# M2. Cost Concepts Homework

## Instructions

5 POINTS

Module 2 Homework: Cost

In Chapter 4 of Fundamentals of Healthcare Finance, you read about cost and different methods of allocation.

Please download and complete Module 2 Assignment. Submit the completed assignment (worth 5 points) in this drop box by Sunday before midnight EST.

• Save your homework assignment using the following file-naming format to receive full credit: HSA3170_Mod 2HW_Last Name.

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Student Name:

HSA: Health Care Finance

Module Two Assignment

 In Chapter 4 in your book, you learned about cost.Use what you have learned in your readings to complete the following problems.Show all work for full credit.

1.(2 pts) Assuming that your fixed costs for a Rehabilitation Center are \$125,000 per year.Your average variable expenses come to \$25 per procedure.

a. What are your total fixed costs if you perform 10,000 procedures?

b. What would they be if the volume increased to 20,000 procedures?

2. (2 pts) Assuming that you have two departments in this Rehabilitation Center, PT and OT.The cleaning crew that services the building spends 30% of their time in PT, and 70% in OT due to the square footage that each department uses.

a. What would be the allocation be to PT if the total annual cost of housekeeping is \$20,000?

b. What would be the allocation be to OT if the total annual cost of housekeeping is \$20,000?

3. (1pt) If you looked at billing for this center, and decided to use the Activity-Based Costing method, what would the allocation of Check-In cost be to PT for 6,000 procedures considering the following information:

ActivityAnnual CostCost DriverTotal Volume of PT and OT

Check-In\$20,000Number of Visits10,000

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This is CH.4 –

## ESTIMATING COSTS

THEME SET-UP: COST STRUCTURE

As you know from chapter 3, Big Sky Dermatology Specialists is a small group practice located in Jackson, Wyoming. Jen Latimer, a recent health administration graduate and newly hired manager for the group, completed her review of Big Sky’s revenue sources. Now she wants to take a closer look at Big Sky’s cost structureâ€”that is, the way Big Sky’s total costs change as volume changes.

Jen remembers from her healthcare finance courses that a business’s costs can be classified in several ways. The major classifications are (1) the relationship of the cost to the amount of services offered (does the cost increase as volume increases?) and (2) the relationship of the cost to the subunit being analyzed (does the cost go away if the subunit is abolished?).

As she thought about these classifications, she breathed a sigh of relief. Big Sky was not formally divided into departments (subunits), so she would not have to develop a system to allocate overhead costs, such as billing expenses, to separate departments in the practice. Still, she had to identify the costs that are unrelated to volume (fixed costs) and the costs that are tied to volume (variable costs). By identifying these two types of costs, Jen would be able to forecast Big Sky’s profit potential under different assumptions about volume (number of visits).

By the end of this chapter, you will have an appreciation for the costs inherent to healthcare businesses and how those costs are classified. Then you, like Jen, will be able to apply this knowledge to estimate the cost structure of Big Sky Dermatology Specialists.

LEARNING OBJECTIVES

After studying this chapter, you will be able to do the following:

• Discuss the nature and purpose of managerial accounting.
• Explain how costs are classified according to their relationship with volume.
• Describe how costs are classified according to their relationship with the unit being analyzed.
• Explain why proper cost allocation is important to healthcare organizations.
• Define the terms cost pool and cost driver, and describe the characteristics of a good cost driver.
• List the three primary methods used to allocate overhead costs among revenue-producing (patient services) departments.
• Describe three methods used to cost individual services: the cost-to-charge ratio (CCR), relative value units (RVUs), and activity-based costing (ABC).
• Articulate the differences between traditional costing and ABC.

4.1 INTRODUCTION

Healthcare managers have many responsibilities. The more important ones include planning for the future, overseeing the day-to-day activities of line employees, and establishing policies that control the operations of the organization.

For example, the practice manager of a primary care practice must estimate future demand (volume) and see to it that the practice has the facilities, staff, and supplies necessary to meet this demand. He does so primarily by creating budgets that use forecasted future volume to estimate the resources needed to meet expected patient demand. As the future unfolds, the practice manager must monitor operations to see if the volume estimates were correct. If not, supplies and staffing requirements must be adjusted to reflect variations from forecasts. Finally, he must constantly review the resources used to ensure that they are being used appropriately and efficiently and are being acquired at the lowest possible costs.

All of these activities require informationâ€”a great deal of it. Furthermore, it has to be compiled in a format that facilitates analysis, interpretation, and decision-making. Without timely and relevant information, healthcare managers would be making decisions essentially in the dark. Of course, accurate information does not ensure good decision-making, but without it, the chances of making good decisions are almost nil.

The foundation of a good information system is the manager’s ability to estimate costs with confidence. This task is not easy. You may be able to precisely estimate the cost of your college educationâ€”just add up the costs of tuition, books and supplies, room and board, and so onâ€”but what about the costs of healthcare organizations? Their overall (total) costs can be measured with some precision, such as the total costs of running a hospital or a medical practice. However, what about the costs of running the emergency department, or the costs associated with Medicare patients, or the costs of treating patients who have had heart attacks? Estimating these costs with confidence is essential to sound management, yet many factors complicate the estimation process.

Although cost estimation comes with a multitude of problems, it is far too important to the financial well-being of healthcare providers to do in a sloppy way. Thus, organizations put a lot of time and effort into doing the best possible job.

4.2 THE BASICS OF MANAGERIAL ACCOUNTING

Cost estimation is an accounting function, so our coverage begins with some accounting basics. Accounting is split into two primary areas: managerial accounting and financial accounting. Whereas financial accounting (discussed in chapters 11 and 12) focuses on the reporting of operational and financial results to outsiders, managerial accounting focuses on the development of information used internally for managerial decision-making (see â€œCritical Concept: Managerial Accountingâ€).

Managerial accounting information is used in routine budgeting processes, to allocate managerial bonuses, and to make pricing and service decisions, all of which deal with subunits of an organization. In addition, managers can use managerial accounting data for special purposes, such as assessing alternative modes of delivery or projecting the profitability of a particular reimbursement contract.

Because managers are more concerned with what will happen in the future than with what has happened in the past, managerial accounting is for the most part forward-looking. However, because most of the future is unknown, compiling managerial accounting information requires making many assumptions about future events. For example, as managers create budgets, they often must make assumptions regarding utilization (volume), reimbursement rates, and costs.

A critical part of managerial accounting is the measurement of costs. One issue that makes this task difficult is the fact that no single definition of the term cost exists. Rather, different costs exist for different purposes. As a general rule, for healthcare providers, a cost involves a resource use associated with providing, or supporting, a specific service. However, the cost per service identified for pricing purposes can differ from the cost per service used for management control purposes. Also, the cost per service used for long-range planning purposes may differ from the cost per service defined for short-term purposes. Thus, when dealing with costs, managers have to understand the context so that the correct cost is identified. To complicate matters further, costs do not necessarily reflect actual cash outflows.

Costs are classified in two primary ways: by their relationship to the volume (amount) of services provided and by their relationship to the unit (i.e., department) being analyzed. This chapter focuses on these two cost classifications. In chapter 5, we add revenues to the mix and show how to convert cost estimates into profit estimates.

 CRITICAL CONCEPT Managerial Accounting

The accounting function in businesses is broken down into two major areas: managerial accounting and financial accounting. Financial accounting, which is covered later in the book, involves the creation of financial statements that report what has occurred at the organization. Managerial accounting concerns the creation and use of data needed to manage an organization’s current and future operations. Thus, managerial accounting produces reports used at various levels in an organization, such as department operations, contract negotiations, or specific services delivery, to enhance financial performance.

 SELF-TEST QUESTIONS
1. What is the primary purpose of managerial accounting information?
2. What is meant by the term cost?
3. What are the two primary ways that costs can be classified?

4.3 COST CLASSIFICATION 1: FIXED VERSUS VARIABLE COSTS

One way to classify costs is on the basis of their relationship to the amount of services provided, often referred to as volume or utilization. Future volumeâ€”the number of patient days, visits, enrollees, laboratory tests, and so onâ€”is almost always uncertain.

Volume may be forecasted in a number of ways. One way is to review historical trends, say, over the past five to ten years. In many situations, the past is a good predictor of the future. If the manager believes this to be the case, then she can apply statistical analysis (linear regression) to the historical data to predict future volumes. If past data are not available or if significant changes in the operating environment are taking place, then volume forecasting becomes more difficult. In that situation, the manager must evaluate population and disease trends in the service area, actions of competitors, pricing strategies, the impact of new contracts with insurers, and a whole host of additional factors that influence future volume.

If a provider’s volume forecast turns out to be inaccurate, the consequences can be severe. First, if the market for any particular service expands more than expected and planned for, the provider will not be able to meet its patientsâ€™ needs. Potential patients will go elsewhere, and the provider will lose market share and perhaps miss a major opportunity to maintain or increase its business. On the other hand, if projections are overly optimistic, the provider could end up with excess equipment, supplies, and staff, and hence costs that are higher than necessary.

In spite of the difficulties in forecasting volume with precision, managers typically have some idea of the potential range. For example, the manager of Northside Clinic, a small walk-in clinic, might estimate that the total number of patient visits for next year will likely range from 12,000 to 14,000 or from about 34 to 40 per day. If utilization is not likely to fall outside of these bounds, then the range of 12,000 to 14,000 annual visits defines the clinic’s relevant range. Note that the relevant range pertains to a particular periodâ€”in this case, next year. For other periods, the relevant range might differ from this estimate.

FIXED COSTS

Some costs, called fixed costs, are more or less known with certainty, regardless of the level of volume in the relevant range. For example, Northside Clinic’s labor force would be increased or decreased only under unusual circumstances. Thus, as long as volume falls within the relevant range of 12,000 to 14,000 patient visits, labor costs at the clinic are fixed for the coming year. The actual number of visits might turn out to be 12,352 or 13,877, but labor costs will remain at their forecasted level as long as volume falls in the relevant range (see â€œFor Your Consideration: Cost Structure and Relevant Rangeâ€). Other examples of the clinic’s fixed costs include expenditures on facilities (e.g., rent, property taxes, utilities), diagnostic equipment, and information systems. After an organization has acquired these assets, it typically is locked into them for some period regardless of volume fluctuations, so these costs are known beforehand.

Of course, no costs are fixed over the long run or over large volume changes. At some level of increasing volume, healthcare businesses must incur additional fixed costs for new facilities and equipment, additional staffing, and so on. Likewise, if volume decreases by a substantial amount, an organization likely would reduce fixed costs by shedding some of its facilities and parts of its equipment and labor base.

 FOR YOUR CONSIDERATION Cost Structure and Relevant Range

In general, an organization’s underlying cost structure is defined for a specified relevant range. For example, assume that Atlanta Clinic’s underlying cost structure is given as follows:

Assume that the expected number of visits next year is 75,000 and the relevant range for this cost structure is 70,000 to 80,000 visits. Now, assume that a new payer makes a proposal to the clinic that would increase next year’s volume by 10,000 visits, which would increase the expected number of visits to 85,000. The financial staff presents you, the CEO, with an analysis of the costs under the new proposal that was calculated as follows:

What is your initial reaction to the analysis? Is it valid or must it be redone? What variable in the underlying cost structure is most likely to change at a volume of 85,000 visits?

VARIABLE COSTS

Whereas some costs are fixed regardless of volume (within the relevant range), other resources are more or less consumed as volume dictates. Costs that are related to (depend on) volume are called variable costs (see â€œCritical Concept: Fixed Versus Variable Costsâ€). For example, the costs of the clinical supplies (e.g., rubber gloves, tongue depressors, hypodermics, bandages) used by Northside would be classified as variable costs. Also, some of the clinic’s diagnostic equipment is leased on a per-use basis (a fixed payment each time the equipment is used), which converts the cost of the equipment from a fixed cost to a variable cost. Finally, some healthcare organizations pay their employees on the basis of the amount of work performed, which would convert labor costs from fixed to variable. The bottom line is that fixed costs are independent of the volume of services delivered (within the relevant range), while variable costs depend on volume.

 CRITICAL CONCEPT Fixed Versus Variable Costs

One way to classify costs is by their relationship to volume. Fixed costs are known and predictable regardless of volume (within some relevant range). Conversely, variable costs depend on the volume of services supplied. Consider a clinical laboratory. The costs of the building, equipment, and personnel to run the lab are known with some certainty for the coming year. Furthermore, these costs are independent of the number of tests actually conducted. Such costs are fixed. However, the annual costs of reagents and other test supplies depend on the number (and type) of tests conductedâ€”the greater the number of tests, the greater these costs. Thus, the accounting system would classify these costs as variable.

UNDERLYING COST STRUCTURE

Healthcare managers are vitally interested in how costs are affected by changes in the amount of services supplied. The relationship between costs and volume, called underlying cost structure (or just cost structure), is used by managers in planning, control, and decision-making (see â€œCritical Concept: Underlying Cost Structureâ€). The primary reason for defining an organization’s cost structure is to provide managers with a tool for forecasting costs (and ultimately profits) at different volume levels.

To illustrate the concept, consider the hypothetical cost data presented in exhibit 4.1 for a hospital’s clinical laboratory. The cost structure consists of both fixed and variable costsâ€”that is, some of the costs are expected to be volume sensitive and some are not. This structure of both fixed and variable costs is typical in health services organizations as well as most other businesses (see â€œHealthcare in Practice: The Cost Structures of Medical Practicesâ€). For illustrative purposes, let us assume the relevant range is from zero to 20,000 tests. (Of course, the actual relevant range might be from 15,000 to 20,000 tests.)

As noted in exhibit 4.1, the laboratory has \$150,000 in fixed costs that consist primarily of labor, facilities, and equipment. (We have purposely kept the numbers unrealistically small for ease of illustration.) These costs will occur even if the laboratory does not perform one test. In addition to the fixed costs, each test, on average, requires \$10 in laboratory supplies, such as glass slides, blood test tubes, and reagents.

The per-unit (per test, in this example) variable cost of \$10 is defined as the variable cost rate. If laboratory volume doublesâ€”for example, from 500 to 1,000 testsâ€”total variable costs will double from \$5,000 to \$10,000. However, the variable cost rate of \$10 per test remains the same whether the test is the first, the hundredth, or the thousandth. Total variable costs, therefore, increase or decrease proportionately as volume changes, but the variable cost rate remains constant.

Fixed costs, in contrast to total variable costs, remain unchanged as the volume varies. When volume doubles from 500 to 1,000 tests, fixed costs remain at \$150,000. Because all costs in this example are either fixed or variable, total costs are merely the sum of the two. For example, at 5,000 tests, total costs are Fixed costs + Total variable costs = \$150,000 + (5,000 Ã— \$10) = \$150,000 + \$50,000 = \$200,000. Because variable costs are tied to volume, total variable costs, and hence total costs, increase as the volume increases, even though fixed costs remain constant.

The rightmost column in exhibit 4.1 contains average cost per unit of volume, which in this example is average cost per test. It is calculated by dividing total costs by volume. For example, at 5,000 tests, with total costs of \$200,000, the average cost per test is \$200,000 Ã· 5,000 = \$40. Because fixed costs are spread over more tests as volume increases, the average cost per test declines as volume increases. For example, when volume doubles from 5,000 to 10,000 tests, fixed costs remain at \$150,000, but fixed cost per test declines from \$150,000 Ã· 5,000 = \$30 to \$150,000 Ã· 10,000 = \$15.

With fixed cost per test declining from \$30 to \$15, the average cost per test goes down from \$30 + \$10 = \$40 to \$15 + \$10 = \$25. The fact that higher volume reduces average fixed cost, and therefore average cost per unit of volume, has important implications for profitability related to volume changes. (In economics, the state of declining average cost as volume increases is called economies of scale.)

The cost behavior presented in exhibit 4.1 in tabular format is presented in graphical format in exhibit 4.2. Here, costs are shown on the vertical (y) axis, and volume (number of tests) is shown on the horizontal (x) axis. Because fixed costs are independent of volume, they are shown as a horizontal dashed line at \$150,000. Total variable costs appear as an upward-sloping dotted line that starts at the origin (0 tests, \$0 costs) and rises at a rate of \$10 for each additional test. When fixed and total variable costs are combined to obtain total costs, the result is the upward-sloping solid line parallel to the total variable costs line but beginning at the y-axis at a value of \$150,000 (the fixed costs amount). In effect, the total costs line is nothing more than the total variable costs line shifted upward by the amount of fixed costs.

Note that exhibit 4.2 is not drawn to scale. Furthermore, the relevant range is unrealistically large. The intent here is to emphasize the general shape of a cost structure graph and not its exact position. Also, note that total variable costs plot as a straight line (linear), because the variable cost rate is assumed to be constant over the relevant range. We assume throughout the book that the variable cost rate is constant, and hence total variable costs are linear, at least within the relevant range. For most healthcare organizations in most situations, such an assumption is not unreasonable.

Before we leave this illustration of underlying cost structure, we should mention that fixed and variable costs represent two ends of the volume classification spectrum. Here, in the relevant range, the costs are either independent of volume (fixed) or directly related to volume (variable). A third classification, semifixed costs, falls between the two extremes. To illustrate, assume that the actual relevant range of volume for the clinical laboratory is 15,000 to 20,000 tests. However, the laboratory’s current workforce can only handle up to 17,500 tests per year, so an additional technician, at an annual cost of \$35,000, would be required if volume exceeds that level. Now, labor costs are fixed from 15,000 to 17,500 tests and again at a higher level from 17,500 to 20,000 tests, but they are not fixed at the same level throughout the entire relevant range of 15,000 to 20,000 tests. Semifixed costs are fixed within ranges of volume, but multiple ranges of semifixed costs occur within the relevant range. To keep the illustrations manageable, we do not include semifixed costs in our examples in this book.

 CRITICAL CONCEPT Underlying Cost Structure

The underlying cost structure of a business defines the relationship between volume and costs. To illustrate, assume you plan to sell customized pens to your classmates to make some extra money. To get started, you pay someone \$50 to design the logo for the pens. Then, you pay \$1.75 for each pen. The cost structure of your pen business consists of \$50 in fixed costs and a variable cost rate of \$1.75. Thus, the cost structure of the business can be written as:

If you sell 100 pens, your total costs are \$225:

 HEALTHCARE IN PRACTICE The Cost Structures of Medical Practices

Different healthcare organizations have different cost structures. Even in the same type of organization, cost structure differences occur. For example, medical practices that are hospital based, such as some radiology groups, tend to have low fixed costs (the hospital pays those). Other practices, such as cardiology, can have a great deal of diagnostic equipment and hence high fixed costs. In addition, the size of a practice influences its underlying cost structure.

Still, by examining the costs associated with a typical practice, we can get some feel for the cost structures involved. We have chosen a primary care practice to represent a typical medical practice. Because the costs involved in the practice are a function of the number of physicians in the practice, most of the data presented here are on a per-physician basis.

In 2011, the most recent data available, the average primary care practice employed roughly five full-time equivalent (adjusted to account for part-time staff) physicians. In addition, each practice, on average, employed two nonphysician providers, such as physician assistants and nurse practitioners, and a support staff of about 20. Thus, if we count the nonphysician providers as support staff for the physicians, each physician had about 4.4 individuals working to support her patient services activities.

The total operating cost to support each physician was about \$325,000, not including physician compensation. Of these costs, about \$160,000 were labor costs, with the remaining costs devoted to facilities, equipment, malpractice insurance, and supplies. Thus, practice costs (again, excluding physician compensation) were about evenly split between labor and nonlabor components. Taking a closer look at support staff costs, about 47 percent of the labor costs were for clinical staff, 34 percent for front-office staff (e.g., receptionists), and 19 percent for business office staff (e.g., coding, billing, collections).

On average, each primary care physician handled about 2,300 patients, who represented about 5,300 encounters (visits), during which the physician performed about 11,000 procedures. Thus, if we use patient visit as the unit of output (volume), the operating cost per visit averages out to be roughly \$325,000 Ã· 5,300 = \$61 per visit. The data do not break out fixed versus variable costs.

However, variable costs, which consist mostly of administrative supplies (e.g., forms, letterhead) and medical supplies (e.g., rubber gloves, needles, vaccines, dressings), were relatively small, say, \$10 per visit. Thus, the underlying cost structure for an average primary care physician looked something like the following:

Total costs = \$272,000 + (\$

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