1. Chapter 14 Cost Concepts and Decision Making

2. Learning Objectives Discuss ways to classify costs Discuss four major categories of costs Explain what cost behavior is and identify five types of cost behavior Differentiate between controllable and noncontrollable costs Discuss four types of costs relevant when considering alternative projects Explain the role of direct and indirect costs in costing process

3. Learning Objectives, cont. Describe three methods of cost allocation Establish the importance of semi-variable cost function Calculate estimated fixed and variable costs using one of the described methods Calculate break-even and the volume necessary to achieve a desired net income

4. Cost Information Cost information is produced by the firm’s financial accounting system Can be used by department managers, third- party payers and planning agencies Cost objects: products (outputs and services) and responsibility centers (e.g. departments)

5. Cost Classifications Costs can be classified according to the decision maker’s specific need Major classifications of cost include: 1.Traceability to the object being costed 2.Management responsibility for control 3.Relation of costs to budget 4.Relation of costs to time 5.Behavior of cost to output or activity

6. Cost Classification Example

7. Traceability Classification of costs by their traceability depends on the cost object Cost object – an item for which a separate cost measurement is required –e.g., product, process, department, activity Major cost categories: –Direct costs –Indirect costs

8. Direct Costs vs. Indirect Costs Direct costs that can be specifically linked to a given product or service –e.g., direct labor (salaries), supplies, rent expense Indirect costs are not easily traceability to a product or service, but support production of a product or service. –e.g., administrative overhead, depreciation, employee benefits

9. Cost Behavior Cost behavior describes the cost variability in relation to output or activity The measurement of cost behavior is influenced by department’s classification of cost (e.g. direct vs. indirect) Five major categories of costs classified by their behavior –Variable Costs –Fixed Costs –Mixed, included Semifixed costs (also referref to as “step fixed” costs) Semivariable costs Curvilinear costs

10. Variable Costs Changes proportionally as output, volume or other activity level changes The activity what causes the incurred variable costs. –e.g., direct labor hours, discharges, patient visits Consider the following example: –All supply costs are variable –For each unit increase in relative value units (RVUs), supply costs increase by $.50

11. Figure 14–1 Cost Behavior of Supplies Cost, Variable

12. Fixed Costs Fixed costs do not change or vary in response to changes in activity Fixed costs are a function of time, not output Consider the following example: –Fixed costs behavior for the depreciation costs of the lab –Each month depreciation cost is $160, irrespective of output levels

13. Figure 14–2 Cost Behavior of Depreciation, Fixed

14. Semifixed (Step Fixed) Costs Costs change with changes in output, but not proportionally Might be considered variable or fixed, depending on the size of steps relative to the range of volume Consider the following example: –Salary cost of the lab is semifixed –Assume for every additional 2,000 RVUs, one additional full-time employee (FTE) must be employed –Within each range of 2,000 RVUs, salary costs will be fixed.

15. Figure 14–6 Cost Behavior of Aggregated Costs

16. Semivariable Costs Include elements of both fixed and variable costs There is some fixed requirement per unit of time, regardless of volume But, there is also a direct, proportional relationship between activity (volume) and costs Utility costs are a good example of this concept

17. Figure 14–4 Cost Behavior of Other Costs, Semivariable

18. Curvilinear Costs Variable costs do not always behave strictly in linear fashion However, within a relevant range, costs can be approximated with a straight line. The relevant range is the range of activity within which the assumptions about the cost behavior are valid. Managers should understand that assumptions about any type of cost behavior may not be valid outside the relevant range.

19. Figure 14–5 Curvilinear costs and the relevant range

20. Management Responsibility for Control To evaluate management control process, costs must be assigned to individual responsibility centers Which types of costs can manager’s control?

21. Figure 14–7 Laboratory Cost Behavior Organization

22. Controllable Costs Can be influenced by designated responsibility center with a defined time period Main approaches to designate controllable costs: –May be identified as the total costs charged to the department ($21,360 in the example below) –May be limited to direct costs ($20,000 of the $21,360) –May be defined as only those costs that are direct and variable ($9,000 in the example) Regardless of the chosen method, it should be applied consistently across departments

23. Other Costs Relevant to Decision Making Decision making involves selection among alternatives. Certain costs are important to the process of selecting among alternative decisions, including: –Avoidable Costs –Sunk Costs –Incremental Costs –Opportunity Costs

24. Avoidable Costs Avoidable costs that can be eliminated or saved if an activity is discontinued; these costs will only remain only if activity continues Variable costs are usually a subset of avoidable costs Some fixed costs may also be avoidable when large changes in volume are considered

25. Sunk Costs Sunk costs are retrospective costs that have already been incurred Sunk costs are unaffected by the decision under consideration Typically, sunk costs are a subset of fixed costs

26. Incremental Costs Incremental costs represent the change in cost that results from a specific management action/decision Incremental costs are similar to marginal costs, or the cost to provide an additional unit of service or product. Therefore, incremental costs refer to the change in costs that results from a management decision or action that increases volume.

27. Opportunity Costs Opportunity costs are the values forgone by using a resource in a particular way instead of next best alternative Consider the decision to expand of nursing home –Historical cost of land is $1 M and the current market value is $10 M –The opportunity cost of using this land to expand the nursing home is represented by the next best alternative, which in this case, is selling the land for $10M

28. Costs in Relation to Budget Budgeted costs: the amount that has been “planned” or authorized to be spent in a specific category for a specific purpose Actual costs: the amount which is spent in a specific category or for a specific purpose.

29. Cost Allocation Cost allocation – process of assigning pooled indirect costs to specific cost objects (products, departments, etc) Uses allocation base that represents a major business function Allocation base (“cost driver”) – an item that is used to allocate costs, based on its relationship to why costs occurred –E.g. square footage, number of FTEs, direct-labor hours

30. Importance of Cost Allocation The cost of indirect, nonrevenue departments need to be allocated to direct revenue departments for decision making purposes For example, reimbursement may be based on the departments full costs (i.e. both direct and indirect costs) Similarly, pricing decision and financial return evaluation should be based on full costs of a specific program or service line

31. Cost Allocation Equity is critical in allocating indirect department costs to direct departments. Cost allocation should: –Reflect the actual indirect cost incurred by the direct department –Motivate managers of direct departments to reduce costs

32. Methods of Cost Allocation To allocate indirect costs, two decisions must be made: 1.Selection of the cost driver or basis of allocation 2.Method of cost apportionment. These methods include: Step-down method Double-distribution method Simultaneous-equations method

33. Step-Down Method The step down method used by most health care facilities The idea here is that the indirect department that receives the least amount of service from other indirect departments and provides the most service to all other departments allocates its cost first Similar analysis is conducted for the remaining indirect departments

34. Step-Down Method Example Consider a hospital with four departments: laundry/linen, housekeeping, radiology, & nursing The first step is to decide which department provides the most service to the other for each department. Assume the laundry/linen department provides the most service to the other departments, so their costs ($15K) are allocated first The cost driver for laundry/linen is pounds of laundry used. Of the 100,000 lbs of laundry used –Housekeeping uses 5% and is therefore allocated $750 ($15K x 5%) of laundry/linen’s direct cost. –Radiology similarly uses 5% and is also allocated $750. –Nursing uses 90% of the laundry and is allocated $13,500.

35. Step-Down Method Example, cont Now, the total direct costs of housekeeping to be allocated to radiology and nursing is $30,750 ($30,000 of housekeeping’s original direct cost plus $750 of allocated laundry/linen). Housekeeping is allocated to radiology and nursing based on the numbers of housekeeping hours used. Therefore, radiology is allocated $9,711 and nursing is allocated $21,039 of housekeeping’s costs. The full costs of the radiology department, including indirect costs, is $145, 461. The full costs of the nursing department is $304, 539

37. Step Down Method It’s important to remember, that in the step down method, the order of department allocation is important. In addition, the allocation base (or cost driver) can also create differences in cost allocation. What would happen to the full costs of radiology and nursing if housekeeping allocated their costs first?

38. Double-Distribution Method Refinement of step-down method Instead of closing individual department after allocating its costs, it is kept open and receives the costs of other indirect departments After one complete allocation sequence, the former departments are closed using the normal step-down method

39. Simultaneous-Equations Method Used to calculate the exact cost allocation amounts Mathematically correct allocations are computed through a system of equations Consider the previous example: Laundry cost (LC) = $15,000 +.05 HC Housekeeping cost (HC) = $30,000 +.05 LC Radiology cost (RC) = $135,000 +.05LC +.30HC Nursing cost (NC) = $270,000 +.90LC +.65 HC

40. Estimating Fixed and Variable Costs Cost functions can be estimated using a variety of methods Four main estimation methods we will consider here are: –Visual-fit –High-low –Semi-averages –Regression

41. Estimation Methods Example Consider following example: –Determine labor cost function for radiology department –Six biweekly payroll data points

42. Visual-Fit Method In the visual-fit method, the data points are plotted on graph Straight line is drawn through the points to provide the best fit through the points The slope of the line can provide an estimate of the cost per additional films. The visual-fit method is a good first step in any method of cost estimation

43. Figure 14–8 Visual Fitting of Radiology Data

44. High-Low Method Technique used to estimate the variable and fixed-cost coefficients of a semivariable cost function The variable cost parameter is solved first: change in cost from highest to lowest, divided by the change in output:

45. High-Low Method, cont. The fixed-cost parameter is solved next by subtracting the estimated variable cost from total cost Fixed labor hours per pay period = 320 – (.50 x 600) = 320 – 300 = 20

46. Semi-Averages Method Similar to the high-low method in the mathematical form To derive the estimate of variable cost, the difference between the mean of the high-cost points and the mean of the low-cost points is divided by the change in output from the mean of the high-cost points to the mean of the low-cost points Fixed costs are solved in the manner identical to that used in high-low method

47. Semi-Averages Method Example

48. Simple Linear Regression (SLR) Method Also called “Least-squares regression” method Produces estimates of variable cost (VC) and fixed cost (F) that will minimize the variance between predicted and actual observations Mathematically more precise version of visual-fit method Standard errors estimates are used to consider whether differences are statistically significant General regression equation:

49. Simple Linear Regression, cont. Excel provides built-in tools to perform SLR Regression lines can be used to visually depict relationship between independent (x) and dependent (y) variables in the graph Straight line – linear trend in the data, first order equation (e.g. y = 3x + 4) Curved line – relationship is described by a higher order equation (e.g. y = 2x² + 5x – 8)

50. Simple Linear Regression, cont. To start, enter data into Excel Select data to be graphed Click icon to start Chart Wizard Choose chart type Follow prompts in Wizard until scatter plot is produced

51. Plotting Data in Excel

52. After selecting data, click on the Chart Wizard.

53. Using “Add Trendline” Command

54. Regression Analysis Here, the regression equation is given by: y =.5012 + 22.91X

55. Multiple Regression Method An extension of simple linear regression Used when the dependent variable (i.e., cost) is caused by more than one factor –E.g. shipping costs may depend on both the number of units shipped and the weight of the units So include multiple dependent variables in the regression analysis.

56. Break-Even Analysis Also called cost-volume-profit (CVP) analysis Quantifies the relationship between profit and various factors, e.g.: –Rates or prices –Volume –Variable cost –Fixed cost –Payer mix –Bad debts

57. Break-Even Analysis, cont. An equation sets profit equal to zero and revenue equal to costs and solves for break-even (BE) volume (Q): TR = TC + Zero Profit P x Q = FC + (VC x Q) Q BE = FC / (P – VC) Where: TR = Total Revenue TC = Total Cost FC= Fixed Cost VC = Variable Cost P = Price Q = Quatity

58. Break-Even Analysis, cont. Consider example: :

59. Break-Even Analysis, cont. Interpretation – if volume exceeds 72 cases, the hospital will make a profit If volume is below 72 cases, the hospital will incur a loss

60. Figure 14–9 Break-Even Chart

61. Break-Even Analysis, cont. An alternative form of BE chart may display the difference between the total cost and total revenue line – net income

62. Multiple-Payer Model of BE Analysis Previous BE analysis is based on a single- payer system In health care there are usually more than one payer or purchaser of services Main categories of payers: –Cost payers –Fixed-price payers –Charge payers

63. Multiple-Payer BE Analysis BE formula for the three payer situation: Where individual variables are:

64. Multiple-Payer BE Example VC = $1,000/ case FC = $100,000/ period Profit required = $6,000

65. Multiple-Payer BE Example, cont.

66. Computation of Marginal Profit One of special applications of BE formula Determines how sensitive profit is to possible swings in volume: