Question

Resource Usage, Special Order

St. John’s Medical Center (SJMC) has five medical technicians who are responsible for conducting cardiac catheterization testing in SJMC’s Cath Lab. Each technician is paid a salary of $36,000 and is capable of conducting 1,000 procedures per year. The cardiac catheterization equipment is one year old and was purchased for $250,000. It is expected to last five years. The equipment’s capacity is 25,000 procedures over its life. Depreciation is computed on a straight-line basis, with no salvage value expected. The reading of the catheterization results is conducted by an outside physician whose fee is $120 per test. The technician’s report with the outside physician’s note of results is sent to the referring physician. In addition to the salaries and equipment, SJMC spends $50,000 for supplies and other costs needed to operate the equipment (assuming 5,000 procedures are conducted). When SJMC purchased the equipment, it fully expected to perform 5,000 procedures per year. In fact, during its first year of operation, 5,000 procedures were run. However, a larger hospital has established a clinic in the city and will siphon off some of SJMC’s business. During the coming years, SJMC expects to run only 4,200 cath procedures yearly. SJMC has been charging $850 for the procedure—enough to cover the direct costs of the procedure plus an assignment of general overhead (e.g., depreciation on the hospital building, lighting and heating, and janitorial services).

At the beginning of the second year, an HMO from a neighboring community approached SJMC and offered to send its clients to SJMC for cardiac catheterization provided that the charge per procedure would be $550. The HMO estimates that it can provide about 500 patients per year. The HMO has indicated that the arrangement is temporary—for one year only. The HMO expects to have its own testing capabilities within one year.

Required:

1. Which of the resources associated with the cardiac catheterization activity can be classified as committed resources?

Cardiac catheterization equipment and technicians

Which of the resources associated with the cardiac catheterization activity can be classified as flexible resources?

Supplies and other costs, Outside physician reading of results

2. Calculate the activity rate for the cardiac catheterization activity. Break the activity rate into fixed and variable components.

Activity rate	$	per procedure
Fixed activity rate	$	per test
Variable activity rate	$	per test

Which of the activity resources are relevant with respect to the following alternatives: (1) accept the HMO offer, or (2) reject the HMO offer?

Supplies and other costs, and outside physician reading of results

3. Assume that SJMC will accept the HMO offer if it reduces the hospital’s operating costs. Should the HMO offer be accepted?

Yes

4. Assuming that SJMC wants to bring in the same revenues earned in the cardiac catheterization activity’s first year less the reduction in resource spending attributable to using only four technicians, how much must SJMC charge for a procedure? If rounding is required, round your answer to the nearest dollar.

$ per procedure ____________

Answer 1

1.     Committed resources: Cardiac catheterization equipment and technicians

        Flexible resources: Supplies and other costs, outside physician reading of results

2.

Activity costs:

        Technician salaries................................................................          $180,000

        Depreciation.........................................................................              50,000

        Supplies and other................................................................              50,000

        Physician reading.................................................................             600,000

              Total expected costs.......................................................          $880,000

        Practical capacity..................................................................         ÷     5,000 procedures

              Activity rate per procedure............................................         $         176

        Fixed activity rate = ($180,000 + $50,000)/5,000 = $46 per test

        Variable activity rate = ($50,000 + $600,000)/5,000 = $130 per test

Relevant: Supplies and other costs and physician results reading. These are flexible resources; if activity demand changes then they are relevant. In this case, the demand for tests increases by 500 units.

Irrelevant: Depreciation (sunk cost), technician salaries (demand increase is less than unused capacity).

3.     If the offer is accepted, SJMC receives $550 per procedure and will spend $130 per procedure, for a net benefit of $420 each. The total benefit is $210,000 ($420 × 500). The offer should be accepted since it reduces the hospital’s oper­ating costs by $210,000.

4.

The charge to receive the same revenues as before less the resource spending reduction is computed as follows:

        Price = [($850 × 5,000) – $28,000*]/4,200 = $1,005

        *$36,000 – (4 × $2,000) = $28,000