Business

Case 1

Houston Dialysis Center
(Cost Allocation Concepts)

Houston Dialysis Center is a department of Houston General Hospital, a fullservice not-for-profit acute care hospital with 325 beds. The

bulk of the
hospital’s facilities are devoted to inpatient care and emergency services.
However, a 100,000 square-foot section of the hospital complex is devoted to
outpatient services. Currently, this space has two primary uses. About 80
percent of the space is used by the Outpatient Clinic, which handles all
routine outpatient services offered by the hospital. The remaining 20 percent
is used by the Dialysis Center.
The Dialysis Center performs hemodialysis and peritoneal dialysis, which are
alternative processes for removing wastes and excess water from the blood for
patients with end-stage renal (kidney) disease. In hemodialysis, blood is
pumped from the patient’s arm through a shunt into a dialysis machine, which
uses a cleansing solution and an artificial membrane to perform the functions
of a healthy kidney. Then, the cleansed blood is pumped back into the patient
through a second shunt.
In peritoneal dialysis, the cleansing solution is inserted directly into the
abdominal cavity through a catheter. The body naturally cleanses the blood
through the peritoneum—a thin membrane that lines the abdominal cavity. In
general, hemodialysis patients require three dialyses a week, with each
treatment lasting about four hours. Patients who use peritoneal dialysis
change their own cleansing solutions at home, typically about six times per
day. This procedure can be done manually when active or automatically by
machine when sleeping. However, the patient’s overall condition, as well as
the positioning of the catheter, must be monitored regularly at the Dialysis
Center.
The hospital allocates facilities costs (which primarily consist of building
depreciation and interest on long-term debt) on the basis of square footage.
Currently, the facilities cost allocation rate is $15 per square foot, so the
facilities cost allocation is 20,000 × $15 = $300,000 for the Dialysis Center
and 80,000 × $15 = $1,200,000 for the Outpatient Clinic.
All other overhead costs, such as administration, finance, maintenance, and
housekeeping, are lumped together and called “general overhead.” These costs
are allocated on the basis of 10 percent of the revenues of each patient

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service department. The current allocation of general overhead is $270,000
for the Dialysis Center and $1,600,000 for the Outpatient Clinic, which
results in total overhead allocations of $570,000 for the Dialysis Center and
$2,800,000 for the Outpatient Clinic.
Recent growth in volume of the Outpatient Clinic has created a need for 25
percent more space than currently assigned. Because the Outpatient Clinic is
much larger than the Dialysis Center, and because its patients need frequent
access to other departments within the hospital, the decision was made to
keep the Outpatient Clinic in its current location and to move the Dialysis
Center to another location to free up space. Such a move would now give the
Outpatient Clinic 100,000 square feet, a 25 percent increase.
After attempting to find new space for the Dialysis Center within the
hospital complex, it was soon determined that a new 20,000 square foot
building must be built. This building will be situated two blocks away from
the hospital complex, in a location that is much more convenient for dialysis
patients (and Center employees) because of ease of parking. The new space,
which can be more efficiently utilized than the old space, allows for a
substantial increase in patient volume, although it is unclear whether or not
the move will result in additional dialysis patients.
The new dialysis facility is expected to cost $3,000,000. Additionally,
furniture and other fixtures, along with relocation expenses of current
equipment, would cost $1,000,000, for a total cost of $4,000,000. The funds
needed for the new facility will be obtained from a 20-year loan at local
bank. The loan (including interest) will be paid off over 20 years at a rate
of $400,000 per year. Because the specific financing details are known, it is
possible to estimate the actual annual facilities costs for the new Dialysis
Center, something that is not possible for units located within the hospital
complex.
Table 1 contains the projected profit and loss (P&L) statement for the
Dialysis Center before adjusting for the move. The hospital’s department
heads receive annual bonuses on the basis of each department’s contribution
to the bottom line (profit). In the past, only direct costs were considered,
but the hospital’s chief executive officer (CEO) has decided that bonuses
would now be based on full (total) costs. Obviously, the new approach to
awarding bonuses, coupled with the potential for increases in indirect cost
allocation, is of great concern to Linda Rider, the director of the Dialysis
Center. Under the current allocation of indirect costs, Linda would have a
reasonable chance at an end-of-year bonus, as the forecast puts the Dialysis
Center in the black. However, any increase in the indirect cost allocation
would likely put her “out of the money.”

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At the next department heads’ meeting, Linda expressed her concern about the
impact of any allocation changes on the Dialysis Center’s profitability, so
the hospital’s CEO asked the chief financial officer (CFO), Roger Hedgecock,
to look into the matter. In essence, the CEO said that the final allocation
is up to Roger but that any allocation changes must be made within outpatient
services. In other words, any change in cost allocation to the Dialysis
Center must be offset by an equal, but opposite, change in the allocation to
the Outpatient Clinic.
To get started, Roger created Table 2. In creating the table, Roger assumed
that the new Dialysis Center would have the same number of stations as the
old one, would serve the same number of patients, and would have the same
reimbursement rates. Also, operating expenses would differ only slightly from
the current situation because the same personnel and equipment would be used.
Thus, for all practical purposes, the revenues and direct costs of the
Dialysis Center would be unaffected by the move.
The data in Table 2 for the expanded Outpatient Clinic are based on the
assumption that the expansion would allow volume to increase by 25 percent
and that both revenues and direct costs would increase by a like amount.
Furthermore, to keep the analysis manageable, the assumption was made that
the overall hospital allocation rates for both facilities costs and general
overhead would not materially change because of the expansion.
Roger knew that his “trial balloon” allocation, which is shown in Table 2 in
the columns labeled “Initial Allocation,” would create some controversy. In
the past, facilities costs were aggregated, so all departments were charged a
cost based on the average embedded (historical) cost regardless of the actual
age (or value) of the space occupied. Thus, a basement room with no windows
was allocated the same facilities costs (per square foot) as was the fifth
floor executive suite. Because many department heads thought this approach to
be unfair, Roger wanted to begin allocating facilities overhead on a true
cost basis. Thus, in his initial allocation, Roger used actual facilities
costs ($400,000 per year) as the basis for the allocation to the Dialysis
Center.
Needless to say, Linda’s response to the initial allocation was less than
enthusiastic, but before Roger was able to address Linda’s concerns, he
suddenly left the hospital to take a new position in another city. The task
of completing the allocation study was given to you, Houston General’s
current administrative resident. You believe that any cost allocation system
should be perceived as being “fair,” but you also realize that in practice
cost allocation is very complex and somewhat arbitrary. Some department heads
argue that the best approach to overhead allocations is the “Marxist
approach,” by which allocations are based on each patient service
department’s ability to cover overhead costs, but this approach has its own
disadvantages.

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Considering all the relevant issues, you must develop and justify a new
facilities cost allocation scheme for outpatient services. Be prepared to
justify your recommendations at the next department heads’ meeting.

Table 1
Houston General Hospital Dialysis Center:
Forecasted P&L Statement Assuming Status Quo
Revenues
Hemodialysis program
Peritoneal dialysis program
Total revenues

$2,100,000
600,000
$2,700,000

Direct Expenses
Salaries and benefits
Supplies
Utilities
Equipment lease expense
Other expenses
Total expenses

$1,100,000
150,000
80,000
320,000
450,000
$2,100,000

Net profit before indirect costs

$

600,000

$

Indirect Expenses
Facilities costs
General overhead
Total overhead costs

$

300,000
270,000
570,000

Net profit

$

30,000

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Table 2
Houston General Hospital:
Dialysis Center (DC) and Outpatient Clinic (OC) Preliminary Forecasts

P&L Statements:

With Expansion
Initial Allocation
Alternative Allocation
DC
OC
DC
OC

Without Expansion
DC
OC
Total revenues
$2,700,000
Direct expenses
2,100,000
Direct cost profit $ 600,000

$16,000,000
9,833,155
$ 6,166,845

$2,700,000
2,100,000
$ 600,000

$20,000,000
12,291,444
$ 7,708,556

$2,700,000
2,100,000
$ 600,000

$20,000,000
12,291,444
$ 7,708,556

Facilities costs
General overhead
Total overhead

$

$ 1,200,000
1,600,000
$ 2,800,000

$

$ 1,500,000
2,000,000
$ 3,500,000

$

$

$

300,000
270,000
570,000

$

$

Full cost profit

$

30,000

$ 3,366,845

($

$ 4,208,556

$

$

$

400,000
270,000
670,000
70,000)

270,000

2,000,000

QUESTIONS
1. Is it “fair” for the Dialysis Center to suffer in profitability, and hence
for Linda to possibly lose her bonus, just because the Outpatient Clinic
needs additional space?
2. In the past, the medical center has aggregated all facilities costs, and
then allocated the total amount on the basis of square footage. The proposed
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 new methodology? Do you support the new allocation
scheme?
3. If the new allocation method for facilities costs is implemented, what
should be the facilities allocation to the Dialysis Center in 20 years, when
the loan, and hence total cost of the move, has been paid off and there are
no longer any actual facilities costs?
4. Do you think the new Dialysis Center will be able to attract more patients?
What impact would additional volume have on the facilities allocation
decision?
5. Although not shown on Table 1, the Center uses (sells) $800,000 of drugs
annually in its dialysis treatments, which cost the hospital (pharmacy)
$400,000. The $400,000 profit on these drugs accrues to the pharmacy, which
records $800,000 of revenues and $400,000 of costs on its P&L statement.
Does this seem fair? If not, what could be done to remedy the situation?
6. When all issues related to the decision are considered, what is your
recommendation regarding the handling of the pharmacy revenues and the final
allocation amounts?