Cost allocation, downward demand spiral. Western Health Maintenance (WHM) operates a chain of ten hospitals in the Los Angeles area. For many years, it has operated a central food¬

catering facility in Santa Monica, which delivers meals to the ten hospitals. The Santa Monica facility has the capacity to serve 3,650,000 meals a year (10,000 meals a day). In 2007 it budgeted for 2,920,000 meals (8,000 meals a day), based on demand estimates from each hospital con¬

troller. The budgeted variable costs per meal in 2007 are $4.56, which includes delivery to the hospital. Budgeted fixed costs for 2007 are $5,256,000.

In July 2007, the new WHM president announces that each hospital is to be a profit centre. In addition, the head of each hospital can purchase services from outside WHM, pro¬

viding these services meet the WHM quality requirements. The president gives catering as an example. Roy Cheung, the head of the $anta Monica catering facility, is less than pleased.

This facility will also become a profit centre (it has been a cost centre for many years) under the reorganization.

Cheung charged each hospital $6.36 per meal in 2007—comprising $4.56 variable cost plus $1.80 allocation of budgeted fixed costs, fieveral hospitals complained about the cost and the quality of the food. (Cheung sarcastically labels the quality complaints as “recycled mystery-meat stories.”) Indeed, the cost rose from $5.88 in 2006 to $6.36 in 2007. Cheung defended the increase, claiming he needed to spread the same fixed costs over a smaller num¬

ber of patient-days in 2007. WHM experienced negative press on a local TV station in 2006 and early 2007, and local doctors are referring fewer patients to the WHM hospitals.

In October 2007, Cheung started to prepare the 2008 budget, including the new cost to be charged per meal. He estimated that the total annual demand for meals at all ten WHM hospitals will be 2,550,000. Then he learned that three of the ten hospitals will use an outside canteen service, which reduces the 2008 budgeted demand at the fianta Monica facility to 2,000,000 meals. No change in total fixed costs or variable costs per meal is expected in 2008.

Required 1. How did Cheung compute the budgeted fixed costs per meal in 2007?

2. What alternative cost-per-meal figures might Cheung compute for meals delivered to WHM hospitals in 2008? Which cost figure should Cheung use? Why?

3. What factors should Cheung consider in pricing meals the $anta Monica facility prepares for the WHM hospitals?