Westwood Retirement Residence
ABC Costing at Westmount
Westmount Retirement Residence has not met its expected return on investment that has been established by its historical performance history. The industry in which this organization operates is growing at an exponential rate given the fact that the population, on the whole, is aging as well. It is reasonable to suspect that the increase in demand should equate to an increase in profitability as well. Unfortunately for Westmount this has not been the case and therefore inquiries into the causality of such a trend has prompted Westmount to investigate its accounting methods to find solutions.
The current method of accounting allocates costs to residents based on the square footage of the room they occupy. Furthermore, based on this system, the residents are billed on a flat rate no matter which services or how often they utilize them. This system benefits currently benefits the residents that frequently use services and furthermore financially punishes those who do not use all the services available to them. For example, a resident with a larger room doesn’t necessarily use services more than someone who is staying in a smaller room. However, the current model of accounting assumes that the individual uses a proportionally equal amount of services to that of their room size.
Therefore it is recommended that a different model for cost accounting be integrated into company’s accounting procedures. The ideal method for attributing the costs to the residents would be with an activity-based costing method. Under this method, the residents would be charged in accordance with what services they use and how often they use them. Therefore, the cost to the residents for items such as dietician services would be independent of the room size and, more likely than not, be nearly the same for most residents. Other items, such as physical therapy services would vary greatly to the residents based on the amount of usage they require. Operating margins in this industry can range from roughly 15% to 40% given the occupancy rate and the organizations ability to control costs (GMB, 2006). Give a conservative 20% margin the organizaiton should of made roughly 490,000. Thus the urgency to revamp the pricing/costing system should be immediately considered.
Activity-based costing (ABC) is a method of allocating overhead into costs in a company’s accounting functions. The method has had mixed receptions in different industries. It was first introduced primarily in the manufacturing industry in order for executives to better identify the most profitable mix of products that they manufactured (Turney, 2008). Since then, like any other technology, it has evolved and new applications have been identified for its use. Turney (2008) has developed a model of the lifecycle of ABC that identifies its adoption rate among accounting professionals.
The hype cycle illustrates how the ABC method increased exponentially in popularity in the beginning but then declined as rapidly. Other metrics were developed during the down cycle that contributed to its decline (Katz, 2002) such as the balanced scorecard and value added methods as well as numerous users being frustrated by its complexity over traditional methods. However, it has retained its popularity with several different industries due to the fact that it more accurately is able to match costs with various production or service processes. One industry that has been keen to adopt ABC methods is the enterprise resource planning (ERP) software system manufactures. Many of these companies, such as SAP, have include the accounting method in there software platforms.
The ABC costing method has found a warm reception within the healthcare industry (Canby, 1995). It is reasonable to suspect that part of its popularity in this industry is due to the fact that certain costs of treatments are incredibly high as well as the number of treatments that are available. Since the ABC method is more apt to associate the correct costs to the processes that utilize them then it allows for more accurate billing to the clients. For example, an x-ray process can be broken down into four primary cost drivers, administrative check-in, patient exposure, patient return, and film processing, which can be accounted for and billed based on usage for each separate process.
ABC Costing at Westmount
Given a reasonable amount of gross margin that should be expected in the industry (GMB, 2006) the gross margin should of provide a return of over 490,000 worth of profit on the financial statement. Therefore either there must be more revenue or better controls on costs; most likely a combination of the two. The calculation is as follows:
The current costing arrangement at Westmount depended completely on the square footage of the residents unit. Thus it is reasonable to anticipate that all stakeholders would benefit from the application of the activity-based costing system; except of course those residents who required the most services. The costs were identified to fall into six categories:
1. Food Services
2. Support Services
Previously, each of these costs was allocated overhead by a simple calculation that divided fixed costs associated by the number of residents (with multipliers for the rooms larger than the studio). Furthermore the administration and executive salaries were allocated to each cost department equally.
One cost driver that can be identified from the case is dietician consults. The case notes that while some use dietician services, such as the clients with diabetes, others rarely or never use dietician services. Therefore if the consult from a dietician was made a cost driver then this would more accurately account for the costs for that service. For example, if a resident used ten separate consults in a month then this would be able to be billed for twice as much as a client that only required five consults to manage their diabetes.
Another cost driver should be associated with both laundry and housekeeping. In the case of laundry the cost driver could be applied per load of clothing. Each load would have a cost that includes an amount of the related overhead included in it. Therefore, clients who requires more frequently or larger amounts of laundry would be billed fairly for their contribution to the overhead. In the case of housekeeping, it is probably sufficient to make the cost driver represent one trip to clean. For example, some residents might require one housekeeping service per week while others may use two or three. It is reasonable to believe that breaking this down any further might overcomplicate the cost driver. For example, say if housecleaning trip took six hours and another only took one then this might not be the most accurate way to allocate costs. However, the bulk of housekeeping trips should fall within a fairly reasonable range of time spent.
Westmount could increase profitability by instituting an activity-based costing method. First, profitability could be achieved by more accurately matching costs with activities; which have been identified as successful in the healthcare industry. The customers who require specialty or increased frequency of service would be required to pay for services in the amounts equivalent to their usages. Furthermore, this would also provide an incentive for residents not overuse any services unless necessary; thus potentially reducing the amount of staffing requirements.
Canby, J. (1995, February). Applying activity-based costing to healthcare settings. Retrieved February 14, 2011, from CBS Business Network: http://findarticles.com/p/articles/mi_m3257/is_n2_v49/ai_16565845/
Katz, D. (2002, December 31). Activity-Based Costing. Retrieved February 18, 2011, from CFO Magazine: http://www.cfo.com/article.cfm/3007694
Turney, P. (2008). Activity-Based Costing. Retrieved February 18, 2011, from SAS: http://www.sas.com/resources/whitepaper/wp_5073.pdf
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