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QUESTION: If the true cost concept is applied, what would be the allocation in the 21st year, after the mortgage had been paid off?

Big Bend Medical Center is a full-service, not-for-profit acute care hospital with 325 beds. The bulk of the hospitals 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 primary uses. About 80 percent of the space is used by the Outpatient Clinic, which handles all routine outpatient services offered by the hospital. The remaining 20 percent is used by the Dialysis Center. The Dialysis Center performs hemodialysis and peritoneal dialysis, which are alternative processes for removing 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 shunt into a dialysis machine, which uses a cleansing solution and an artificial membrane to perform the functions 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 peritoneuma thin membrane that lines the abdominal cavity. Typically, hemodialysis patients require three dialyses a week, with each treatment lasting about four hours. Patients who use peritoneal dialysis change their own cleansing solutions at home, usually about six times per day. This procedure can be done manually when active or automatically by machine when sleeping. However, the patients overall condition, as well as the positioning of the catheter, must be monitored regularly at the Dialysis Center. Big Bends cost accounting system, which was installed two years ago, allocates facilities costs (which at Big Bend essentially consist 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 $15 = $300,000 for the Dialysis Center and 80,000 $15 = $1,200,000 for the Outpatient Clinic. All other overhead costs, such as administration, finance, maintenance, and housekeeping, are lumped together and called general overhead. These costs are allocated on the basis of 10 percent 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 percent more space than currently assigned. Because the Outpatient Clinic is much larger than the Dialysis Center, and because its patients need frequent access to other departments within the hospital, 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. Such a move would boost the Outpatient Clinic space to 100,000 square feet, a 25 percent increase. After attempting to find new space for the Dialysis Center within the hospital complex, it was soon determined that a new 20,000 square foot building must be built. This building will be situated three blocks away from the hospital complex, in a location that is much more convenient for dialysis patients (and Center employees) because of ease of parking. The 20,000 square feet of space, which can be more efficiently utilized than the old space, allows for a substantial increase in patient volume, although it is unclear whether the move will result in additional dialysis patients. Construction cost of the new building is estimated at $120 per squarae foot, for a total cost of $2,4000,000. Additionally, the purchase of land, furniture and other fittings, along with relocation of current 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. With both the principal amount (which can be considered depreciation) and interest are amortized over 20 years, the end result is an annual cost of financing of $4,000,000. 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 hospital complex. Table 1 contains the projected profit and loss (P&L) statement for the Dialysis Center before adjusting for the move. The hospitals department heads receive annual bonuses on the basis of each departments contribution to the bottom line (profit). In the past, only direct costs were considered, but the hospitals 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, 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 expressed his concern about the impact of any allocation changes on the Dialysis Centers profitability, so the hospitals CEO asked the chief financial officer (CFO), Rick Simmons, to look into the matter. In essence, 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 Table 2 (see Excel spreadsheet). In creating the table, 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 have the same reimbursement rates. Also, direct operating expenses would differ only slightly from the current situation 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 Table 2 for the expanded Outpatient Clinic are based on the assumption that the expansion would allow volume to increase by 25 percent and that both revenues and direct costs would increase by a like amount. Furthermore, to keep the analysis manageable, the assumption was made that the overall hospital allocation rates for both facilities costs and general overhead would not materially change because of the expansion. Rick knew that his trial balloon allocation, which is shown in Table 2 in the columns labeled Initial Allocation, would create some controversy. In the past, facilities costs were aggregated; 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 fifth floor executive suite. Because many department heads thought this approach to be unfair, Rick wanted to begin allocating facilities overhead on a true cost basis. Thus, in his initial allocation, Rick used actual facilities costs ($400,000 per year) as the basis for the allocation to the Dialysis Center. Needless to say, Johns response to the initial allocation was less than enthusiastic. Specifically, he was concerned over several issues. **First, is it fair for the Dialysis center to suffer (in terms of profitability) because it will be charged actual facilities costs for its new location? After all, the Outpatient Clinic forced the move, which is being charged for facilities at the lower average allocation rate. Under the concept of charging for actual facilities costs department heads might be better off by resisting proposed moves to new (and potentially more efficient) facilities because such moves would result in increased facilities allocations. **Also, even if the actual cost concept were 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? Finally, it appears that the revenue the Dialysis Center receives from patient use of 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 this 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 the facility to be the CFO of a competing investor-owned hospital. The task of completing the allocation study was given to you. You remember that to be of most benefit to the organization, cost allocations should 1- be perceived as fair by the parties involved and 2-Promote overall cost savings within the organization. However, you also realize that, in practice, cost allocation is very complex and somewhat arbitrary. Some department heads argue that the best approach to overhead allocations is the Marxist approach. By which allocations are based on each patient service departments ability to cover overhead costs. Considering all the relevant issues, you must develop and justify a new indirect cost allocation scheme for outpatient services. **Summarize the results in the Alternative Allocation columns in table 2. Complete the blank lines (show equation) and be prepared to justify your recommendations at the next department heads meeting.