The Crimson Press Curriculum Center

First Page and the Assignment Questions:
    For decades, hospitals have used one of two methods to compute the cost of their intermediate products (such as a laboratory tests and radiological procedures): a ratio of costs to charges(RCC) or relative value units (RVUs). Both methods are highly flawed. CFOs who use either of these methods to ascertain the full cost of an intermediate product are making a mistake that can have serious financial consequences for their institutions. Indeed, CFOs who use one of these methods during negotiations with payers about capitation or subcapitation rates, diagnosis-related group payments, or fees for individual services may end up proposing prices that are too high to obtain the contract. Or perhaps worse, the hospital might end up with a contract in which its service-delivery costs exceed the associated revenue.

The Stage-2 Dilemma in Full-Cost Accounting

A full-cost accounting effort goes through two stages. In Stage 1, the hospital’s accounting staff:

•    Defines cost centers, distinguishing between production (or revenue) centers and service centers

•    Assigns all costs to one or more of those cost centers

•    Determines appropriate bases of allocation for service centers

•    Allocates the service center costs (sometimes called “overhead” or “indirect costs”) to the production centers

The end result is that all costs reside in production centers. Although it has some flaws, the Stage 1 effort is well developed in many hospitals and, when done well, results in reasonably accurate production-center costs.

It is in Stage 2, when a production center’s costs are attached to its products, that problems arise. During this stage, the production center’s costs are divided into direct and indirect categories. Direct costs are those that can be attached to a product unambiguously; they typically comprise direct labor and direct materials. There is no big problem here.

With indirect production center costs, however,