Chapter 6: Cost Allocation

Direct Costs

Cost that are unique to a sub-unit.

Cost Allocation

The purpose of cost allocation is to assign all overhead costs to the departments that create the need for such costs, these departments are typically the patient service departments.

Traditional Allocation Process

1. Identify the Cost Pool 2. Determine the Cost Driver 3. Calculate the Allocation Rate 4. Determine the Allocation Amount

What is a cost driver?

A cost driver is the criterion upon which the allocation is made. For example, a hospital may allocate housekeeping costs to its other departments on the basis of the size of each department's physical space. In this situation, the number of square feet of occupied space would be the cost driver.

What is a cost pool?

A cost pool is any grouping of overhead (indirect) costs that must be allocated. One example is the set of costs of the housekeeping department.

Cost Pool

A group of overhead costs for an overhead department to be allocated such as facilities costs or marketing costs.

Indirect Costs

Costs associated with shared resources used by the entire organization and not borne exclusively by the department. (Overhead Costs) Ex: administrative costs

Allocation Methods

Direct Method Step-Down Method Reciprocal Method

What are the primary differences between direct and indirect costs?

Direct costs are those costs that are unique and exclusive to the unit and, as such, often are relatively easy to measure. For example, the direct costs of a clinical department, say, routine care, would include the labor costs for department personnel, the costs of equipment and supplies used by the department, and so on. In contrast, indirect, or overhead, costs are inherently difficult to measure because these costs result from the sharing of resources by two or more units. To illustrate, a clinical department shares the physical space of the entire organization as well as infrastructure services, so the department must share in the costs of physical plant, utilities, information systems, housekeeping, maintenance, medical records, general administration, and so on.

4. Determine the Allocation Amount

Each user department is then allocated some portion of Housekeeping overhead costs. Assume the Critical Care Department occupies 10,000 square feet of space. Its allocation would be $0.50 x 10,000 = $5,000.

Effective cost drivers, and hence the resulting allocation systems, must have what two important attributes?

First, and perhaps the less important attribute, is fairness. That is, do the cost drivers chosen result in an allocation that is fair to the patient services departments? The second, and perhaps more important, issue is cost control. Do the cost drivers contribute to cost control within the organization? That is, do the cost drivers create an incentive for using departments to use less of an overhead (support) service?

1. Identify the Cost Pool

Identify the Cost Pool, which is the dollar cost of the overhead activity to be allocated. Ex: Assume that a hospital's Housekeeping Department has direct costs of $100,000.

Cost Driver

Is the basis on which the cost pool will be allocated. Ex: the cost driver for facilities overhead (depreciation, maintenance, utilities, etc.) might be the amount of space used by each patient service department.

Reciprocal Method

Recognizes all of the support department inter-relationships, but it requires a system of simultaneous equations or a complex set of iterative calculations. It may not pass the cost-benefit relationship to use this method.

Step-Down Method

Some (but not all) of the intra-support department relationships are recognized. This method is more complex than the direct method, but still manageable.

3. Calculate the Allocation Rate

The Allocation Rate is the numerical value used to make the allocation: Allocation Rate = Dollars in Cost Pool / Total Volume of Cost Driver Ex: the allocation rate is $100,000 / 200,000 = $0.50 per square foot of space occupied.

How is the allocation rate determined?

The allocation rate is obtained by dividing the cost pool by the cost driver. For example, in the housekeeping illustration, the allocation rate is total housekeeping costs divided by the total space (square footage) occupied by the departments receiving the allocation. This procedure results in an allocation rate measured in dollar cost per square foot of space utilized. The development of meaningful allocation rates enhances the ability of managers to make judgments concerning price negotiations, service profitability, and cost reduction.

Which is the better cost driver for the costs of a hospital's financial services department: patient services department revenues or number of bills generated? Explain your rationale.

The better cost driver is the number of bills generated. The logic here is to choose a driver that best reflects the relationship between the output of a patient services department and its use of financial services. The use of financial services is more closely linked to the number of bills than to the amount of revenues generated. In addition to fairness, the number of bills generated is a better cost driver because it creates a better incentive for cost control. Lowering revenues makes no sense, but the number of bills might be reduced without lowering revenues if billing for services provided to a single patient could be consolidated from multiple statements into one.

2. Determine the Cost Driver

The cost driver is the basis on which the overhead costs will be allocated. Assume the cost driver for housekeeping services is the amount of space occupied. User departments in total occupy 200,000 square feet of space.

Direct Method

The costs of each support department are allocated directly to, and only to, the patient services departments.

What is the goal of Cost Allocation?

The goal of cost allocation is to assign all of the costs of the organization to the activities that cause them to be incurred. Ideally, managers of healthcare providers would like to track and assign costs by individual patient, physician, diagnosis, reimbursement contract, and so on. With complete cost data at hand in the organization's managerial accounting system, managers can make better decisions regarding cost control, what services should be offered, and how these services should be priced. Of course, the more complex the managerial accounting system, the higher the costs of developing, implementing, and operating the system. As in all situations, the benefits associated with more accurate cost data must be weighed against the costs required to develop the data.

What are the differences between the cost allocation methods?

The key differences among the methods are how support services provided by one department are allocated to other support departments. The direct method totally ignores services provided by one support department to another; the reciprocal method recognizes all of the intra-support department services; and the step-down method represents a compromise that recognizes some, but not all, of the intra-support department services.

What are the three methods of cost allocation?

The three primary methods of traditional cost allocation are (1) the direct method, (2) the reciprocal method, and (3) the step-down method. Regardless of the method, all of the support costs within an organization ultimately are allocated from support departments to the departments that generate revenues for the organization, and hence create the need for the support services.