1. If not, can you propose an solution that works for all of the parties involved? 2. How do you make it fairer and more transparent mathematically? Please use below data to answer the above two questions. Baker Medical Center: Cost Allocation Concepts Baker Medical Center is a full-service not-for-profit acute care hospital with 325 beds located in Baker, Texas. The bulk of the Bakers facilities are devoted to inpatient care and emergency services. However, a 100,000 square-foot section of the hospital complex is devoted to outpatient services. Currently, this space has two primarily uses: (1) About 80% of the space is used by the Outpatient Clinic, which handles all routine outpatient services by the hospital and (2) The remaining 20% is used by the Dialysis Center. The Dialysis Center performs hemodialysis and peritoneal dialysis, which are alternative processes that remove wastes and excess water from the blood for patients with end stage renal (kidney) disease. In hemodialysis, blood is pumped from the patients arm through a stunt into a dialysis machine, which uses a cleansing solution and an artificial membrane to perform the function of a healthy kidney. Then, the cleansed blood is pumped back into the patient through a second shunt. In peritoneal dialysis, the cleansing solution is inserted directly into the abdominal cavity through a catheter. The body naturally cleanses the blood through the peritoneum - a thin membrane that lines the abdominal cavity. Typically, hemodialysis patients required three dialyses per week, with each treatment lasting about 4 hours. Patients who use peritoneal dialysis change their own cleansing solution at home, usually about 6 times per day. This procedure can be done manually when the patient is active or automatically by machine when the patient is sleeping. However, the patients overall condition, as well as the positioning of the catheter, must be monitored regularly by nurses and technicians at the Dialysis Center. Bakers cost accounting system, which was installed two years ago, allocates facilities costs (which at Baker essentially consists of building depreciation and interest on long-term debt) on the basis of square footage. Currently, the facilities cost allocation rate is $15 per square foot, so the facilities cost allocation is 20,000 X $15= $300,000 for the Dialysis Center and 80,000 X $15= $1,200,000 for the Outpatient Clinic. All other overhead costs, are lumped together and called general overhead. These costs are allocated on the basis of 10% of the revenues of each patient service department. The current allocation of general overhead is $270,000 for the Dialysis Center and $1,600,000 for the Outpatient Clinic, which results in total overhead allocations of $570,000 for the Dialysis Center and $2,800,000 for the Outpatient Clinic. Recent growth in volume of the Outpatient Clinic has created a need for 25% more space than is currently assigned. Because the Outpatient Clinic is much larger than the Dialysis Center, and its patients need frequent access to other departments within Baker, the decision was made to keep the Outpatient Clinic in its current location and to move the Dialysis Center to another location to free up space within the Baker complex. Such a move would increase the Outpatient Clinic space by 25% to 100,000 square feet. After attempting to find space for the Dialysis Center within the complex, Bakers leadership soon determined that a new 20,000 square foot building had to be built. This building would be 2 situated three blocks away from the complex, in a location that would be much more convenient for the dialysis patients and employees because of ease of parking. The 20,000 square feet of space, which can be more efficiently used then the old space, allows for some increase inpatient volume, although it is unclear whether the move will generate additional dialysis patients. Construction cost of the new building is estimated at $120 per square foot, for a total cost of $2,400,000. In addition, the purchase of land, furniture, and other fittings, along with the relocation of equipment, files, and other items, would cost $1,600,000, for a total cost of $4,000,000. The $4,000,000 cost would be financed by a 7.75%, 20-year first-mortgage loan. When both the principal amount (which can be considered depreciation) and interest are amortized over 20 years, the result is an annual cost of financing of $400,000. Thus, it is possible to estimate the actual annual facilities costs for the new Dialysis Center, something that is not possible for units located within the complex. Exhibit 3.1 contains the projected Profit and Loss (P&L) Statement for the Dialysis Center before adjusting for the move. Bakers department heads receive annual bonuses on the basis of each departments contribution to the hospitals bottom line (profit). In the past, only direct costs were considered, but Bakers Chief Executive Officer (CEO) has decided that bonuses would now be based on full (total) costs. The new approach to awarding bonuses, coupled with the potential for increases in indirect cost allocation, is of great concern to John Van Pelt, the Director of the Dialysis Center. Under the current allocation of indirect costs (see Exhibit 3.1), John would have a reasonable chance at an end-of-year bonus, as the forecast puts the Dialysis Center in the black. However, any increase in the indirect cost allocation would likely put him out of the money. At the next department heads meeting, John voiced his concern about the impact of any allocation changes on the Dialysis Centers reported profitability. Bakers CEO asked the Chief Financial Officer (CFO), Rick Simmons, to conduct an analysis. The CEO said that the final allocation is up to Rick, but that any allocation changes must be made within outpatient services. In other words, any change in indirect cost allocation to the Dialysis Center must be offset by an equal, but opposite, change in the allocation to the Outpatient Clinic. To get started, Rick created Exhibit 3.2. In creating the exhibit, Rick assumed that the new Dialysis Center would have the same number of stations as the old one, would serve the same number of patients, and would receive the same reimbursement rates. Direct operating expenses would differ only slightly from the current expenses because the same personnel and equipment would be used. Thus, for all practical purposes, the revenues and direct costs of the Dialysis Center would be unaffected by the move. The data in Exhibit 3.2 for the expanded Outpatient Clinic are based on the assumption that the expansion will allow volume to increase by 25% and that both revenues and direct costs will increase by a like amount. Furthermore, to keep the analysis manageable, the overall hospital 3 allocation rates for both facilities costs and general overhead were assumed to not materially change as a result of the expansion. Rick knew that his trial balloon allocation, which is shown in the Initial Allocation columns in Exhibit 3.2, would create some controversy. In the past, facilities costs were abrogated, so all departments were charged a cost based on the average embedded (historical) cost, regardless of the actual age (or value) of the space occupied. Thus, a basement room with no windows was allocated the same facilities costs (per square foot) as was the 5th floor executive suite. Because many department heads considered this approach unfair, Rick wanted to begin allocating facilities overhead on a true cost basis. Thus, in his initial allocation, Rick used actual facilities costs as the basis for the allocation to the Dialysis Center. Johns response to the initial allocation was less than enthusiastic. Specifically, he was concerned about several issues: 1. Is it fair for the Dialysis Center to suffer (in profitability) from the move even though it had nothing to do with it? 2. Should the Dialysis Center be charged actual facilities costs for its new location? After all, the move was forced by the Outpatient Clinic, which is being charged for facilities at the lower average allocation rate. Under the concept of charging the actual facilities costs, department heads might be better off resisting proposed moves to new (and potentially more efficient) facilities because such moves would result in increased facilities allocations. 3. Even if the true cost concept was applied to the Dialysis Center, is the $400,000 annual allocation amount correct? After all, the building has a useful life that is probably significantly longer than 20 years the life of the loan used to determine the allocation amount. If the true cost concept is applied, what would be the allocation in the 21st year, after the mortgage had been paid off? 4. The revenue that the Dialysis Center receives from patient use of the pharmacy appears to be passed on directly to the pharmacy. That is, the Dialysis Center books $800,000 in annual revenue but then is charged $800,000 for the drugs used. Should this revenue be counted when general overhead allocations are made? To make his point, John discovered that the pharmacy supplies used for dialysis actually cost the pharmacy $400,000, so the pharmacy makes a profit of $400,000 on drugs that are actually sold by the Dialysis Center. Before Rick was able to respond to Johns concerns, he suddenly left Baker to be the CFO of a competing investor owned hospital. The task of completing the allocation study was given to you, Bakers current administrative fellow. You remember that to be of most benefit to the organization, cost allocations should (1) be perceived as being fair by the parties involved and (2) promote overall cost savings within the organization. However, you also realize that in practice cost allocation is complex and sometimes arbitrary. Some department heads argue that the best approach to overhead 4 allocations is the Marxist approach, by which allocations are based on each patient service departments ability to cover overhead costs. Exhibit 3.1 Baker Medical Center Dialysis Center: Pro Forma Profit and Loss Statement Assuming Status Quo Revenues Hemodialysis Program $1,300,000 Peritoneal Dialysis Program $600,000 Pharmaceutical Supplies $800,000 Total Revenues $2,700,000 Direct Expenses Salaries And Benefits $900,000 Pharmaceutical Supplies $800,000 Other Medical/Administrative Supplies $100,000 Utilities $80,000 Lease Expense $120,000 Other Expenses $100,000 Total Expenses $2,100,000 Net gain (loss) before indirect costs $600,000 Indirect Expenses Facilities Costs $300,000 General Overhead $270,000 Total Overhead Costs $570,000 Net profit $30,000 Note: pharmacy revenues are based on reimbursement amounts, not costs 5 Exhibit 3.2 Bakers Medical Center: Dialysis Center (DC) and Outpatient Clinic (OC) Summary Projections P&L Statements Without Expansion With Expansion Initial Allocation DC OC DC OC Revenues/Direct Costs Total Revenues $2,700,000 $16,000,000 $2,700,000 $20,000,000 Direct Expenses $2,100,000 9,833,155 2,100 000 12,291,444 Contribution Margin $600,000 $6,166,845 $600,000 7,708,556 Percent of Revenues 22.2% 38.5% 22.2% 38.5% Indirect costs Facilities Costs $300,000 $1,200,000 $400,000 $1,500,000 General Overhead $270,000 $1,600,000 $270,000 $2,000,000 Total Overhead $570,000 $2,800,000 $670,000 $3,500,000 Net Profit $30,000 3,366,845 ($70,000) $4,208,506 Percent of Revenues 1.1% 21.0% (2.6%) 21.0% Facilities Cost Allocation: Square Footage 20,000 80,000 20,000 100,000 Facilities Cost Per Square Foot $15 $15 $20 $15 Other Overhead Allocation: General Overhead Costs as a Percent Of Revenue 10.0% 10.0% 10.0% 10.0% Note: the term contribution margin as used here means the amount available to cover overhead costs, as opposed to the traditional meeting of the amount available to cover fixed costs.