What are direct and indirect cost in your own organization ( Human Services/ Autism)?

Overview: Direct and Indirect Costs Departments serving patients in large healthcare organizations require support from multiple departments that do not generate revenue to complete their work. The support services include housekeeping, maintenance, billing and payroll services, human resources, accounting and finance, administration, and so on. The cost of non-revenue-generating departments must be recouped in revenue-producing departments to ensure that an organization's total revenues exceed its total expenses (i.e, the charges for services must cover the department's cost plus the costs of support services). Direct costs can be specifically associated with a particular patient, work group, or department. The critical distinction for a manager is that the cost is under their control (i.e., they can increase or decrease the level of the expenditure). Whatever the manager is responsible for-that is, patient, work group, or department-is known as a cost object. The somewhat vague definition of a cost object is any unit for which a separate cost measurement is desired. It might help the manager to think of a cost object as a cost objective instead. 1 The important thing is that direct costs can be traced to a cost object. Indirect costs, on the other hand, cannot be specifically associated with a particular cost object. The cost to run the accounting and finance services is an example of indirect cost. Accounting and finance services are essential to the overall organization itself, but their cost is not specifically or directly associated with providing healthcare services, Indirect costs usually cannot be traced to the work performed by the patient-serving departments but are allocated or apportioned to revenue-producing departments. 2 Figure 7.1 illustrates the direct-indirect cost distinction. by increasmg wolume or revenue of redacing covets. and bo evaluatied on the profit carned Jonesb report for modiology kervices is at the bottom tight of Figure 7.3 Het report shown the controllable expenses the is respondible for ter. Therefore, fones is tioponsible fot enpecines Io rectuce stue cost foer X-ray are incurnd for the sale benchi of a parcutar patarat or departmen. As a nile of thumb of the answer to she following question is "Wo" the cots crast be incurred? Whira a departanent can be eliminued or a parient er froop of pacients do roc rect cost For example. claminatiog the emengency department would arno ont us expenses. but the cost of turining accountang, and finanor exvices. would remann the sime. Indirect coves are incurres for the overall oret mation and rot for arry one puncht of depanenent. because they are starcd, ind inct costs ase somedinch called foint or comamon costs As a nule of thutnb. Af the answer to the follonang quesnom is Yes. Whe cost onder to be assigncd so a rrvenue-prodscong department soch as ntarsing or ancallary units? Allocating Indirect Costs It is important for maminers to recogaise dirbet and Two sets of excimples illustrate the reporting of dincet and indirect costs. The first example concerns ratale 7x = ine Pernod costs, in the onsinal munulacturang. isterpretation, are not contrected with the mana. facturing process. They are masched wh h rewentie on the basis of when the cost is incurred (thus penod coses). The tertu comes frotn the span of time in which matching occurs, known as time period Service organizations have no manufacturing process as such. The business of healtheare service anganizations is service delivery, not the manufacturing of products Although the overall concept of prodact versus period cost is not as vital to service delivery, the distinction remains important for healthcare managers to know. In bealtheare organizations, product cost can be viewed as traceable to the cost object of the department, dhision, or unis. A period cant is not traceable in this manner. Another way to wese this distinction is to think of prodoct cosas as thove costs nectevary to actually delivet the service. Whereas period costs ate costs necervary to stipport the existence of the organitation hsel. Finally, modical supply and pharmacy departments do have inventones on hand in their case, a product is purchased (rather than manufictured) and placed ino irventory white watting to be dispensed. When that product is dispensed; the product is matched with revenue and recognized as a cost of providing the service to the patient. Therefore, the product cost concept is importan to managers of departments thas bold a stgrifican amount of inventory: Summary This chapter examined direct and indirect costs Direct costs are those that are under the control of a manager, and indirect costs are incurred in other areas and are allocated to revenue-producing departments. The distinction between direct and indirect costs is imponant as indirect costs reduce the reported profitability of revenue-producing departments and are often beyond the control of their managers (i.e, their decisions and actions have no influence on the expenses allocated to their departments). Managers of cost and expense centers should be evaluated on their ability to keep their expenses low as they cannot control patient volume or revenue. Managers of profit centers should be evphated on their abslity to serve patients (volume), the prices and services offered (revenue), and maintenance of low expenses (te, they should be axsessed on protiz earned in their arsa). Managers of investment centers ate responsible for an entre openation, so in addition to controlling volume, revenue. and expenses, they should also be assessed on where investments are made. Investment center managers should be assessed on whether their organization makes comparable profits to similar organizations. Chapter 8 explores fixed and variable costs (i.e, whether a cost changes with output) to recognize how much control a manager has over their direct costs. of these costs, 100%16,7%,560,000 for administration and $40,000 for facility costs. The total allocated itudirect cost must equal the total cost in the support departments, and the revenues generated by the patient service departments must cover their ditect and andirect costs for the organization to survive. Table 7.3 represents a report with the direct and allocated indirect costs for the rehabilitation cost center The report is divided into three types of therapy. physical, occupational, and speech therapy, with the total allocated indirect cost for thice support departments, administration, accounting and finance, and information tectunology, whose costs are allocated on different bases. In this report. the manager can observe the diflerences between direct and indirect costs and the differences. among the three types of therapies Markup indicates how much prices mus. be increased over direct expenses to cover the allocated costs. The allocation of indirect costs is provided in Table 7.4. Note that the Allocated Indirect Cods" in column 5 of Table 74 are the same as the Nllocated inditect Costs" in columin 3 of Table 7.3. Thas, Table 74 is a subsidiary report showng, the allocation of indrect costs in the mam repott. The use of one of mote sup porting teports to teveal derails behind the main repott is quine cotumon in managertal reports The allocation of indurect cosis subsidiary report details how indirect costs were distributed to the three tevenue generating therapy deparuments Table 7.4 shows the expenses, sdministrative. services, accounting and finance, and informamon technolory included in the 5185,000 indirect cost total. It also shows how each of these expenses was allocated to the physical, occupational, and speech therapy departments Adminisurative setvice expense was allocated bused on the number of patient visis, accounting and finance experse was allocated on the percent of direct costs, and information ucchnology expense was allocated on the number of computers in service. The calctilations for physical therapy are of Firote 73. This mpont shoms ibe CSAA cos: the case of GSEA, Emcrson sbingla sartwe lo caturt thars thise of samilet organitavos. Eincreon in his wole of CEO is alvo mopesible for the entine Wotade ogerption That a. the overall Wescade operation sh his imesused center. Macrefore, Eiversons finumedal ecport. teproduced on the leth side of Fegune 73, owetains the rewals of both profit cetacts and the ooct and expenk exners. The surplas fiestes froen $70,000 and 585,000 , respoctivly tic, revenucs cxeced experises). The expene-only ficuses forn Emersons. GSEA sapport center sepost and from joriess radiology sapport center seport are negthe figutes of $80,000 and 520,000 . respectively. Therefore, to determine net incecse for the entite Westude operzicn, the $80,000 and the $20,000 expense figuro ate subcracied from the surplus Gigurs to arrive at a net incoene of $55,000. Emeron should be cvaluated on overall paofe; be should ensure that futare investnents ate made in the units that would yicld the greates financial benefit. Future investments could be sought to enluace the grofitability of surgical or theripy services or lower the costs of GKAA or radiology services. Table 7.6 idustrates the effect of changing the allocation base to revenue. Tables 7.5 and 7.6 show a negligble difference in the profit margins of the two revenue centers (cg, the ambulatory surgical center magin falls from 12.5% to 121% when revenue is used as the allocition base). Howewer, the importance of the allocarion base should be judged by its effect on employee behavior. Allocating indirect cost based on revenue does not encourage Emerson or Hacket! and radiogd uts profin margin by 3.5%; note use The botwoen hall of Tabte 7.7 shows the cops. to this cove. if the ambulatory surgery centes. direcar seduces his expenses by 54,650 (3.95). his profis matgin increase frost 12.5% to 149%. a 1925 increave. The impervernent is toe wo the lower direct costs and a shift of an additwonal. 57+0 of indired costs to the tehabihtation cos. centet. Rechabitivation's profit mangin is redaced by 28%, but Wistides owerall profie increases from 555.000 to $59.650, an 8.5% increase. Allocal. tion buses showld be selected to encourage value increaing actiots from managers such as betier utiluzation of stalf, supplies, and equipment. Ahough the lines of managerial responstbit. ity wh vary in other onganizations. the relationships between and among investment, profit, and cost centers and overall superviston will remain as shown in this example. Product and Period Costs Product costs is a term that was originally ass ciated with manufacturing rather than with 5 vices. The concept of product costs assumes 1 a product has been manufactured and placed inventory while waiting to be sold. When product is sold, the product is matched with enue and recognized as a cost. Thus, cost of sa the common usage for manufacturing firms. by 597,500, and she may arwee that a differem allocation method shoold be used (e, s. allicise ing accouming and firsance experses on patient visies rather than discet costs would reduce the P1 allocation and increase the Allocamon to or and ST. These cosas must be recoupcd to ensure that the oryanization earms a profit. We previously dikeussed rewemue centers, where managers are responstble for generating revenue (or volume). and cost centers, wbere managers are tesponsible for managing and controling costs. A profit center makes a manager responsible for both the volume and revenue (inflow) side and the expense (outflow) side of a deparment, division, unit, or program. In other words, the manager is resporistble for setuing prices and determining product mix (revenue) and input mix (cost). We will examine the type of information a manager receives about his or her own responsibility center by reviewing the Westside Clinic operations. Westside Clinic offers two basic types of services: an ambulatory surgery center (ASC) and a rehabilitation center. Bill Emerson, the chicf executive officer (CEO), is responsible for the overall profitability of Westside and supervises Joe Clark, director of the ambulatory sungery center: Bonnie Hacket, director of the rehabilitation center, and Denisha Jones, a part-time radiologist, who provides radiology services on an as-needed basis. Figure 7.2 illusurates the managerial relationships. To restate the relationships shown in Figure 7.2 , Clark manages the ambulatory surgery servces profet corner, and Hackest manuges the services repreiens the traniness of the Whatside. Clisic Josies manapes the fadiology services cost center supporting the satgery and rehabiliatiots profit centen Encrson, the CEO, manages the investment center thas includes all of the functions just described plus the gerieral and sdministrauve support center. Emerson recelves the accounting, neport. shown in Table 7.5, thas contains the net incouve For each responsibility center in the Westside operation. Indirect experises are allocated based on direct experses, so the ambulatory susgery center is allocated $41.892 of indirect expenses. ($155,000+$370,000)$100,000) Clark's report for the ambulatory surgery center shows $225,000 in revenueless the $155,000 of controllable experses he is tesponsible for. The difference is labeled -Surplus. The surplus amounts to $70,000,$225,000$155,000, after $41,892 is deducted for indirect costs, the net income for the ambulatory surgery center is $28,108. Hackeu's rehabilitation center is the second line of Table 7.5. Her report shows $300,000 in revenues less \$215,000 of controllable experses she is responsible for. The difference is again labeled "Surplus". The surplus amounts to $85,000,$300,000$215,000, after allocared costs are deducted, $8,108, het net incom is $26,892. Clark and Hacket should work increase the profits of their area of responsibit Figure 7.2 Lines of Managerial Responsibility at Westside Clinic Overview: Direct and Indirect Costs Departments serving patients in large healthcare organizations require support from multiple departments that do not generate revenue to complete their work. The support services include housekeeping, maintenance, billing and payroll services, human resources, accounting and finance, administration, and so on. The cost of non-revenue-generating departments must be recouped in revenue-producing departments to ensure that an organization's total revenues exceed its total expenses (i.e, the charges for services must cover the department's cost plus the costs of support services). Direct costs can be specifically associated with a particular patient, work group, or department. The critical distinction for a manager is that the cost is under their control (i.e., they can increase or decrease the level of the expenditure). Whatever the manager is responsible for-that is, patient, work group, or department-is known as a cost object. The somewhat vague definition of a cost object is any unit for which a separate cost measurement is desired. It might help the manager to think of a cost object as a cost objective instead. 1 The important thing is that direct costs can be traced to a cost object. Indirect costs, on the other hand, cannot be specifically associated with a particular cost object. The cost to run the accounting and finance services is an example of indirect cost. Accounting and finance services are essential to the overall organization itself, but their cost is not specifically or directly associated with providing healthcare services, Indirect costs usually cannot be traced to the work performed by the patient-serving departments but are allocated or apportioned to revenue-producing departments. 2 Figure 7.1 illustrates the direct-indirect cost distinction. by increasmg wolume or revenue of redacing covets. and bo evaluatied on the profit carned Jonesb report for modiology kervices is at the bottom tight of Figure 7.3 Het report shown the controllable expenses the is respondible for ter. Therefore, fones is tioponsible fot enpecines Io rectuce stue cost foer X-ray are incurnd for the sale benchi of a parcutar patarat or departmen. As a nile of thumb of the answer to she following question is "Wo" the cots crast be incurred? Whira a departanent can be eliminued or a parient er froop of pacients do roc rect cost For example. claminatiog the emengency department would arno ont us expenses. but the cost of turining accountang, and finanor exvices. would remann the sime. Indirect coves are incurres for the overall oret mation and rot for arry one puncht of depanenent. because they are starcd, ind inct costs ase somedinch called foint or comamon costs As a nule of thutnb. Af the answer to the follonang quesnom is Yes. Whe cost onder to be assigncd so a rrvenue-prodscong department soch as ntarsing or ancallary units? Allocating Indirect Costs It is important for maminers to recogaise dirbet and Two sets of excimples illustrate the reporting of dincet and indirect costs. The first example concerns ratale 7x = ine Pernod costs, in the onsinal munulacturang. isterpretation, are not contrected with the mana. facturing process. They are masched wh h rewentie on the basis of when the cost is incurred (thus penod coses). The tertu comes frotn the span of time in which matching occurs, known as time period Service organizations have no manufacturing process as such. The business of healtheare service anganizations is service delivery, not the manufacturing of products Although the overall concept of prodact versus period cost is not as vital to service delivery, the distinction remains important for healthcare managers to know. In bealtheare organizations, product cost can be viewed as traceable to the cost object of the department, dhision, or unis. A period cant is not traceable in this manner. Another way to wese this distinction is to think of prodoct cosas as thove costs nectevary to actually delivet the service. Whereas period costs ate costs necervary to stipport the existence of the organitation hsel. Finally, modical supply and pharmacy departments do have inventones on hand in their case, a product is purchased (rather than manufictured) and placed ino irventory white watting to be dispensed. When that product is dispensed; the product is matched with revenue and recognized as a cost of providing the service to the patient. Therefore, the product cost concept is importan to managers of departments thas bold a stgrifican amount of inventory: Summary This chapter examined direct and indirect costs Direct costs are those that are under the control of a manager, and indirect costs are incurred in other areas and are allocated to revenue-producing departments. The distinction between direct and indirect costs is imponant as indirect costs reduce the reported profitability of revenue-producing departments and are often beyond the control of their managers (i.e, their decisions and actions have no influence on the expenses allocated to their departments). Managers of cost and expense centers should be evaluated on their ability to keep their expenses low as they cannot control patient volume or revenue. Managers of profit centers should be evphated on their abslity to serve patients (volume), the prices and services offered (revenue), and maintenance of low expenses (te, they should be axsessed on protiz earned in their arsa). Managers of investment centers ate responsible for an entre openation, so in addition to controlling volume, revenue. and expenses, they should also be assessed on where investments are made. Investment center managers should be assessed on whether their organization makes comparable profits to similar organizations. Chapter 8 explores fixed and variable costs (i.e, whether a cost changes with output) to recognize how much control a manager has over their direct costs. of these costs, 100%16,7%,560,000 for administration and $40,000 for facility costs. The total allocated itudirect cost must equal the total cost in the support departments, and the revenues generated by the patient service departments must cover their ditect and andirect costs for the organization to survive. Table 7.3 represents a report with the direct and allocated indirect costs for the rehabilitation cost center The report is divided into three types of therapy. physical, occupational, and speech therapy, with the total allocated indirect cost for thice support departments, administration, accounting and finance, and information tectunology, whose costs are allocated on different bases. In this report. the manager can observe the diflerences between direct and indirect costs and the differences. among the three types of therapies Markup indicates how much prices mus. be increased over direct expenses to cover the allocated costs. The allocation of indirect costs is provided in Table 7.4. Note that the Allocated Indirect Cods" in column 5 of Table 74 are the same as the Nllocated inditect Costs" in columin 3 of Table 7.3. Thas, Table 74 is a subsidiary report showng, the allocation of indrect costs in the mam repott. The use of one of mote sup porting teports to teveal derails behind the main repott is quine cotumon in managertal reports The allocation of indurect cosis subsidiary report details how indirect costs were distributed to the three tevenue generating therapy deparuments Table 7.4 shows the expenses, sdministrative. services, accounting and finance, and informamon technolory included in the 5185,000 indirect cost total. It also shows how each of these expenses was allocated to the physical, occupational, and speech therapy departments Adminisurative setvice expense was allocated bused on the number of patient visis, accounting and finance experse was allocated on the percent of direct costs, and information ucchnology expense was allocated on the number of computers in service. The calctilations for physical therapy are of Firote 73. This mpont shoms ibe CSAA cos: the case of GSEA, Emcrson sbingla sartwe lo caturt thars thise of samilet organitavos. Eincreon in his wole of CEO is alvo mopesible for the entine Wotade ogerption That a. the overall Wescade operation sh his imesused center. Macrefore, Eiversons finumedal ecport. teproduced on the leth side of Fegune 73, owetains the rewals of both profit cetacts and the ooct and expenk exners. The surplas fiestes froen $70,000 and 585,000 , respoctivly tic, revenucs cxeced experises). The expene-only ficuses forn Emersons. GSEA sapport center sepost and from joriess radiology sapport center seport are negthe figutes of $80,000 and 520,000 . respectively. Therefore, to determine net incecse for the entite Westude operzicn, the $80,000 and the $20,000 expense figuro ate subcracied from the surplus Gigurs to arrive at a net incoene of $55,000. Emeron should be cvaluated on overall paofe; be should ensure that futare investnents ate made in the units that would yicld the greates financial benefit. Future investments could be sought to enluace the grofitability of surgical or theripy services or lower the costs of GKAA or radiology services. Table 7.6 idustrates the effect of changing the allocation base to revenue. Tables 7.5 and 7.6 show a negligble difference in the profit margins of the two revenue centers (cg, the ambulatory surgical center magin falls from 12.5% to 121% when revenue is used as the allocition base). Howewer, the importance of the allocarion base should be judged by its effect on employee behavior. Allocating indirect cost based on revenue does not encourage Emerson or Hacket! and radiogd uts profin margin by 3.5%; note use The botwoen hall of Tabte 7.7 shows the cops. to this cove. if the ambulatory surgery centes. direcar seduces his expenses by 54,650 (3.95). his profis matgin increase frost 12.5% to 149%. a 1925 increave. The impervernent is toe wo the lower direct costs and a shift of an additwonal. 57+0 of indired costs to the tehabihtation cos. centet. Rechabitivation's profit mangin is redaced by 28%, but Wistides owerall profie increases from 555.000 to $59.650, an 8.5% increase. Allocal. tion buses showld be selected to encourage value increaing actiots from managers such as betier utiluzation of stalf, supplies, and equipment. Ahough the lines of managerial responstbit. ity wh vary in other onganizations. the relationships between and among investment, profit, and cost centers and overall superviston will remain as shown in this example. Product and Period Costs Product costs is a term that was originally ass ciated with manufacturing rather than with 5 vices. The concept of product costs assumes 1 a product has been manufactured and placed inventory while waiting to be sold. When product is sold, the product is matched with enue and recognized as a cost. Thus, cost of sa the common usage for manufacturing firms. by 597,500, and she may arwee that a differem allocation method shoold be used (e, s. allicise ing accouming and firsance experses on patient visies rather than discet costs would reduce the P1 allocation and increase the Allocamon to or and ST. These cosas must be recoupcd to ensure that the oryanization earms a profit. We previously dikeussed rewemue centers, where managers are responstble for generating revenue (or volume). and cost centers, wbere managers are tesponsible for managing and controling costs. A profit center makes a manager responsible for both the volume and revenue (inflow) side and the expense (outflow) side of a deparment, division, unit, or program. In other words, the manager is resporistble for setuing prices and determining product mix (revenue) and input mix (cost). We will examine the type of information a manager receives about his or her own responsibility center by reviewing the Westside Clinic operations. Westside Clinic offers two basic types of services: an ambulatory surgery center (ASC) and a rehabilitation center. Bill Emerson, the chicf executive officer (CEO), is responsible for the overall profitability of Westside and supervises Joe Clark, director of the ambulatory sungery center: Bonnie Hacket, director of the rehabilitation center, and Denisha Jones, a part-time radiologist, who provides radiology services on an as-needed basis. Figure 7.2 illusurates the managerial relationships. To restate the relationships shown in Figure 7.2 , Clark manages the ambulatory surgery servces profet corner, and Hackest manuges the services repreiens the traniness of the Whatside. Clisic Josies manapes the fadiology services cost center supporting the satgery and rehabiliatiots profit centen Encrson, the CEO, manages the investment center thas includes all of the functions just described plus the gerieral and sdministrauve support center. Emerson recelves the accounting, neport. shown in Table 7.5, thas contains the net incouve For each responsibility center in the Westside operation. Indirect experises are allocated based on direct experses, so the ambulatory susgery center is allocated $41.892 of indirect expenses. ($155,000+$370,000)$100,000) Clark's report for the ambulatory surgery center shows $225,000 in revenueless the $155,000 of controllable experses he is tesponsible for. The difference is labeled -Surplus. The surplus amounts to $70,000,$225,000$155,000, after $41,892 is deducted for indirect costs, the net income for the ambulatory surgery center is $28,108. Hackeu's rehabilitation center is the second line of Table 7.5. Her report shows $300,000 in revenues less \$215,000 of controllable experses she is responsible for. The difference is again labeled "Surplus". The surplus amounts to $85,000,$300,000$215,000, after allocared costs are deducted, $8,108, het net incom is $26,892. Clark and Hacket should work increase the profits of their area of responsibit Figure 7.2 Lines of Managerial Responsibility at Westside Clinic