Refer to Lakeside Memorial Hospital Cost Allocation Concepts in the Assignment area of the course and develop and justify a new, indirect cost allocation scheme for outpatient services of Lakeside Memorial Hospital. Summarize your results in the "Alternative Allocation" columns of Table 3.2, and be prepared to justify your recommendations (in the form of an executive summary) at the next department head's meeting. The above-mentioned executive summary AND Any attachments as needed (i.e., Excel tables) is required.

LAKESIDE M EIMORIAL HOSPITAL C O S T ALLOCATION CONCEPTS L AKESIDE E M O R I A L M HOSPITAL a 250-bed, not-for-profit, acute is care hospital located in Milwaukee, Wisconsin. T h e bulk of the hospital's facilities are devoted to inpatient care. However, a ioo,ooo square foot section of the main 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 Lakeside. The remaining 20 percent is used by the Dialysis Center. The Dialysis Center performs hemodialysis and peritoneal dialysis, which are alternative processes that remove wastes and excess water from the blood for patients with end-stage renal (kidney) disease. In hemodialysis, blood is pumped from the patient's arm through a shunt into a dialysis machine, which uses a cleansing solution and 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 iinserted directly into the abdominal cavity through a catheter. The body naturally cleanses the blood through the peritoneum-a thin membrane that lines the abdominal cavity. In general, hemodialysis patients require three dialyses a week, with each treatment lasting about four Ihours. Patients who use peritoneal dialysis change their own cleansing :solutions at home, typically four times a day. However, the patient's overall condition, as well as the positioning of the catheter, must be monitored regularly at the Dialysis Center. Lakeside's new cost accounting system, which was installed two years ago, allocates facilities costs, which at Lakeside consist of depreciation, 26 C ases in Healthcare Finance interest, and overhead lease expense, 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 x $15 = $300,000 for the Dialysis Cenf ter and 80,ooo x $15 = $i72oo,oc)o or the Outpatient Clinic. All other overhead costs, s uch as administration, finance, maintenance, and housekeeping, are lumped together and called "general overhead." These costs are allocated on the basis of l o percent of each patient service department revenues. The current allocation of general overhead is $27o,ooo for the Dialysis Center and $i76oo,ooofor the Outpatient Clinic, which result in a total overhead allocation of $ 5~o,oooor f the Dialysis Center and $2,8oo,ooo for the Outpatient Clinic. Recent growth in utilization,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 complex, the decision was made to keep the Outpatient Clinic in its current location and to move thle Dialysis Center to free up space. Such a move would give the Outpatient Clinic ioo,ooo square feet, for a 25 percent increase. After attempting to find space for the Dialysis Center in the main complex, it was soon determinled that a new 20,000 square foot building must be built. This building would be situated two blocks from the main complex, in a location that would be much more convenient for both workers and dialysis patients. The 20,000 square feet of space allows for increased patient volume, although it is unclear whether or not the move will generate additional patient usage. Building cost is estimated at $120 per square foot, for a total cost of $ ~,400,000. dditionally, furniture and other fittings, along with reloA cation of equipment, files, and other items, would cost $i76oo,ooo,for a total cost of $4 million. This $4 million would be financed by a 7.75 percent, to-year loan. When both the ~ r i n c i ~ a mount and interest al are amortized over 20 years, the end result is an annual cost of financing of $4oo,ooo. Table 3.1 contains the projected profit and loss ( P &L) statement for the Dialysis Center before adjusting for the move. Lakeside's department heads receive annual bonuses on the basis of each department's contribution to the hospital's bottom line (profit). In the past, only direct costs were considered, biut Lakeside's C E O has decided that bonuses would now be based on full (total) costs. Obviously, the new Lukeside Memorial Hospital: Cost Allocation Concepts 27 Revenues Hernodialysis program Peritoneal dialysis program Medical (pharmacy) supplies Total revenues $ 1,300,000 TABLE 3.1 Dialysis Center: 600,000 Pro Forma P&L 800,000 Statement Assuming Status Quo $2,700.000 Direct Expenses Salaries and benefits Pharmacy purchases Other medical/administrative supplies Utilities Lease expense Other expenses Total expenses Net gain (loss) before indirect costs Indirect Expenses Facilities costs General overhead Total overhead costs Net profit Notes: (1) Revenues from hemodialysis are based on the Medicare rate of $110 per treatment. (2) Revenues from peritoneal dialysis are based on the Medicare rate of $47 per treatment. approach to awarding bonuses, coupled with the potential for increases in indirect cost allocation, is of great concern to Jan'Morris, t he director of the Dialysis Center. Under the c urrent (Table 3.1) allocation of indirect costs, Jan 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 her "out of the money." At the next department heads7meeting, Jan voiced her concern about the impact of any allocation changes on the Dialysis Center's profitability, so Lakeside7sC E O asked the C FO,Brian Stanton, to look into 28 C ases in Healthcare Finance the matter. In essence, the C E O said that the final allocation is up to Brian, 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, Brian createdl Table 3.2. The new Dialysis Center would have the same number of stations as the old, the same patients would be served, and the reirrtbursement rates would remain unchanged. 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 Table 3.2 data for the expanded Outpatient Clinic are based on the assumption that the expansion would allow utilization to increase by 25 percent, and that both revenues and direct costs would increase by a like amount. Furthermore, to keep the problem as simple as possible, the assumption was made that the overall hospital allocation rates for facilities costs and general overhead would not materially change because of the expansion. Brian knew that his "trial balloon" allocation, which is shown in Table 3.2 in the columns labeled '"InitialAllocation," 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 of the space occupied. In his initial allocation, Brian used actual costs as the basis for the allocation to the Dialysis Center. Needless to say, Jan's response to the initial allocation was less than enthusiastic. Specifically, she raised these points: Is it fair for the Dialysis Center to suffer (in profitability) from the move even though it had nothing to do with it? (2) Should the Dialysis Center be charged actual facilities costs for its new location? After all, the move was forced by the Outpatient Clinic, which is being charged for facilities at the lower average allocation rate. Under the concept of charging for actual marginal facilities costs, departments might be better off by (1) W ith Expansion P&L Statements: Without Expansion Initial Allocation Alternative Allocation RevenuesDirect Costs Total revenues Direct expenses Contribution margin Percent of revenues Indirect Costs Facilities costs General overhead Total overhead Net profit Percent of revenues Faciiities Cost A iiocationi Square footage Facilities costs per square fooJt $ 15.00 $ 15.00 $ 20.00 $ 15.00 $ $ O ther Overhead Allocation: General overhead costs as a % of revenue 10.0% Note: The term "contribution margin" as used here means the amount available to cover overhead costs as opposed t o the more traditional meaning of the amount available to cover fixed costs. g. 3 30 C ases in Healthcare Finance resisting proposed moves to new (and potentially more efficient) facilities. (3) Even if the marginal allocation concept were used, is the $4007000annual allocation correct? After all, the building has a useful life that is probably significantly longer than t o years -t he life of the loan used to finance the move. (4) It appears that the revenue that the Dialysis Center "receives" from patient use of the pharmacy is passed on dire;tly to the pharmacy. Should this "revenue7'be counted when general overhead allocations are made? But before Brian was able to respond to Jan7s concerns, he suddenly left Lakeside to be the C E o of a competing investor-owned hospital. The task of completing the allocation study was given to you, Lakeside's current administrative resident. You remember that to be of most benefit to the organization, cost allocation 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 ar'bitrary. Perhaps the best approach to overhead allocations is what might be called the "Marxist approach," by which allocations are based on each patient service department's ability to cover overhead costs. But, this approach has its disadvantages, too. Considering all the relevant issues, you must develop and justify a new indirect cost allocation scheme for outpatient services. Summarize your results in the "Alternative Allocation" columns of Table 3.2, and be prepared to justify your recommendations at the next department head's meeting