As an illustration of how standard costs are more helpful than allocated costs for establishing prices, suppose a local company asked you to provide physicals for their employees. The company operates on a limited budget but needs to have the following tests performed.

	TB Test
	Drug Screen
	Urinalysis
	CBC

This will be new business for you and will increase your volume by 1,000 encounters annually. The plant manager wants to pay an even $80.00 for these tests. Will you agree?

Referring to worksheet #2, a review of the data shows that standard cost was greater than the allocated costs by $14.37 for all four tests, an error potential of $14,370. Note that your price for these tests is $157.24 and your total standard cost is $86.08. If he pays $80.00, will you lose $6.08 per encounter? Probably not, because your direct (variable) costs are just $52.22. So, for every encounter, you will collect $80.00 for every encounter and your cost of providing the service will be $52.22, garnering a bottom line profit of $27.78 for every physical exam.

After discussing this volume with your lab manager, you might learn that this volume would not affect her staffing. Since $8.57 of your direct cost was for additional staffing, the profit may be as high as $36.35.

Clearly, you need to be able to drill down to detail when making a key management decision. Your cost system must have sufficient variable and fixed cost detail to allow this level of analysis.

Standard Cost and Profitability

Since charges are no longer an accurate predictor of profitability, then the formula for profit must be payment minus cost. In order to determine the profitability of each hospital endeavor, the workable cost system will have the means to determine payment for each patient.

It is not feasible, however, to wait until every payment is made for every patient in order to make a decision. Payments for patients during a given month will extend over several months. Consequently, the manager must have the ability to calculate expected payment for every patient, based payer contracts. The payment component must be an integral part of any cost system for the manager to be able to fully use this powerful tool.

This should help explain why a simple allocation of costs across the service codes is inadequate for management decisions. It may even be worse than the way we have done it for years. We guessed.

What is the Purpose of Cost Accounting?