Western Dialysis Clinic Issues

Executive Summary

Western Dialysis Clinic is an independent, non-profit full service rental dialysis clinic. The clinic currently provides two types of treatments, which include Hemodialysis (HD) and Peritoneal (PD).

The existing system used by Western Dialysis Clinic is the traditional ratio-of cost-to-charges (RCC) method. Under this system the traceable supply costs are assigned directly to the two types of treatment. And also currently both the treatments seem profitable. Due to this David Thomas, the controller of Western Dialysis has recognized two major

issues: First, the procedure currently being used to assign common expenses may not be correctly presenting the underlying use of the common resources by two different procedures. Secondly, David has also recognized the need for process improvement in order to obtain a better understanding of the costs, to make better decisions about the profitability of the two procedures, HD and PD at Western Dialysis.

To facilitate the analysis of these issues and to come up with recommendations David has decided to explore the idea of implementing ABC principles to obtain a better idea regarding the profitability. This will consist of analyzing two phases under ABC: in Phase I, the focus will be on the General Overhead category, under which this category will be decomposed into different resource cost pools and cost drivers to better represent the use by two treatments. In Phase II the nursing service category along with the general overhead category (as in Phase I), will be disaggregated into its respective resource pools and cost drivers. Based on this analysis it will be decided which treatment can be regarded profitable and if unprofitable what steps should be taken to reduce the various costs associated or whether it will be beneficial for the clinic to discontinue the treatment.

Introduction

This report will analyze and discuss the impact of implementing activity based costing principle over the traditional costing method, on the profitability of Western Dialysis Clinic under different Phases. The recommendations regarding the optimal decision will be provided to the senior management.

ABC analysis

Activity Based Costing (ABC) is an accounting technique that allows an organization to determine the actual cost associated with each product and service produced by the organization without regard to the organizational structure. Activity based costing systems refine costing systems by focusing on individual activities as the fundamental cost objects. The logic of ABC systems is that more finely structured costs in the cost pool along with their cost drivers lead to more accurate costing of activities.

Presently at Western Dialysis, the existing cost system is the traditional costing system, under which both the treatments were categorized as a single category- dialysis treatment; and the total service costs were allocated based on a cost-based reimbursement program; as a consequence both the procedures seem to be profitable. Therefore under the ABC costing system the two categories of general overhead and the nursing resource will be decomposed into their subjective cost pools and drivers. The analysis will be based on projecting income statements under these two alternatives and calculating individual profitability of the two treatments. All the analyses for determining the profit to the company for different alternatives are based on various assumptions which are summarized on page 5.

Assumptions

The above given analysis for Western Dialysis Clinic is based on the following main assumptions:

* Under Phase I, it is assumed that, the nursing costs are allocated as 85% towards HD and 15% towards PD, based on the experience and judgment of the staff. (Different for Phase II).

* The durable equipment costs including maintenance and depreciation will be the same for both phases (proportion of 85% allocation towards HD and 15% towards PD), due to the relatively small size of the category.

* ABC analysis is valuable in people-intensive departments. In this case Western Dialysis is considered a people intensive organization so implementing ABC is a good way to allocate the costs to determine accurate profits.

* It is anticipated that ABC will provide significantly different results from the traditional method used at the clinic. Given this the cost information generated by ABC should be used by the management for significant decisions and must be regarded as superior.

* It is also assumed that the HD procedure requires more expensive equipment facilities, administration and support staff since it is administered at the clinic. On the other hand PD procedure requires more assistance costs, and ordering costs since administered by patients at home.

Analysis of different alternatives

The Existing System

The existing cost system at Western dialysis is the traditional ratio-of cost-to charges. This system assigns the traceable supply costs directly to the two types of treatments. For the projected income statement under the existing cost system please refer to Exhibit 1.

Under this system the total service costs of approx $1,800,000, are allocated based on the percentage of total revenues represented by each treatment, which is 61% for the HD treatment and 39% for PD. The clinic also receives a reimbursement on the basis of a fixed fee and not the cost of service provided, which resulted in a weekly reimbursement of $389.10 for each patient by allocating both the treatments into one category. Therefore based on this system Western dialysis calculated HD per treatment revenue to be $129.70 (performed three times a week at the clinic) and per treatment revenue for PD to be $55.59 (performed seven times a week by