Introduction
For organizations in any industry, it is of utmost importance to take a rational approach to costs. Cost allocation is the process that allows identifying and keeping track of cost objects that affect an organization’s financial situation by inflicting significant losses or making substantial profits. This essay aims to discuss the cost allocation process in the context of healthcare, including its goals, key steps, and methods.
The Goal of Cost Allocation
Cost allocation involves identifying costs, collecting enough information about them, and assigning costs to specific cost objects, such as particular departments or products. In the healthcare system, the goal of performing the aforementioned actions is to improve the organization’s financial situation by distributing costs between responsibility centers in a fair and effective manner (Edgington, Kerman, Shi, & Koh, 2019; Story, 2012). Healthcare organizations consist of different responsibility centers, including profit centers that generate revenues from patient care services (patient care units, hospital laboratories, etc.) (Public Health Finance & Management, n.d.). Additionally, there are cost centers that are not directly responsible for revenues from patient care but still incur costs, such as housekeeping and administrative departments (PHFM, n.d.). With the help of cost allocation methods, hospital managers use data on different departments’ profitability to make the best possible cost-related decisions, such as diverting more money to profitable departments. Also, to some degree, cost allocation can shed light on specialists’/departments’ performance and its role in the organization’s profitability, which has positive implications for employee motivation.
Effective Cost Drivers
The selection of effective cost drivers promotes the success of financial analysis activities by enabling healthcare organizations to assess the profitability of cost objects. To be effective, cost drivers should be fair and promote the reduction of administrative costs (Swierkowski & Barnett, 2018; PHFM, n.d.). Regarding the first characteristic, good cost drivers accurately reflect differences between profit centers in terms of service use, which promotes fair cost allocation. Some examples of widely used cost drivers include the occupied floor space (Nakagawa, Yoshinara, & Nakagawa, 2012). If a certain department occupies more space than the others, it is fair to reflect the difference when allocating costs. As for the second feature of effective cost drivers, it is essential for such drivers to create incentives for the reduction of overhead costs. Thus, the occupied space can be used as a cost driver when making decisions regarding the allocation of housekeeping costs. In this case, the cost driver is fixed, easy to measure and verify, and has a clear link to housekeeping activities, which allows using it to reduce unnecessary costs where possible.
Steps in the Cost Allocation Process
The process of cost allocation consists of four essential steps that have implications for financial analysis. Firstly, it is critical to establish the cost pool or a certain group of ongoing indirect expenditures needed to operate the business (PHFM, n. d.). To form a pool, it is possible to accumulate all costs associated with a certain department (for instance, personnel). Secondly, keeping in mind the aforementioned characteristics of cost drivers, one has to choose the most applicable driver. For instance, to distribute personnel costs between wards, one can use the number of patient beds or the average length of stay as cost drivers (Nakagawa et al., 2012). Thirdly, it is necessary to calculate the allocation rate or the portion of the cost pool that each profit center uses. Accounting professionals determine allocation rates by dividing the cost pool (the sum of money) by the volume of the selected cost driver for each profit center, thus getting specific allocation rates for different profit centers. Fourthly, by multiplying individual allocation rates by the cost pool, one can calculate allocation amounts for specific profit centers.
Methods
There are three prominent techniques helping to conduct financial analysis and allocate costs in healthcare. They differ in terms of complexity and the degree to which links between diverse cost centers are recognized. These techniques include the direct method (overhead departments’ costs are allocated directly to profit centers) and the reciprocal method (all existing interconnections and exchanges between different overhead departments are considered) (PHFM, n.d.; Yigezu et al., 2020). Within the frame of the reciprocal method, the identification of allocation bases is followed by the use of the technique of simultaneous equations to make allowances for each interaction between support departments (Yigezu et al., 2020). Finally, the step-down method combines the methods above by making sure that cost centers enter the cost allocation process in a specific order (Penner, 2017). In this method, links between cost centers in terms of cost generation are partially considered.
The step-down approach is probably the best cost allocation technique. Being recommended by Medicare for cost reports, it is more accurate than the direct method since it does not treat each support department as an isolated entity (Penner, 2017). At the same time, the required calculations are not overly complex, which makes it less time-consuming compared to the reciprocal method. Regarding the accuracy of results, the direct method is criticized and is not considered universally applicable (Penner, 2017). Thus, despite its convenience and simplicity, I would regard the direct method as the worst option if accuracy is emphasized.
Conclusion
Cost allocation procedures are used to improve healthcare organizations’ success and promote employee motivation and fair cost allocation. Typically, the cost allocation process involves four steps, including identifying cost pools and effective cost drivers and calculating allocation rates/amounts with their help. There are three cost allocation methods, and the key differences between them refer to accuracy and the recognition of complex interconnections between cost centers.
References
Edgington, J., Kerman, X., Shi, L., & Koh, J. L. (2019). How to perform an economic healthcare study. In V. Musahl, M. T. Hirschmann, O. R. Ayeni, J. L. Koh, R. G. Marx, N. Nakamura, & J. Karlsson (Eds.), Basic methods handbook for clinical orthopedic research (pp. 373-380). Springer, Berlin, Heidelberg.
Nakagawa, Y., Yoshinara, H., & Nakagawa, Y. (2012). A new cost accounting model and new indicators for hospital management based on personnel cost. In A. Kolker & P. Story (Eds.), Management engineering for effective healthcare delivery: Principles and applications (pp. 419-435). Hershey, PA: IGI Global.
Penner, S. J. (2017). Economics and financial management for nurses and nurse leaders (3rd ed.). New York, NY: Springer Publishing Company.
Public Health Finance & Management. (n.d.). Cost allocation study notes. Web.
Story, P. (2012). Dynamic capacity management (DCAMM™) in a hospital setting. In A. Kolker & P. Story (Eds.), Management engineering for effective healthcare delivery: Principles and applications (pp. 46-68). Hershey, PA: IGI Global.
Swierkowski, P., & Barnett, A. (2018). Identification of hospital cost drivers using sparse group lasso. PloS One, 13(10), 1-19.
Yigezu, A., Alemayehu, S., Hamusse, S. D., Ergeta, G. T., Hailemariam, D., & Hailu, A. (2020). Cost-effectiveness of facility-based, stand-alone and mobile-based voluntary counseling and testing for HIV in Addis Ababa, Ethiopia. Cost-Effectiveness and Resource Allocation, 18(1), 1-12.