Costing and Pricing at DDM Lab DDM Lab computes the prices that it charges to its clients based on the full costs. In 2020 DDM Lab generated a small profit of $12,382 Exhibit 1). The total cost of each procedure consists of the cost of Direct Labour (DL) and an allocation of overhead costs. Overhead costs are allocated as a function of DL $ by calculating a cost rate per direct labour dollar used by a specific test Exhibit 2). Exhibit 3 presents the consumption of DL $ by individual tests. Direct Labour includes all activities related to the wages of employees preparing the patient, calibrating the equipment, administering the test, and performing general upkeep of the equipment Overhead mostly relate to the depreciation of the equipment and with operating the imaging facility, including maintenance of the physical facility, general testing of equipment and supplies, energy and water costs, and outsourced specialised equipment maintenance. While DDM Lab currently still operates at a profit, CFO Pietch is increasingly concerned, as profitability has fallen significantly in the past few years. Despite her efforts to cut costs that are not closely related to primary operations, the cost rate has increased to almost 155%, from its original 90% just four years ago. On Wednesday morning, staff meeting resumes. Novak (CEO) states: Our high overhead is becoming increasingly worrying and demands our immediate attention. We have already significantly cut costs, and I am unsure how much scope we have there. However, overhead costs seem to continue to increase and are preventing us from achieving our target profit margins." Watson, Operations Manager, believes that such statements are overblown. He believes the increase in overhead costs is logical, as the Lab has shifted to become more dependent upon high-tech equipment. The use of tech-heavy CAT and MRI scans has increased within the past few years, which has, on the other hand, effectively diminished direct labour costs. However, he admits, it has also increased spending in specialised maintenance for upkeeping the machines. Moreover, Lazzarini reports that their clients seem to agree with Novak's concern. Many physicians and surgeons affiliated with the University hospital have complained about the price of x-rays and fluoroscopies at DDM Lab, stating that they are unreasonably high compared to other competing medical imaging centres. They have started to refer their patients elsewhere, further hurting DDM Lab's bottom-line profit. Managers managing x-ray and fluoroscopy accounts agreed that the Lab's prices are making their quotes increasingly uncompetitive. X-ray and fluoroscopy technicians, however, believed their 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 were unclear as to why sales would need to price them at uncompetitive prices to maintain positive margins and demanded explanations of the cost calculations that support such a high price setting. In anticipation of this discussion, CEO Novak and CFO Pietch invited the company's management accountant, Nina Kastelic, to attend the staff meeting this morning so that the management team could gain a better understanding of the costing system. After describing the current costing process to the team, Kastelic suggests the following: I suggest that we elaborate our current one-overhead-pool costing system. A more refined breakdown of the overhead is necessary to reflect more accurate costs for individual tests. Currently, DDM Lab 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 specialised maintenance of the equipment. Equipment-related overhead is the largest contributor to overhead and differs widely across tests. I propose to break down overhead costs into two core components, direct labour related overhead and equipment related overhead. Equipment related overhead should be allocated to each test by using machine hours per year, as it is a direct function of use. This will provide a more accurate allocation of cost and allow us to price our services with more precision. Kastelic presented the proportion of overhead that was equipment related and the annual use of each piece of equipment by the four tests as shown in Exhibit 4. In addition, Novak hired an external consultant, Micheal Postman, renowned for his specialisation in healthcare organisations because of the seriousness of the profitability problem. Postman reviewed Kastelic's findings and proposes yet another solution: I propose to break down the overhead costs even further than it was proposed by Ms Kastelic. Equipment costs are not just a function of total use. Some machines are notably more high-tech than others and hence are more expensive. 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." Postman collected additional information to further break down the use of each piece of equipment per year into the use of High-tech and Low-tech equipment. He disaggregated the Equipment related overhead in high tech equipment related overhead and low tech-related overhead (Exhibit 5). Exhibit 1: DDM Lab 2020 Financial Results Revenues 4,576,023.4 Direct Labour 1,788,242.3 Overhead 2,775,399.2 Total Expenses 4,563,641.5 Profit 12,381.9 Exhibit 2: Calculation of the cost rate at DDM Lab Overhead 2,775,399.20 Direct Labour 1,788,242.30 Cost rate 1.55 Exhibit 3: DDM Lab Direct Labour Cost Breakdown by Test Test Direct labour $ Projectional Radiographs 542,194.9 Flouroscopies 538,261.1 CAT Scan 352, 105.0 MRI Scan 355,681.3 1,788,242.3 Exhibit 4: Additional information required for cost system proposed by accountant Type of Overhead Cost Cost Direct Labour Related Overhead 1,009,948.8 Equipment Related Overhad 1,765,450.4 Total overhead 2,775,399.2 Utilization of equipment Projectional Radiographs Flouroscopies CAT Scan MRI Scan Run time/year (hours) 1,431.00 1,771.20 1,881.90 3,395.25 8,479.35 Exhibit 5: Additional information required for cost system proposed by consultant Type of overhead cost Cost High tech 1,290,510.2 Low tech 474,940.2 1,765,450.4 Utilization of high- and low-tech equipment by test in hours per year Test High-tech Low-tech Projectional Radiographs 361.80 1,069.20 Flouroscopies 781.65 989.55 CAT Scan 1,105.65 776.25 MRI Scan 3,395.25 5,644.35 2,835.00 0.00 4. Calculations & Interpretations - Quantitative Analysis (15 marks) This section requires you to undertake quantitative analysis on the case. You are to perform calculations that are relevant to the problem and issues that you identified in Section 2. In particular: 1. Calculate the product cost for each of the four tests in accordance with: The existing one-pool costing system (3 marks) The two-pool costing system proposed by Nina Kastelic, the accountant (4 marks) The three-pool costing system proposed by Micheal Postman, the consultant (4 marks) 2. Consider DDM Lab's recent investment in 3D MRI equipment. While it allows DDM Lab to stay at the forefront of technological developments, it is currently underutilised. Make additional analyses to understand how the costs per test change in relation to a 100% utilisation of the MRI scanner. (4 marks)