. Or, you could identify the maximum Variable Cost Per Unit you could afford at different volumes (Quantity) and/or prices (Revenue Per Unit).
Another way of determining the break-even point is by calculating the Contribution Margin. The Contribution Margin represents the difference between revenues and variable costs, usually applied on a per unit basis. It is the dollar amount per unit that first must be used to cover fixed costs before any additional revenue can be used to contribute to profit. In equation form, it is:
Contribution Margin = Revenues – Variable Costs
The break-even point can be calculated using the Contribution Margin. If you know the fixed costs, you can calculate the number of units (Quantity) you need to sell to break even. The formula is:
Break Even Quantity = Total fixed Costs ÷ Contribution Margin Per Unit
The Contribution Margin can also be used to determine what would be needed to achieve a certain level of profit (Net Income). Using the following formula:
Total Revenues – Total Variable Costs – Fixed Costs = Profit (Net Income)
That is the same as saying:
Contribution Margin – Fixed Costs = Profit (Net Income)
It is often useful for comparison purposes to express the contribution margin in the form of a percentage of the revenues, showing you which “product” is generating more toward covering variable costs.
Here are some examples:
You can play with this formula to determine any of its components. If you look at your revenues as 100%, if your fixed costs are equal to your contribution margin, then net income is zero. This is called break-even. To see this as the above example:
What would you need to generate for revenues in order to have a net income of $10,000?
Assumptions: Fixed costs are $55,000 and the contribution margin percentage is 45%.
The Contribution Margin is $65,000 (Target Net Income of $10,000 + Fixed Costs of $55,000). If you divide that amount by 45% you will find the amount of Revenues ($144,444). You will need revenues of $144,444 to have a net income of $10,000.
To fill out our example, Variable Costs can then be obtained by subtracting the contribution margin ($65,000) from the revenue ($144,444), getting $74,444.
Short-Term Non-Routine Decision Making
There are other short-term decisions that must be made, but which are not a part of the everyday operations. The most common of these are “make-or-buy” decisions, “adding or dropping a service” decisions, and “minimum pricing” decisions. The process for making such decisions may be called either a “Differential or Incremental Analysis” or a “Marginal Cost Analysis.” In both cases, this refers to calculating the financial effect of making a particular decision. The names given to the specific types of decisions are self-explanatory.
Make-or-Buy decisions allow managers to compare the costs of producing a product themselves or purchasing it from others.
Adding or Dropping a Service decisions analyze the costs or benefits of adding a new service or eliminating a current service.
Minimum Pricing decisions generally come into play for health care providers when evaluating a contract with a payer (e.g., a managed care organization) is worthwhile. Such contracts often are based on a fee lower than usual charges in return for volume guarantees. They are sometimes called volume discounts. This type of analysis allows the organization’s managers to calculate the comparative value of such contracts.
Cost Allocation The categorization of costs and various formulae for using them in decision making that we have looked at here are very useful, but fall short of one other important managerial tool – matching costs to the department or activity that generates them. Knowing where costs come from can help greatly in identifying the relative value of the organization’s services. Yet, as we have seen earlier, most units have a combination of direct and indirect costs. The indirect costs relate to services that are important to them, but are generated by departments/units beyond their control. For example, a patient care unit relies on the housekeeping department to keep the unit clean. Some of the housekeeping department’s costs relate to cleaning that unit. How do we assign a portion of the housekeeping costs to the patient unit?
The process is known as Cost Allocation. It is an accepted method of determining what portion of indirect costs should be added to the direct costs of each unit. It can be thought of as a pricing process within the organization whereby managers allocate the costs of one department to others. It is particularly valuable when determining prices to charge. Each identifiable component (department, unit, section) of the organization that accumulates costs is called a cost center. Through cost allocation, the costs created by cost centers that do not generate revenue (e.g., administration) can be assigned to those cost centers that do (e.g., patient services). The latter are also called revenue centers.
One of the more important (and some say most difficult) parts of the cost allocation process is determining how to distribute indirect costs, also referred to as overhead costs. The distribution should be based on some measure of the value of the indirect cost to the revenue-generating cost center. For example, housekeeping costs are usually distributed on the basis of square feet of space cleaned, or on actual hours spent cleaning a particular area. Most maintenance departments now use work orders to more accurately price their “services” to other departments. Costs associated with a human resources department would probably be distributed on the basis of the number of personnel in each department.
Cost Allocation Methods
There are three generally accepted methods of allocating co
sts. Briefly, they can be differentiated as follows:
The Direct Allocation method assigns costs from non-revenue cost centers directly to revenue-generating centers.
The Reciprocal Allocation method uses matrix algebra equations to allocate costs from all cost centers to all other cost centers.
The Step-Down Allocation method first allocates overhead costs from non-revenue cost centers to other non-revenue centers, then allocates those newly computed costs to revenue centers.
While these and a few other methods of cost allocation can all be used to produce the managerial information desired, health care organizations may be required by certain payers such as Medicare or Medicaid to use specific methods.
COSTING OF OUTPUTS
The final portion of this unit provides additional detail concerning how managers use cost information to improve the organization’s financial health. Much of its focus is on accurate identification of costs associated with outputs (services offered) and using that information to control costs.
An organization may have numerous revenue-generating services within a single revenue center. To cost and price those services accurately, it is necessary to determine their direct and indirect costs. Several methods for estimating the costs of providing those services are presented here.
Ratio of Costs to Charges (RCC)
The Ratio of Costs to Charges (RCC) Method uses the relationship between a revenue center’s costs and its charges to cost individual services within that center. The ratio includes both direct and indirect costs.
Ratio of Costs to Charges = Revenue Center Costs ÷ Revenue Center Charges
That result of that computation is then multiplied against a charge to estimate the associated cost.
Relative Value Units (RVUs)
Relative Value Units (RVUs) provide a means of assigning direct costs to output units. Health care workers are familiar with Medicare’s Diagnostic Related Groups (DRGs), which are a form of RVUs. The concept is quite simple, but must be based on a very careful analysis of the output units being compared. Using different levels of patient care as an example, you must first compare those levels in terms of the amount of labor, supplies, etc. needed for each. One such level would be chosen as a base and assigned a value of one (1). Then, other levels are compared to it and assigned values relative to the base. Those values can then be used to determine costs for each unit of service.
Using the Cost Information
This type of cost information can be used both to control costs and to determine pricing. How it relates to pricing will be covered in more detail in Lesson 5. As for controlling costs, it is necessary to separate them once again into categories. This time the categories are Controllable and Uncontrollable.
Controllable costs are, as the name implies, costs that a manager can control, at least to some degree. The manager may be able to control the number of staff assigned, or the amount of supplies used per patient day. If so, those are controllable costs. However, there are other costs over which the manager may have little control. In a health care setting, those uncontrollable costs might include tests or procedures ordered by physicians, or length of stay. It is important to identify for each unit or cost center which costs are within the control of the manager and which are not. Controllable costs allow some flexibility in determining budgets, which will be discussed in Lesson 6.
Planning for the future in health care can involve a bit of analysis of market trends, as well as a good dose of luck. Health care reform is a huge topic; there are numerous ideas and proposals for achieving better care outcomes at lower costs. Not only does the discussion involve health care providers and financial experts, but also politicians and policymakers. Even within the broader spectrum of health care, reform may mean different things to different types of providers. For example, the impact of reform may affect hospitals, physician prac
tices, home health agencies, and skilled nursing facilities in very different ways. The assigned reading from the Cognizant website offers a solid, yet brief, summary of likely future trends in health care delivery.
Accurate identification and allocation of costs is critical to using financial information to make managerial decisions. It is equally important in budgeting and pricing of services, as will be discussed in the next two lessons.