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# Chapter 2 Problems:

4-2:
You are considering starting a walk-in clinic. Your financial projections for the first year of
operations are as follows:
Number of visits: 10,000 Utilities: \$2,500
Wages and benefits: \$220,000 Medical supplies: \$50,000
Rent: \$5,000 Administrative supplies: \$10,000
Depreciation: \$30,000
Assume that all costs are fixed except supplies costs, which are variable.
a) What is the clinics underlying cost structure?
Fixed costs: Wages and benefits + Rent + Depreciation +
Utilities
Variable costs: supplies costs \$50,000 + \$10,000 = \$60,000 /
10,000 (# of visits) = \$6
Volum Fixed Variable cost Total Cost Average
e Cost cost per
unit
7,500 \$257,50 \$6 x 7,500 = \$302,500 \$40.33
0 \$45,000 (\$257,500 +
\$45,000)
10,00 \$257,50 \$6 x 10,000 = \$317,500 \$31.75
0 0 \$60,000 (\$257,500 +
\$60,000)
12,50 \$257,50 \$6 x 12,500 = \$332,500 \$26.60
0 0 \$75,000 (\$257,500 +
\$75,000)
b) What are the clinics expected total costs? \$317,500
Expected total costs = total fixed costs (a) + (variable cost x
volume (b))
\$317,500 = \$257,500 + (\$6 x 10,000)
a. Total fixed costs = Wages and benefits + utilities +
depreciation + rent
Total fixed costs = \$220,000 + \$2,500 + \$30,000 + \$5.000
Total fixed costs = \$257,500
b. Total variable cost = Medical supplies + administrative
supplies
\$60,000 = \$50,000 + \$10,000
Total variable cost per visit = total variable cost / # of
visit
\$6 = \$60,000/ 10,000
c) What are the clinics estimated costs at 7,500 visits? At 12,500 visits?
a. At 7,500 visits: \$302,500
i. Total cost = fixed cost + (variable cost x volume)
\$302,500 = \$257,500 + (\$6 x 7,500)
b. At 12,500 visits: \$332,500
i. \$257,500 + (\$6 x 12,500) = \$332,500
d) What is the average cost per visit at 7,500, 10,000 and 12,500 visits?
a. At 7,500: \$40.33 <- from (\$302,500/7,500)
b. At 10,000: \$31.75 <- from (\$317,500/10,000)
c. At 12,500: \$26.60 <- from (\$332,500/12,500)
4-6

Assume that the hospital uses the direct method for cost allocation.
Furthermore, the cost driver for General Administration and Financial
Services is patient services revenue, while the cost driver for Facilities is
space utilization.
a. What are the appropriate allocation rates?
Allocation rate: direct cost / patient service revenue
1) GENERAL ADMINISTRATION
a. For Routine Care: 0.07
Allocation rate = direct cost / patient service revenue
(routine care)
Allocation rate = (\$2,000,000) / (\$30,000,000) = 0.07
b. For Intensive Care: 0.5
Allocation rate = (\$2,000,000)/(\$4,000,000) = 0.5
c. For Diagnostic Services: 0.33
Allocation rate = (\$2,000,000)/(\$6,000,000) = 0.33
d. For Other Services: 0.2
Allocation rate = (\$2,000,000)/(\$10,000,000) = .2
2) FINANCIAL SERVICES
a. For Routine Care: 0.1
Allocation rate = (\$3,000,000) / (\$30,000,000) = 0.1
b. For Intensive Care: 0.75
Allocation rate = (\$3,000,000)/(\$4,000,000) = 0.75
c. For Diagnostic Services: 0.5
Allocation rate = (\$3,000,000)/(\$5,000,000) = 0.5
d. For Other Services: 0.3
Allocation rate = (\$3,000,000)/(\$10,000,000) = .3
3) FACILITIES (allocation = direct cost / space utilization)
a. For General: \$500
Allocation rate = (\$5,000,000) /10,000 = \$500
b. For Faciliites: \$250
Allocation rate = (\$5,000,000)/20,000 = \$250
c. For Financial Service: \$333
Allocation rate = (\$5,000,000)/15,000 = \$333
b. Allocate the hospitals overhead costs to the patient services
departments.
Overall allocation: total overhead cost / patient service revenue
a. For Routine Care: 0.3
Allocation rate = direct cost / patient service revenue
(routine care)
Allocation rate = (\$10,000,000) / (\$30,000,000) = 0.2
b. For Intensive Care: 2.5
Allocation rate = (\$10,000,000)/(\$4,000,000) = 2.5
c. For Diagnostic Services: 1.67
Allocation rate = (\$10,000,000)/(\$6,000,000) = 1.67
d. For Other Services: 1
Allocation rate = (\$10,000,000)/(\$10,000,000) = 1

4-7 Assume that the hospital uses salary dollars as the cost driver for
General Administration, housekeeping labor hours as the cost driver for
Facilities, and patient services revenue as the cost driver for Financial
Services. (The majority of the costs of the Facilities Department are devoted
to housekeeping services.)
a. What are the appropriate allocation rates?
a. General Administration cost driver: Salary Dollars
allocation rate = direct cost / salary driver
i. General administration = 1.33
(\$2,000,000/\$1,500,000)
ii. Facilities = .67 (\$2,000,000/\$3,000,000)
iii. Financial services = 1 (\$2,000,000/\$2,000,000)
b. Facilities cost driver: Labor hours -> allocation rate =
direct cost / labor hours
i. General administration = 2,500
(\$5,000,000/2,000)
ii. Facilities = 1,000 (\$5,000,000/5,000)
iii. Financial services = 1,667 (\$5,000,000/3,000)
c. Financial Services cost driver: patient service revenue
-> allocation rate = financial services / patient service
revenue
i. Routine care: 10% (\$3,000,000/\$30,000,000)
ii. Intensive care: 75% (\$3,000,000/\$4,000,000)
iii. Diagnostic care: 50% (\$3,000,000/\$6,000,000)
iv. Other services: 30% (\$3,000,000/\$10,000,000)
b. Allocate the hospitals overhead costs to the patient services
departments.
Allocation rate = direct cost / patient service revenue
a. For Routine Care: 0.3
Allocation rate = direct cost / patient service revenue
(routine care)
Allocation rate = (\$10,000,000) / (\$30,000,000) = 0.2
b. For Intensive Care: 2.5
Allocation rate = (\$10,000,000)/(\$4,000,000) = 2.5
c. For Diagnostic Services: 1.67
Allocation rate = (\$10,000,000)/(\$6,000,000) = 1.67
d. For Other Services: 1
Allocation rate = (\$10,000,000)/(\$10,000,000) = 1
c. Compare the dollar allocations with those obtained in Problem 4.6.
Explain the differences.
To observe the differences between 4.6 and 4.7, I decided to
compare how the hospital allocated costs for facilities (vs
general administrative or financial services). In 4.6, the
hospital allocated costs for facilities using space utilization
as the cost driver in a very direct method. In 4.7, the cost
facility for facilities was determined using the cost driver of
housekeeping labor hours. In general, the amount is greater
when using housekeeping labor hours rather than space
utilization but the distribution of costs which general
administrative being the greatest, then financial services
then facilities remained the same for both models.
Support 4.6 Cost 4.7 Cost
service: Facility Facility
(space (housekee
utilization ping labor
) hours)
General \$500 \$2,500
administrat
ive
Facilities \$250 \$1,000
Financial \$333 \$1,667
services
d. Which of the two cost driver schemes is better? Explain your
answer.
In observing the cost driver schemes for facilities I believe
that that the cost driver scheme used in 4.7 where they
utilized housekeeping labor hours is a better cost driver
scheme than 4.6. This is because 4.6 utilizes the direct
method of cost allocation where only direct costs (space
utilization in regards to facilities) is applied and it doesnt
take into effect the impact of indirect costs. The method
utilized in 4.7 uses housekeeping labor hours as a cost
driver for facilities and I believe this is a more fair and
accurate correlation between the amount of overhead
services used by the patient services department.
In regards to the overall cost driver scheme that would be
the most accurate representation of overhead services to
patient service department it would most likely be
financial services because it utilizes patient service revenue
and it would be the most positive correlation between the
amount of overhead services used by the patient services
department.

5-2:
The Audiology Department at Randall Clinic offers many services to the
clinics pa- tients. The three most common, along with cost and utilization
data, are as follows:
Service Variable cost per Annual direct Annual # of visits
service fixed costs
Basic Exam \$5 \$50,000 3,000
Advanced \$7 \$30,000 1,500
Exam
Therapy \$10 \$40,000 500
session

a. What is the fee schedule for these services, assuming that the goal is
to cover only variable and direct fixed costs?
Fee schedule = total cost of variable cost + direct cost of each
service since desired profit is \$0
a) For basic exam services: \$65,000
Fee schedule: Variable cost + Fixed cost
Fee schedule: (3,000 x \$5) + \$50,000 = \$65,000
b) For advanced exam services: \$40,500
Fee schedule: Variable cost + Fixed cost
Fee schedule: (1,500 x \$7) + \$30,000 = 40,500
c) For therapy services: \$45,000
Fee schedule: Variable cost + Fixed cost
Fee schedule: (500 x \$10) + \$40,000 = \$45,000

## b. Assume that the Audiology Department is allocated \$100,000 in total

overhead by the clinic, and the department director has
allocated \$50,000 of this amount to the three services listed
above. What is the fee schedule assuming that these overhead costs
must be covered? (To answer this question, assume that the allocation
of overhead costs to each service is made on the basis of number of
visits.)
Allocatted amount: \$50,000
Desired profit: \$0
1 a) Basic Exam: \$95,000
Overhead = \$50,000 x (3,000/5,000) = \$30,000
Fee schedule = Variable cost (\$5x3,000) + Fixed cost (\$50,000) +
Overhead (\$30,000) + Desired profit (\$0)
Fee schedule = \$95,000
b) Advanced exam: \$55,500
Overhead = \$50,000 x (1,500/5,000) = \$15,000
2 Fee schedule = Variable cost (\$7x1,500) + Fixed cost (\$30,000) +
Overhead (\$15,000) + Desired profit (\$0)
Fee schedule = \$55,000
3 c) Therapy service: \$50,000
Overhead = \$50,000 x (500/5,000) = \$5,000
4 Fee schedule = Variable cost (\$10x500) + Fixed cost (\$40,000) +
Overhead (\$5,000) + Desired profit (\$0)
Fee schedule = \$50,000

## c. Assume that these services must make a combined profit of \$25,000.

Now, what is the fee schedule? (To answer this question, assume that
the profit requirement is allocated in the same way as overhead costs.)
Desired profit: \$25,000
1 a) Basic Exam: \$110,000
Profit allocation = \$25,000 x (3,000/5,000) = \$15,000
Fee schedule = Variable cost (\$5x3,000) + Fixed cost (\$50,000) +
Overhead (\$30,000) + Desired profit (\$15,000)
Fee schedule = \$110,000
b) Advanced exam: \$63,000
Profit allocation = \$25,000 x (1,500/5,000) = \$7,500
2 Fee schedule = Variable cost (\$7x1,500) + Fixed cost (\$30,000) +
Overhead (\$15,000) + Desired profit (\$7,500)
Fee schedule = \$63,000
3 c) Therapy service: \$52,500
Profit allocation= \$25,000 x (500/5,000) = \$2,500
4 Fee schedule = Variable cost (\$10x500) + Fixed cost (\$40,000) +
Overhead (\$5,000) + Desired profit (\$2,500)
Fee schedule = \$52,500

5-7
General Hospital, a not-for-profit acute care facility, has the following cost
structure for its inpatient services:
Fixed costs: \$10,000,000
Variable cost per inpatient day: \$200
Charge (revenue) per inpatient day: \$1,000
The hospital expects to have a patient load of 15,000 inpatient days next
year.
a. Construct the hospitals base case projected P&L statement
a. Total revenue: \$15,000,000 (\$1,000x15,000)
b. LOSS -> Variable cost: \$3,000,000 (\$200x15,000)
c. LOSS -> Fixed cost -> \$10,000,000
d. Profit: \$2,000,000 (\$15,000,000 - \$3,000,000 -
\$10,000,000)
b. What is the hospitals breakeven point? \$13,000,000
Breakeven point = Total fixed cost + total variable cost
= \$10,000,000 + (\$200 x 15,000)
= \$10,000,000 + \$3,000,000
= \$13,000,000
c. What volume is required to provide a profit of \$1,000,000? A profit of
\$500,000?
a. Profit of \$1,000,000: volume of 13,750 inpatient days
X = Volume
Desired profit (\$1,000,000) = Total revenue (\$1,000X) Total
fixed cost (\$10,000,000) Total variable cost (\$200X)
\$1,000,000 = \$1,000X - \$10,000,000 - \$200X
\$1,000,000 = \$800X - \$10,000,000
\$11,000,000 = \$800X
X = 13,750
b. Profit of \$500,000: volume of 13,125 inpatient days
X = Volume
Desired profit (\$500,000) = Total revenue (\$1,000X) Total
fixed cost (\$10,000,000) Total variable cost (\$200X)
\$500,000 = \$1,000X - \$10,000,000 - \$200X
\$500,000 = \$800X - \$10,000,000
\$10,500,000 = \$800X
X = 13,125

## d. Now, assume that 20 percent of the hospitals inpatient days come

from a managed care plan that wants a 25 percent discount from
charges. Should the hospital agree to the discount proposal?
-> Inpatient days at 20%: 15,000 x .2 = 3,000
-> Managed care revenue 25% discount form charges would be
\$750 (\$1,000x .25 = \$250 deducted from \$1,000 = \$750)
-> Fixed cost of Managed Care: (\$10,000,000/15,000) x 3,000 (20%
inpatient days) = \$2,000,000
P&L Statement:
a. Total revenue: \$2,250,000 (\$750 x 3,000)
b. LOSS -> Variable cost: \$600,000 (\$200 x 3,000)
c. LOSS -> Fixed cost: \$2,000,000 (\$10,000,000/15,000) x
3,000 (20% inpatient days
d. Total: LOSS of \$350,000 (\$2,250,000 - \$600,000 -
\$2,000,000)