ACC281: Accounting Concepts for Health Care Professionals- Product Costing
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From your text and at least one scholarly source, describe how service center costs are allocated using the various allocation methods. Illustrate its use by using a
health care example.
Chapter 11
Product Costing: Attaching Costs
to Patient Services
Learning Objectives
• Understand why and how costs are attached to patient services.
• Describe how direct materials, direct labor, and clinic/hospital overhead are costed to
patient services.
• Explain why predetermined overhead rates are usually used for costing.
• Identify the main differences among alternative measures for the denominator in the
overhead rate.
• Explain why services should be costed for pricing purposes by using an overhead rate
computed at normal volume levels.
• Describe how to allocate service center costs so that they can be included in overhead
rates of operating departments.
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Section 11.1 Costing of Patient Services CHAPTER 11
Chapter Outline
Introduction
11.1 Costing of Patient Services
11.2 Costing of Direct Costs
Costing of Direct Materials
Costing of Direct Labor
11.3 Costing of Hospital/Clinic Overhead
Predetermined Overhead Rate
Multiple Overhead Rates
Alternative Concepts of Volume
11.4 Cost of Providing Services
Direct Method
Step (Sequential) Method
Treatment of Revenues
Allocation of Costs by Behavior
11.5 Ethical Issues For Cost Allocation
Introduction
Costs are used to accomplish an assortment of needs: to evaluate the profitability of
goods and services, to aid in pricing and bidding decisions for negotiating contracts
with insurers, to plan and budget operations, to evaluate performance, to control costs,
and to establish inventory values for the balance sheet and cost of goods and services sold
for the income statement.
This chapter discusses accounting for costs and presents ways to identify costs with products
or services. Accounting for direct materials and direct labor comes first. Then, accounting
for clinic/hospital overhead covers simple to more complex situations. Finally, we
discuss how service center costs, such as transportation or laboratory costs, are included
in patient service costs.
11.1 Costing of Patient Services
Serving patient needs involves the use of resources. As mentioned in Chapter 9, the
costs of these resources are typically classified as materials, labor, and overhead. The
costs are accumulated by jobs (patient care or procedure) or by departments. Then they
are assigned to each unit of output (product, such as medical equipment, or service, such
as nursing care or laboratory test) based on each unit’s use of the resources. These relationships
for assigning costs to products or services are depicted in Figure 11.1.
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Section 11.2 Costing of Direct Costs CHAPTER 11
Figure 11.1: A view of cost linkage
The principles underlying product costing are applicable to manufacturing companies
and service organizations. For example, a hospital may be interested in determining the
cost of a specific medical treatment or the cost of outpatient care. A medical supply store
may wish to know the costs associated with carrying and selling a particular line of wheelchairs.
A building contractor, on the other hand, will accumulate costs by project. If a contractor
is constructing a hospital for a community, for instance, the contractor will identify
and trace the costs to the hospital project. A university may be interested in the estimation,
measurement, and control of a program to train nurses and physicians. A museum may
want to determine the cost of a particular exhibit for a season.
Regardless of the type of organization, costs are identified as direct costs when they can be
readily connected to a cost objective. Indirect costs, which cannot as easily be connected
to an objective, must be allocated using some reasonable basis for allocation. For example,
all patient care requires heat and light, but that would not be billed per patient; instead it
would be an indirect cost.
In a medical setting, costs are allocated by patient or by medication. A job would include
everything involved in an individual patient’s care. Some of these costs can be allocated
directly, such as the costs for medications used, laboratory tests done, and staff time (physicians,
nurses, and others) that is tracked directly by patient. Other costs will be overhead
costs, such as housekeeping, transportation, administrators, and everything else that goes
into operating a hospital or clinic that cannot be identified as direct patient care.
First, we take a look at costs that can be identified by patient. Then we a look at indirect
costs that are allocated using a process called overhead costing.
11.2 Costing of Direct Costs
We now discuss how to determine the costs that are directly traceable to patient care.
These costs consist of direct materials and direct labor.
Costing of Direct Materials
Materials include the medical supplies that have been purchased for patient care and can
be allocated by patient. Many medical facilities today use a system to scan a medication or
medical supply by bar code before providing care. That way, each type of medical supply
can be directly allocated by patient. After a hospital stay, the bill the patient receives can
have hundreds of these supplies listed. Direct materials are those that are identified with
the treatment of a specific patient and are easily and economically traced to the patient;
their costs represent a significant part of the total patient cost. All other materials and
Outputs
(Products or Services)
Resources
(Costs)
Activities
(Departments or Jobs)
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Section 11.2 Costing of Direct Costs CHAPTER 11
supplies that become part of patient care are called indirect materials, which are part of
hospital/clinic overhead.
The costs associated with acquiring materials and having them ready for patient care typically
fall into four categories:
1. the acquisition cost purchase price of the materials;
2. in-transit charges, such as freight, insurance, storage, customs and duty charges;
3. credits for trade discounts, cash discounts, and other discounts and allowances;
and
4. the costs of purchasing, receiving, inspecting, and storing activities.
Categories 1 through 3 are typically included in the cost of materials, whether direct or
indirect materials. Category 4 is treated as hospital/clinic overhead. We allocate those
costs to patient services with one of the several approaches that will be discussed later in
the chapter.
Suppose that Julz Medical Clinic purchased medical supplies on account for $75,000.
Upon receipt of the materials, we increase Medical Supplies and Accounts Payable by
$75,000 as follows:
Medical Supplies Accounts Payable
$75,000 $75,000
Nurses requisition from the supply room the medical supplies required for a specific
patient’s care. Thus, each requisition becomes the basis for charging the cost of medical
supplies to a specific patient. Assume that a month’s requisitions at Julz Enterprises
show that direct materials costing $60,000 have been transferred from the medical supplies
inventory to patient care. The total of $60,000 is moved from Medical Supplies to
Patient Billing (or Accounts Receivable). The latter account is a focal account for the tracking
of costs to be billed to the patient or the insurance company. The costs of the three
cost elements—direct materials, direct labor, and hospital/clinic overhead—are funneled
through this account, as will be shown later. It is, therefore, the control account for all
patient billing. The movement of medical supplies used in production for the month is
shown as:
Medical Supplies Patient Billing
$75,000 $60,000 $60,000
Costing of Direct Labor
Labor is the total labor cost expended for the benefit of an individual patient. Direct labor
can be specifically identified with an individual patient in an economically feasible
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Section 11.3 Costing of Hospital/Clinic Overhead CHAPTER 11
manner. Indirect labor is not readily traced to an individual patient, such as housekeeping
or nursing administrative time.
Labor-related costs include the wages and salaries of the employees plus any additional
expenditures made by an employer on behalf of an employee. These typically include
bonuses, overtime premiums (i.e., the additional wages for overtime), shift differentials,
idle time, employer’s payroll taxes, and fringe benefits. These additional expenditures are
usually treated as part of the hospital/clinic overhead costs. Some of these expenditures
cannot easily be traced to individual patients. Others, such as overtime premiums and
shift differentials, are treated as hospital/clinic overhead, so those patients receiving care
during overtime hours or late shifts are not unfairly penalized.
Some medical facilities track nursing time by individual patients. This automatically
generates a labor report. These reports show how much of the nurses’ time and cost is
charged to each patient. For the sake of simplicity, we will assume that all of Julz Medical
Clinic’s labor is direct labor. Suppose that during one month, the labor costs for Julz
Medical Clinic were $10,000 and the workers’ take-home pay totaled $7,400. The resulting
transaction is shown:
Patient Billing Wages Payable
$60,000 $7,400
10,000
Other Labor-Related
Payables
$2,600
Other medical facilities don’t try to calculate these costs with this much precision because
they don’t have an automated system to track nursing time, and it would be too costly
to do it manually. Instead they may allocate nursing time per patient per day based on
historical averages. For example, in an ICU unit more nursing time per patient will be
allocated than in a lower-level-of-care floor. Check with your medical facility to find out
how medical staff costs are allocated per patient.
11.3 Costing of Hospital/Clinic Overhead
Hospital/clinic overhead, unlike direct materials and direct labor, cannot be measured
directly as a cost of any particular patient care. Overhead consists of a variety of
costs, such as indirect materials, indirect labor, administration, insurance, depreciation,
utilities, repair, and maintenance—all of which are indirectly related to patient services.
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Section 11.3 Costing of Hospital/Clinic Overhead CHAPTER 11
The indirect nature of overhead costs with respect to patient services creates difficulty in
identifying service costs for each patient. For our purposes at this point, we take an overall,
simplified approach to costing of hospital/clinic overhead to patient services. This
is to convey the concepts involved. Later in the chapter, we explain overhead costs by
employing departmental rates.
For the discussion that follows, hospital/clinic overhead is attached to services by means
of a cost driver that links costs to patient services. The cost driver chosen as a basis for
overhead allocation should be related logically to both the overhead and the service. For
example, the operation of an MRI machine will include overhead costs such as power cost,
lubrication, maintenance, repairs, depreciation, and other costs closely related to machine
operation. The benefits received by the products can probably be best measured against
the cost of the machine hours used in providing patient care. Therefore, these overhead
costs should be allocated to the products on the basis of machine hours used to provide
patient care. For other types of patient services whose operations are more labor intensive
than capital intensive, direct labor cost or direct labor hours may be more appropriate for
overhead allocation. The most common cost drivers chosen for overhead allocation are
direct labor hours and direct labor cost.
The total cost driver activity for the hospital/clinic is divided into the total overhead cost
to obtain an overhead rate. Services then are assigned overhead cost by multiplying the
actual quantities of the activity by the rate calculated. Suppose that Julz Medical Clinic
uses direct labor cost to allocate overhead. During the month in the earlier example, for
which direct labor cost was $10,000, the total overhead for the clinic was $15,000. Consequently,
the overhead rate would be 150% of direct labor cost. During that month, the
direct labor cost incurred to treat patients amounted to $2,700. Hence, $4,050 ($2,700 3 1.5)
of overhead cost would be allocated to each patient.
Predetermined Overhead Rate
Thus far, we have discussed actual costing, where the product costs consist of actual direct
materials used, actual direct labor cost, and overhead allocation based on total actual overhead
costs and total actual activity. Most companies, however, use a normal cost system
or a standard cost system. The latter will be covered in Chapter 13. Normal costing differs
from actual costing in that overhead is allocated using a predetermined overhead rate,
defined as:
Predetermined overhead rate 5
Budgeted hospital/clinic overhead 4 Budgeted cost driver activity.
With normal costing, the applied overhead would be determined by multiplying the predetermined
overhead rate by the actual cost driver activity for the patient care. Typically,
companies use a 1-year time horizon to calculate predetermined overhead rates.
Two major reasons exist for the use of normal costing rather than actual costing. The first
is the timing of overhead cost incurrence. For example, air conditioning costs in the summer
for many facilities in the Sunbelt tend to be higher than heating costs are in the winter.
Should we allocate the higher air conditioning costs to patients who were served during
the summer? The facilities and workers must be maintained regardless of the weather.
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Section 11.3 Costing of Hospital/Clinic Overhead CHAPTER 11
In addition, discretionary costs may fluctuate widely from month to month. For instance,
managers may decide to incur substantial maintenance costs during some months and
very little during other months. Because of seasonal and discretionary aspects of overhead,
a more stable overhead rate requires a longer time horizon, such as 1 year.
The second reason for the use of normal costing is the potential fluctuation in the activity
represented by the cost driver. Most companies do not have a constant level of activity
every month. For example, employees take vacations during the summer months, or
operations are scaled back to accommodate major repairs and maintenance. Normal costing,
by using a 1-year time horizon for the overhead rate, averages costs over the units of
work regardless of when work is performed. Therefore, patients are not penalized because
they are treated during a period of low volume.
Calculating an actual overhead rate using a 1-year time horizon, prices, and other costbased
decisions could not be done until the end of the year. Clearly, medical facilities cannot
operate this way. The use of a predetermined overhead rate allows costs of patient care
to be calculated throughout the year as necessary. Moreover, a predetermined overhead
rate helps managers to prepare bids when negotiating contracts with insurers or other
third-party payers.
To illustrate the application of overhead in a normal cost system, suppose that, for 20X3,
Bodker Medical Clinic has budgeted $50,000 for fixed overhead costs and $3 per direct
labor hour for variable overhead costs. This is its overhead cost function. These budgeted
costs correspond to a budget activity of 10,000 direct labor hours. The predetermined
overhead rate would be computed as:
[$50,000 1 $3(10,000)] 4 10,000 5 $8 per direct labor hour.
Assume there were 10,000 direct labor hours worked, at a rate of $50 per hour, during
20X3. Assume also that $95,000 of direct materials was used. During production, various
entries were made to cost the patient care. We could quite literally add $8 to the patient bill
every time one more hour of direct labor is worked. In normal accounting activity, these
transfers to the patient bill are done periodically, most likely on a daily basis. If done in
aggregate, a summary transfer of all overhead applied to patient services would show the
following:
Facility Overhead Patient Billing
$80,000 $ 95,000
100,000
80,000
Multiple Overhead Rates
Some reasonable, causal, or beneficial relationship should exist among the costs accumulated
in facility overhead accounts, the cost driver selected, and the services to which
the costs will be allocated. Simply stated: The activity (as represented by the cost driver)
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Section 11.3 Costing of Hospital/Clinic Overhead CHAPTER 11
is the link between the output of services and facility overhead spending. The implication
is that more output requires more activity and, therefore, more overhead spending.
For example, if a company uses direct labor hours as a cost driver, facility overhead costs
should consist primarily or exclusively of costs that support direct workers. Such costs
may include supervision and facilities for workplaces, as well as travel, training, and
fringe benefits of workers.
In the examples up to this point in the chapter, we have assumed that only one cost driver
is appropriate for the total facility overhead. However, diversity of products and services
will often result in distorted cost allocations when only one cost driver is used. The greater
the differences in services, the greater the diversity that exists in the operations. The more
diverse the operations, the more likely it is that one cost driver cannot assign costs to all
services fairly. In these situations, departmental overhead rates will assign costs more
accurately to services than will one facility-wide overhead rate. A facility-wide overhead
rate can only be justified for a clinic that specializes in one or two types of patient care.
For example, the patient transportation department must have the equipment for transporting
patients and the staff to make those transports. An overhead allocation would be
developed for the depreciation of equipment, storage of equipment, and the supervisory
staff. This would be very different from the radiology department whose overhead would
include much more expensive equipment that would need to be depreciated, technical
staff as well as medical staff that would not be easy to allocate directly, supervisory staff,
utilities, and other costs. The overhead allocated for services from this department would
likely be higher than the overhead calculated for patient transportation.
When patients use the services of these two departments, patient transportation overhead
may be allocated by patient transported, while radiology overhead may be allocated by
test performed. For example, one patient could be sent to radiology for numerous tests.
This could involve one patient transport and three possible tests.
Alternative Concepts of Volume
When selecting the denominator for the overhead rate, volume can be measured in one of
four ways:
1. ideal capacity;
2. practical capacity;
3. expected volume; or
4. normal volume.
Ideal capacity is the maximum amount of service that can be rendered with available
facilities. This is often too perfect a goal to be realized and is generally recognized to be
beyond realistic expectations. Certain interruptions and inefficiencies in service are to
be expected.
Practical capacity is full utilization of facilities with allowance made for normal interruptions
and inefficiencies. For example, service will be slowed or stopped at times because
of breakdowns, shortages of labor and materials, or retooling. These possibilities are considered
in arriving at practical facility capacity.
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Section 11.4 Cost of Providing Services CHAPTER 11
Expected volume is the level of operation budgeted or estimated for the current period.
This may be at or below practical capacity. It is the level at which management expects to
operate during the next month or year.
Normal volume is generally a balance between practical capacity and patient care demand
in the long run. Over a period of years, the peaks and valleys of patient care demand are
leveled by averaging, and the average level of plant utilization is considered to be normal
volume.
It may seem, at first, that overhead per unit should be calculated at the expected level
of operation for the next year. Indeed, this is the practice of most healthcare providers.
However, for service-pricing purposes, a better approach is to use the normal volume.
Why should normal volume be used when you already know that the company may be
operating below that level? After all, a rate computed at the expected level of operation
will come closer to costing all of the overhead to the products, and product cost will be
more in line with actual cost.
The problem with using an overhead rate based on expected, rather than normal, volume
is illustrated by the following example. Assume that the normal level of operation for
Cherrywood Medical Laboratory is 200,000 labor hours and that 100,000 items can be
analyzed in that time. The fixed overhead for the year is budgeted at $500,000. The normal
fixed overhead per item is then $5, computed as:
$500,000/100,000 5 $5 Fixed overhead per item.
But management expects to operate at only 100,000 labor hours next year and to analyze
50,000 items. An overhead rate at expected volume would be $10 per item:
$500,000/50,000 5 $10 Fixed overhead per item.
If the lab plans to operate below normal volume, an overhead rate computed at the
expected level of operations will result in more fixed overhead being assigned to each
item. If prices are set by adding a markup to total cost, the cost of operations will be higher
when fewer items are analyzed. Billing will not change because that is determined by
negotiated contract rates.
For this reason, the objective is not necessarily to assign all overhead costs to products.
The products should bear the normal overhead costs, and any unabsorbed fixed overhead
should be recognized as a period expense. (Overabsorbed fixed overhead would likewise
result in a reduction of period expenses.) Rather than allocating unabsorbed fixed overhead
to products produced, this approach treats the costs of idle capacity as the costs of
products the company did not produce.
11.4 Cost of Providing Services
An entity that provides services instead of tangible products may not operate with a
formal cost accounting system that traces costs to jobs. Instead, all service job costs
are treated as period costs and are often left in their original cost categories such as supplies
expense, labor expense, and depreciation expense.
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Section 11.4 Cost of Providing Services CHAPTER 11
Nevertheless, costs will be used to measure performance by type of service and by patient
groups. A rehabilitation facility, for example, provides an exercise room for its patients.
The cost of supplies used exclusively for the exercise room, such as rubbing lotions and
bandages, along with the salaries and wages of the room’s employees, such as the manager
and therapists, is identified with the exercise activities. Also, costs of special equipment
used, such as depreciation and maintenance expenses, and other overhead costs
increased by operating this service, will be included. These costs can be used as a basis for
deciding how much must be added to a patient’s bill to cover all costs and allow for profit.
See Table 11.1 for example service centers and possible cost drivers.
Table 11.1: Possible cost drivers used for selected service centers
Service Center Possible Cost Drivers
Purchasing Number of orders, cost of materials, line items ordered
Receiving and inspection Cost of materials, number of units, number of orders, labor hours
Storerooms Cost of materials, number of requisitions, number of units handled,
square or cubic footage occupied
Personnel Number of employees, labor hours, turnover of labor
Laundry Pounds of laundry, number of items processed
Cafeteria Number of employees
Custodial services Square footage occupied
Repair and maintenance Machine hours, labor hours
Medical facilities Number of employees, hours worked
Facility administration Total labor hours, number of employees, labor cost
Power Kilowatt hours, capacity of machines
Occasionally, companies may not allocate service center costs to operating departments,
or organizational units most closely tied to the productive effort that results in products
or services to customers, in order to ensure that the services are fully utilized by the operating
managers. Some examples of this phenomenon include internal audit departments,
credit-check services, facilities management, and computer services.
Two common approaches are available for allocating the costs of service centers: direct
method and step (sequential) method. To illustrate the allocation of service center costs for
the first two methods, we will use data from the Nursing School at Hardknox University.
The Nursing School wishes to determine overhead costs per credit hour for its undergraduate
and graduate programs. We will treat these as the two operating departments. The
Nursing School has three service centers: Building Services, Staff Services (e.g., secretarial
support, computer support, and photocopying), and Administration. Budgeted data for
the coming year appear as follows:
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Section 11.4 Cost of Providing Services CHAPTER 11
Square Feet
Occupied Employees
Overhead
Costs
Service Centers
Building Services 1,000 30 $165,000
Staff Services 2,000 20 90,000
Administration 8,000 20 330,000
Operating Departments
Graduate program 10,000 30 265,000
Undergraduate program 20,000 90 420,000
Building Services costs are allocated on square footage of classroom and office space. Staff
Services and Administration costs are allocated based on number of employees (i.e., faculty
and staff). Budgeted credit hours for the year are 20,000 for the graduate program and
60,000 for the undergraduate program.
Direct Method
Direct method allocations are made from each service center to operating departments in
proportion to activity performed for each. Thus, the direct method does not assign costs
to other service centers for work performed for other service centers. Allocation of service
center costs uses only those cost drivers pertaining to operating departments. Once the
service centers have their costs allocated, operating department overhead rates per unit of
activity are calculated.
Space associated with the graduate program is 10,000 square feet; for the undergraduate
program, the space used is 20,000 square feet. The allocation base, therefore, totals 30,000
square feet. Building Services costs are then prorated over the two programs as follows:
Graduate program 10,000 sq. ft. 1/3 3 $165,000 5 $ 55,000
Undergraduate program 20,000 2/3 3 $165,000 5 110,000
Total 30,000 sq. ft. Total cost $165,000
The double line is used to designate totals.
The same approach follows for Staff Services and Administration. These are summarized
as follows:
Graduate program 30 employees 1/4 3 $90,000 5 $ 22,500
Undergraduate program 90 3/4 3 $90,000 5 67,500
Total 120 employees Total cost $ 90,000
Graduate program 30 employees 1/4 3 $330,000 5 $ 82,500
Undergraduate program 90 3/4 3 $330,000 5 247,500
Total 120 employees Total cost $330,000
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Section 11.4 Cost of Providing Services CHAPTER 11
In a clinical setting, a similar calculation would be used. Suppose you are allocating space
for various sections in a clinic. A cancer care facility may have a radiology treatment section
and a chemo treatment section. There are probably many more sections in a cancer
care facility, but we are keeping things simple to introduce this concept.
Space associated with the chemo section is 2,000 square feet; for the radiology section,
the space used is 4,000 square feet. The allocation base, therefore, totals 6,000 square feet.
Building Services costs are then prorated over the two programs as follows:
Chemo section 2,000 sq. ft. 1/3 3 $75,000 5 $25,000
Radiology section 4,000 2/3 3 $75,000 5 50,000
Total 6,000 sq. ft. Total cost $75,000
The same approach follows for Staff Services and Administration. These are summarized
as follows:
Chemo section 15 employees 1/4 3 $ 60,000 5 $ 15,000
Radiology section 60 3/4 3 $ 60,000 5 45,000
Total 75 employees Total cost $ 60,000
Chemo section 15 employees 1/4 3 $160,000 5 $ 40,000
Radiology 60 3/4 3 $160,000 5 120,000
Total 75 employees Total cost $160,000
Another way to perform these allocations is to divide the service center costs by the cost
driver and apply the resulting rate to the operating department usage amount. For example,
Building Services would have a rate of $5.50 per square foot ($165,000/30,000).
The results of service center allocations and the subsequent calculation of overhead rates
for the operating departments are summarized as follows:
Building
Services
Staff
Services
Administrative
Graduate
Program
Undergraduate
Program
Costs $165,000 $90,000 $330,000 $265,000 $420,000
Building Services (165,000) 55,000 110,000
Staff Services (90,000) 22,500 67,500
Administration (330,000) 82,500 247,500
$ 0 $ 0 $ 0 $425,000 $845,000
Credit hours 4 20,000 4 60,000
Overhead rate
per credit hour
$ 21.25 $ 14.08
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Section 11.4 Cost of Providing Services CHAPTER 11
Step (Sequential) Method
Another more complicated method of allocating costs performed by other service centers
is called the step (sequential) method. However, recognition of those services is a oneway
process. The service centers are arranged in a sequence, and their costs are allocated
one after the other. Once a service center’s costs are allocated, no other costs are allocated
back to that service center even though it may use resources of other service centers. The
first service center’s costs are allocated to all subsequent service centers and operating
departments. The second service center’s costs are then allocated to all subsequent service
centers and operating departments, but not to the first service center. This process continues
until all service centers’ costs have been allocated to operating departments. The
number of allocation steps will equal the number of service centers.
In a hospital setting, the Medicare cost step-down method to allocate costs by service line
is the most common. This information is then used to develop an income matrix. That
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