On Monday morning in June 2021, CEO of DDM Labs Ivan Novak just adjourned the management board meeting at DDM Labs. The motivation of the management team was somewhat down. The profit generated in 2020 plummeted compared to a year ago, and the discussion about the plans for the following year was quite tense. Marta Lazzarini, the Sales Manager, was seriously concerned about the demand for DDM's services. The major client requires that the company decrease its sales prices in 2021, or it would take its orders elsewhere. This would hurt. There was, namely, plenty of low-cost competitors ready to jump in. Lazzarini's team had tried hard to sustain their clients' satisfaction. Still, she was no longer convinced that the quality of the relationship would be decisive to retain them if prices were to stay at these levels or increase again this year. Something needed to be done to contain costs of production and quickly. Mark Watson, Operations Manager, reacted quite defensively to Lazzarini's statement. In his view, their processes were as lean as they could be, their technology was better than it had ever been, and in the last year, his team implemented many efficiency improvements. He doubted that the cause of the increased costs were operations. According to Watson, his department had been allocated many costs that were not under their control, and he questioned the appropriateness of the cost allocations built in the costing system. CFO Lara Pietch ensured Watson that costs were accounted for correctly. Pietch suggested that a cause of high costs was a recent purchase of a new, expensive, state-of-the-art 3D MRI machine, which Watson has justified as being a source of competitive advantage. However, because the machine is only little utilised, she questioned whether it had been a wise investment since it had failed to generate sufficient returns to cover its expenses.

DDM Lab's Services and Clients

DDM Labs operates as an independent medical imaging centre. It offers a wide variety of medical imaging services to its clients, including radiographs (commonly known as x-rays), fluoroscopies, computerised axial tomography (CAT), and magnetic resonance imaging (MRI) scans. These tests differ vastly in function and cost.

X-rays are the most common form of medical imaging. They are used to examine bones and are only short in duration usually seconds. Despite developments in imaging, x-rays remain popular due to their low cost, low-time requirement, and a high degree of accuracy. The second type of service DDM Labs offers is fluoroscopies, which are inexpensive and employ x-rays at a lower radiation rate. Fluoroscopies allow physicians to see both the internal structure and functions of a patient. DDM Labs also provides more advanced medical imaging procedures such as CAT scans and MRIs. Both produce cross-sectional images of the body and are used to examine soft tissue. CAT scans are typically most appropriate for diagnosing chest problems, as well as detecting cancer. MRI scans are used to diagnose ligament and tendon injuries, spinal cord injuries, and brain tumours. In contrast to CAT scans, MRIs do not expose the patient to any radiation.

DDM Lab is closely affiliated with the University Hospital, a large regional teaching hospital. DDM Lab is its primary provider of medical imaging services. However, the University Hospital can also refer its patients to other labs if, in peak periods, DDM Lab lacks availability or if other providers offer lower prices. As a result of this cooperation, in 2020, DDM Lab had provided about 90% of the University Hospital total imaging needs, with the rest performed by DDM Lab's competitors.

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Because it cooperates with this reputable University hospital, DDM Lab tries to stay at the forefront of imaging technology developments. That is why Lazzarini and Watson had obtained Novak's approval to purchase a new 3D MRI machine. They suggested that it would secure DDM Lab a significant strategic advantage over its competitors. In addition to producing images in three dimensions, a 3D MRI scanner utilises computer analytics to analyse whether tumours absorb chemotherapy. It can also distinguish between live and dead tumour cells, which is highly effective in assessing cancer treatments. However, physicians seem to be less familiar with the new technology and request 3D MRI scans only for very complex cancer diagnoses. Consequently, at DDM Lab, the MRI scanner is currently only used for about 10% of its capacity. Lazzarini believes that the demand for 3D MRI scans will soar in the near future and that the investment will soon start to pay off.

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:

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"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).

After consulting both Kastelic's and Postman's suggestions, CEO Novak is not convinced that either solution would solve the issue. His management team needs to have greater clarity on how imaging services costs are calculated to optimise the utilisation of the equipment and price their services appropriately. Both proposals for overhead allocations lead to results differing widely from the current costing system. Since DMM Lab bases prices on full costs of the tests provided, the importance of adequately allocating overhead cannot be understated.

"We cannot change our prices drastically without being sure that these new calculations are accurate. They have serious implications for the future profitability of our organisation."

Moreover, Novak is aware that any costing system would successfully support future strategic decisions as long as it generated significant buy-in by the management team. Watson and Lazzarini look particularly puzzled. 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? Watson turns to Pietch for clarification:

"I might be biased by my engineering education, but in my understanding, the cost of a product or a service should simply reflect the cost of the resources used to produce it. I am always perplexed 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 process for our outsourced equipment maintenance services, for that matter."

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 system that so strongly impacts various business decisions. All they want is to realign the effort of the entire management team toward a common strategic goal.

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Exhibit 1: DDM Lab 2020 Financial Results

Revenues Direct Labour Overhead Total Expenses Profit

4,576,023.4 1,788,242.3 2,775,399.2 4,563,641.5

12,381.9

Exhibit 2: Calculation of the cost rate at DDM Lab

Overhead Direct Labour Cost rate

2,775,399.20 1,788,242.30 1.55

Exhibit 3: DDM Lab Direct Labour Cost Breakdown by Test

Test Projectional Radiographs Flouroscopies CAT Scan MRI Scan

Direct labour $ 542,194.9 538,261.1 352,105.0 355,681.3 1,788,242.3

Exhibit 4: Additional information required for cost system proposed by accountant

Type of Overhead Cost Direct Labour Related Overhead Equipment Related Overhad Total overhead

Utilization of equipment Projectional Radiographs Flouroscopies CAT Scan

MRI Scan

Cost 1,009,948.8 1,765,450.4 2,775,399.2

Run time/year (hours) 1,431.00

1,771.20 1,881.90 3,395.25 8,479.35

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Exhibit 5: Additional information required for cost system proposed by consultant

Type of overhead cost High tech Low tech

Cost 1,290,510.2 474,940.2 1,765,450.4

Utilization of high- and low-tech equipment by test in hours per year

Test High-tech Projectional Radiographs 361.80 Flouroscopies 781.65 CAT Scan 1,105.65 MRI Scan 3,395.25

5,644.35

Low-tech 1,069.20 989.55 776.25 0.00 2,835.00

THE END OF CASE STUDY

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REQUIREMENTS

Your case study write-up should include the first five sections listed below:

1. Background (1 mark)

In this section you are to provide a brief overview of the important background information relating to the company. This information presented in the Background section should be relevant to your discussion of the company's problem and issues that you are to identify in Section 2. Ideally, you should briefly describe the company's core business, services, pricing and the current costing system.

Address the appropriate background information* in relation to the entity's

- Business and services

- Costing systems

- Pricing

- Other significant aspects if any *no repetition of large volumes of case material

2. Problem & Issues (3 marks)

In this section you are to identify and briefly discuss: a. The problem the company is facing at the time of the case, (1 mark) b. The issues that may have led to the problem the company is facing, (1 mark) c. The rationale that links the problem and issues you have identified - explain how the issues you have identified lead to the company's problem? (1 marks)

Note: A problem is something that the organization must overcome to be sustainable/profitable and is reasonably well understood. An issue is more specific to the company's situation and has led to the problem. It also requires attention but needs to be investigated and better understood (which you will attempt to do in Sections 3 & 4) before specific solutions are considered.

3. Theoretical Analysis (3 marks)

This section requires your analysis of the qualitative aspect of the underlying cause(s) of the problems and issues that you have identified in Section 2. Your analysis should be supported by the relevant theory and concepts covered in ACCT2102. Identify at least three advantages that are associated with multiple pools costing system over the standard costing system.

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:

Calculatetheproductcostforeachofthefourtestsinaccordancewith:

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)

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)