Background
Business and Services
DDM Lab is an independent medical imaging facility offering various diagnostic services, including magnetic resonance imaging (MRI), computerized axial tomography (CAT), fluoroscopies, and radiographs. The tests differ significantly in their function and cost implications. For instance, radiographs, also known as X-rays, are used for bone assessments and are the most popular due to their high accuracy, low-cost implication, and short turnaround time.
The imaging center also offers fluoroscopies to examine the presence of any internal structural or functional anomalies in a patient. Other advanced diagnostic procedures include CAT scans and MRI, which generate cross-sectional body images of soft tissue. As an affiliate and the primary medical imaging services provider to the University Hospital, DDM Lab delivered about 90% of the regional teaching healthcare facility’s imaging needs. This cooperation compels the imaging center to continually improve its technological capacity, including the recently acquired 3D MRI scanner.
Costing Systems
DDM Lab currently operates a process costing system through which it assigns the costs incurred in each of the offered services. Under this approach, the variable costs of labor and overheads are apportioned to the distinct, identifiable activities incidental to the delivery of a particular procedure. This implies that the total fee charged for each service comprises the costs of direct labor (DL) and the associated overheads. DDM Lab allocates the indirect costs as a function of the DL dollar by computing a cost rate for all labor used in a given test. Notably, the DL consists of such activities relating to employees’ wages as patient preparation, machine calibration, test administration, and the general upkeep of the laboratory equipment. The overheads mostly pertain to equipment depreciation and imaging facility management, particularly maintaining the physical establishment, assessing the apparatus and supplies, and outsourcing specialized technicians.
Pricing
DDM Lab operates a premium pricing strategy inspired by the facility’s growing dependence on high-tech equipment and the subsequent superiority of the services offered. According to Ashraf et al. (2017) and De Toni et al. (2017), this is a value-based pricing approach through which a service provider intends to communicate the product’s exceptional quality.
For instance, the acquisition of such advanced equipment as a 3D MRI scanner enables DDM Lab to gain a significant strategic advantage over the competitors due to the ability to conduct highly effective and complex diagnostic assessments. Such technologies reinforce the laboratory’s cooperation with the University Hospital. However, the high price setting has significantly eroded the laboratory’s competitiveness, with many surgeons and physicians directing patients to the competing medical imaging outlets. As a result, the pricing mechanism has adversely affected DDM Lab’s overall revenue performance and bottom-line profits.
Problem and Issues
The Problem Faced by the Company
The accurate computation of the production costs for each product or service is critical for decision-making since it often forms the foundation for sales price determination. DDM Lab is experiencing challenges in its bottom-line performance, which are occasioned by the current one-overhead-pool costing mechanism. Under this system, the laboratory combines all the indirect costs and then apportions them to each procedure based on the DL dollar rates. This approach disregards the disparities, which characterize the overheads incurred by the laboratory.
For instance, apportioning the costs of general testing of the equipment and supplies and the maintenance of outsourced apparatus on tests and procedures will misrepresent the actual expenditures. Huang (2018) contends that a plantwide overhead assignment technique distorts the product cost and is most appropriate where DL constitutes a substantial proportion of the overall production expenses. From this perspective, this approach is inapplicable in DDM Lab since DL costs have significantly reduced due to the overdependence on high-tech equipment.
Issues Leading to the Problems
In DDM Lab, equipment-driven overheads constitute the largest proportion of indirect costs and differ widely across the procedures and tests. This implies that using the plantwide overhead allocation approach results in the over and under-costing of the services rendered, depending on their low and under consumption of resources, respectively. For instance, tests and procedures requiring reduced levels of DL will be overpriced, while those consuming high quantities of DL will be underpriced, resulting in unrecognized losses on sales.
Notably, this is the primary cause of rising overheads and declining profitability despite the sizeable reduction in costs unrelated to primary operations. In this regard, the failure to refine the overheads occasions their misallocation and ranks as one of the issues leading to the problem. More specifically, there lacks a precise distinction between DL and equipment-related indirect costs, which are currently combined, leading to the erroneous allocation, and the resultant mispricing of the services.
The Rationale Linking the Issues to the Problem
A fundamental component in effective product pricing and profitability computation is the proper and precise allocation of overheads. The traditional costing approach adopted by DDM Labs fails to apportion the indirect costs correctly, leading to costing distortion and imprecise pricing decisions. Due to the significant disparities and diversities in their production process, adopting a more sophisticated and accurate overhead allocation approach is imperative. For instance, despite becoming more dependent on high-tech equipment leading to diminished labor costs, the facility still uses the DL rate as the overhead assignment method. The outcome of this approach is cost distortion and the subsequent mispricing of the services offered.
Theoretical Analysis
Accurately apportioning overheads is one of the critical determinants for effective product costing and forms the basis of selling price computation. Although all costing models attempt to establish the actual cost of a particular product or service, a one-overhead-pool costing system leads to significant costing distortion due to its disregard for the disparities and diversities in activities. However, this model is applicable in facilities producing services or products with less diversity. In DDM Lab’s scenario, such sophisticated technique of apportioning indirect costs as activity-based costing (ABC), is indispensable.
According to Quesado and Silva (2021) and Ebele and Meshach (2016), a multiple pool costing system enables accurate product costing, recognizes cost drivers’ distinct attributes and behaviors, and enhances effective product pricing. Therefore, DDM Lab should adopt an overhead allocation model, which increases direct cost tracing and facilitates refined apportionment.
Calculations and Interpretations – Quantitative Analysis
Product cost under the existing one-pool costing system
Product cost = Direct labor + overheads
Projectional radiographs: 542,194.9 X 1.55 = $841,500.80
Fluoroscopies: 538,261.1 X 1.55 = $807,391.70
CAT Scan: 352,105 X 1.55 = $542,762.75
MRI Scan: 355,681.3 X 1.55 = $551,306.0
Total: $2,742,961.25
two-pool costing system
Direct labor-related overhead:
Projectional radiographs: 1,009,948.8 ÷ 542,194.9 X 1,431 = 2,665.5
Fluoroscopies: 1,009,948.8 ÷ 538,261.1 X 1,771.2 = 3,323.30
CAT Scan: 1,009,948.8 ÷ 352,105 X 1,881.9 = 5,397.9
MRI Scan: 1,009,948.8 ÷ 355,681.3 X 3,395.25 = 9,640.7
Equipment-related overhead:
Projectional radiographs: 1,765,450.4 ÷ 1,431 = 1,233.7
Fluoroscopies: 1,765,450.4 ÷1,771.2 = 996.8
CAT Scan: 1,765,450.4 ÷ 1,881.9 = 938.1
MRI Scan: 1,765,450.4 ÷ 3,395.25 = 520
Total direct labor and equipment-related overhead:
Projectional radiographs: 2,665.5 + 1,233.7 = 3,898.7
Fluoroscopies: 3,323.3 + 996.8 = 4,320.1
CAT Scan: 5,397 + 938.1 = 6,335.1
MRI Scan: 9,640.7 + 520 = 10,160.7
Three-pool costing system
- High-Tech
- Low-Tech
Projectional radiographs: 1,290,510.2 ÷ 361.8 = 3,567 474,940.2 ÷ 1,069.2 = 444.2
Fluoroscopies: 1,290,510.2 ÷ 781.65 = 1,651 474,940.2 ÷ 989.55 = 479.95
CAT Scan: 1,290,510.2 ÷ 1,105.65 = 1,167 474,940.2 ÷ 776.25 = 611
MRI Scan: 1,290,510.2 ÷ 3,395.25 = 380 474,940.2 ÷ 0 = 0
The costs associated with the 3D MRI equipment ought to be split and allocated accurately to the MRI tests. Such an approach will ensure that high costs operational costs of the machine will not be apportioned to the other tests and procedures, which will overstate their actual cost implication. However, this would lead to the price escalation of the MRI tests and further depress the demand for its services. Comparatively, the 3D MRI machine contributes the largest direct labor-related overheads and is associated with the highest high-tech test hours annually. This figure significantly increases when combined with the equipment-related overheads, as shown below. Overall, this DDM Lab costing system analysis demonstrates the essence of adopting the correct cost apportionment model for accuracy and more precise product pricing.
3D MRI Scan
Direct labor-related overheads: 1,009,948.8 ÷ 355,681.3 X 3,395.25 = 9,640.7
Equipment-related overheads: 1,765,450.4 ÷ 3,395.25 = 520
Total Overheads:
9,640.7 + 520 = 10,160.7
Recommendations
DDM Lab should adopt a more sophisticated overhead apportionment model to avoid cost distortion and enhance the effective pricing of their services. Considering the diversity and differences in the tests and procedures, the traditional cost allocation approach is inapplicable and has contributed to the facility’s loss of competitive advantage. Comparatively, the two and three-pool cost allocation strategies provide a more accurate and precise assignment of indirect costs since there is greater refinement and identification of the distinctive cost characteristics than in the traditional model. Therefore, DDM Lab should discard the plantwide overhead allocation approach and adopt the two or three-pool costing system.
References
Ashraf, S., Li, C., & Mehmood, B. (2017). A study of premium price brands with special reference to the willingness of customers to pay. International Journal of Academic Research in Business and Social Sciences, 7(7), 619−639. Web.
De Toni, D., Milan, G., Saciloto, E., & Larentis, F. (2017). Pricing strategies and levels and their impact on corporate profitability. Revista De Administração, 52(2), 120−133. Web.
Ebele, A., & Meshach, I. (2016). Activity-based costing from the perspective of competitive advantage: A study of Nigerian manufacturing firms. International Journal of Finance and Accounting, 1(2), 1−23. Web.
Huang, Q. (2018). Traditional cost system vs. activity-based cost system – A managerial accounting case study. Applied Finance and Accounting, 4(2), 55−66. Web.
Quesado, P., & Silva, R. (2021). Activity-based costing (ABC) and its implication for open innovation. Journal of Open Innovation: Technology, Market, and Complexity, 7(1), 1−20. Web.