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We Care Medical Center: Allocating Costs – Case for Chapter 10
We Care Medical Center is a 110-bed children’s hospital that operates in Denver, Colorado. The hospital is designated as a nonprofit. Most of the hospital is used to provide inpatient care and emergency services, but 50,000 square feet are dedicated to outpatient care and orthopedics. The outpatient portion of the hospital currently uses about 75% of the space for routine medical care and the other 25% used for orthopedic care.
Currently, director bonuses are paid based on a percentage of net income made for each of the associated departments. Because bonuses are based on net income, it is imperative for the directors of each department to properly understand how indirect (overhead) costs are allocated. You are the director of the orthopedics department and have a desire to better understand how these costs are allocated to your department. Even though We Care Medical Center is a nonprofit, it still needs to generate positive net income to keep services operational and to fund any planned expansions, therefore tying bonus to net income provides an incentive for directors such as yourself to find ways to cut costs and generate additional income. But before you get ahead of yourself, it is important to understand how net income is calculated, which means learning about how costs are allocated to your department.
We Care Medical Center can accurately allocate direct costs based on actual costs incurred by each department. Salary and benefits are allocated to each department based on the actual staff being utilized within each department and the same is true with supply costs. The routine care department is currently staffed by five physicians, three advanced practitioners, and an array of support staff. The orthopedics department is currently staffed by two physicians, two advanced practitioners, and an array of support staff. Indirect costs need to be allocated based on cost drivers that are best associated with each indirect expense. The medical center currently allocates indirect costs based on revenue generated by each department, routine care, and orthopedics. Last fiscal year the routine care department generated $2,050,000 in revenue and the orthopedics department generated $1,301,000 in revenue. The total direct expenses for both departments total $2,760,000 and the associated allocation amount for each department can be found on TABLE 18.4. The total indirect costs associated with routine care and the orthopedic department are $502,500. There are two main expenses which make up the indirect expenses, facilities expense and general overhead. General overhead includes the expenses associated with accounting, human resources, and technology support. Total facilities expense equals $335,000 and total general overhead is $167,500. Additionally, the breakdown of revenue and expenditure for each department is also shown in TABLE 18.5.
You learn during a directors meeting with the CEO, Jason Cranberry, and the CFO, Jamie Gardner, that due to an increase in demand for the routine care services, the department needs an additional 25% of space, that is 50,000 square feet x 25% or an additional 12,500 square feet. This additional space need would bring the total routine care space needs to 50,000 square feet, the entire current space allotted. Hearing this, you start to worry about what is going to happen to the orthopedics department. Since the routine care department already uses most of the 50,000 square feet allotted to both departments, the choice was made to move the orthopedic department elsewhere, freeing up the space needed for the routine care department to expand. This solves one problem but creates another, the need to find a place to move the orthopedic department. Many options were examined such as moving both the routine care and orthopedic departments off campus to their own facilities and freeing up space for the inpatient hospital services to grow, but there is no large increase of demand for inpatient services, therefore leading to a big potential loss. It was determined that the most feasible option was to keep the orthopedic department on the same campus as the hospital so that if a child needed to be transferred for inpatient care the hospital was right there. The decision was made to build a new building on existing vacant land located on the campus. While the orthopedic department currently only has need for 12,500 square feet, the decision was made to build the new building with 25,000 square feet to help accommodate potential future growth; there is currently a wait time for orthopedic services, so some growth will be achieved with the move resulting in the use of an additional 5,000 square feet equaling a total of 17,500 square feet, but there is no guarantee the orthopedic department will need all of the 25,000 square feet in the new facility.
The construction cost of the new building is estimated to be $100 per square foot. This brings the cost of construction to $100 x 25,000 = $2,500,000. There will be an additional cost of $1,250,000 for items such as equipment, furniture, and relocation costs. This brings the total move cost to the orthopedic department to $2,500,000 + $1,250,000 = $3,750,000. TABLE 18.6 shows the estimated new revenues and expenses for both departments once the move is completed. Because We Care Medical Center is a nonprofit and serves the community, the hospital was able to obtain a no-interest economic development loan which will be paid back in equal payments of $187,500 over the course of 20 years.
The CFO has created a projected income statement associated with the new square-footage for routine care and orthopedics. See Table 18-6. The orthopedic department head (you) has always been skeptical of the current cost allocation method due to the orthopedic department generating more than half of total revenue and occupying only 25% of the overall space. You have never fully understood how the indirect expenses were allocated but have always felt the orthopedic department was being allocated costs that shouldn’t be. You would like to use the projected income statement to see how this move and alternate cost allocation methods could impact your future bonuses. You are not familiar with how the allocation process works or what options are available, so you ask Jamie if she would assist which she is happy to do.
Jamie starts by showing you how the current cost allocation rate is determined. The data needed is in Table 18-4. She walks you through the process where revenue is the cost driver for the allocation rate. You learn that each of the indirect expenses are divided by total revenue, facilities expense/total revenue, and general overhead/total revenue. This comes up with your cost allocation rate for each expense, $335,000/$3,351,000 = $0.10 per dollar of revenue generated for facilities and $167,500/$3,351,000 = $0.05 per dollar of revenue generated for general overhead. She then teaches the next step which is to multiply each cost allocation rate with the corresponding departmental revenue, facilities expense cost allocation rate times routine care revenue and then repeat again with orthopedics revenue. Therefore, the facilities expense allocated to the routine care department is $2,050,000 x $0.10 = $210,000 and the facilities expense allocated to the orthopedic department is $650,000 x $0.20 = $105,000. She shows you that this determines how much of the overall facilities expense should be allocated to each department and the total allocation for each department should equal the total facilities expense, $210,000 + $130,000 = $340,000. You then repeat the process with the general overhead expense and can verify your accuracy by reviewing Table 18-4 and on Table 18-5.
The hospital is considering using the revenue allocation method and the square footage allocation method for the new building. The rates are shown in Table 18-6, with the calculations under the revenue method show as Allocation Rate 1 and the square footage method shown as Allocation Rate 2. The results of the two allocation rates for the expansion are shown in TABLE 18.7.
You now feel more confident about knowing how costs are being allocated to your orthopedic department, but you have now come up with five questions you would like answered.
You first are curious about what the projected net income would be for both the routine care and orthopedics departments after the move. You know this move may have a big impact on your bonus. Using Table 18-6 and Table 18-7 expansion allocation 1, allocate the indirect expenses to both the routine care and orthopedic care departments. Once allocated, you will be able to determine the projected net income for both departments.
Interpreting the results from question 1, do you think the cost allocation method of using revenue as a cost driver is a “fair” allocation method? Why or why not?
Again, using Table 18-6 and Table 18-7, allocate the indirect expenses based on the square-footage after the expansion. (Routine Care = 50,000 SqFt and Orthopedics = 25,000 SqFt).
Now interpret the results from question 3. Is this a “fair” allocation method? Why or why not?
Out of the two cost allocation methods We Care Medical Center utilizes, which do you think is the most accurate for both departments? Why?
Understanding multiple cost allocation methods exist, what are important factors to take into consideration when evaluating which method should be used?