How to Avoid Common Overhead Allocation Mistakes. (Nuts and Bolts of Business).

IN THIS COLUMN...

Paying for overhead in a physician practice can be tricky, especially when it comes to figuring out who pays far what. Examine same common overhead allocation errors and learn how to fix them.

When I talk with physicians from both large and small practices, one of the greatest areas of contention often involves the allocation of overhead fees.

While physicians understand they must pay overhead fees, many are unsure of the methodology used to derive them. In many cases their concerns may well be justified, since the underlying methodology may be flawed. As a result, it is important to recognize the common cost accounting mistakes made in determining overhead.

Three common mistakes frequently are made in determining overhead rates:

1. Failure to trace costs directly

2. Use of inappropriate allocation bases

3. Arbitrary division of common costs

Tracing costs

The first common allocation mistake is the failure to trace costs directly to the individual or individuals who incur that cost.

The result is costs are charged by averaging.

I call this the "peanut butter method" since costs are evenly spread to all involved. While this method is an easy way to distribute costs, it's not always fair.

For example, imagine you are a partner in a group of pediatricians. The group has laboratory facilities in the office and lab costs are allocated to the physicians in the group. If costs are spread evenly among all the physicians, rather than based on utilization, those physicians who do not utilize the services of the lab as frequently as their partners will be charged a higher fee, unfairly decreasing their profitability.

This is known as cross-subsidization.

Inappropriate allocations

The second cost allocation mistake involves an inappropriate allocation base:

Commonly, a fee is charged without a true cause and effect relationship existing between the cost assigned and the allocation base used.

For example, assume that a surgical group charges each surgeon an overhead rate of 7 percent of billings to perform the billing function. On the surface this seems fair. However is there a true cause and effect relationship between the amount of billings and the actual billing functions?

Look at seven surgeons and their billings in Table 1.

With the 7 percent allocation proposed, the surgeons with the highest billings, A, B and D are allocated the highest fees. Does that charge reflect the amount of time it takes the billing office to prepare and deliver the bill?

Assume that the allocation for billings is based on the actual percentage of time it takes the billing office to prepare and post bills for each individual. Factors such as proper documentation, timely dictation of operative notes and coding could influence the amount of time the billing function takes for each surgeon.

Although A is one of the highest billers, it takes the least percentage of time to prepare A's billings.

E, who has the lowest billings, takes the largest percentage of time.

Although the overall charge for the billing function remains the same at $350,000, with the time-based methodology, the fees allocated to each surgeon and the resulting profitability change dramatically.

Recognizing this type of allocation mistake is not only important in fairly allocating costs, it may also point to problems with a particular individual or group.

For example, it's important to investigate why E's billings are so time consuming.

Common costs

The final cost allocation mistake relates to common costs.

Common or indirect costs are related to the overall operating activities of a business rather than to a particular individual. One way to determine if a cost is common is to ask whether that cost would continue if an individual left the practice.

One example is rent. If an individual's departure will not change the rent for office space, then rent is a common cost. If, on the other hand, the departure reduced the actual square footage of office space rented, then the rent would be considered an individual cost.

This concept is important since failure to separate out common costs may adversely affect whether an individual appears profitable or not.

Table 3 shows the contribution income statement for three physicians, namely A, B, and C.

With a financial income statement cost is listed under the broad category of operating expenses. Even if these operating expenses are broken down further into categories, they still don't describe the behavior of those expenses.

Compare that with a contribution income statement, see Table 2.

First, variable expenses are subtracted from revenue, producing what is referred to as the contribution margin. It "contributes" toward covering fixed expenses and toward profits.

Fixed expenses are then subtracted to determine the net income. The contribution income statement is an internal planning and decision-making tool. It is not subject to external audit and reporting, as with the financial income statement.

Variable expenses vary with billing volume.

They could include drugs or disposable equipment. The contribution margin (CM) refers to the revenue contributed after subtracting variable expenses from revenue.

Fixed expenses are independent of billing volume. They include salaries, rent, utilities, plus general and administrative expenses (GA).

As the net income indicates, C is not generating a profit. Should C's salary be reduced?

Before we answer that question, first look at the costs in more detail. Of the fixed costs listed, some of them may in fact be traceable to the individual.

In Table 4, the salary and the portion of the general and administrative costs related to the billings and account receivable functions (BAR) are considered traceable fixed expenses.

Subtracting these traceable fixed expenses along with the variable expenses produces a more accurate individual contribution margin.

The common fixed expenses are subtracted from the total contribution margin since they will not change if an individual leaves the practice.

Notice that after properly assigning costs, it becomes obvious that C is in fact profitable and contributes to the overall net income. Reducing C's income is inappropriate given the contribution C makes to the overall profitability.

In fact, B and C should share equally in the distribution of profits, since each generated the same individual contribution margin.

Paying overhead is a fact of life. However, understanding how it is allocated and avoiding common mistakes may help you gain a better understanding of your practice.

Table 1

Use of an Appropriate Overhead Allocation Base

Surgeon  Flat Fee  Time-Based Fee   Billings   Flat Charge

   A        7%           6%        $1,100,000    $77,000
   B        7%          10%          $800,000    $56,000
   C        7%           8%          $700,000    $49,000
   D        7%          12%          $750,000    $52,500
   E        7%          28%          $400,000    $28,000
   F        7%          15%          $600,000    $42,000
   G        7%          21%          $650,000    $45,000

 Total                             $5,000,000   $350,000

Surgeon  Time Based Charge  Variance

   A          $21,000       $(56,000)
   B          $35,000       $(21,000)
   C          $28,000       $(21,000)
   D          $42,000       $(10,500)
   E          $98,000         $70,000
   F          $52,500         $10,500
   G          $73,500         $28,000

 Total       $350,000
Table 2

Financial vs. Contribution Income Statement


Financial Income Statement: Cost
by Function

Revenue                            $12,000
Operating Expenses                 $11,000
Net Income                          $1,000

Contribution Income Statement:
Cost by Behavior

Revenue                            $12,000
Variable Expenses                 $(3,000)
Contribution Margin                 $9,000
Fixed Expenses                    $(8,000)
Net Income                          $1,000
Table 3

Contribution Income Statement

                                   A         B         C

Revenue            $1,000,000  $500,000  $300,000   $200,000

Variable Expenses     $60,000   $30,000   $20,000    $10,000

CM                   $940,000  $470,000  $280,000   $190,000

Fixed Expenses

 Salaries            $530,000  $250,000  $150,000   $130,000
 Utilities            $12,000    $4,000    $4,000     $4,000
 Rent                 $60,000   $20,000   $20,000    $20,000
 GA                  $150,000   $50,000   $50,000    $50,000

Net Income           $188,000  $146,000   $56,000  $(14,000)
Table 4

Contribution Income Statement with Traceable Fixed Expenses

                          Total          A         B         C

Revenue                   $1,000,000  $500,000  $300,000  $200,000
Variable Expenses            $60,000   $30,000   $20,000   $10,000

CM                          $940,000  $470,000  $280,000  $190,000

Traceable Fixed Expenses

Salaries                    $530,000  $250,000  $150,000  $130,000
BAR                         $120,000   $60,000   $40,000   $20,000

Individual CM               $410,000  $190,000  $110,000  $110,000

Common Fixed Expenses

Utilities                    $12,000
Rent                         $60,000
GA                           $30,000

Net Income                  $188,000