Family Practice Physicians Office (the Group) is a medical practice with four locations in the Indianapolis, IN metropolitan area. The clinical staff is made up of 20 doctors, who practice in one or more areas of family medicine, and 46 auxiliary doctors and nurses. The Group is organized into three patient service departments: Adult Medicine, Obstetrics and Paediatrics. Supporting these patient service departments are three support departments: Administration, Facilities and Finance. Figure 1 contains summary projections of the Group's revenues and costs by department for the coming year. As part of a much-needed review of the cost allocation process, the Group has contracted with a major accounting firm to estimate the amount of services provided by support departments to each other and to each patient service department . The intent of the study was to provide data that would help the Group develop a better cost allocation system than the outdated and arbitrary system currently in use. Therefore, 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, step-down, double split and reciprocal. To help with the decision, the Group CFO commissioned Top Block to conduct the following study: Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Obtain an original essay Provide a recommendation regarding the best allocation method Determine the overhead cost allocations for each method Compare and contrast the results (Sensitivity Analysis) Estimate the relative profitability of patient services departments under the recommended allocation system Methods Allocation The four methods differ in how allocations within support departments are handled and, consequently, in complexity. Direct Method The direct method assumes that support departments provide services only to patient services departments. Therefore, intra-departmental services are not recognized, even if such services exist. This simplifying assumption makes the direct method the simplest to apply but the weakest conceptually. Step-Down Method The step-down method recognizes some intra-department support services, but does so in a relatively simplistic manner. In this method, the support department that provides the most services to other support departments is assigned first (to the support and patient services departments). Then the department is closed and the process goes to the support department which provides the next most services to the other support departments. Because support departments are closed at each step, it is not possible to reallocate support costs to departments that have already closed. Therefore, this method is not as complex to implement in practice as the remaining two, but it is conceptually superior to the direct method. Double-division method The double-division method first recognizes the support provided by service departments to all other service departments as well as to patient services departments. After this phase, called first allocation (distribution), some costs are still borne by the support departments. Then, a second allocation, using the step-down method, is used to move all remaining costs from the support departments to the patient services departments. Inthis method, the support of the service departments is recognized to all other service departments. In the pure step-down method, however, the support of the service department is recognized only to the "downstream" service departments. Here is how we hypothesized that the double split method would be applied to the Group: (This split method can be applied in other ways.) First, direct administrative costs would be allocated to the other five departments (two support and three customer services patients). Second, direct facility costs would be allocated to all other departments (including Administration and Finance). Third, direct financial costs would be allocated to all other departments (including Administration and Facilities). After completing three assignments, the first distribution is finished. Some costs still remain in the supporting departments – the intra-department allocations from the first split – so a second split is needed. The second split is done using the step-down method as is normally applied, except that applying the first split means that the initial 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 the support and patient services departments. This method is the most complex, but does the best job of recognizing intra-department support services. Conceptually the reciprocal method is the best. The double split method is the next best, followed by the step-down 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 accuracy comes at a cost: the greater the accuracy of the allocation method, the greater the cost of implementation (and the more difficult it is to explain to department heads and other stakeholders). Base case allocations and earnings forecasts are summarized in the table below. Under base case conditions, when the allocation method shifts from the direct method to the reciprocal method, the indirect cost allocation mostly decreases to Adult Medicine, increases to Obstetrics, and shows random fluctuations to Pediatrics. However, as discussed in the answer to question 5, changing allocation methods does not materially change the resulting profitability. To facilitate this analysis, we created a new spreadsheet template, which uses Group numbers, to calculate the allocation not only for the reciprocal method but also for the other three methods. Sensitivity Analysis In this sensitivity analysis, allocation rates are kept at their base case values ​​and cost pool amounts are changed. 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. Because Adult Medicine uses the greatest amount of Facility services, its profitability increases substantially when Facility costs are transferred to the Administration. When facility costs are shifted to finance, Adult Medicine's profitability also increases, but not by much. On the contrary, Obstetrics uses the least number of services of the Facilities, therefore its profitability decreaseswhen overhead costs are shifted from Facilities to Administration and Finance. The impact of Pediatrics is not so clear: its profitability decreases when Administration has the largest cost pool, but improves when Finance has the largest. The biggest change here is that general departments use a much larger percentage of each other's services (50%) than in the base case (15%). Here are the results: Calculation 3 This change in allocation rates translates into increased profitability for Adult Medicine, which uses the greatest amount of general services, and lower profitability for Obstetrics, which uses only a small amount of Facilities services. Shifting overhead from patient services departments to general departments benefits the patient services department that uses the majority of general services. Yet, the results do not differ significantly from those of the base case. The ten iterations of the model are now insufficient to complete the allocation with the reciprocal method, so the method shows $13 less in indirect costs, and therefore $13 more in aggregate profit, than the other methods. Analysis and Insights Assess the sensitivity of the patient services department's profitability to: a. The allocation method b. The relative sizes of overhead cost pools c. Allocation Rates There are many ways to answer this question. In the following matrix, the changes in profitability resulting from the reciprocal method (which is assumed to be the best) are listed using the base case inputs of allocation rates and cost pool values. This provides some idea of ​​the impact of a change in allocation methods on departmental profitability, holding other factors constant. Allocation method The results are as we expected: in general the largest deviation from the reciprocal method occurs in the direct method, while the smallest deviation occurs with the double allocation method. As the complexity of the allocation method increases (and the method better allocates intra-departmental costs), the differences from the results of the reciprocal method decrease. The next table examines the differences from the base case of profitability in the three alternatives examined in questions 3 and 4 above. To keep things simple, we have 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 a major concern, because these factors are driven by the operating economics of the company, as opposed to arbitrary decisions made by managers regarding the allocation method used. Considering a wide range of assumptions regarding the relative sizes of cost pools and allocation rates, we find that adult medicine and obstetrics are profitable, while pediatrics is not. Therefore, the inherent operations of Pediatrics need to be examined to see if Westside management can take actions to improve the profitability of this department. However, at least in the revenue and cost framework used in the management accounting system, Pediatrics is probably inherently unprofitable. This does not necessarily mean that closing the department should be considered. The department may be vital to the practice's mission, and the practice may therefore be willing to subsidize the losses with profits from the other two patient services departments. Please note: this is just an example. Get a custom paper from our expert writers now.Get an essay..