Analyze the complexity of cost behaviors in health care organizations and describe how costs are classified according to their relationship with volume. Health services managers are vitally interested in how costs are affected by changes in volume. Before costs can be managed, one must have an understanding of how and why costs are being incurred. For, example medications dispensed from the pharmacy are variable costs items since the more often medications are dispensed to the patient, the higher to the total medication costs (Lang, 2012).
In this example the cost is driven by the prescription of the medication for the patient, which leads to dispensing the medication and incurring the cost. If the medication is not prescribed the total cost would be zero. The salary of the Director of the Pharmacy is a fixed cost, at least over the short run because that person is paid the same salary regardless of how many, or how few, prescriptions they fill. The text defines the relationship between an organization’s total costs and volume as cost behavior or underlying cost structure, is used by mangers in planning, control, and decision making.
The primary reason for defining and organization’s underlying cost structure is to provide healthcare managers with a tool for forecasting cost and profits at different volume levels (Gapenski, 2012). The cost structure of both fixed and variable costs- that is some of the costs are expected to be volume sensitive and some are not- is typical in healthcare organizations. Total variable costs increase or decrease proportionately as volume changes, but variable cost rate remains constant as long as volume remains within the relevant range. Fixed, costs, in contrast to total variable costs, remain unchanged as the volume varies.
The Academy of Healthcare Management Journal states, when attempting to improve profitability by decreasing or controlling costs, cost behavior is particularly important. If activities are limited or decreased to lower variable costs without consideration of fixed costs profits may actually decrease. In conclusion, total costs are merely the sum of the two. Because total variable costs are tied to volume, total variable costs increase as the volume increases even though fixed costs remain constant. Discuss the importance of cost allocation and how it may be leveraged by health care organizations.
Cost allocation is essentially a pricing process within the organization whereby managers allocate the costs of one department to other departments. Cost allocations within healthcare organizations must establish prices that proxy those that would be set under market conditions. Costs within a health services organization must be allocated. Overhead costs of the business, such as those incurred by administrators, facilities management personnel, financial staffs, and housekeeping and maintenance personnel must be allocated to those departments that generate revenues for the organization (Gapenski, 2012).
The goal of cost allocation is to assign all of the costs of an organization to the activities that cause them to be incurred. Health services managers track and assign costs by individual patient, physician, diagnosis, reimbursement contract, and so on. Much of the motivation for more accurate cost allocation systems comes from the recipients of overhead services. Mangers at all levels within health services organizations are under pressure to optimize economic performance, which translates into reducing costs.
To assign costs from one activity to another, two important elements must be identified: a cost pool and a cost driver. A cost pool is a grouping of costs that must be allocated, while a cost driver is the criterion upon which the allocation is made. Clearly, the proper allocation of overhead costs is essential to good decision making within health services organizations. In conclusion, revenues must exceed the total of both fixed costs and variable costs combines in order for an organization to be profitable.