The Office of Family Medicine Physicians (the Group) is a medical practice with four locations in the greater Indianapolis, IN area. The clinical staff is made up of 20 doctors, all of whom practice in one or more areas of family medicine, and 46 assistant doctors and nurses. The Group is organized into three patient-receiving departments: Adult Medicine, Obstetrics and Pediatrics. These patient services departments are supported by three support departments: Administration, Facilities and Finance. Figure 1 presents the Group's summary revenue and cost projections by department for the coming year. As part of a much-needed overhaul of the cost allocation process, the Group engaged a major accounting firm to estimate the amount of services provided by support services to each other and to each patient service. The objective of the study was to provide data that would help the Group develop a better cost allocation system than the outdated and arbitrary system currently in use. Thus, both senior management and department heads of the Group are satisfied with the resulting allocation percentages. The next step in the cost allocation process improvement initiative is to choose the allocation method. Four allocation methods are being studied: direct, degressive, double distribution and reciprocal. To help with the decision, the Group's Financial Director commissioned Top Block to conduct the following study: Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”? Get an original essay Make a recommendation regarding the best allocation method Determine overhead allocations under each method Compare and contrast the results (sensitivity analysis) Estimate the relative profitability of the company's patient service departments under the recommended allocation systemAllocation methods The four methods differ in the way intra-support department allocations are managed and, therefore, in their complexity. Direct Method The direct method assumes that support departments provide services only to patient services departments. Thus, no intra-support service is recognized, even if such services exist. This simplifying assumption makes the direct method the easiest to apply but the weakest conceptually. Progressive Method The progressive method recognizes some intra-support services, but it does so in a relatively simplistic manner. In this method, the support service that provides the most services to other support services is assigned first (to support services and patient services). Then the department is closed and the process returns to the support department that provides the second largest number of services to other support departments. Since support departments are closed at each stage, it is not possible to reallocate support costs to departments that are already closed. Thus, this method is not as complex as the other two to implement in practice, but it is conceptually superior to the direct method. Dual Allocation Method The dual allocation method first recognizes the support provided by service departments to all other service departments as well as patient service departments. After this step, called first allocation (distribution), certain costs still remain in the support services. Then, a second allocation, which uses the declining balance method, is used to transfer all remaining costsfrom support departments to patient service departments. In this method, the support of service departments to all other service departments is recognized. In contrast, in the purely incremental method, after-sales service support is only recognized to “downstream” service departments. Here is how we assumed the dual allocation method would be applied to the Group: (This allocation method can be applied in other ways.) First, the direct administration costs would be distributed among the other five departments (two support services and three patient services). Second, direct facility costs would be allocated to all other departments (including administration and finance). Third, direct costs of finance would be allocated to all other departments (including administration and facilities). three distributions are completed, the first distribution is completed. Some costs remain in the support departments (the intra-support department allocations from the first allocation), so a second allocation is necessary. The second allocation is made using the declining balance method as normally applied, except that applying the first allocation means that the starting cost pool values ​​are much lower. Reciprocal Allocation Method Finally, the reciprocal method uses a system of simultaneous equations (or a number of iterations) to simultaneously allocate overhead costs between support services and patient services. This method is the most complex, but it allows you to better recognize intra-support services. Conceptually, the reciprocal method is the best. The double distribution method comes next, followed by the decreasing method and, finally, the direct method. Although the direct method is conceptually the weakest, it is the simplest and least expensive to implement. As in most situations, greater precision comes at a cost: the more precise the allocation method, the higher the cost of implementation (and the more difficult it is to explain to department heads and other interested parties ). The base case allocations and earnings forecasts are summarized in the following table. Under the base case conditions, as the allocation method changes from direct to reciprocal, the distribution of indirect costs mainly decreases for adult medicine, increases for obstetrics, and exhibits random fluctuations for pediatrics . However, as we explain in the answer to question 5, changing allocation methods does not significantly change the resulting profitability. To facilitate this analysis, we have created a new spreadsheet template, which uses the Group's figures, to calculate the allocation not only for the reciprocal method but also for the other three methods. Sensitivity Analysis In this sensitivity analysis, the allocation rates are kept at their base scenario values ​​and the cost pool amounts are modified. In the base case, facilities have by far the largest cost pool. In Calculation 1, Administration has the largest cost pool, while in Calculation 2, Finance has the largest cost pool. Here are the results: Calculation 1 Calculation 2 In the base case, facilities have the largest cost pool. In Calculation 1, Administration has the largest cost pool, while in Calculation 2, Finance has the largest cost pool. Since adult medicine uses the greatest number of servicesof facilities, its profitability increases considerably when the costs of the facilities are transferred to the administration. When facility costs are shifted to finance, the profitability of adult medicine also increases, but not as much. Conversely, obstetrics uses the least amount of facility services, so its profitability declines when overhead costs are shifted from facilities to administration and finance. The impact of pediatrics is not as clear: its profitability declines when government has the largest cost pool, but improves when the financial sector has the largest cost pool. The most significant change here is that general services use a much larger proportion of each other's services (50%) than in the base scenario (15%). Here are the results: Calculation 3 This change in allocation rates results in increased profitability. in adult medicine, which uses the greatest amount of general services, and reduced profitability in obstetrics, which uses only a small amount of facility services. Shifting overhead amounts from patient services to general services benefits the patient services department that uses the most general services. Still, the results are not significantly different from those of the base scenario. The ten iterations of the model are now insufficient to complete the allocation according to the reciprocal method, so that this method shows $13 less in indirect costs, and therefore $13 more in overall benefit, than the other methods. Analysis and perspectives Evaluate the sensitivity of the profitability of patient services for: a. The allocation method b. The relative sizes of overhead pools c. Attribution Rates There are many ways to answer this question. In the matrix below, the profitability changes from the reciprocal method (which is assumed to be best) are listed using the base case data for allocation rates and cost pool values. This gives an idea of ​​the impact of a change in allocation methods on the department's profitability, holding other factors constant. Allocation method The results are consistent with our expectations: in general, the largest deviation from the reciprocal method occurs in the direct method, while the smallest deviation occurs with the dual allocation method. As the complexity of the allocation method increases (and the method better distributes intra-department overhead), the differences from the results of the reciprocal method decrease. The following table examines the differences from the base case profitability under the three alternatives examined in questions 3 and 4 above. To keep things simple, we've only listed the reciprocal method. Alternative Analysis Here we see that changing assumptions about the relative sizes of cost pools and allocation rates can have a significant effect on the resulting profitability. However, this is not of much concern because these factors depend on the operational economics of the company, as opposed to arbitrary decisions made by management regarding the allocation method used. Over a wide range of assumptions regarding relative sizes of cost pools and allocation rates, we find that adult medicine and obstetrics are cost-effective, while pediatrics is not. Thus, the operations inherent to pediatrics should be examined to see if Westside management can take steps to improve the profitability of this department...