The method of allocation
	The variability of unit costs due to the abnormal activities
	Purchasing anomalies and other variances that are beyond the purview of the attending physician, payer or service line manager and will frustrate them in their quest to achieve their goals.

Standard Costs

Standard costs, on the other hand, are carefully predetermined target costs that are the result of the budget process and are expected to be attained. Prepared in detail, standards solve the problems of variability that are inherent in allocation systems.

A Standard cost system provides the building blocks for a budgeting and feedback system. Using standard costs, you can:

	Determine "normal" costs to serve as benchmarks for measuring performance, processes and services. Standards are used to establish goals and the responsibility to meet those goals.
	Identify standard costs to help build budgets, gauge performance and obtain reasonable product costs to use in setting prices.

Standard costing is especially appropriate for pricing. When pricing, there is a need to determine normal costs of a DRG, procedure (including supplies, drugs, etc.) and all of the processes required to treat a patient. When you know both the variable and fixed costs, you can set prices that will provide a reasonable profit margin.

Allocated Cost Versus Standard Cost

EXAMPLE

Please see worksheet #1  for an illustration of the differences between Allocated and Standard Costs. We have applied the Medicare cost/charge ratio of .4561 from one of our hospitals to each of the laboratory tests at that hospital. The individual differences were significant, some higher than standard and some lower.

We then sorted the differences and printed off the 10 tests that, after reflecting volume, made the largest total dollar impact. Please note that had we used the cost/charge ratios, our costs for these tests would have been understated by $137,870.

It can be argued that we also had tests where allocated cost was overstated. If this is so, then isn't our allocated cost close enough? We submit that this is not "close enough". If cost precision is not important, why go to the trouble of determining cost? The answer is that we determine costs to be able to set accurate prices that may be based on cost or market. Due to payer negotiations these decisions are specific to each service code and may not successfully be driven by "average" cost.

With standard costing we can determine if our negotiated contracts are appropriate and calculate the profitability of our payers, physicians and service lines. If our costs do not reflect reality, then our decisions may be detrimental to the hospital. You might under-price a program and incur a loss. Or, you might over-price the program and lose the business.

Answer the Challenge: Where Did the Costs Come From?

Consider that you may be challenged as to the composition of your costs. During a discussion with a physician who appears to be overusing resources, he asks to see the cost of his patients. When analyzing a specific patient's costs, you will drill down to the details of each charge and cost for that patient. The calculations for each service code of labor and materials used for the procedure, and the incremental equipment cost should dispel any doubts that the cost is real and that you have done your homework.

Support for an allocation of costs will sometimes come from a general ledger accountant who wants to see the procedure costs balance to the general ledger expenses each month.

It must be understood that standard costs will not equal the general ledger costs. Standard cost will vary from actual cost because of efficiency variances during the period. Remember, standard cost is the budget for each service code, developed from your goals as established by your budget. This is what your expenses are supposed to be.

The difference in standard cost (for all procedures) and your actual expenses is efficiency variance (productivity, wage rates, purchase prices etc.). The difference in standard cost and your budgeted expense is due to volume and mix differences (i.e. what actually happened versus as was budgeted).

Let's return to your hypothetical meeting with a physician about his costs. Suppose your costs were a simple allocation of general ledger costs over each service code. Further, suppose he notices that tests had different costs each month. These differences are due to the normal variations of your operation. You bought film three times this month versus twice in other months. Since you don't inventory film, the cost of X-ray exams went up by one-half. You also had a really bad productivity month. The result is that the good doctor's costs are jumping up and down from period to period where you are asking him why his costs are so high.

All you have to do is explain the concept of volume variance and the cost effects of mix. About the time his eyes glaze over you will begin to realize that you're sorry that you took up his valuable time.

The Advantages of Knowing Standard Cost vs Allocated Costs when Reviewing a Potential Managed Care Contract

What is the Purpose of Cost Accounting?