Using ABC in service business

A dialysis clinic provides two types of treatment for its patients. Hemodialysis (HD), an in-house treatment, requires that patients visit the clinic three times each week for dialysis treatments. Peritoneal dialysis (PD) permits patients to self-administer their treatments at home on a daily basis. On average, the clinic serves 102 HD patients and 62 PD patients. A recent development caused clinic administrators to develop a keen interest in cost measurement for the two separate services. Managed care plans such as HMOs began to pay treatment providers a fixed payment per insured participant regardless of the level of services provided by the clinic. With fixed fee revenues, the clinic was forced to control costs to ensure profitability. As a result, knowing the cost to provide HD versus PD services was critically important for the clinic. It needed accurate cost measurements to answer the following questions. Were both services profitable, or was one service carrying the burden of the other service? Should advertising be directed toward acquiring HD or PD patients? Should the clinic eliminate HMO service?

Management suspected the existing cost allocation system was inaccurate in measuring the true cost of providing the respective services; it had been developed in response to Medicare reporting requirements. It allocated costs between HD and PD based on the ratio of cost to charges (RCC). In other words, RCC allocates indirect costs in proportion to revenues. To illustrate, consider the allocation of $883,280 of indirect nursing services costs, which are allocated to the two treatment groups in relation to the revenue generated by each group. Given that the clinic generated total revenue of $3,006,775, an allocation rate of 0.2937633 per revenue dollar was established ($883,280 $3,006,775). This rate was multiplied by the proportionate share of revenue generated by each service category to produce the following allocation.

Type of Service Service Revenue X Allocation Rate = Allocated Rate

HD 1,860,287.00 X 0.2937633 = 546,484

PD 1,146,488.00 X 0.2937633 = 336,796

TOTAL 3,006,775.00 X 0.2937633 = 883,280

To better assess the cost of providing each type of services, the clinic initiated an activity-base costing (ABC) system. The ABC approach divided the nursing services cost into four separate cost pools. A separate cost driver (allocation base) was identified for each cost pool. The cost pools and their respective cost drivers follow.

Nursing services cost pool categories Total HD PD

RNs 239,120.00 ? ?

LPNs 404,064.00 ? ? Nursing administration and support staff 115,168.00 ? ? Dialysis machine operations (tech. salaries) 124,928.00 ? ?

Total 883,280.00 ? ?

Activity cost drivers (corresponding to cost pools) Total HD PD

Number of RNs 7 5 2

Number of LPNs 19 15 4

Number of treatments (Nursing administration) 34,967 14,343 20,624

Number of dialyzer treatments (machine operations) 14,343 14,343 -

Required:

A.

1.Allocate the RN cost pool between the HD and PD service centers

2.Allocate the LPN cost pool between the HD and PD service centers

3.Allocate the nursing administration and support staff cost pool between the HD and PD service centers

4.Allocate the dialysis machine operations cost pool between the HD and PD service centers.

5.What is the total allocated cost?

B.Answer the following questions:

1.Assuming that ABC system provides a more accurate measure of cost, which service center (HD or PD) is overcosted by the traditional allocation system and which is undercosted?

2.What is the potential impact on pricing and profitability for both service centers?

3.How could management respond to the conditions described in the problem?