EAGAN FAMILY PRACTICE is a medical practice with four locations in the Minneapolis/St. Paul area. The clinical staff consists of 20 physiciansall of whom practice in one or more areas of family medicineand 46 advanced practice providers and nurses. Eagan is organized into three patient services departments: Adult Medicine, Obstetrics, and Pediatrics. Supporting these patient service departments are three support departments: Administration, Facilities, and Finance. Exhibit 7.1 shows Eagan's summary revenue and cost projections by department for the coming year.

As part of a much-needed overhaul of the cost allocation process, Eagan contracted with a major accounting firm to estimate the amount of services provided by the support departments to each other and to each patient service department. The intent of the study was to provide data that would help Eagan develop a better cost allocation system to replace the outdated, arbitrary system currently in use. The results of this study are shown in exhibit 7.2. Although expressed as percentages of the total dollar amount of support provided to other departments (instead of the more typical cost allocation rates), the data in exhibit 7.2 are based on an extensive study using sound managerial accounting techniques. Thus, both senior management and department heads at Eagan are comfortable with the resulting allocation percentages. (Hint: To ensure that you apply the percentages properly in your analysis, pay attention to Note 2 at the bottom of exhibit 7.2.)

The second step in the cost allocation process improvement initiative is to choose the allocation method. Four allocation methods are under consideration: direct, step-down, double apportionment, and reciprocal. Jerry Silverman, Eagan's chief financial officer, has asked Ashley Matson, the administrative resident at Eagan, to conduct a study and make a recommendation on the best allocation method. This task can be approached in several ways, but Ashley has decided to examine by doing. She plans to use the data in exhibits 7.1 and 7.2 to determine the overhead cost allocations under each allocation method. Afterward, she can compare and contrast the results.

Of course, the final decision cannot be made without considering the costs involved in implementing each allocation method. When Ashley asked Jerry about the costs inherent in each allocation method, Jerry said, I don't know! Assume that the direct method is the least costly, the reciprocal method is the most costly, and the other two fall somewhere in between. He also expects Ashley to make some judgments on the relative profitability of the patient services departments under the recommended allocation system.

Ashley began her analysis by reviewing the allocation methods presented in her old healthcare finance textbook. She had no problem remembering basic cost allocation concepts, but she did hit two snags. The first problem was that the textbook did not describe the double apportionment method. However, after a little research, Ashley discovered that the double apportionment method is a slightly more complicated version of the step-down method. In the first apportionment, support provided by each service department to the other service departments as well as to the patient services departments is recognized. Because some costs remain in the support departments after the first apportionment, a second apportionment, which applies the step-down method, moves all remaining support department costs to the patient services departments. Thus, in the double apportionment method, service department support to all other service departments is recognized, whereas in the pure step-down method, service department support is recognized only to downstream service departments.

Here's how Ashley assumed that the double apportionment method would be applied to Eagan. (There are alternative ways in which this allocation method can be applied.) First, direct Administration costs would be allocated to the other five departments (two support and three patient services). Second, direct Facilities costs would be allocated to all other departments (including Administration and Finance). Third, direct Finance costs would be allocated to all other departments (including Administration and Facilities). After these three allocations are completed, the first apportionment is finished. Some costs remain in the support departmentsthe intrasupport department allocations from the first apportionmentso a second apportionment is necessary. The second apportionment is conducted using the step-down method as it is normally applied, except that the application of the first apportionment means that the starting cost pool values are much lower.

The second problem Ashley faced was that she did not know how to perform the reciprocal allocation. One method is to use simultaneous equationsbut higher mathematics has never been Ashley's strong suitand another method uses an iterative approach. Fortunately, Ashley had recently read an article in Accounting Monthly discussing an Excel model that uses the iterative approach to perform reciprocal allocation. To help with the analysis, Ashley modified the magazine's model by using Eagan's numbers to calculate the allocation not only for the reciprocal method but also for the other three methods.

Put yourself in Ashley's shoes. Complete her assigned task and prepare a report to present to Eagan's executive committee. In addition, assess the sensitivity of the results to (1) the relative sizes of the direct costs at each support department and (2) the amount of support provided by the support departments to each other. Exhibit 7.3 contains the values that you may use in your sensitivity analysis.

Questions

1. What are the allocations to each patient services department, and resulting profitability, under the four allocation methods using the base case cost estimates (Exhibit 7.1) and allocation rates (Exhibit 7.2).

2. Now consider the sensitivity of the results to changes in the values of the overhead cost pools. Repeat question two, but now use the overhead cost pool amounts from the first section of Exhibit 7.3 along with the base case allocation percentages contained in Exhibit 7.2. (Note that there are two different overhead cost pool amounts [calculation 1 and calculation 2].)

3. Now consider the sensitivity of the results to changes in the allocation percentages. Repeat question two, but now use the percentages from Exhibit 7.3 along with the base case overhead cost pool amounts given in Exhibit 7.1.

4. Assess the sensitivity of patient services department profitability to: a. The allocation method. b. The relative sizes of the overhead cost pools. c. The allocation rates.

5. What does the analysis indicate about the true (but not really observable) profitability of each of the patient services departments?

EXHIBIT 7.1 Eagan Family Practice: Departmental Revenue and Cost Projections Revenues Adult Medicine Obstetrics Pediatrics Total revenues $12,000,000 6,000,000 2,000,000 $20,000,000 $ 6,000,000 3,600,000 1,200,000 $10,800,000 Direct Costs Patient Services Adult Medicine Obstetrics Pediatrics Subtotal Support Administration Facilities Finance Subtotal Total expenses $ 1,000,000 4,400,000 1,800,000 $ 7,200,000 $18,000,000 Pretax profit $ 2,000,000 Percentage of Services Provided by EXHIBIT 7.2 Eagan Family Practice: Allocation Percentages Services Provided to Administration Facilities Finance 5% 5% Administration Facilities Finance 5 10% 10 10 Adult Medicine Obstetrics Pediatrics 35 20 55 10 20 50 25 25 15 Total 100% 100% 100% Percentage to support departments 20% 15% 10% Percentage to patient service departments 80% 85% 90% Notes: 1. The allocation percentages are based on a two-year analysis of the actual services provided by the support departments to other departments. 2. To use the percentages to perform an allocation, they may have to be adjusted to ensure that the entire amount of the cost pool is allocated. To illustrate, in the direct method, all of Administration's costs ($500,000) have to be allocated directly in a single allocation to the three patient service departments. If the raw percentages were used, only 35% + 20% + 25% = 80% of the cost pool would be allocated, so the allocation percentages have to be adjusted so that 80 percent represents the entire allocation (100 percent). Thus, instead of a 35 percent allocation to Adult Medicine, its adjusted allocation is 35%/80% = 43.75%. In a similar manner, the adjusted allocation to Obstetrics is 20%/80% = 25%, while the adjusted allocation to Pediatrics is 25%/80% = 31.25%. When done correctly, the adjusted percentages must sum to 100%: 43.75% + 25% + 31.25% 100% Sensitivity to Changes in Relative Overhead Costs: EXHIBIT 7.3 Eagan Family Practice: Sensitivity Analysis Values New Direct Expenses for Calculation 1 Administration Facilities Finance Total overhead expenses $4,400,000 1,000,000 1,800,000 $ 7,200,000 New Direct Expenses for Calculation 2 Administration Facilities Finance Total overhead expenses $1,000,000 1,800,000 4,400,000 $7,200,000 Sensitivity to Allocation Percentages: Percentage of Services Provided by Services Provided to Administration Facilities Finance 25% Administration Facilities Finance 20% 20 30% 30 25 32 33 Adult Medicine Obstetrics Pediatrics 18 10 12 6 17 12 10 Total 100% 100% 100% Percentage to support departments 60% 50% 40% Percentage to patient service departments 40% 50% 60% EXHIBIT 7.1 Eagan Family Practice: Departmental Revenue and Cost Projections Revenues Adult Medicine Obstetrics Pediatrics Total revenues $12,000,000 6,000,000 2,000,000 $20,000,000 $ 6,000,000 3,600,000 1,200,000 $10,800,000 Direct Costs Patient Services Adult Medicine Obstetrics Pediatrics Subtotal Support Administration Facilities Finance Subtotal Total expenses $ 1,000,000 4,400,000 1,800,000 $ 7,200,000 $18,000,000 Pretax profit $ 2,000,000 Percentage of Services Provided by EXHIBIT 7.2 Eagan Family Practice: Allocation Percentages Services Provided to Administration Facilities Finance 5% 5% Administration Facilities Finance 5 10% 10 10 Adult Medicine Obstetrics Pediatrics 35 20 55 10 20 50 25 25 15 Total 100% 100% 100% Percentage to support departments 20% 15% 10% Percentage to patient service departments 80% 85% 90% Notes: 1. The allocation percentages are based on a two-year analysis of the actual services provided by the support departments to other departments. 2. To use the percentages to perform an allocation, they may have to be adjusted to ensure that the entire amount of the cost pool is allocated. To illustrate, in the direct method, all of Administration's costs ($500,000) have to be allocated directly in a single allocation to the three patient service departments. If the raw percentages were used, only 35% + 20% + 25% = 80% of the cost pool would be allocated, so the allocation percentages have to be adjusted so that 80 percent represents the entire allocation (100 percent). Thus, instead of a 35 percent allocation to Adult Medicine, its adjusted allocation is 35%/80% = 43.75%. In a similar manner, the adjusted allocation to Obstetrics is 20%/80% = 25%, while the adjusted allocation to Pediatrics is 25%/80% = 31.25%. When done correctly, the adjusted percentages must sum to 100%: 43.75% + 25% + 31.25% 100% Sensitivity to Changes in Relative Overhead Costs: EXHIBIT 7.3 Eagan Family Practice: Sensitivity Analysis Values New Direct Expenses for Calculation 1 Administration Facilities Finance Total overhead expenses $4,400,000 1,000,000 1,800,000 $ 7,200,000 New Direct Expenses for Calculation 2 Administration Facilities Finance Total overhead expenses $1,000,000 1,800,000 4,400,000 $7,200,000 Sensitivity to Allocation Percentages: Percentage of Services Provided by Services Provided to Administration Facilities Finance 25% Administration Facilities Finance 20% 20 30% 30 25 32 33 Adult Medicine Obstetrics Pediatrics 18 10 12 6 17 12 10 Total 100% 100% 100% Percentage to support departments 60% 50% 40% Percentage to patient service departments 40% 50% 60%