2345CHAPTER_4_Estimating_CostsIntroduction_to_managerial

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CHAPTER 4 Estimating Costs

Introduction to managerial accounting

Cost classifications

Fixed versus variable

Direct versus indirect (overhead)

Cost behavior

Cost allocation

Activity-based costing

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Managerial Accounting

There are two main areas of accounting:

Financial

Managerial

Financial accounting involves creating financial statements to report the financial status of the overall business. These statements are used primarily by outsiders.

Managerial accounting involves creating information for internal use in managerial decision making. This chapter focuses on managerial accounting.

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Cost Classifications

Cost measurement is a critical part of managerial accounting.

Unfortunately, there is no single definition of the term cost. Different costs are used for different purposes.

Costs are classified in two major ways:

By their relationship to volume

By their relationship to the sub-unit being analyzed

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Is there a difference between a cost and an expense?

Discussion Item

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Cost Behavior

The relationship between costs and the volume of services provided is called cost behavior or underlying cost structure.

If the underlying cost structure is known, managers can forecast costs at different levels of patient volume.

In this context, costs may be

fixed (independent of volume), or

variable (dependent on volume).

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Cost Behavior (cont.)

In the long-run, all costs are variable; hence, the fixed versus variable classification can hold only in the short-run—say, for one year.

Also, no costs are fixed throughout an infinite range of volumes. Thus, the concept of cost classifications according to volume must be applied within some relevant range of patient volume.

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What are some examples of fixed and variable costs for a hospital’s clinical laboratory?

Discussion Item

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Cost Behavior Example: Walk-In Clinic

Variable Costs Per Visit Fixed Costs Per Year

Clinical supplies $20 Facilities $30,000

Other supplies 5 Salaries 190,000

Variable cost rate $25 Overhead 80,000

$300,000

Total Fixed Variable Total Average

Volume Costs Costs Costs Cost

1 $300,000 $ 25 $300,025 $300,025

100 300,000 2,500 302,500 3,025

200 300,000 5,000 305,000 1,525

1,000 300,000 25,000 325,000 325

5,000 300,000 125,000 425,000 85

10,000 300,000 250,000 550,000 55

25,000 300,000 625,000 925,000 37

Note: The relevant range is this example is unrealistic.

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Cost Behavior Example (cont.)

Consider a volume of 5,000:

Fixed costs = $300,000.

Variable cost rate = $25.

Total variable costs = $125,000.

Total costs = $425,000.

Average cost per visit = $85.

Now consider a volume of 10,000:

Fixed costs = $300,000.

Variable cost rate = $25.

Total variable costs = $250,000.

Total costs = $550,000.

Average cost per visit = $55.

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The average cost per visit decreases as volume increases.

In economics, what is this relationship called?

What characteristic of a business’s cost structure makes this relationship possible?

Discussion Items

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Graph of Cost Behavior

Costs

($)

Volume

(number of visits)

Total costs

Fixed costs

Total variable costs

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The Second Cost Classification

In addition to their relationship to volume, costs can be classified by their relationship to the unit of activity:

Direct: costs unique and exclusive to a sub-unit

Indirect, or overhead: costs associated with shared resources used by the entire organization

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What are some examples of direct and indirect (overhead) costs for a hospital’s clinical laboratory?

Discussion Item

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Cost Allocation

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

To begin, we must define two terms used in cost allocation:

Cost pool

Cost driver

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Cost Pool

A cost pool is the overhead amount to be allocated.

In general, a cost pool consists of the direct costs of one overhead department.

However, if the costs of a single overhead department differ substantially in nature and are used in different proportions, multiple cost pools should be used. For example, financial services overhead might be divided as follows:

Billing and collections cost pool

Budgeting cost pool

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Cost Driver

A cost driver is the basis on which the cost pool will be allocated.

For example, the cost driver for facilities overhead (building space depreciation, maintenance, utilities, and so on) might be the amount of space used by each patient service department.

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Cost Drivers (cont.)

The selection of cost drivers is critical to the cost allocation process.

Cost drivers should create an allocation that is highly correlated with the actual amount of overhead services consumed.

Good cost drivers will have two important attributes:

They are perceived as fair.

They promote organizational cost reduction.

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Discussion Items

Overhead cost allocation is a “pain.” Why is it necessary?

Suppose a hospital uses amount of space occupied (square footage) as the cost driver for the allocation of housekeeping services. Does this measure have the attributes of a good driver?

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Traditional Allocation Process

1. Identify the cost pool.

The cost pool is the dollar cost of the overhead activity to be allocated.

To illustrate, assume that a hospital’s housekeeping department has direct costs of $100,000.

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Traditional Allocation Process (cont.)

2. Determine the cost driver.

The cost driver is the basis on which the overhead costs will be allocated.

Assume that the cost driver for housekeeping services is the amount of space occupied. User departments in total occupy 200,000 square feet of space.

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Traditional Allocation Process (cont.)

3. Calculate the allocation rate.

Here, the allocation rate is $100,000 ÷ 200,000 = $.50 per square foot of space occupied.

Allocation rate = .

Dollars in cost pool

Total volume of cost driver

The allocation rate is the numerical value used to make the allocation:

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Traditional Allocation Process (cont.)

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 $.50 × 10,000 = $5,000.

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Allocation Methods

Mechanically, cost allocation can be accomplished in a variety of ways.

Regardless of the method, all overhead costs must ultimately be allocated to the departments that create the need for such costs—the patient service departments.

There are several allocation methods:

Direct method

Step-down method

Reciprocal method

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Allocation Methods (cont.)

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

In the 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.

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Allocation Methods (cont.)

The reciprocal method recognizes all of the support department interrelationships, but it requires a system of simultaneous equations or a complex set of iterative calculations.

Which method is used most commonly in practice?

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Direct Method (DM) Illustration (Situation)

Consider the direct cost allocation system used at Mercy Hospital.

To simplify the illustration, we have reduced the number of departments to four:

Support (overhead) departments

Facilities services

General administration

Patient services departments

Routine care

Critical care

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DM Illustration (Situation cont.)

Mercy uses the following cost drivers:

The cost driver for the facilities services cost pool is the amount of space used by each patient services department.

The cost driver for the general administration cost pool is the amount of revenue generated by each patient services department.

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DM Illustration (Data)

Projected Revenues by Patient Services Department

Routine care $22,000,000

Critical care 5,000,000

Total revenues $27,000,000

Projected Costs for All Departments:

Patient Service Departments (Direct Costs)

Routine care $ 8,300,000

Critical care 3,300,000

Total direct costs $11,600,000

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DM Illustration (Data)

Projected Costs for All Departments (cont.):

Support Departments (Direct Costs)*

Facilities services $ 8,600,000

General administration 5,250,000

Total overhead costs $13,850,000

Total costs of both patient

and support services $25,450,000

Projected overall profit $ 1,550,000

*Note: The direct costs of the support departments will become the overhead costs of the patient services departments.

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DM Illustration (Data)

Selected Patient Services Department Data

Square Feet Revenue

Routine care 261,000 $22,000,000

Critical care 39,600 5,000,000

Total 300,600 $27,000,000

Why aren’t the support departments listed here?

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DM Illustration (Allocation Rates)

Facilities Services

$8,600,000 in overhead costs to be allocated across 300,600 square feet: $8,600,000 ÷ 300,600  $28.61 per square foot. This is the allocation rate.

General Administration

$5,250,000 in overhead costs to be allocated across $27,000,000 in revenue dollars: $5,250,000 ÷ $27,000,000  $.194 per revenue dollar.

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DM Illustration (Allocation Amounts)

From facilities services:

To routine care

$28.61 × 261,000 = $7,467,066

To critical care

$28.61 × 39,600 = $1,132,934

$8,600,000

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DM Illustration (Allocation Amounts)

From general administration:

To routine care

$.194 × 22,000,000 = $4,277,778

To critical care

$.194 × 5,000,000 = $ 972,222

$5,250,000

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DM Illustration (P&L Statements)

Routine Care Margin

Revenues $22,000,000

Direct costs 8,300,000

Profit on direct costs $13,700,000 62.3%

Indirect costs:

Facilities services 7,467,066

General administration 4,277,778

Profit on total (full) costs $ 1,955,156 8.8%

Critical Care

Revenues $ 5,000,000

Direct costs 3,300,000

Profit on direct costs $ 1,700,000 34.0%

Indirect costs:

Facilities services 1,132,934

General administration 972,222

Profit on total (full) costs −$ 405,156 −8.1%

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Discussion Items

Suppose you are the critical care department head at Mercy Hospital. Your bonus depends on good financial performance. What would be your reaction to the allocation results?

What would be your first line of defense?

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Activity-Based Costing (ABC)

Unlike traditional cost allocation, which is a top-down system, activity-based costing (ABC) begins with the individual activities that compose the services provided.

Although it is useful for costing individual services, it requires more information and is more complex than traditional costing.

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ABC Illustration

Assume a physician practice does only executive physicals, which (ignoring lab tests) consist of three separate activities:

Patient check-in

Physical examination (minor or major)

Report and consultation

The following slide contains the ABC analysis for the practice.

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ABC Illustration (cont.)

Annual Activity Data Allocation

Costs Driver Minor Major Total Rate

Check-in $ 25,000 Exams 1,500 500 2,000 $12.50

Physical exam 300,000 Minutes 60 120 150,000 2.00

Report/consult 75,000 Minutes 30 60 75,000 1.00

$400,000

Minor Exam Major Exam

Rate Consumption Cost Consumption Cost

Check-in $12.50 1 $ 12.50 1 $ 12.50

Physical exam 2.00 60 120.00 120 240.00

Report/consult 1.00 30 30.00 60 60.00

Cost per exam $162.50 $312.50

Allocation Rate Calculation

Service Cost Calculation (Per Exam)

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This concludes our discussion of Chapter 4 (Estimating Costs).

Although not all concepts were discussed, you are responsible for all of the material in the text.

Do you have any questions?

Conclusion

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