The direct distribution methodology is all about allocating costs to the cost centers. The allocation of indirect costs is the responsibility of the executive management and of the financial staff. At the same time the department directors are required to monitor and control costs.
This method allocates indirect costs generated by non-revenue cost centers to the revenue cost centers. In the context of Table 4 – 1, the rehabilitation non-personal costs of $10, 272, is the non-revenue costs allocated to this particular cost center. The non-revenue cost center or cost pools that contribute costs to the revenue center are called “support services”.
Overhead rate method of direct distribution
It is one of the simplest methods of allocating indirect costs to calculate the overall overhead rate for direct distribution. This averages all indirect costs by the number of service units such as patient days. I feel the drawback of the system is that it averages all. This also does not give flexibility to the executive team to give strategic direction.
Overhead rate cost-finding
The overhead rate method begins with cost-finding, or calculating indirect costs per service unit. As per Table 7-1, the overhead estimate for Freeston ElderCare, the administration, rehabilitation, ancillary, dietary, and plan operations and property expense are assume to be non-revenue cost centers. Their total overhead was calculated as $4,256,086, and then the overhead rate was calculated.
Overhead Rate = Total Overhead / Total Service Units
$77.34 = $4,256,086 / 55,034 patient days.
The overhead rate thus calculated is used to allocate costs to the revenue cost centers. With 15,906 patient days budgeted for the Assisted Living department, the allocated overhead cost would be $1,230,100 ($77.34 * 15,906). For nursing service, the allocated overhead cost is $3, 025,987. The total costs of each revenue center are then calculated by adding the direct costs to its overhead costs. The total costs are then calculated by adding the total costs of each revenue center.
Cost pool method of direct distribution
This approach attempts to overcome the limitations of the overhead rate method. First, identify the direct costs for each cost center and differentiate between revenue and non-revenue cost centers. In contrast to the pool method, instead of combining all indirect costs and averaging all over the service units, it develops cost drivers which reflect the estimated resources to be used by respective revenue cost centers.
Cost pool cost allocation
Costs are then allocated between Assisted Living and Nursing Services using cost driver for each cost pool. Based on overall calculation, the total amount of indirect costs allocated to Assisted living is $1,181,176 and for Nursing service it is $3,074,910. These costs are then added to the direct cost for each revenue center to get a total of $1,281,610 for Assisted living and $6,133,527 for Nursing services. The total overall cost for both departments is calculated to be $7,415,374.
Cost Pool Cost-finding
According to Table 7 – 3, the direct cost PPD for Assisted Living are $6.31 and for Nursing Services $78.17. The indirect costs PPD for Assisted Living are $74.26 ( or $1,181,176 / 15,906) and for Nursing Services $78.59. The total cost for each revenue cost center PPD are calculated by dividing the total costs by the number of patient days. For Assisted Living the total cost PPD are $80.58 and for Nursing Services is $156.76.
The identification of cost pools and the development of cost drivers are expected to vary among work settings. In cost allocation, it is helpful to separate the cost of individual programs. Also, increasing the detail and complexity of non-revenue cost centers will also refine cost allocation.
Taking further the discussion, the Cost pool method of direct distribution method builds upon the Overhead rate of direct distribution. The Overhead method is rather simple, and easy to calculate, but it creates average of everything. As a result it becomes very difficult to link hospital’s strategy with accounting principles. With Cost pool method, there is an opportunity in creating cost drivers, and then distributing costs accordingly. This entails, in comparison to Overhead rate method, to do cost allocation after cost findings. Also, the process of creating cost drivers gives company executives a strategic leverage, which is a way of setting priorities customized on the basis of requirements of each of the cost centers. It recognizes the fact that each cost center would have its own peculiar requirements. So, in conclusion, the Cost pool method may be complex, but it is more suited to the diverse needs of various cost centers. And so, helps in better cost allocation.
Works Cited
Penner, S. "Introduction to Health Care Economics and Financial Management: Fundamental Concepts with Practical Application." Penner, S. Introduction to Health Care Economics and Financial Management: Fundamental Concepts with Practical Application. 2003. 135 - 141, 70 - 82.
