Reference no: EM13503722

Mary White Dialysis Clinic is an independent, non-profit-service renal dialysis clinic. The clinic provides two types of treatments. Hemodialysis (HD) requires patients to visit a dialysis clinic three times a week, where they are connected to special, expensive equipment to perform the dialysis. Peritoneal dialysis (PD) allows patients to administer their own treatment daily at home. The clinic monitors PD patients and assists them in ordering supplies consumed during the home treatment. The total and product-line income provides statement for the clinic is shown below:

CLINIC INCOME STATEMENT TOTAL HD PD

Revenues

Number of patients 164 102 62

Number of treatments 34,967 14,343 20,624

Total revenue $3,006,775 $1,860,287 $1,146,488

Supply costs

Standard supplies (drugs, syringes) 664,900 512,619 152,281

Episodic supplies (for special conditions) 310,695 98,680 212,015

Total supply costs $975,595 $611,299 $364,296

Service costs

General overhead (occupancy, administration) 785,825

Durable equipment (maintenance, depreciation) 137,046

Nursing services (RNs, LPNS, nursing

administrators, equipment technicians) 883,280

Total service costs 1,806,151 1,117,463 688,688

Total operating expenses $2,781,746 $1,728,762 $1,052,984

Net income $225,029 $131,525 $93,504

The existing cost system assigned the traceable supply costs directly to the two types of treatments. The service costs, however, were not analysed by type of treatment. The total service costs of $1,800,000 were allocated to the treatments using the traditional ratio-of-cost-to-charges (RCC) method developed for government cost-based reimbursement programs. With this procedure, since HD treatments represented about 61 % of total revenues, HD received an allocation of 61 % of the $1,800,000 service expenses (approximately $1,100,000).

For many years, clinics such as Mary White received much of their reimbursement on the basis of reported costs. Starting in the 1980s, however, payment mechanisms shifted (ie introduction of case-mix funding), and Mary White now received most of its reimbursement on the basis of a fixed fee, not the cost of service provided. In particular, because HD and PD procedures were categorised by the government as a single category - dialysis treatment - the weekly reimbursement for each patient was the same: $389.10. As a consequence, the three HD treatments per week led to a reported revenue per HD treatment of $129.70, and the seven PD treatments per week led to a reported revenue per PD treatment of $55.59. Both procedures appeared to be profitable, according to the clinic's existing cost and revenue recognition system. David Thomas, the financial controller of Mary White Dialysis Clinic was concerned, however, that the procedures currently being used to assign common expenses may not be representative of the underlying use of the common resources by the two different procedures. He wanted to understand their costs better so that Mary White's managers could make more-informed decisions about extending or contracting products and services and about where to look for process improvements. Thomas had recently attended a CPA Australia seminar titled 'Activity-Based Costing - fad v fab costing system'. In the seminar, Adam Barr-Coward (the ABC expert) argued that every organisation should focus on the activities performed by the organisation and try to link the cost of performing these activities directly to the products for which they were performed. The ABC principles outlined by Adam Barr-Coward appeared to address many of the problems Thomas had encountered at the Mary White Dialysis Clinic. Thomas decided to explore whether activity based costing principles could provide a better idea of the underlying cost and profitability of HD and PD treatments.

Information for the ABC system

Thomas divided the General Overhead service cost category into four activity pools. He interviewed various staff and found that the facility costs included items such as rent, maintenance and cleaning. The administration and support staff were primarily responsible for items such as processing the weekly reimbursements from the government. The communications systems and medical records pool was primarily concerned with maintaining up to date records of patients' treatments. Finally the utilities pool primarily contained electricity costs.

GENERAL OVERHEAD RESOURCE COST POOL SIZE OF POOL COST DRIVER

Facility costs $233,226 ?

Administration and support staff 354,682 ?

Communications systems and medical records 157,219 ?

Utilities 40,698 ?

Total $785,825

Thomas was unsure of how to handle the durable equipment service costs. Rather than continue to use the RCC method for allocating these costs, he asked the clinic staff for their judgments about how these costs should be allocated. On the basis of the staff s experience and judgment, they felt that HD treatments used about 75% of these resources, and PD about 25%.

With regard to the nursing services service costs, he knew that this category contained a mixture of different types of personnel: registered nurses (RNs), licensed practical nurses (LPNs), nursing administrators, and machine operators. He thought it was unlikely that each of these categories would be used in the same proportion by the two different treatments. Therefore Thomas disaggregated the nursing service category into four activity pools. He interviewed various staff and found that, as expected, registered nurses and licensed practical nurses were not evenly distributed between the two types of treatments. The nursing administration and support staff were responsible for organising the delivery of both types of treatments, while the dialysis machine operators were solely involved in administering treatments at the clinic only.

NURSING SERVICES RESOURCE POOL SIZE OF POOL COST DRIVER

Registered nurses $239,120 ?

Licensed practical nurses 404,064 ?

Nursing administration and support staff 115,168, ?

Dialysis machine operators 124,928 ?

Total $883,280

Thomas then went to medical records and other sources to identify the quantities of each cost driver for the two treatment types:

COST DRIVERS HD PD TOTAL

# of registered nurses 5 2 7

# of licensed practical nurses 15 4 19

Number of patients 102 62 164

Number of treatments 14,343 20,624 34,967

Number of clinic dialysis treatments 14,343 0 14,343

Area occupied (in square feet) 22,000 8,000 30,000

Estimated electricity (Kw) usage 563,295 99,405 662,700

Required

You are David Thomas, the financial controller of the clinic. After attending Adam Barr-Coward's seminar on 'Activity-Based Costing - fad v fab costing system' and conducting a preliminary analysis of the Mary White Dialysis Clinic's existing costing system; you are convinced that the Organisation would benefit from implementing an ABC system. However, the clinic's chief executive officer (CEO), Ms. M.T. Blairda, is sceptical of such a move and stated:

"David, you cannot expect me to authorise additional expenditure for a new costing system when there is nothing wrong with our current one - I always go by the motto 'if it ain't broke, don't fix it'. Secondly, I've never heard of ABC before. Surely if it is as good as you make it out to be, I would have heard of it! In my professional opinion, it's probably just another example of consultants attempting to make more money. I cannot justify expenditure on such a system unless you can clearly demonstrate the additional benefits that will accrue to the clinic from its use. Have a detailed report on my desk - 5 PM Tuesday at the latest!

After your brief conversation with Ms. M.T. Blairda, you rush back to your office, slam the door and sketch out a brief outline of what to include in your detailed report. Based upon the CEO's lack of understanding of ABC, and the need to demonstrate the benefits of such a system, you decide to report specifically the following issues:

1. What is an ABC system? Your discussion should address the following issues:

• How does an ABC system work and how does it differ from traditional product costing systems?
• When is an ABC approach most advantageous/appropriate?
• What are the perceived benefits vs. costs of an ABC system (you are not expected to quantify the costs benefits)?

2. What are the problems associated with the costing system currently used by the clinic and how will an ABC system overcome these problems?

3. Use the information provided in the case study to calculate revised product line income statements (and average charge, cost and profit per treatment) for HD and PD under an ABC approach. How do these results compare with figures reported under the clinic's existing costing system? If they are different, explain why.

4. Analyse the newly produced information and assess its implications for management at Mary White Dialysis Clinic. What decisions might managers of the clinic make with this new information that might differ from those made using information from the RCC method only?

5. The limitations of the clinic's proposed ABC system (including how it could be improved) and limitations of ABC systems in general.