Question

Dynamic Medical Solutions

Case Questions

After reading the Dynamic Medical Solutions Case answer the questions below. Type your answers to the questions below in a Word document and send in through the designated drop box. Please be sure to fully answer each question. Most questions (with the exception of questions number three and five) will require at least one paragraph (three to five sentences) to answer.

Why are government regulators sensitive to the amount of claims submitted to the government insurance programs in comparison to retail prices?

Why could/would government programs reimbursement amounts exceed the retail sales prices for products?

Consider the information provided for the two products (Nutrition Supplement and Nondurable Gloves) as shown in Table 3. In accordance with the Office of the Inspector General (OIG) for “substantially in excess” are the government programs reimbursement rates for each product presently “substantially in excess” of the “usual charges?”

HINT: To determine your answer use the threshold of 120% of proposed by the OIG from page two of the case narrative and assume that DMS is charging the maximum permitted selling price to the government as shown in Table 3 on page three.

Please provide details of the details of your calculations in your submission.Use the format shown below and fill in the numbers.

	Retail Price Paid by Cash & Carry Customers	Multiplied by 120%	Maximum Amount) Price charged to Government Customers
Nutrition Supplement
Nondurable Gloves

Based on your answer above - Assume at least one of the products violates OIG’s suggestion for “substantially in excess and consider the following scenarios.

DMS reacted by changing the price charged to cash and carry customers. Assume that the government programs reimbursement rate was no more than 20% higher than the newly calculated amount. What effect would this decision be likely to have on the future business of cash and carry customers?

DMS reacted to the dilemma by requesting reimbursement amounts below the maximum allowable reimbursement rates in order to be within 20% of the prices charged to cash and carry customers. What effect would this decision potentially have on the company’s profit margins?

OIG proposed that “good cause” for substantially in excess charges could be established in a number of ways, including, for example, “evidence of increased costs associated with serving Medicare or Medicaid beneficiaries.” Using the information from the time study conducted by DMS that is presented in Table 5 along with the department operating expenses from table 2, determine how customer service, billing, and compliance costs could be allocated by customer type.

Operating Expenses by Dept.	and Cost	Allocations by Customer
	Total Costs	Government Programs	Cash & Carry
Customer Service

Do you think the DMS should track costs for the shipping and receiving departments and try to establish “good cause” for charging Medicare and Medicaid beneficiaries substantially more than cash and carry customers for the same products?

What thoughts do you have concerning how DMS should address the company’s weaknesses in preparation for the upcoming audit?

COMPANY INTRODUCTION AND CASE BACKGROUND
Dynamic Medical Solutions (DMS) is a small company that sells (as a retailer of products manufactured by others) durable and nondurable medical products to customers in seven states across the United States. Some of the popular durable products sold by the company are hospital beds, diabetic footwear, and mobility equipment (i.e., wheelchairs, scooters, etc.). A large portion of the company’s business involves the sale of durable and nondurable medical supplies including nutrition supplements, gloves, and personal care products used in patient care. All of the products carried by DMS are over-the-counter items and thus do not require a physician’s prescription.1 Like most companies in the medical products supply industry, DMS serves a multitude of customers, including those with (1) no insurance (i.e., cash and carry), (2) Medicare and Medicaid benefits (i.e., government programs),2 and (3) private insurance. Accordingly, DMS has a billing department internally for customers with such benefits and insurance. Many customers, including those enrolled in government programs and those who pay for products out of pocket (i.e., cash and carry) are elderly and/or reside in assisted-living facilities. The company employs sales representatives who visit these facilities and interact with the customers and their caregivers on a regular basis and establish the ordering process for the customers via phone or fax. Customers also are able to purchase goods at one of the company’s five retail stores via the company’s website or through the phone/fax process with a sales representative.
In regard to cash and carry customers, DMS strives to offer competitive prices as the company is directly competing with large national retail stores that offer many types of medical products and operate on small profit margins. Serving cash and carry customers is fairly straightforward, involving no other considerations beyond the typical sales initiation (i.e., visits from a sales representative), point-of-sale sales, and warehouse shipping or customer pick-up processes.
On the other hand, serving government programs customers is more restrictive and requires an extensive number of internal processes and procedures. The prices charged to these customers (i.e., the reimbursement amount) are set by the program entity (i.e., Medicaid or Medicare). Most importantly, the process of selling goods involves additional mandated (by law) considerations beyond the normal cash-and-carry process, including the written verification of medical necessity from the customer’s physician, the processing of insurance claims, and the substantiation of product delivery. For many of the nondurable medical supplies, such as nutrition supplements and gloves, the process is even more cumbersome as these products are supplied to customers on a monthly basis. Accordingly, proof of medical necessity for these products also has to be updated on a recurring basis. This involves
IMA EDUCATIONAL CASE JOURNAL VOL. 7, NO. 2, ART. 3, JUNE 2014
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ISSN 1940-204X
Dynamic Medical Solutions:
Expanding the Application of Cost Management Principles to Channel and Customer Profitability Analysis
Casey J. McNellis, Ph.D., CPA
University of Montana
Ronald F. Premuroso, Ph.D., CPA, CFE
University of Montana
additional interaction by the company with primary care physicians and Medicare/Medicaid representatives, as well as increased processing of paperwork.
Sales to customers using private insurance comprise an immaterial amount of the company’s revenues. Most private insurance companies cover only a minor amount of the charges for the products offered by DMS, often after a government program has been billed first and has paid for the majority of the charge billed by DMS.
Table 1 provides a breakdown of DMS’s sales for the most recent financial year, along with other relevant financial information (excluding an immaterial amount for private insurance-related sales).
Table 1: DMS Sales by Customer Type and Other Financial Information
Sales
% of Total Sales
Government Programs Sales
$3,000,000
75.0%
Cash and Carry Sales
$1,000,000
25.0%
Total Net Sales
$4,000,000
100.0%
Cost of Sales
($1,300,000)
32.5%
Gross Profit
$2,700,000
67.5%
Operating Expenses
($2,200,000)
55.0%
Operating Income
$ 500,000
12.5%
The company’s operations are divided into five departments: Customer Service, Shipping, Billing, Compliance, and Administration. Table 2 includes a breakdown of the operating expenses by department along with a brief description of the general functions carried out by each department for the most recent financial year.
Table 2: Department Operating Expenses and Descriptions
Department
Operating Expenses
Description of Functions
Customer Service
$660,000
Process sales orders; support customer base
Shipping
$870,000
Prepare orders for shipment; track shipments to delivery
Billing
$120,000
Submit insurance claims; monitor customer eligibility for government programs
Compliance
$120,000
Monitor company policies regarding government programs
Administration
$430,000
Perform bookkeeping, payroll, and marketing functions; heat, light, and power; insurance expenses; execute strategic plan
Total Operating Expenses
$2,200,000
REGULATORY ENVIRONMENT
As Table 1 depicts, DMS’s primary source of sales are from customers who are eligible for assistance from government-related healthcare programs. As such, the company’s success is largely based on understanding government regulations, policies, and procedures governing Medicare and Medicaid programs, including reimbursements.
Because of past alleged abuses of these government insurance programs by healthcare providers, Federal and state authorities have enacted several regulations under the Social Security Act for providers like DMS involved with submitting reimbursement claims under government programs. For example, the Department of Health and Human Services (HHS) has the power to revoke a company’s privileges to serve Medicare and Medicaid customers if the company has been involved in criminal activity, patient abuse, and/or healthcare fraud. Additionally, the Act also allows HHS to prohibit a company from engaging in business activities with Medicare and/or Medicaid if the company submits product reimbursement claims for government programs customers significantly higher than amounts charged to cash and carry customers. Specifically, Section 1128(b) of the Act states that HHS:
“…may exclude…from participation in any Federal health care program…any individual or entity that the Secretary determines…has submitted or caused to be submitted bills or requests for payment (where such bills or requests are based on charges or cost) under Title XVIII or a State health care program containing charges (or, in applicable cases, requests for payment of costs) for items or services furnished substantially in excess of such individual’s or entity’s usual charges (or, in applicable cases, substantially in excess of such individual’s or entity’s costs) for such items or services, unless the Secretary finds there is good cause for such bills or requests containing such charges or costs.” (Emphasis added.)
The language of this regulation was further interpreted in a proposal by the Office of the Inspector General (OIG) in June 2007.3 The phrase “usual charges” was suggested to include “charges billed directly to cash paying patients” (i.e., cash and carry customers). The term “substantially in excess” was defined by the OIG proposal as charges exceeding “120 percent of an individual’s or entity’s usual charges.” Finally, the OIG proposed that “good cause” for “substantially in excess” charges could be established in a number of ways, including, for example, evidence of “increased costs associated with serving Medicare or Medicaid beneficiaries.”
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DMS’S DILEMMA
DMS sends a member of the management team to a government programs seminar, where firms are provided information and guidelines regarding Federal regulations governing Medicare and Medicaid reimbursements. The team member is amazed by the number of regulations governing these programs, including the one mentioned earlier. Because the team member is not familiar with the methods that ensure DMS is in compliance with these regulations, he holds a meeting with the rest of the management team to discuss the regulations. The management team agrees it is necessary to hire a healthcare consultant to review DMS’s policies, procedures, and billing practices for products sold to customers under government programs.
After examining DMS’s operations in some detail, the healthcare consultant hired by DMS informed management of a grim, unexpected finding: DMS’s product pricing appeared to be in violation of Federal regulations governing Medicare and Medicaid reimbursements. The aforementioned regulation was the issue referenced by the healthcare consultant in determining DMS was potentially in violation of the Federal Act. The consultant examined all of the company’s products and determined many of them had Medicaid reimbursement rates “substantially in excess” of prices charged to cash and carry customers. According to the consultant, DMS would likely have to change its pricing structure and/or potentially eliminate the sale of certain products sold by the company to remedy the violation. Accordingly, the company was advised to employ one of the following courses of action: either raise cash and carry prices for products not complying with the 120% proposed “rule,” or eliminate sales of the two selected products to cash and carry customers. Discouraged by the findings and faced with uncertainty and potentially disastrous consequences, the DMS management team members contemplated their next moves.
DMS’S INITIAL CONCERNS AND RESPONSE
Given the substantial portion of DMS’s sales from customers eligible for government program reimbursements, the issue of product pricing is therefore critical to the company. Prices offered to cash and carry customers must be competitive, yet they must be within a certain percentage of government program reimbursement claims in order for DMS to comply with government regulations. As such, pricing decisions have the potential to not only adversely impact DMS’s market share of cash and carry customers but also may put the company’s ability to sell and receive reimbursement for these products under the respective government programs in jeopardy.
Unhappy with these two alternatives suggested by the consultant, company officials began compiling product pricing and costing data, as well as observing and documenting key operational aspects of the business to determine the extent of the problem revealed by the consultant and to develop potential alternative courses of action.
SELECTED PRODUCT PRICING DATA
The first two products examined by management were the nutrition supplement and nondurable gloves, two products eligible for reimbursement under government insurance programs. Table 3 includes selected information for these two products in the latest financial year.
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Table 3: Information for Selected Products Offered by DMS
Nutrition Supplement (1 can)
Nondurable Gloves (1 box)
Retail sales price (paid by cash and carry customers)
$1.54
$6.95
Maximum permitted selling price to government*
$2.20
$8.82
Product cost
$0.66
$2.65
Product sales as a % of cash and carry sales
3%
4%
Quantity of product sold to cash and carry customers
19,480 cans
5,755 boxes
Product sales as a % of government programs sales
6%
6%
Quantity of product sold to government programs customers
81,800 cans
20,408 boxes
*This maximum permitted selling price to the government applies to all companies in general under specific regulations pertaining to these products issued by the government.
BUSINESS OBSERVATIONS
Management was inclined to believe disproportionate shares of company resources were being devoted to serving government program customers, especially in the case of nutrition and nondurable products (i.e., gloves), which involved additional processing costs in order to comply with regulations. But they had no formal evidence to support this belief and thus needed to obtain relevant information about the efforts being exerted to serve the two different customer types: cash and carry and government programs. As a first step, the officials observed employees from each department to obtain an understanding of the sales and order fulfillment processes, separately, for the cash and carry and government program customers. Information about these processes from new sales origination all of the way through billing are detailed in Table 4.
As part of these observations, company employees from selected departments were asked to keep track of the amount of time they spent on the different types of customer orders and related activities for a one-month period. Because of increased work demands at the time the study was performed, similar time data was not immediately obtained from employees working in the Shipping or Administration departments. The results are presented in Table 5.4
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Table 4: Summary of Relevant Portions of Company Processes
New sales origination
Cash and carry: A company salesperson visits nursing homes, hospitals, and assisted-living facilities, speaking with potential customers and guardians. The salesperson takes orders and phones/faxes them to warehouse customer service representatives.
Government programs: Same as cash and carry.
Recurring sales
Cash and carry: A customer service representative contacts customers and takes sales orders.
Government programs: Same as cash and carry.
Order fulfillment
Cash and carry: A representative from customer service enters the order into the company’s accounting system. The system produces a pick slip, which is forwarded to Shipping. The employees in Shipping fill the order, which is then given to a third-party courier for delivery. A copy of the pick slip is sent back to the customer service representative.
Government programs: Per regulations, DMS must obtain a valid identification card proving the customer’s eligibility for the government program. To establish medical necessity, a doctor’s order is required to be submitted with each order. A customer service representative prepares fax inquiries to the customer’s physician (to establish medical necessity) and to the customer for valid proof of eligibility (if a copy was not obtained by the salesperson). Upon receipt of this documentation, the order is entered into the accounting system. The system produces a pick slip, which is forwarded to Shipping. The employees in Shipping fill the order, which is then given to a third-party courier for delivery. A copy of the pick slip is sent to a Billing representative. Shipping employees track shipments with the courier’s website to confirm delivery.
Billing
Cash and carry: A representative from customer service examines the pick slips sent back from Shipping and prepares an invoice to the customer. The customer has 30 days to pay the invoice.
Government programs: A representative from Billing prepares a government program claim and submits it. The reimbursement usually takes between 15-60 days.
Other
Government programs: Renewals for nutrition and nondurable goods: Periodically, a customer’s physician order and proof of eligibility documentation are required to be renewed. A billing representative tracks these customers and prepares renewal requests when appropriate.
Government programs: Oversight: Per regulations, DMS is required to have a compliance program staffed with a compliance officer, whose sole responsibility is to oversee compliance issues and related employee training.
Retail store and website transactions
Customers also visit the company’s retail stores and website on their own. For cash and carry customers, the retail store process in similar to point-of-sale transactions of major retail stores. For website sales, a sales representative is not involved. Rather, the customer places the order, which is then sent to a customer service representative. At that point, the customer service representative processes the order in the same way as described under “Order fulfillment.” Transactions with government programs customers visiting the retail stores are still processed in accordance with the steps above. But no sales representative is involved in the transaction. In general, government programs customers do not place orders via the company website.
CASE QUESTIONS
1. Why are government regulators sensitive to the amount of claims submitted to the government insurance programs in comparison to retail prices?
2. Why potentially could/would government programs reimbursement amounts exceed the retail sales prices
for products?
3. Consider the information provided for the two products shown in Table 3. In accordance with the OIG’s suggestions for “substantially in excess,” are the government programs
reimbursement rates for each product presently “substantially
in excess” of the “usual charges”? Provide the details of your calculations in your submission.
4. Assuming at least one of the products violates the OIG’s suggestion for “substantially in excess,” discuss the impact of the following three potential solutions to this dilemma on DMS’s market share, operations, exposure to liability, and so on. In your assessment, consider the future financial implications of the three alternatives along with the assumptions you have made in your analysis.
a. Raise prices charged to cash and carry customers such that the government programs reimbursement rate is no more than 20% higher than the newly calculated amount.
b. When submitting government program claims, request reimbursement amounts below the maximum allowable reimbursement rates in order to be within 20% of the prices charged to cash and carry customers.
c. Attempt to establish “good cause.” Refer to some of the principles and concepts you have learned or are learning in your cost management course (for example, Customer Profitability Analysis and allocations of overhead) in establishing “good cause.” Provide details of your calculations, which will aid DMS in establishing “good cause” and apply them to the two specific products shown in Table 3. (Hint: This will require you to perform cost allocations and select appropriate bases for the allocation(s).) What are your revised total cost per unit and overall profit margin amounts on the two products?
5. Looking back at your calculations and analyses performed in question 4c, do you believe the company can establish and support “good cause’ in submitting claims for the maximum allowable rates offered by government programs? In answering the question, first consider the qualitative evidence you have already developed. Second, develop a quantitative analysis appropriate to use in establishing or supporting your qualitative evidence.
6. In anticipation of the regulating agencies performing an investigation into the pricing structure of DMS, identify the strengths and weaknesses of the work performed by DMS in response to the consultant’s findings as well as the analysis you provided in the previous questions. How should DMS address the weaknesses in preparation for the audit?
ENDNOTES
1 On the other hand, customers with private insurance or access to government medical programs are required to provide evidence of medical necessity, which is often indicated by physician orders, for reimbursement.
2 Medicare is a national social insurance program administered by the U.S. Federal Government since 1966, which guarantees access to health insurance coverage for U.S. citizens age 65 or older who have worked and paid into the program. Medicaid is a U.S. government insurance program for all U.S. citizens whose income or personal resources are unable to pay for their personal healthcare.
3 Department of Health and Human Services (HHS) and the Office of the Inspector General (OIG), “Medicare and State Health Care Programs: Fraud and Abuse; Clarification of Terms and Application of Program Exclusion Authority for Submitting Claims Containing Excessive Charges,” Federal Register Volume 72, No. 116, June 18, 2007.
4 The firm does not have any type of bank borrowings or debt, and thus there is no interest expense in overhead-related expenses to consider.

Answer 1

Why are government regulators sensitive to the amount of claims submitted to the government insurance programs in comparison to retail prices?

Solution:

Reimbursement for goods provided to government programs customers are funded by taxpayer dollars directed to the appropriate government agencies. As such, companies like DMS engage in order fulfilment with the customer, but submit billing requests to government agencies for reimbursement. This arrangement provides companies with the potential opportunity to abuse the system by submitting fictitious claims excessive claims, and so on. Government programs reimbursement claims that are excessive in comparison to cash and carry prices may be indicative of the potential for such abuses and misappropriation of government funds.

Why could/would government programs reimbursement amounts exceed the retail sale prices for products?

Solution:

There could be several reasons:

Primary Reason: Additional mandates for serving customers of government programs.

Considerations include

(1) verification of medical necessity

(2) verification of eligibility

(3) Proof of delivery

These activities require more resources than those required for the typical point-of-sale process that are in place for cash and carry customers. Government agencies are compensating providers not only for the retail value of the goods provided but also for the resources consumed by these types of government mandates.

Second reason: Government reimbursement rates may not have been updated to incorporate changes in marketing pricing for the goods.

Consider the information provided for the two products (Nutrition Supplement and Nondurable Gloves) as shown in Table 3. In accordance with the Office of the Inspector General (OIG) for “substantially in excess” are the government programs reimbursement rates for each product presently “substantially in excess” of the “usual charges?”

HINT: To determine your answer use the threshold of 120% of proposed by the OIG from page two of the case narrative and assume that DMS is charging the maximum permitted selling price to the government as shown in Table 3 on page three.

Please provide details of the details of your calculations in your submission. Use the format shown below and fill in the numbers.

Item	Retail Price Paid by Cash & Carry Customers	Multiplied by 120%	Maximum Amount) Price charged to Government Customers	Difference
Nutrition Supplement	$1.54
Nondurable Gloves	6.95

Solution:

Item	Retail Price Paid by Cash & Carry Customers	Multiplied by 120%	Maximum Amount) Price charged to Government Customers	Difference
Nutrition Supplement	$1.54	1.54 * 1.2 = 1.848	$2.8	2.8 / 1.54 = 1.43%
Nondurable Gloves	6.95	6.95 * 1.2 = 8.34	$8.82	8.82 / 6.95 = 127%

Based on your answer above - Assume at least one of the products violates OIG’s suggestion for “substantially in excess and consider the following scenarios.

DMS reacted by changing the price charged to cash and carry customers. Assume that the government programs reimbursement rate was no more than 20% higher than the newly calculated amount. What effect would this decision be likely to have on the future business of cash and carry customers?

Solution:

		Nutritional Supplement	Nondurable Gloves
Maximum permitted selling price to government (given)		$2.20	$8.82
OIG Threshold % (for determining “substantially in excess”)	120%	120%	120%
Newly calculated “Cash & Carry” Price (based on government program pricing)		2.20 / 120% = $1.83	8.82 / 120% = $7.35
Original Pricing (given)		$1.54	$6.95
% increase to original “Cash & Carry” pricing		(1.83 – 1.54 ) / 1.54 = 19%	(7.35 – 6.95) / 6.95      = 6%

Note: Although this price increase to cash and carry customers would push up pricing for government programs customers to the maximum reimbursable amounts, market competition from the national retail superstores would drive the cash and carry customers to purchase from those stores at lower prices.

DMS reacted to the dilemma by requesting reimbursement amounts below the maximum allowable reimbursement rates in order to be within 20% of the prices charged to cash and carry customers. What effect would this decision potentially have on the company’s profit margins?

Solution:

		Nutritional Supplement	Nondurable Gloves
“Usual” charges (paid by cash & carry” customers		$1.54	$6.95
OIG Threshold % (for determining “substantially in excess”)	120%	120%	120%
Maximum Reimbursement (from government, based on current pricing)		1.54 * 120% = $1.85	6.95 * 120% = $8.34

Note: This course of action could be problematic for several reasons:

1. 75% of total sales are to governmental programs customers. (i.e., reducing the reimbursements claims amount across the board will have a disastrous effect on the company’s margins)
2. The company may inadvertently provide the government agencies with a basis for cutting reimbursements rates. (i.e., you would be slashing revenues with no corresponding reduction in costs)
3. By lowering reimbursements rates, you may be affecting future reimbursement rates, as budgeted amount for government programs may be slashed in the future due to the lack of perceived need for higher amounts.

OIG proposed that “good cause” for substantially in excess charges could be established in a number of ways, including, for example, “evidence of increased costs associated with serving Medicare or Medicaid beneficiaries.” Using the information from the time study conducted by DMS that is presented in Table 5 along with the department operating expenses from table 2, determine how customer service, billing, and compliance costs could be allocated by customer type.

Operating Expenses by Dept.	and Cost	Allocations by Customer
	Total Costs	Government Programs	Cash & Carry
Customer Service	$660,000
Billing	$120,000
Compliance	$120,000

Solution:

	Allocation	Allocated Amounts		Total
Customer Service	Time (85 / 15)	($561,000)	($99,000)	($660,000)
Shipping	Sales (75 / 25)	($652,500)	($127,500)	($870,000)
Billing	Time (100 / 0)	($120,000)	0	($120,000)
Compliance	Time (100 / 0)	($120,000)	0	($120,000)
Administration	Sales (75 /25)	($322,500)	($107,500)	($430,000)
Total Operating Expenses		($1,776,000)	($424,000)	($2,200,000)
Operating Income		$249,000	$251,000	$500,000

	Government		Cash & Carry
	Nutrition	Gloves	Nutrition	Gloves
% Sales	6%	6%	3%	4%
Overhead	$106,560	$106,560	$12,720	$16,960
Units Sold	81,800	20,408	19,480	5,755
Overhead Cost (per unit)	$1.30	$5.22	$0.65	$2.95
Product Cost (per unit)	$0.66	$2.65	$0.66	$2.65
Total Cost (per unit)	$1.96 ($1.30 + 0$0.66)	$7.87 ($5.22 + $2.65)	$1.31 ($0.65 + $0.66)	$5.60 ($2.95 + $2.65)
Price per unit – Cash & Carry			$1.54	$6.95
Price per unit – (Government)	$2.20	$8.82
Profit%	10.79%	10.75%	14.74%	19.47%

Do you think the DMS should track costs for the shipping and receiving departments and try to establish “good cause” for charging Medicare and Medicaid beneficiaries substantially more than cash and carry customers for the same products?

What thoughts do you have concerning how DMS should address the company’s weaknesses in preparation for the upcoming audit?

Solution:

Even though government program reimbursements are larger than amounts paid by cash and carry customers, the profit % on government program customers are lower. This would provide some initial evidence to support “good cause” for the company’s current pricing of both nondurable gloves and the nutrition supplement to government program customers.

The detailed fulfilment process requirements outlined in Table 4 of the case provides additional evidence that more time and effort are expended on government program customers compared to cash and carry customers. Not only does the government reimbursement process entail more tasks, it also requires entire departments devoted to handling the business of processing government program orders.

What thoughts do you have concerning how DMS should address the company's weaknesses in preparation for the upcoming audit?

Solution:

Weaknesses of Analysis:

The regulators could insist that a traditional costing approach (i.e., based purely on sales volume of products) would be more appropriate since these products (1) are a relatively small portion of overall sales, (2) have similar sales volumes by percentage.

The regulators could argue the appropriateness of your use of cost allocation based on both stages of the process. First stage allocations were based on either time spent by the departments or the % of sales. Then, second stage allocations (to individual products) were again based on % of sales. Where other allocation bases (e.g., % of orders processed) considered and how would profitability change be using other allocation bases? Why was it appropriate to utilize the % of sales as an allocation base for both shipping and Administration departments (vs. time spent, which was used for the other departments)?

Since Shipping and Administration make up such a large portion (60%) of the total operating costs, DMS should consider tracking several different allocation bases to see how allocations of operating costs might be affected.

DMS should consider trading many different allocation bases to ensure that their conclusions with respect to costs and pricing are as robust as possible.