Calculate the product cost for each of the four tests 1.The existing costing system 2.The costing system proposed by Crest, the accountant 3.The costing system proposed by Posh, the consultant

Which costing system would you use and why?

VMD Medical Imaging Center It is late on a January Friday night and President Ron Becks just decided to adjourn the first staff meeting of 2016 at VMD Medical Imaging Center. The morale of the senior management team could certainly use a boost. Despite having recorded a profit in 2015, the discussion about the forecast for the upcoming year had become increasingly tense. Christine Widemeier, VP of Sales, had expressed serious concerns about the trend of the demand for VMD's services. If they wanted to maintain their usual margins, sales prices needed to be increased in 2016 and that was going to hurt. Their major client had already threatened to find an alternative provider, and there was a long line of low-cost competitors ready to jump in. Widemeier's team had made every possible effort to sustain their client's satisfaction, but she wasn't sure that the quality of the relationship would be enough to retain them going forward if prices were to be increased again this year. Something needed to be done to contain costs in production, and quickly. Mike Jankoski, Director of Operations, reacted quite defensively to Widemeier's statement. In his opinion, their processes were as lean as they could be, their technology was better than it had ever been to date, and during the past year his team had achieved many significant efficiency improvements. He did not feel that the root cause of the increased costs were to be searched in operations. Jankoski's view was that his department had been charged with so many costs that were not under his control, and he questioned the appropriateness of the allocations built in the costing system. CFO Laura Gleason did not appreciate Jankoski's reaction and ensured the team that costs were accounted for appropriately. Gleason, instead, pointed to a recent purchase of a new, expensive, state-of-the-art 3D MRI machine, which had been justified as a source of competitive advantage. Due to its current low utilization, she wasn't sure it had been a wise investment, since it had insofar failed to generate sufficient returns to cover the expenses. Before the conversation could get out of hand, Becks decided to send everybody home and suggested to regroup first thing on Monday, hoping that the weekend would restore the collaborative spirit that he was used to seeing in his management team. Medical Imaging Services VMD Medical Imaging Center (VMD MIC) operates as a local, independent medical imaging center. The Center offers a wide array of medical imaging applications for the needs of its clients, including projectional radiographs (commonly known as x-rays), fluoroscopies, computerized axial tomographs (CAT), and magnetic resonance imaging (MRI) scans. These various forms of medical imaging tests differ widely in function and cost. X-rays are the most widespread form of medical imaging. These scans are typically used to examine bone or bone density, and require only a short amount of time- usually seconds to complete. While more advanced forms of medical imaging have been introduced, x-rays remain popular due to their low-cost, low-time requirement, and high degree of accuracy. Additionally, hospitals often order fluoroscopies, another inexpensive, quick procedure employing a constant input of x-rays at a lower radiation rate. Fluoroscopies allow physicians to see both the internal structure and functions of a patient, such as the pumping action of the heart or the patient's swallowing. VMD MIC also utilizes more advanced medical imaging procedures such as CAT scans and MRI's. Both produce cross-sectional images of the body and are used primarily to evaluate soft tissue. CAT scans are typically best suited for diagnosing lung and chest problems, as well as in cancer detection. They are also extensively used in emergency rooms because the scan itself takes less than five minutes. MRI's are similarly used to examine differences in soft tissue, but are typically utilized to diagnose ligament and tendon injuries, spinal cord injuries, and brain tumors. Differently than CAT scans, MRI's do not subject the patient to any radiation exposure. However, MRI's do vary widely in terms of time needed to complete the procedure, with quick scans requiring only 10 to 15 minutes, while longer in- depth scans requiring up to two hours. VMD MIC is closely affiliated with Winthrop Nelson Emerald (WNE), a large regional teaching hospital. A formal agreement between the two organizations defines VMD MIC as the primary provider of medical imaging services for the hospital. However, in cases of limited availability at VMD MIC, or in situations where other providers might be able to offer lower prices, WNE is allowed to refer its patients to other medical imaging centers, on condition that WNE inquired with VMD MIC first. As a result of this policy, in 2015 VMD MIC had supplied about 87% of WNE's total imaging needs, with the remaining 13% performed by VMD's competitors. Given its affiliation with this reputable teaching hospital, VMD MIC strives to stay at the forefront of imaging technology developments. Recently, Widemeier and Jankoski had obtained Becks' approval to purchase a new 3D MRI machine by positioning it as a way to gain significant strategic advantage over their competitors. They held that 3D MRI technology would represent a significant step forward from the more common 2D MRI processes. In addition to rendering images in three dimensions, as opposed to the "stack" of 2D images produced by the current technology, 3D MRI employs computer analytics to monitor whether tumor tissues absorb chemotherapy delivered through the blood supply, as well as to distinguish between live and dead tumor cells, which helps in the evaluation of the effectiveness of cancer treatments. Due to its newness, however, physicians request 3D MRI scans only for patients with very complex cancer diagnoses. Consequently, at VMD MIC the machine is currently being utilized for not more than 10% of its capacity. Widemeier is confident that the demand for 3D MRI scans will increase in the near future and the investment in the technology will soon start to pay off. Costing and Pricing at VMD MIC Prices charged by VMD MIC to its clients are based on the full cost incurred by VMD. In 2015 VMD MIC recorded a small profit of $162,013 (Exhibit 1). The total cost of each procedure, comprises of the cost of Direct Labor (DL), plus an allocation of overhead costs. Overhead costs are allocated as a function of DL $ through the calculation of a burden rate per direct labor dollar consumed by a specific test (Exhibit 2). This consumption of DL $ by individual tests is indicated in Exhibit 3. Direct Labor includes all activities specifically pertinent to the administration of individual tests, and it includes the wages of employees preparing the patient, calibrating the equipment, administering the test, and performing general upkeep of the equipment. Overhead encompasses all other costs associated with running the imaging facility, including maintenance of the physical facility, general testing of equipment and supplies, energy and water costs, year-round landscaping, and outsourced, specialized maintenance of equipment required to comply with current US health standards, as prescribed by the Federal Food, Drug and Cosmetic Act (FFDCA). While VMD MIC is currently still operating at a profit, Gleason has become increasingly worried, as profitability has decreased significantly in the past few years. Despite her best efforts to cut costs unassociated with primary operations, the burden rate has nonetheless increased to nearly 145%, from its original 93% just five years ago. As the January 2016 staff meeting resumes on Monday morning, Becks states: Our high overhead costs are becoming increasingly worrisome and require our immediate attention. We have already taken steps to cut costs to lower our burden rate. However, overhead costs continue to rise and are preventing us from achieving our target profit margins. Jankoski rebuts that such concerns are overblown. He believes the increase in overhead costs is natural, as the MIC has shifted to become more dependent upon high-tech equipment. Thus, the use of tech-heavy CAT and MRI scans has increased within the past few years, effectively diminishing direct labor costs, while increasing spending in specialized maintenance for upkeep. Widemeier, on the other hand, reports that clients seem to agree with Becks' concern. A large number of physicians and surgeons affiliated with WNE hospital and their administrative support staff, has lodged concerns about the price of x-rays and fluoroscopies at VMD MIC, stating that they appear to have risen to unreasonably high levels compared to other competing medical imaging centers. They have begun to take their business elsewhere, further hurting VMD MIC's bottom-line profit. Other sales managers, especially those managing x-ray and fluoroscopy accounts, agree that the prices the MIC is making them quote are becoming increasingly uncompetitive. X-ray and fluoroscopy technicians, however, believe their own operations are in fact much more efficient than those of competitors in these areas, as they have perfected the processes with their years of experience. They are unclear as to why sales would need to price them at uncompetitive prices to maintain positive margins, and question the cost calculations that support such price setting. Anticipating this discussion, Becks and Gleason invited their most senior management accountant, James Crest to attend the staff meeting, so that the management team could gain an initial understanding of the issue and explore potential solutions. After describing the current costing process to the team, Crest suggests the following: I would propose VMD MIC to break away from its current one-overhead-pool costing system. Further breakdown of the overhead cost pool is necessary to reflect more accurate costs for individual tests. In its current method, VMD MIC groups all overhead costs together and then allocates them based on DL $. This ignores the differences in the equipment necessary for each test and the specialized maintenance and upkeep needed for each piece of equipment. Equipment-related overhead is the largest contributor to overhead and differs widely across tests. We currently do not have a good understanding of this overhead component. propose to break down overhead costs in two core components, Direct Labor Related Overhead and Equipment Related Overhead. Equipment Related Overhead should then be allocated to each test by their use of equipment time per year, as both the wear and tear of the equipment and the maintenance are direct functions of use. This will provide a more accurate breakdown of cost and allow us to price our services with better precision. With additional research, Crest identifies the part of overhead that was equipment related and the yearly use of each piece of equipment by the four tests (Exhibit 4). Meanwhile, because of the severity of the profitability problem and the risks this entails for the future of VMD MIC, Becks hires an external consultant, Melanie Posh, of Posh and Associates, a management consulting firm renowned for their specialization in healthcare organizations. Ms. Posh reviews Crest's findings and proposes yet another solution: I propose to break down the overhead costs even further than it was proposed by Mr. Crest. Equipment costs are not just a function of total use. Some machines are notably more high-tech than others and hence are more expensive, and require extra attention to meet federal regulations. By further breaking down equipment run time into high-tech and low-tech, we will be able to gain an even better understanding of the true costs of each test. Ms. Posh collects additional information to further break down the use of each piece of equipment per year into use of High-tech and Low-tech equipment and disaggregates the Equipment Related Overhead in High Tech Equipment Related Overhead and Low Tech Related Overhead (Exhibit 5). After reviewing both Crest's and Ms. Posh's findings, Becks is not convinced that either solution would resolve the issue at the root of the situation. His management team needs to have greater clarity on how imaging services costs are calculated, so that they can plan the best utilization of the equipment and price their services appropriately going forward. Both proposals for overhead allocations lead to results differing widely from our current cost system, and since we base our prices on full costs of the tests provided, the importance of properly allocating overhead cannot be understated. We cannot act on a whim and change our prices dramatically without being sure these new calculations are accurate. They have widespread implications for the future profitability of our organizations. Furthermore, Becks knows that any costing system would be successful in supporting future strategic decisions only as long as it generated significant buy-in by the management team. Jankoski and Widemeier look particularly baffled. How can it be possible to have three different costs for the same service? Which one is the right cost? Which costing proposal should they implement going forward? Jankoski turns to Gleason for clarification: I might be biased by my engineering education, but from where I stand, the cost of a product or a service should simply reflect the cost of the resources used to produce it. I am always confused by how little precision we seem to have when we calculate our costs here. Also, if you want me to reduce the costs of operations, they need to reflect resources that I can control. I take no part in the negotiation of process for our outsourced equipment maintenance services, or landscaping for that matter. Gleason and Becks are well aware of the concerns regarding the allocation of overhead costs. This will likely be a long meeting, but, at the same time, they welcome it as an opportunity to reach higher clarity on the accounting mechanism and, hopefully, to realign the effort of the management team toward a common strategic goal. Exhibit 1 VMD Medical Imaging Center 2015 Summary Financial Results $3,520,018 $1,375,571 Revenues Direct Labor Overhead Total Expenses Profit $1,982,428 $3,357,999 $162,019 Source: Casewriters. Exhibit 2 Calculation of Burden Rate at VMD MIC Overhead Direct Labor $1,982,428 $1,375,571 144.1167% Source: Casewriters. Exhibit 3 VMD MIC Direct Labor Cost Breakdown by Test Test Projectional Radiographs Fluoroscopies Computerized Axial Tomography (CAT) Scan Magnetic Resonance Imaging (MRI) Scan Total Direct Labor ($) $417,073 $414,047 $270,850 $273,601 $1,375,571 Source: Casewriters. Exhibit 4 Additional Information Required for Cost System Proposed by Accountant A: Breakdown of Overhead Expenses Type of Overhead Cost Direct Labor Related Overhead Equipment Related Overhead Total Overhead Cost $721,392 $1,261,036 $1,982,428 B: Utilization of Equipment by Test Test Projectional Radiographs Fluoroscopies Computerized Axial Tomography (CAT) Scan Magnetic Resonance Imaging (MRI) Scan Total Run Time / Year (Hours) 1,060 1,312 1,394 2,515 6,281 Source: Casewriters. Exhibit 5 Additional Information Required for Cost System Proposed by Consultant Cost $921,793 $339,243 $1,261,036 A: Breakdown of Equipment Related Overhead Type of Overhead Cost High Tech Equipment Related Overhead Low Tech Equipment Related Overhead Total Equipment Related Overhead B: Utilization of High- and Low-Tech Equipment by Test Test High-Tech Utilization (Hours) Projectional Radiographs 268 Fluoroscopies 579 Computerized Axial Tomography (CAT) 819 Scan Magnetic Resonance Imaging (MRI) Scan 2,515 Total 4,181 Low-Tech Utilization (Hours) 792 733 575 0 2,100 Source: Casewriters