Cost Allocation Methods on Eagan Family Practice Group Example

Introduction

Eagan Family Practice Group is located the Minneapolis area. There are 20 physicians as well as 46 physician nurses among the Group's clinical staff. Eagan consists of 3 departments that specialize in service to patients: Pediatrics, Obstetrics, and Adult Medicine. There are also 3 support departments that to aid the 3 patient service departments. They include Finance, Facilities, and Administration.

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Due to the need for the Cost Allocation process to go through an overhaul, The Group offered a contract to one of the accounting firms for an estimation of the services that the support departments provide to one another as well as the amount they provide to the patient service departments. The exercise's intention was to avail data important data for Eagan to come up with a system of cost allocation to take the place of the older, arbitrary system still in use.

The next stage in the initiative to improve the cost allocation process is to select the method of allocation. We can consider 4 cost allocation methods: Reciprocal, double apportionment, step-down, and direct method. This paper will attempt to analyze and explain the sensitivity of allocation methods to the patient service departments, compare the sizes of the overhead costs, and the rates of allocation. Furthermore, this paper's purpose is to discuss what the analysis shows about the profitability of the departments of patient service. Finally, I will discuss and defend my recommendation pertaining to the most suitable cost allocation method for the practice.

Reciprocal Method

In every healthcare institution, the department that generates revenue utilizes the services of the support department accomplish the tasks the medical professionals have allocated them (Popesko, Novak & Papadaki, 2015). We can trace the costs incurred in the support departments to the amount of level of service provision, while user departments are allocated the other costs incurred by the support department. The main advantage of the allocation method is that it provides a higher level of accuracy for the information pertaining to service costs (Huang, 2016).

There are 3 major purposes for the allocation of costs: acquiring the much-needed motivation, obtaining reimbursement or justifying the cost, and calculating income or valuation of assets. This allocation method allocates costs with consideration of the fact that the service departments offer services to one another and to the departments involved in the production (Nakagawa, Yoshihara & Nakagawa, 2011). This is beneficial because the relationship between the departments will make it simpler to determine the cost allocations of the service departments.

The allocation of costs by the support department to other departments that generate revenue is facilitated by the reciprocal method using the matrix approach (Popesko, Novak & Papadaki, 2015). Accounting for costs in healthcare institutions depends on the allocation of costs and the matrix approach is used because of the support department's increasing costs and numbers. Financial reporting in healthcare institutions improves when there is greater accuracy in allocation costing. Better information on costs also improves the decision-making role of the management (Nakagawa, Yoshihara & Nakagawa, 2011).

Eagan Family Practice has 3 service departments and 3 support departments. The 3 service departments generate revenue as follows:

• Adult medicine- $12,000,000,
• Obstetrics- $6,000,000
• Pediatrics- $2,000,000

The total revenue generated from these departments is $20,000,000. Also, the direct costs from the patient service department are $6,000,000, $3,600,000, and $1,200,000 which totals to $10,800,000. Furthermore, the direct costs from the support services department are as follows:

• Administration- $1,000,000
• Facilities- $4,000,000
• Finance-$1,800,000

The total direct cost for the support department is $18,000,000. A computation of the difference between the revenues and direct costs is $2,000,000. A representation on a table would have the following outlook.

From the figures in the above table, Adult Medicine would yield the following results:

• 0.35 / 0.8 = 43.75 %
• 0.2 / 0.8 = 25%
• 0.25 / 0.8 = 31.25%

Adult Medicine would yield the following results:

• 0.55 / 0.85 = 64.71%
• 0.1 / 0.85 =11.76 %
• 0.2 /0.85 = 23.53

Pediatrics would yield the following results:

• 0.5 / 0.9 = 55.55%
• 0.25 /0.9 =27.78%
• 0.15 / 0.9 = 16.67 %

Profit yield in the department of patient services.

The analysis of patient services shows that Obstetrics and Adult Medicine provide higher profit than Pediatrics. Despite the fact that profitability of Pediatrics is lower, it remains to be a very crucial department in health practice. Some of the most important departments of an organization do not always yield the highest profit. The main reason for the establishment of such departments is the provision of health services that are needed the most by patients. The importance of the Pediatrics department is greater compared to the other departments because its role is to provide necessary mental and physical health examinations to infants and adolescents.

The following calculations show the level of profitability of each of the patient services using double apportionment, step-down, and direct methods.

Discussion and Defense for the Reciprocal Method

I have used 4 cost allocation methods namely reciprocal, double-apportionment, step-down, and direct method. I recommend that the firm selects the reciprocal method in coming up with the necessary data. Managers are becoming more concerned about the provision of accurate cost allocation information. The method that will provide such accurate information is the reciprocal method of cost allocation. The only challenge with using the reciprocal method is that it is more complex to use compared to the other methods (Yereli, 2009). This means that the person who does the computation needs to be well informed on how to go about the computations. Despite this challenge, I feel that the reciprocal method suits the organization more since all the departments will be recognized collectively which will provide a platform for their comparison.

Learning points

This study provides very important learning points for any health institution that needs information on which cost allocation method is the best. Most health organizations are usually undecided on which cost allocation method suits the organization more. However, the level of accuracy of data provided by each method differs. From Eagan Family Practice Group's situation, I have learned how to allocate costs in different departments of the organization, that is the support department and the patient services department. I have also learned that the most important departments do not necessarily earn the organization the highest profits (Popesko, Papadaki & Novak, 2015). Lastly, I have bettered my understanding of how to calculate cost allocation using the reciprocal, double-apportionment, step-down, and direct methods and how to interpret the cost data. This knowledge will be important when I am required to perform such tasks in my career.

Conclusion

Eagan Family Practice located in Minneapolis comprises of the patient service department and the support department. The patient service department is made up of the Pediatrics, Adult Medicine, and Obstetrics. The support department consists of Facilities, Administration, and finance. The whole organization has a total of 20 physicians and 46 nurses and physician extenders. The aim of contracting the firm was to give an estimation of how much service each of the departments offer one another. The resultant data from the accounting firm would facilitate Eagan's objective of coming up with a better system of cost allocation hence replacing the older system that the Group finds ineffective. After a comparison between the 4 methods of cost allocation, I have come to the conclusion that the reciprocal method is the best alternative for the organization. The strength of the reciprocal is that it provides more accurate data that will aid the management to make better decisions on cost allocation. It also has a challenge in that it requires more complex mathematical calculations compared to the other methods of cost allocation. This is the reason many similar organizations rarely choose this method. However, it is imperative to overlook the challenges if the method will provide positive results that will lead higher profitability of Eagan. Overall, the reciprocal method is the best option for Eagan.

References

Huang, Y. T. (2016). Evaluation and recommendation of implementing time-driven activity-based costing in healthcare (Doctoral dissertation, The University of Texas School of Public Health).

Nakagawa, Y., Yoshihara, H., & Nakagawa, Y. (2011). New indicators based on personnel cost for management efficiency in a hospital. Journal of medical systems, 35(4), 625-637.

Popesko, B., Novak, P., & Papadaki, S. (2015). Measuring diagnosis and patient profitability in healthcare: Economics vs ethics. Economics and Sociology.

Popesko, B., Papadaki, S., & Novak, P. (2015). Cost and reimbursement analysis of selected hospital diagnoses via activity-based costing. E+ M Ekonomie a Management, (3), 50.

Yereli, A. N. (2009). Activity-based costing and its application in a Turkish university hospital. AORN journal, 89(3), 573-591.