Cases in Healthcare Finance, 7th Edition

1. Is it “fair” for the Dialysis Center to suffer in profitability, and hence for the department head to possibly
lose his bonus, just because the Outpatient Clinic needs additional space?

Unfortunately, finance theory provides little help in questions of fairness. Furthermore, we are going to be of
little help in the problem at hand. Basically, there are two competing views.

One view holds that the Dialysis Center is gaining the advantages of a new facility at a better location.
These advantages have some “true” costs associated with them, and hence it is fair for the Center to be
charged for these additional costs. Additionally, the new facilities and better location put the Dialysis Center
in a better position relative to its competitors, which could be the basis for a marketing program that
increases utilization and hence revenues. Indeed, it may be possible for the Dialysis Center to increase its
revenues, net of direct costs, by more than the $100,000 increase in facilities allocation proposed in the
initial allocation. If this occurs, the Dialysis Center (and its department head) would actually benefit from the
move and increased allocation.

Conversely, the move, at least initially, is not expected to have any impact on patient volume, revenues, or
direct costs. In effect, the Center will be doing exactly the same thing as before, but at a different location.
Furthermore, the department head and staff at the Dialysis Center were perfectly happy in their old space.

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The move is not a result of any actions taken by the Dialysis Center, and hence there is no reason why it
should be penalized financially.

In general, there are advantages and disadvantages to including indirect (overhead) costs when calculating
bonuses and evaluating performance. If the basis on which overhead costs are allocated is controllable by
department heads, then including these costs in performance evaluation may incentivize reduction in the
use of overhead services. Additionally, when department heads are aware of the full costs of operating their
respective units, they may be motivated to increase revenues or create efficiencies that reduce direct costs
in order to improve the department’s bottom line. However, often overhead costs are not controllable at the
department or unit level. In that case, it may be demoralizing for managers to be evaluated (and in some
cases financially penalized) based on results over which they have no authority or control.

2. In the past, the medical center has aggregated all facilities costs and then allocated the total amount on
the basis of square footage. This methodology assigns an average facilities cost rate to each patient
service department regardless of whether its space is new or old, prime or poor. The proposed initial
allocation for the Dialysis Center, on the other hand, requires it to bear the true facilities costs of its new
space. What are the advantages and disadvantages of the proposed methodology? Do you support the
proposed initial allocation scheme?

This, like much of this case, is a tough one. When choosing cost drivers, the goal is to pick the driver that
best matches the actual utilization, and hence costs, of the overhead services provided. Thus, it seems
appropriate that facilities costs be assigned in the way that most accurately matches the true costs of the
facilities used by each patient service activity. Under this premise, activities in newer (or better) spaces
would be charged higher facilities costs than activities that are housed in similar-sized older (or worse)
spaces. However, in general, and in this situation in particular, the advantage of most closely approximating
actual costs is offset by several disadvantages.

First, it usually is difficult to determine actual facilities costs. In this case, a new stand-alone facility is being
built, so the exact costs can be estimated with some confidence. However, if the Dialysis Center were being
moved to another location within the main medical center complex, the determination of actual facilities
costs would be much more difficult, if not impossible.

Second, the move is necessary because all space within the medical center complex currently is occupied.
Thus, in a sense, all medical center departments bear the responsibility for higher costs associated with the
move, so it is only “fair” that they be assessed some of these costs. The case restricts any cost burden
sharing resulting from the move to the Outpatient Center, but it might be better to spread the cost inherent in
the new space to all patient service activities.

All in all, we believe that all units are equally responsible for the facilities costs of any organization.
Furthermore, in most situations, it is impossible to measure the actual costs of different spaces within the
organization. Thus, we (and most practitioners) prefer that all facilities costs be aggregated, and then
allocated on some rational basis such as square footage. Then, the higher cost of newer facilities is borne
by all space occupants, and not just the occupants of the higher-cost space. Note, though, that this view is
not universally accepted. Furthermore, it is based more on practicality than it is on economic merit.

An alternative scheme would be to allocate costs as indicated above, and then incrementally increase or
decrease the allocation to individual departments on the basis of the “quality” of their occupied space. This
would be done somewhat arbitrarily and in such a way that the total amount allocated remains unchanged.
While such a scheme may be perceived as fairer than a strictly aggregate approach, it would likely be a very
manual and costly process, requiring ongoing assessments of space quality, and negotiations about how to
measure quality.

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3. If the proposed initial allocation method for facilities costs is implemented, what should be the facilities
allocation to the Dialysis Center in 20 years, when the loan (which is the basis for the higher cost
allocation) has been paid off and there are no longer any actual facilities costs?

This question raises one of the negatives associated with allocating “true” facilities costs. If after 20 years,
the facilities are paid off, and the allocation is based on true costs, the implication is that the Dialysis Center
should be allocated zero (or very low) facilities costs. Yet, there is surely a cost associated with using the
space. At a minimum, there is an opportunity cost associated with the space. If the Dialysis Center were not
using the space, it could be used by other medical center activities, or it could be rented out or sold. Thus,
some opportunity cost must be assigned for its use. Businesses could try to determine the opportunity costs
for space occupied by all activities, but, in general, that would be a very difficult process. The traditional
system of facilities allocation assigns an equal opportunity cost across all space (activities), and hence does
not create the problem that is inherent in the new method.

4. Explain how the revenue and costs from medical (pharmacy) supplies are currently handled for profit
and loss reporting purposes. Are there any problems with the current system? Are there better ways of
reporting pharmacy revenue and costs? If so, what are the options? What would you recommend?

Under the current system of accounting for profits and losses, the Dialysis Center records the
pharmaceuticals used in patient services as revenues (presumably because the Center bills for such items),
and then records the same amount as an expense (to reflect the transfer price, or cost of pharmaceutical
supplies charged by the pharmacy). Then, the Pharmacy Department records the same value as revenue,
and the actual cost of supplies as an expense. In essence, all of the pharmaceutical revenues are “passed
through” to the Pharmacy Department, and only the cost of the pharmaceuticals is charged to the Pharmacy
Department, which gives it the entire profit on the sales.

On the surface, this might not appear to be a problem, because the system is profit neutral to the Dialysis
Center. However, because general overhead is allocated on the basis of departmental patient service
revenues, the pass through artificially increases the general overhead allocation to the Dialysis Center while
creating no financial benefit for the Dialysis Center from the pharmaceutical sales.

One solution to the problem would be for the revenues and costs to be booked directly by the Pharmacy
Department, without passing through the Dialysis Center. This approach would be profit neutral to the
Dialysis Center when only direct costs are considered, and it would lower the Center’s revenues and hence
lower its general overhead allocation (indirect costs). The end result would be an increase in the Dialysis
Center’s reported profits. Our solution (answer to Question 5) reflects this change. This solution also avoids
another potential problem in the allocation of general overhead. Under the pass-through structure, the
revenue from pharmaceutical sales appears in the profit and loss statements of both the Dialysis Center and
the Pharmacy. Unless this is explicitly accounted for in the allocation rate, if all departments are allocated
general overhead on the basis of revenues, then both the Dialysis Center and the Pharmacy are charged for
general overhead on the basis of the same revenue (in other words, the revenue is double-counted if there
is no elimination process).

A second option would be to maintain the pass-through system where equal amounts of pharmaceutical
revenue and expenses are recorded by the Dialysis Center, but the pharmaceutical revenue is excluded
from the total revenue when calculating the general overhead cost allocation. This would be fairer to the
Dialysis Center and, like the first option, would avoid double-counting the pharmaceutical revenue when
allocating general overhead.

A final, and perhaps better, alternative would be to give the Dialysis Center some credit for generating the
pharmacy revenues and, presumably, profits for the hospital. In this approach, some of the profit on the
pharmaceutical sales would be left with the Dialysis Center by assigning a cost (transfer price) for the drugs
to the Dialysis Center that is less than the payments received. This amount would then be recorded as
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revenue by the Pharmacy, and any remaining profit would accrue to the Pharmacy Department because its
costs of Dialysis Center pharmacy supplies would be less than the revenues booked on those supplies. This
approach would increase the Dialysis Center’s “bottom line” and provide some justification for the allocation
of general overhead costs on each dollar of pharmacy supplies’ revenue. However, there may need to be
some adjustment in the general overhead allocation as a portion of the pharmaceutical revenues would still
be counted in both the Dialysis Center and the Pharmacy Department.

To illustrate the final option, suppose the $800,000 in pharmaceuticals actually cost the hospital $400,000.
In this situation, the Pharmacy could “charge” the Dialysis Center $600,000 for the supplies. (It is really a
transfer price.) Then, the Dialysis Center would show $800,000 in revenues and $600,000 in costs, for a
$200,000 profit on the pharmacy sales, while the Pharmacy would show $600,000 in revenues and
$400,000 in costs, for an identical profit. However, recognize this results in total recorded revenue (including
both the Dialysis Center and the Pharmacy Department) of $800,000 + $600,000 = $1,400,000 when, in
fact, only $800,000 of revenue was actually generated for the hospital. The use of internal transfer prices
requires consolidation and elimination of internal transactions at the organization level. Although the director
of the Pharmacy might object to this change in transfer pricing, he or should recognize that the sale of these
drugs would not occur if the Dialysis Center were closed, and hence some benefit from these sales should
accrue to the Center.

5. When all issues related to the decision are considered, what is your recommendation regarding the
treatment of pharmacy revenues, and the final amounts of facilities and general overhead allocated to
the Dialysis Center and the Outpatient Clinic? Justify your recommendation.

There are many possible “solutions” to this case. We grade student work more on thought processes and
strength of argument than on the actual answer. Nevertheless, if our feet were being held to the fire
regarding a solution, here is what we would do.

First, we would remove the pharmacy revenues and expenses (set each to zero as shown in the instructor
model). With the pharmacy revenues and costs (pass-through) taken out, Dialysis Center revenues would
fall to $2,700,000 – $800,000 = $1,900,000. Assuming no change in the allocation rate of 10 percent of
revenues (an assumption given in the case), the new general overhead allocation would be 0.10 
$1,900,000 = $190,000. Since the case does not restrict changes in the general overhead allocation to only
the outpatient departments, there is no change in the general overhead allocation to the Outpatient Clinic.
This is likely fine since the general overhead on the pharmacy revenues is being allocated to the Pharmacy
Department.

Next, we would aggregate the facilities costs within outpatient services, producing total facilities costs of
$400,000 + $1,500,000 = $1,900,000. With a total square footage of 120,000 for the two departments, the
new allocation rate is $1,900,000 / 120,000 = $15.8333 per square foot. Applying this rate gives an
allocation of $15.8333  100,000 = $1,583,333 for the Outpatient Clinic and $15.8333  20,000 = $316,667
for the Dialysis Center. Here are the results:

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In this allocation, the Outpatient Clinic must bear some of the costs associated with the move. However,
the reduction in profitability is minimal, from 21.0 percent of revenues to 20.6 percent of revenues. On the
other hand, the profitability of the Dialysis Center improves from a negative 2.6 percent of revenues to a
positive 4.9 percent of revenues. Of course, the imposition of additional overhead costs on the Outpatient
Clinic is made more palatable by the fact that the Outpatient Clinic is much larger than the Dialysis Center
and inherently more profitable. If the two outpatient activities were of equal size and profitability, the new
allocation would have a much more negative impact on the Outpatient Clinic.

Ultimately, we believe that the increased facilities cost of the new building should be shared by the entire
organization. Thus, we would push for a total reallocation scheme for facilities services that includes all
patient services departments, rather than confining changes to outpatient services. Additionally, a
complete examination of the allocation of general overhead should be undertaken, including whether
more cost pools should be used as well as the appropriateness of the cost driver(s).

As an alternative solution, we believe that the Dialysis Center should receive some benefit for the
pharmacy supplies used by its patients. To illustrate, as we discussed in Question 4, assume that the
$800,000 in pharmaceutical revenues remains, but the matching expense is reduced to $600,000. With
no change in revenues from the base case, and assuming no change in the allocation rate of 10 percent of
revenues (an assumption given in the case), the general overhead allocations remain at 0.10  $2,700,000
= $270,000 for the Dialysis Center and $2,000,000 for the Outpatient Clinic.

Treating the facilities overhead as in the solution above, the end result is the same: $316,667 allocated to
the Dialysis Center and $1,583,333 to the Outpatient Clinic. Although the indirect expenses for general
overhead increase by $270,000 – $190,000 = $80,000 in this alternative solution, the contribution margin
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increases by $200,000 because of the change in pharmacy costs. The end result is an additional profit of
$120,000, boosting the total profit to $213,333 and the profit margin to 7.9 percent. This solution may
require the hospital to examine how general overhead is allocated to the Pharmacy Department. Here are
the results:

P&L Statements:

Revenues/Direct Costs

Without Expansion Initial Allocation Final Allocation

DC OC DC OC DC OC
Total revenues $ 2,700,000 $ 16,000,000 $ 2,700,000 $ 20,000,000 $ 2,700,000 $ 20,000,000
Direct expenses: 2,100,000 9,833,155 2,100,000 12,291,444 1,900,000 12,291,444
Contribution margin* $ 600,000 $ 6,166,845 $ 600,000 $ 7,708,556 $ 800,000 $ 7,708,556
Percent of revenues 22.2% 38.5% 22.2% 38.5% 29.6% 38.5%

Indirect costs

Facilities costs $ 300,000 $ 1,200,000 $ 400,000 $ 1,500,000 $ 316,667 $ 1,583,333

General overhead 270,000 1,600,000 270,000 2,000,000 270,000 2,000,000
Total overhead $ 570,000 $ 2,800,000 $ 670,000 $ 3,500,000 $ 586,667 $ 3,583,333

Net profit $ 30,000 $ 3,366,845 $ (70,000) $ 4,208,556 $ 213,333 $ 4,125,223

Percent of revenues 1.1% 21.0% -2.6% 21.0% 7.9% 20.6%

Facilities Cost Allocation:

Square footage 20,000 80,000 20,000 100,000 20,000 100,000

Cost per square foot $ 15.00 $ 15.00 $ 20.00 $ 15.00 $ 15.83 $ 15.83

General Overhead Allocation:

General overhead
as a percent of revenues 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%

6. In your opinion, what are three key learning points from this case?

(1) Finance theory is not very useful in assessing fairness. Finance theory gives managers a great
deal of guidance regarding such issues as financing decisions and capital budgeting decisions.
However, when it comes to the issue of fairness between two parties involved in a financial decision,
finance theory typically offers little help.
(2) Be careful of unintended consequences. In some situations, revenue/cost decisions can have
unintended negative implications. In this case, the booking of pharmacy revenues and subsequent
reduction of those revenues by matching costs seemed to be benign. Yet, this decision reduced the
profitability of the department because it increased the indirect cost allocation.
(3) It is very difficult to allocate facilities overhead on the basis of actual costs. Fairness dictates that
facilities overhead should be allocated to departments on the basis of the actual cost of the facilities

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occupied. However, in most situations actual facilities costs are very difficult to measure. Thus, such
overhead typically is allocated evenly on the basis of amount of space occupied.

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