This example illustrates the type of footnote that an organization might provide in its cost accounting report. It also is intended to serve as a template for such a footnote, where options are provided at various points throughout the footnote to tailor the report to an organization’s specific circumstances. It originally accompanied the article “Selecting the Right Costing Model,” by Paul Selivanoff, CPA, in the November 2018 hfm.
A note to the reader of this report:
This footnote is provided to assist you in understanding how the cost data were prepared and the degree to which you can rely on the cost data displayed in this report. Different approaches to costing can yield dramatically different results for the same period expenses and production mix. Because there are no commonly promulgated industry standards for preparing and presenting cost information, every organization must establish its own framework for costing. This note provides an important source of information about how the cost data were prepared, which is essential for the reader to understand to be able to draw accurate conclusions from the data.
Selection of the Cost Accounting Methodology
Ideally, the organization’s computer systems would be able to capture the actual costs associated with rendering a particular service based on actual resources consumed. However, because this is not usually the case, estimates are used instead. Estimates are averages and may bear little resemblance to actual cost of specific cases. The estimates are created by assigning all period expenses to all period services using an allocation formula or by summing up the cost of the components of a service that, itself, has its cost derived from a standard list of quantities and unit costs of the inputs (e.g., average hourly labor rate, average purchase price), or by specifically identifying the resource and its cost.
The table below summarizes the methods used to cost items for [specific cost objects used in this report/the entire cost database]. It also shows the relative dollar value of items costed by each method. Based on the mix of methods used and the years since it was last updated, the weighted average accuracy is calculated at ___%.
Methods Used to Cost Items
Please note that the overall accuracy of the reported costs will increase with the size of the population included in the sample. For example, even though RCC is only considered 25–35% accurate, when hundreds of patients who received hundreds of different services from many different cost centers are aggregated, the overstatement and understatement of cost for each service rendered tends to cancel out and yield a significantly more accurate result.
In the article “The Ratio of Costs to Charge: How Good a Basis for Estimating Cost,” published in the Fall 1995 issue of Inquiry, Michael Shwartz, David Young, and Richard Siegrist found overall the accuracy of RCC ranged from 85% to 95% at the product line or DRG level. However, when the reported population is small, the reader should exercise caution in drawing conclusions when any method but micro-costing or actual costing is used.
How Cost Accounting Works
There are four basic methods of calculating the cost of services rendered to customers.
Calculated Versus Actual Costs Using Ratio of Cost to Charge (RCC)
Ratio of Cost to Charge (RCC). This method assumes that the cost of an item is the ratio of cost to charges for the department multiplied by the item’s selling price. The method works if there is a constant markup for all services being costed. However, most prices are set based on market models that have little to do with actual cost. In those cases, costs computed by an average ratio of cost to charge vary significantly from true cost. This method of costing has been found to be 25% to 35% accurate at the service code level.
Relative Value Unit (RVU). This method assigns period expenses to each service rendered in a department based on a weight factor that is a proxy for the relative intensity of resource consumption for that service. The most important element of an RVU is not its point value; rather, it is the point value in relation to the point value of all the other services’ RVUs. If a single RVU is used for all expenses, the assumption is that all costs are driven by the single weight factor. This is often not the case—for example, a service may be labor intensive but use no supplies, or it may use very expensive supplies, but not require much labor. In this case, using a single weight factor to assign cost to a service will result in reported costs varying significantly from true cost. To rectify this problem, costs from the operating expense accounts are grouped into “cost pools” by cost driver, and each cost pool is allocated to the services based on a weight factor that most closely matches the estimated relative amount of resources consumed. For example, it is common, but not required, to use a different weight factor for each service for each category of cost—direct labor, supplies, other variable costs, and overhead. This method (also known as the multiple RVU or activity-based costing (ABC) methodology) has been found to be between 35% and 65% accurate at the service code level.
Micro-cost. This method creates a list of all the cost components in a product or service based on [best practice/actual, frequency-adjusted usage]. The cost of each component [is/is not] recomputed to be the actual average cash price paid by the company for that component during the period costed. This method may be between 65% and 90% accurate, depending on how consistent the organization is in how it delivers the service, and how up to date the list of components is.
Actual cost. Under this method, the actual resources consumed by a particular customer receiving a service are captured and reported. This method typically requires a sophisticated computer system capable of real-time logging of service events—such as using radio-frequency identification (RFID) to capture the amount of time a nurse actually spends with a patient, or tracking a specific supply from purchase order to use by a particular customer. This method is assumed to be 100% accurate and is used as the standard for comparison with the other methods.
The costs presented in this report are categorized by cost behavior into the following classifications
Variance of Costs by Classification
The terms used in the “Cost Classification” column above have the following meanings:
- Fixed – Does not vary with changes in volume
- Variable – Clear association of variability with volume changes
- Indirect – Cannot be associated with a particular charge code
- Direct – Directly traceable to a particular charge code
The column labeled Variance % if Micro-Costed is computed by taking all the period expenses assigned to the specific cost classification in relation to the projected amount of period expenses that were expected to be found in the cost classification based on the total volumes of services rendered. How well the projected costs match the actual costs is one indication of the underlying quality of the micro-cost list of components, and accordingly, one would expect the total variance to be less than ____% based on common cause variation. For labor, this percentage may also represent the average productivity level of the department for which consideration should be given accordingly.
Cost Accounting Model Assumptions
1. For comparability in reporting, this organization has chosen to utilize the same allocation statistics used in the Medicare Cost Report.
2. Cost Exclusions:
a. For purposes of aligning costs of care to patients seen, the following department’s costs are not included or allocated to patient services:
– [list departments]
These departments are noted for reconciliation of the cost database to the General Ledger.
b. Expenses that are not a part of current period operations, such as one-time write-offs, accounting adjustments, [were/were not] removed from [direct expenses/all expenses].
c. Policy for handling revenue offsets and expense reclasses is [describe]
Period costs are grouped by cost behavior and assigned to cost objects—typically charge codes. Not all period costs should necessarily be used in the costing process. For example, certain expenses of discontinued or restructured operations would unnecessarily overstate the cost of future operations, thus clouding decision making. In some cases, historical cost may be expected to continue, but the cost classification may need to be adjusted, such as when an organization converts a per unit equipment lease to an owned asset. The historical approach attempts to reflect costs as perfectly as possible in the cost categories “as it was” during the period, while the future approach takes some liberty with expenses that are not expected to occur in future periods. Our model takes a purely [historical/future] approach. General ledger accounts are organized by natural expense classification, not cost behavior. In the conversion of natural expenses into cost categories based on cost behavior, some judgment and estimation is required. Our model is biased toward treating uncertainty as [fixed/variable]. To the extent that variable costs are overstated, contribution margin is understated, which we believe is more conservative for most decisions.
Dept Indirect expenses were assigned to cost objects based on ______ [describe method].
Hospital Overhead expenses were assigned to cost objects based on _____[describe method].
Supply cost objects [include/do not include] an allocation for department indirect expenses and [if so] were based on _____[describe method].
Supply cost objects [include/do not include] an allocation for hospital overhead and [if so] were based on _____[describe method].
Cost objects [include/do not include] services rendered at [multiple locations/different shifts] that have different operating processes, procedures, and staffing costs. The costs therefore presented represent “averages” and do not reflect actual practice at any [one location/shift]. Accordingly, care should be used when using these data to analyze costs at a single location or for a single shift.
The reader should note that significant distortions may arise in department indirect or hospital overhead depending on the data slice included in the report. For example, allocating these costs at one per procedure will have the effect of unduly increasing the amount of overhead assigned to patients who have a large number of small charges relative to patients who have a few large charges. And allocating these costs based on procedure charge or cost may unduly increase the amount of overhead assigned to inpatients over outpatients when an organization uses a tiered pricing model or has separated cost centers for outpatient services.
Please feel free to contact __________ for a more detailed explanation of how the costing model used to generate this report affects the use and interpretation of the report.