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Chapter 5 – Activity-Based Costing

St. Francis Healthcare and Dialysis Clinic

St. Francis Healthcare and Dialysis Clinic (SFHDC) is an independent, nonprofit full-service renal dialysis clinic. The clinic provides two types of treatments. Hemodialysis (HD) requires patients to visit a dialysis clinic three times a week, where they are connected to special, expensive equipment to perform the dialysis. Peritoneal dialysis (PD) allows patients to administer their own treatment daily at home. The clinic monitors PD patients and assists them in ordering supplied consumed during the home treatment. The total and product-line income statement for the clinic is shown below:

CLINIC INCOME STATEMENT	TOTAL		HD		PD
Revenues
Number of patients	164		102		62
Number of treatments	34,067		14,343		20,624
Total revenue	$3,006,775		$1,860,287		$1,146,488
Supply costs
Standard supplies (drugs, syringes)	664,900		512,619		152,281
Episodic supplies (for special conditions)	310,695		98,680		212,015
Total supply costs	975,595		611,299		364,296
Service costs
General overhead (occupancy, administration)			785,825
Durable equipment (maintenance, depreciation)			137,046
Nursing services (RNs, LPNs, nursing administrators
equipment technicians)			883,280
Total service costs	1,806,151		1,117,463		688,688
Total operating expenses	2,781,746		1,728,762		1,052,984
Net income	$225,029		$131,525		$93,504
Treatment Level Profit
Average charge per treatment		$129.70		$55.59
Average cost per treatment		120.53		51.06
Profit per treatment		$9.17		$4.53

The existing cost system assigned the traceable supply costs directly to the two types of treatments. The service costs, however, were not analyzed by type of treatment. The total service costs of $1,806,151 were allocated to the treatments using the ration-of-cost-to-charges (RCC) method developed for government cost-based reimbursement programs. With this procedure, since HD t4reatments represented about 61% of total revenues, HD received an allocation of 61% of the $1.8 million service expenses.

For many years, the clinics such as SFHDC received much of their reimbursement on the basis of reported costs. Starting in 2015, however, payment mechanisms shifted, and now SFHDC received most of its reimbursement on the basis of a fixed fee not the cost of the service provided. In particular, because HD and PD procedures were categorized by the government as a single category – dialysis treatment-the weekly reimbursement for each patient was the same $389.10. As a consequence, the three HD treatments per week led to a reported revenue per HD treatment of $129.70, and the seven PD treatments per week led to a reported revenue per PD treatment of $55.59.

Both procedures appeared to be profitable, according to the clinic’s existing cost and revenue recognition system. Francis Bernadone, the controller of SFHDC was concerned, however, that the procedures currently being used to assign common expenses may not be representative of the underlying use of the common resources by the two different procedures. He wanted to understand their costs better so the SFHDC’s managers could make more-informed decisions about extending or contracting products and services and about where to look for process improvements. Bernadone decided to explore whether activity-based costing principles could provide a better idea of the underlying cost and profitability of HD and PD treatments.

PHASE I

In his initial analysis, Bernadone decided to focus on the General Overhead category. But rather than continue to use the RDD method for allocating equipment and nursing costs, he asked the clinic staff for their judgements about how these costs should be allocated. On the basis of the staff’s experience and judgement, they felt that HD treatments used about 85% of their resources and PD about 15%.

Bernadone composed the General Overhead category into four resource cost pools. Then for each pool, he chose a cost driver that represented how that resource was used by the two treatments. The summary of the analysis is presented below:

GENERAL OVERHEAD RESOURCE COST POOL	SIZE OF POOL		COST DRIVER
Facility costs (rent, depreciation)	$233,226		Square feet of space
Administration and support staff	354,682		Number of patients
Communication systems and medical records	157,219		Number of treatments
Utilities	40,698		Estimated kilowatt usage
Total		$785,825

Bernadone then went to medical records and other sources to identify the quantities of each cost driver for the two treatment types:

GENERAL OVERHEAD COST DRIVER	TOTAL	HD	PD
Square feet	30,000	18,900	11,100
Number of patients	164	102	62
Number of treatments	34,967	14,343	20,624
Estimated kilowatt usage	662,700	563,295	99,405

PHASE II

Bernadone was uncomfortable with the consensus estimate that nursing and equipment costs should be split 85:15 between HD and PD treatments. In particular, he knew that just the nursing resource category contained a mixture of different types of personnel: registered nurses (RNs), licensed practical nurses (LPNs), nursing administrators and machine operators. He thought it was unlikely that each of these categories would be used in the same proportion y the two different treatments. In the next phase of analysis, Thomas disaggregated the nursing service category into four resource pools and as with general overhead, selected an appropriate cost driver for each resource pool.

NURSING SERVICES RESOURCE POOL	SIZE OF POOL	COST DRIVER
Registered nurses	$239,120	Full-time equivalents (FTEs)
Licensed practical nurses	404,064	FTEs
Nursing administration and support staff	115,168	Number of treatments
Dialysis machine operators	124,928	Number of clinic treatments
$883,280

NURSING SERVICES COST DRIVER	TOTAL		HD		PD
RNs, FTE	7		5		2
LPNs, FTE	19		15		4
Total number of dialysis treatments	34,967		14,343		20,624
Number of clinic dialysis treatments		14,343		14,343

Bernadone felt that the 85:15 spilt was still reasonable for the durable equipment use, and, in any case, the relatively small size of this resource expense category probably did not warrant additional study and data collection.

REQUIRED

1) Prepare the revised set of cost estimates and treatment profit and loss statements for HD and PD using the information gathered during Phase I. What led to any major difference between the RDD method for allocating cost and the Phase I ABC method?

2) Use the information on the distribution of nursing and machine operator resources to calculate revised product-line income statements and profit and loss statements for individual treatments.

3) Analyze the newly produced information and assess its implications for managers at SFHDC. What decisions might managers of the clinic make with this new information that might differ from those made using information from the RCC method only?

4) What improvements, if any, would you make in developing an ABC model for SFHDC?

Prepare you case response using the five steps of strategic decision making. Only steps one through four are relevant since time-series data is not available

Answer 1

1… Phase   I
GENERAL OVERHEAD RESOURCE COST POOL	SIZE OF POOL	COST DRIVER	HD		PD
Facility costs (rent, depreciation)	233226	Square feet of space	233226/30000*18900=	146932	233226/30000*11100=	86294
Administration and support staff	354682	Number of patients	354682/164*102=	220595	354682/164*62=	134087
Communication systems and medical records	157219	Number of treatments	157219/34967*14343=	64489	157219/34967*20624=	92730
Utilities	40698	Estimated kilowatt usage	40698/662700*563295=	34593	40698/662700*99405=	6105
Total	785825			466610		319215
2.   Phase II
NURSING SERVICES RESOURCE POOL	SIZE OF POOL	COST DRIVER	HD		PD
Registered nurses	239120	Full-time equivalents (FTEs)	239120/7*5=	170800	239120/7*2=	68320
Licensed practical nurses	404064	FTEs	404064/19*15=	318998	404064/19*4=	85066
Nursing administration and support staff	115168	Number of treatments	115168/34967*14343=	47240	115168/34967*20624=	67928
Dialysis machine operators	124928	Number of clinic treatments	124929/14343*14343=	124928		0
	883280			661966		221314

CLINIC INCOME STATEMENT	TOTAL	HD	PD
Revenues
Number of patients	164	102	62
Number of treatments	34,067	14,343	20,624
Total revenue	3006775	1860287	1146488
Supply costs :
Standard supplies (drugs, syringes)	664900	512619	152281
Episodic supplies (for special conditions)	310,695	98,680	212015
Total supply costs	975,595	611,299	364,296
Service costs :
General overhead (occupancy, administration)	785825	466610	319,215
Durable equipment (maintenance, depreciation)85:15	137,046	116489	20557
Nursing services (RNs, LPNs, nursing administrators.equipment technicians	883280	661966	221314
Total service costs	1806151	1245065	561,086
Total operating expenses(Supply+service costs)	2781746	1856364	925,382
Net income	225029	3923	221106
Treatment Level Profit
Average charge per treatment(Total Revenue/No.of Treatments)		129.70	55.59
Average cost per treatment(Total Cost/No.of treatments)		129.43	44.87
Profit per treatment(Av. Chg.-Av. Cost)		0.27	10.72

Analysis of individual service costs:
General overhead (occupancy, administration)	785825	466610	319,215
% to Total		59.38%	40.62%
Nursing services (RNs, LPNs, nursing administrators.equipment technicians(85:15)	883280	661966	221314
% to Total		74.94%	25.06%
Durable equipment (maintenance, depreciation)	137,046	116489	20557
% to Total		85%	15%

In all the cases, proportionate charge of service costs is not the same as 61:39 as under RCC method .

Durable equipment (maintenance & depn.) is understandably more for HD treatments as it is entirely hospital-based.

Also nursing services are more in HD treatments, for the same reason.

And there is a slight decrease in general OH

Because of the revision in service cost allocation , both total cost & per treatment charge has gone up for HD & decreased for PD treatments.

So, profit per treatment has decreased for HD & increased for PD

The Goal of ABC analysis is to determine the accurate cost so as to measure profits accurately

So,there should be accuracy in identifying all activities, without any exception, & allocating costs to each activity

Also the cost & time element should justify the exercise.

Pros & cons   with the existing system should be analysed

and finally ABC should be justified as a cost effective exercise.