Reference no: EM131772688

Cost Allocation Problem -

One year ago, Academic Hospital and nearby Western Hospital merged. As part of the merger, Academic Hospital eliminated its small maternity service, and Western Hospital eliminated most of its internal laboratory. The two hospitals are both owned by one parent organization, yet they remain distinct profit centers, with an "each tub on its own bottom" philosophy.

A problem recently arose when Western Hospital demanded a price reduction for the laboratory work associated with an amniocentesis. This procedure is performed at Western on a regular basis, but after the merger, the laboratory work for it has been performed at Academic.

However, Western had recently found that an independent laboratory would do the work for $375, as compared with the $400 Academic was charging. Although the total dollars involved were not substantial (Western only had about 300 amniocenteses per year), all agreed that an important policy issue was involved and that resolution should be sought.

A joint oversight committee of the two hospitals found that the direct incremental costs of performing the amniocenteses were $300 in labor and supplies. In addition, Academic was charging $90 for overhead that would be incurred whether or not the amniocentesis laboratory tests were done at Academic, and $60 for profit. It was also found that Western was currently making a $105 profit on the entire procedure but could raise that profit by $75 if it could get the laboratory work done for $75 less.

How much would the transfer price be under

• full charges,
• variable costs,
• market price, and
• negotiated price?

How much profit does each hospital make under each alternative? How much do the combined hospitals make under each of the above alternatives? What would happen if Western purchased from an outside laboratory for $375?

What methods of cost allocation were used?

How were cost centers determined?

How would fixed and variable costing differ in this situation?