Variance analysis refines overhead cost control

Healthcare Financial Management, Feb, 1992 by J.C. Cooper, James D. Suver

About the authors

Jean C. Cooper, Phd, CPA, is assistant professor of accounting in the college of business and economics at the University of Kentucky in Lexington, Ky.

James D. Suver, FHFMA, DBA, is director of programs in health administration and professor of health administration in the college of allied health professions at the University of Kentucky.

Many healthcare organizations may not fully realize the benefits of standard cost accounting techniques because they fail to routinely report volume variances in their internal reports. If overhead allocation is routinely reported on internal reports, managers can determine whether billing remains current or lost charges occur. Healthcare organizations' use of standard costing techniques can lead to more realistic performance measurements and information system improvements that alert management to losses from unrecovered overhead in time for corrective action.

Because of current cost reduction pressures from healthcare payers, healthcare decision makers need better cost information for performance measurement, pricing decisions, and management of activities. Like other service organizations, many healthcare facilities have adapted cost accounting systems and techniques developed for the manufacturing sector--such as standard costing and variance analysis--to generate necessary information. But healthcare managers may not realize all potential benefits from variance analysis.

Because of high fixed and indirect costs, estimated at 80 to 85 percent of total costs in most healthcare organizations, overhead control is challenging to healthcare managers., Standard cost systems, such as overhead volume variance, can aid overhead cost control because they are based on predetermined measures of resource consumption. These measures help managers control operations and evaluate performance by giving them standards with which to compare actual results.

Pricing decisions

For effective management of pricing and budgeting decisions, full costs per unit must be determined in advance of providing a service. Determining a service's variable cost component is fairly straightforward because facilities use variable costs directly in the pricing process and can estimate them accordingly.

Most healthcare providers, however, have relatively few true variable costs--costs that vary directly with changes in volume of input or output. Although only fee-for-service and material-related costs such as food and inpatient supplies meet this definition, many healthcare providers treat nursing or other clinical labor costs as variable costs. But unless staff members are paid fee-for-service, their labor is not a true variable cost.

Since most caregivers are salaried, their pay does not change automatically with patient volume.

Only their time allocation between patient and nonpatient activities will change as patient volume changes. To change total costs, administrators must decide to increase or decrease staff.

As a result, fixed costs present a more challenging pricing problem. A healthcare organization must estimate the total amount of fixed cost and the volume used as an allocation base. Because most organizations provide several products or services, using a common surrogate, such as labor hours, can be problematic. For example, when the amount of nursing time for a specific diagnosis related group (DRG) already is being recorded, it may be expedient to use nursing hours to allocate direct and indirect overhead costs. If more

nursing hours are used than planned, more overhead would be allocated even if total overhead costs were not increased. This apparent change in overhead costs must be recognized in pricing and control decisions.

Estimated per-unit costs are unique, however, to the specific level of estimated fixed costs and the specific volume of estimated output. Whether fixed costs are direct fixed costs in a department or indirect fixed costs of general administration, both must be recovered through pricing.

Exhibit 1 presents standard costs for a healthcare procedure. The per-unit costs ($127) and desired profit margin (10 percent or $12.70) could be used to evaluate offers discounted from the full charge of $164.35. Standard costs also can provide useful planning data for budgeting and control purposes.

A hospital department could develop an income statement to estimate the next month's profit for a certain procedure, assuming a forecast of 50,000 procedures. This income data also would determine the department's budget: TABULAR DATA OMITTED

Projected profit of Procedure 101 for the next accounting period would be $635,000, assuming that:

* 50,000 procedures will be completed during the month and capacity in the department is sufficient to accomplish this level without additional costs (such as overtime) being incurred;

* All 50,000 procedures will be billed at the stated charge of $164.35 and allowances will equal 15 percent of charges;

* All cost figures (such as salary costs) occur as planned; and