View the step-by-step solution to:

C CHAPTER Cost Behavior Learning Objectives After reading this chapter, the student should be able to: Define cost.


Cost Behavior

Learning Objectives
After reading this chapter, the student should be able to:
1. Define cost.
2. Distinguish variable from fixed cost for a service or process.
3. Distinguish direct from indirect cost for a responsibility center or service.
4. Allocate indirect costs to revenue centers using appropriate techniques.
5. Perform simple statistical cost analyses.
6. Perform simple cost/volume/profit analyses.

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Key Terms
Activity-based Indirect cost
costing Per-unit contribution margin
Cost Reciprocal cost allocation
Cost allocation method
Cost center Responsibility center
Cost drivers Revenue center
Cost/volume/profit analysis Shadow cost center
Direct allocation method Step-down allocation method
Direct cost Step-fixed cost
Double distribution method Variable cost
Fixed cost

Controlling costs is not, strictly speaking, a financial function. Controlling costs
involves attention to internal controls (rules for making purchases and for using
assets), parsimony in spending, and the elimination of waste of materials and repe-
tition of service. Process improvement staff, operating personnel, and purchasing
authorities all play roles in cost control.
Most health care professionals, however, view cost control as being in the realm
of financial management. The financial management staff certainly have a role in
educating their colleagues as to the nature and level of cost. Managerial account-
ants, part of the financial team, are charged with measuring and analyzing costs.
In addition, understanding the behavior of costs as volume changes (the subject of
this chapter) is essential to carrying out the critical financial function of budgeting
(the subject of Chapter 8).
After completing this chapter, the reader should be able to (1) allocate costs
from cost centers to revenue centers, (2) perform simple statistical cost analyses,
and (3) predict the level of service volume at which a health care organization can
break even, equating its revenue to its costs.

There may be no word more widely used, but more misunderstood, than costs.
Consumers speak of what a service "costs" when they mean the price of the serv-
ice. Policy analysts speak of national health care costs when they mean total
national spending on health care. All of this verbal sloppiness is very confusing
and obscures the meaning of costs as accountants, economists, and managers use
In accounting, economics, and managerial decision making, the cost of a good
or service is its cost of production. That is, the cost of a home health visit is the
market value of all of the resources that are employed in the delivery of that visit
(Burik & Duval, 1985). The cost of an appendectomy and of a day's inpatient stay
is the market value of all of the resources that are involved in delivering that
appendectomy and overnight stay. The costs of producing a service are not neces-
CHAPTER 7 Cost Behavior · 127

sarily the same as the price that the consumer (or his insurance carrier) pays for
the service. In fact, good managers work hard to keep cost well below price.
Consumers pay a price; providers bear the cost.
Thus the costs of minor surgery and an overnight stay include the obvious
items: the wholesale price (not the price charged to the patient) of the patient's
food, the wholesale price of the surgical packs used, the wholesale price of all of
the pharmaceuticals consumed, the wholesale price of laundry products, and the
patient's share of the labor costs involved in delivering care. The cost of care also
involves some indirect costs that are as real and as important as the obvious items.
These include a share of the cost of construction and maintenance of the hospital
building, a share of the cost of running the hospital's administrative units (admin-
istration, human resources, finance, marketing, patient accounts, information sys-
tems), and a share of the organization's financing costs. For society, the costs of
care are greater than they are for the hospital. These nonhospital costs include the
market value of physicians' services, the costs of home care after discharge, and
any earnings the patient loses during illness and recovery.
For any organization, including health care providers, knowledge of costs is
critical to sound management decision making. One can't control costs without
knowing what they are. Without knowledge of what costs were in September, one
cannot determine whether or not one is successful in controlling costs in October.
For an organization to survive, the prices it charges must be at least as great as its
costs. Pricing, then, depends on knowledge of costs. One cannot budget (plan)
resource use for the next year without knowing what costs one is likely to incur
during that period (the subject of Chapter 8).

Costs in Health Care
As important as knowledge of costs is to any organization, it is still rare among
health care providers. As hospitals evolved during the late 19th and early 20th cen-
turies (Stevens, 1999), they were either small adjuncts to physicians' practices or
charitable organizations. Management expertise was in short supply. Overt con-
cern with cost flew in the face of the ethos of charity. Hospital costs were simply
ignored. Medical practices often kept track of their expenses but seldom had the
resources or the inclination to determine the cost of any one service. Public health
departments, often the most financially strapped health care organizations, were
required to prepare financial reports for their governments, but were loathe to do
any more involved analysis.
With the passage of the Social Security Amendments of 1965, particularly with
the original structuring of Medicare payment, cost determination took on new
meaning, at least in the hospital sector. Medicare Part A promised to "reimburse"
hospitals for 80 percent of their "allowable costs" and required hospitals to file
Medicare Cost Reports on which those reimbursements would be based.
Parenthetically, it was this payment structure that introduced the myth that all
payments to providers were merely "reimbursement" for costs incurred.
After 1965 hospitals not only were required to file cost data with the U.S. Health
Care Financing Administration (administrators of the Medicare system, now the
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Centers for Medicare and Medicaid Services) but also had incentives to treat their
costs in a very special way. As discussed in the following section, the costs of facili-
ties and administration can be allocated in any of several different ways.
Medicare's cost-based payment system, and the adoption of similar systems by
other third-party payors, provided hospitals with the incentive to allocate the most
costs possible to the most generous payer. Cost finding was not intended to sup-
port managerial decision making but to maximize reimbursement. The cost
accounting systems marketed and serviced by public accounting firms were not
designed to support either cost control or budgeting but were "revenue maximiza-
tion" systems (Balachandran & Dittman, 1978). Although investor-owned hospitals
(and a few aggressive not-for-profit hospitals) had decision support systems for
cost analysis, they represented only a very small share of hospitals and of hospital
With the passage of the Social Security Amendments of 1983, Medicare "reim-
bursement" entered a new era, that of prospectively determined payment. The
new payment system promised hospitals a fixed payment for each admission,
based on diagnosis (Koch, 1999). Cost-based reimbursement was to become a
thing of the past. Now cost analysis had a new function. The cost of caring for an
angina patient, for example, was important, not because those costs would be re-
imbursed, but because the hospital needed to keep average angina care costs be-
low their (fixed) Medicare payment level. It is in this prospective payment era
that, slowly, cost analysis systems to support managerial decisions have been in-
troduced into the hospital sector (Burik & Duval, 1985).

The cost of producing an item (a bandage, for example) or of providing a service (a
bed-day in the medical unit) is the market value of all of the resources employed
in producing the item or providing the service. Cost includes the market value of
administrative inputs, outlays to repay financiers, and the periodic expenses asso-
ciated with running an organization that are not tied to any single product or serv-
ice (rent, utilities, and professional license fees, for example).
Costs can be classified in several ways. First, costs are either direct or indirect.
Direct costs are those incurred directly as a result of providing a specific good or
service. Thus, the direct cost of a bed day in the adult medicine unit of a hospital
includes all resources tied directly to that bed day: nursing care, food consumed,
drugs administered, and others. Indirect costs are those that, although very real,
cannot be tied directly to the patient's stay in the bed. These include shares of
depreciation, the cost of the administrative division, and the fixed costs (see below)
of laundry and food service.
The direct/indirect distinction above is the one preferred by most accountants,
as it focuses on the unit of service as the cost object. An older way of making the
distinction focuses on the budget unit (or responsibility center, see below). In that
view, costs incurred within the budget unit are direct, and costs incurred in other
budget units are indirect to the unit in question.
CHAPTER 7 Cost Behavior · 129

Second, costs are fixed, variable, or step-fixed. Fixed costs are those that do not
vary as service volume varies. Those include rent and utilities, which are set for
each month regardless of whether or not any patients appear. Costs need not be
immutable, forever unchanging, in order to be fixed. The definition of a fixed cost
is only that it does not change as volume changes. Variable costs do change as vol-
ume changes.
Step-fixed (or semivariable) costs behave in complex ways. These are costs that
are fixed over some range of service volume but rise to a new level for a higher
range of service volumes. For example, three nurses may be needed if there are 5
or fewer patients on a floor. For 6 to 10 patients, however, one might need to call in
a fourth nurse. Nursing costs, then, would be step-fixed: fixed over ranges, but
changing in discrete increments as patient volume rises from range to range.
Figure 7­1 shows the classification of costs, for a hospital nursing unit, along
two dimensions, direct/indirect and fixed/variable, and provides some examples.
The salaries of the unit managers and the depreciation of the equipment specifi-
cally assigned to the unit are both direct (they can be tied directly to the care of
specific patients) and fixed (they would be incurred even if the patient census were
zero). Note that they are fixed with respect to patient census only, the managers'
salaries could be increased by hiring more management.
The nursing unit will usually be assigned costs from other responsibility centers
(discussed later). These are indirect from the standpoint of the unit's patients.
Variable costs change with patient volume. The purchase price of the syringes
used within the nursing unit (and of other supplies) varies with patient volume, as
do the wages paid to nurses on call by the unit. These are both variable and direct.
Algebraically, total costs (TC) equals fixed costs (FC) plus variable cost per unit
( VC u ) times the quantity of units delivered (Q):
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Costs occur somewhere. The places where costs occur, and which have budgets,
are called responsibility centers. A responsibility center is a subunit of the larger
organization that is responsible for some type of budget. Responsibility center
accounting, the assignment of costs to responsibility centers and the evaluation of
the budgetary and cost-control performance of those centers, is an important com-
ponent of internal control and good budget practice.
Some responsibility centers, cost centers, are charged with managing their costs
only. Cost centers have no revenue budgets (see Chapter 8 for definitions of the
various types of budgets) and no obligation to earn revenues for the organization.
Administration is always a cost center, as are human resources and housekeeping.
Being a cost center does not make a unit any less important than any other unit in
the organization. For example, in many hospitals, nursing (to the great chagrin of
many nurses) is a cost center. Although it is true that a hospital cannot function
without nursing service, nursing's being a cost center merely means that, in those
hospitals, "nursing service" does not bill for its services. Managers who starve cost
centers in order to control organizational costs are not practicing good manage-
Some cost centers, shadow cost centers, exist as budgets on paper only. For
example, rent and utilities and depreciation of plant and equipment are large-budget
items for any organization. These are cost centers even though there is no one in
the center. For cost allocation purposes, however, rent, utilities, and depreciation
need to be treated as cost centers.
Those centers that are charged with controlling costs and with generating rev-
enue for the organization are revenue centers. A revenue center is charged with
both an expense budget and a revenue budget. It is evaluated on its ability to meet
the goals embedded in its revenue budget. An organization's revenue centers, col-
lectively, have the obligation to meet, through their production of revenues, the
costs of all cost centers and of all revenue centers.

Revenue centers, collectively, must meet the total costs of their organizations. In
order to determine how effectively any one revenue center is doing its share in
meeting costs, one must allocate to that revenue center its proper share of cost cen-
ters' costs. This section and the one that follows present simplified models of cost
allocation and discuss their effects on managerial decisions. Readers wishing to
study these methods in greater detail should consult a textbook on managerial
accounting (Finkler & Ward, 1999).
In the cost allocation process, one assigns to every responsibility center benefiting
from the services of cost center X some share of the costs generated in center X. Thus,
as every responsibility center in the organization "benefits" from the services of the
chief executive's office, every center is assigned a share of the costs of that office. Any
cost allocation is based on (1) an allocation method and (2) a set of allocation criteria.
CHAPTER 7 Cost Behavior · 131

Suver, Neumann, and Boles (1992) describe four cost allocation methods: direct,
step-down, double distribution, and reciprocal. Figures 7­2 through 7­6 show how
costs would be allocated in a simple organization, Sample Clinic, using the direct and
step-down methods, respectively. Sample Clinic has two revenue centers, pediatrics
and adult medicine. These are served by six cost centers: rent and utilities (a shadow
center), the executive office, financial affairs, imaging, nursing, and the laboratory. The
cost allocation problem for Sample Clinic is to allocate the costs generated in the six cost
centers to the two revenue centers.

Direct Allocation Method
The direct allocation method is the easiest to implement, but it ignores intermedi-
ate cost flows. Figure 7--2 shows that, under direct allocation, all costs incurred in
each of the cost centers are allocated, through some set of allocation criteria,
directly to the revenue centers, with no intermediate allocations. That the financial
affairs office enjoys the services of rent and utilities is ignored in this allocation

Step-Down Allocation Method ,
The step-down allocation method, although somewhat more difficult to imple-
ment, improves on the direct allocation method by recognizing intermediate cost
flows. Figure 7--3 illustrates the first steps in that method. In the first step, respon-
sibility centers are arrayed in a hierarchy. At the top of that hierarchy is the center
that provides resources to the most other centers, in this case, rent and utilities.
The costs of that "top" center are then allocated, according to the appropriate allo-
cation criterion, to all other centers. After all of the costs of the "top" center are
allocated, it is "closed." Once the top responsibility center is closed, no costs are
allocated to it.
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Figure 7--4 shows the second step in the step-down process. Rent and utilities
has been closed. Now all of the costs (including those that were allocated from rent
and utilities) of the next center (or centers) in the hierarchy are allocated to the
remaining responsibility centers. In this case, all of the costs of the executive office
(including the costs that were allocated to the executive office from rent and utili-
ties) are allocated, via application of the appropriate allocation criterion, to the
remaining responsibility centers. The executive office is then closed and no costs
are allocated to it.
Figures 7--5 and 7--6 show the remainder of the step-down process, with all of
the costs (including those allocated from above) being allocated down from each
succeeding layer of responsibility centers. The process ends when all cost centers
have been closed and all of the organization's costs are allocated to the revenue

Double or Multiple Distribution Method
The double (or multiple) distribution method of cost allocation improves on the
step-down method by recognizing that resources flow in more than one direction.
For example, in Sample Clinic, financial affairs enjoys the supervision and direc-
tion of the executive office, but also may provide services (analysis, counseling) to
the executive office. In the double distribution method, centers are not closed on
the first pass of costs through the hierarchy of responsibility centers. Rather, dur-
ing the first pass through the hierarchy, costs are allocated "upward" as appropri-
ate. Only in the second pass through the hierarchy (double distribution) or in some
later pass (multiple distribution) are centers closed. The process ends when all of
the organization's costs are allocated to the revenue centers.
CHAPTER 7 Cost Behavior · 133
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Reciprocal Cost Allocation Method
The recognition that resources flow in many directions among responsibility cen-
ters is pushed to the limit in the application of the reciprocal cost allocation
method. That method recognizes that resources flow from every responsibility cen-
ter to every other responsibility center. Once considered too complex to manage,
reciprocal cost allocation problems can be treated as solutions to matrix problems
with modern spreadsheet software. The end result of this allocation process, like
that of every other, is to allocate all of the organization's costs to its revenue cen-

The allocation of costs from any one center to other centers, whichever allocation
method is used, depends on an allocation criterion. The allocation criterion is the
rule for how to divide the costs of Center A among the centers it serves. For exam-
ple, the costs of rent and utilities might reasonably be divided among the other
centers on the basis of each center's proportion of net allocatable square feet of
space. The costs of financial affairs might be divided according to each center's
percentage of budget (taking care that it is the percentage of the budget of centers
below financial affairs in the hierarchy that is used). The cost of the human
resources office might be divided according to each center's percent of payroll
(again, payroll of centers below human resources in the hierarchy). There is no one
correct criterion for allocating the cost of any responsibility center. One must, how-
ever, take care to ensure that the allocation criteria for fixed costs used are not
functions of service volume. To allocate indirect fixed costs on the basis of service
volume (percent of bed-days, percent of inpatient visits) would be to treat fixed
costs as if they were variable costs.
Table 7--1 shows the step-down allocation of monthly costs for fictitious Sample
Clinic. The hierarchy of responsibility centers shown is the same as that in Figures
7--3 through 7--6. The allocation criteria are given next to the name of each center.
Rent and utilities is to be allocated on a percentage-of-square-feet basis (the square
feet for the responsibility centers, including public spaces, are also shown). Thus,
because the executive office occupies 17 percent of total square feet, it is allocated
17 percent ($2,482.76) of total monthly rent and utilities. After the $15,000 in rent
and utility costs are allocated to the other seven responsibility centers, rent and
utilities is closed.
In the second step, the executive office has its own $12,000 of direct cost to allo-
cate to other responsibility centers, plus the $2,482.76 that it was allocated from
rent and utilities. These costs are allocated on the basis of percentage of direct cost.
Of the total $14,482.76 to be allocated from the executive office, the financial office
will be allocated $428.77, because direct costs in that responsibility center consti-
tute 2.96 percent of total direct costs for those responsibility centers below the
executive office in the hierarchy. After the executive office's $14,482,76 in total costs
are allocated, it is closed.
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In the third step, financial affairs' costs are allocated. These include the $4,500 in
direct costs plus the $517.24 that it was allocated from rent and utilities plus the
$428.77 that it was allocated from the executive office. The total costs of financial
affairs are then allocated on a percentage-of-direct-cost basis, where the percent of
direct cost is based on the direct costs of the responsibility centers below financial
affairs in the allocation hierarchy. After all of the costs of the financial office have
been allocated, it is closed.
At the end of the process, all of the organization's costs ($179,000) have been
allocated to the two revenue centers ($82,955.92 + $96,044.08 = $179,000).
Remember that different allocation criteria lead to different final cost allocations.
Use of another allocation method, such as reciprocal allocation, would also change
the final allocation. Decisions based on the cost of operating the pediatric product
line in Sample Clinic, then, are based on ambiguous information. There is no one
correct measure of the monthly cost of operating that revenue center.

One of the most important recent innovations in cost analysis has been the devel-
opment of activity-based costing (ABC) (Baker, 1998; Chan, 1993). ABC has helped
to identify the costs of particular services better than was previously possible, and
has been a valuable tool in the performance evaluation approach known as the
"Balanced Scorecard" (Kaplan and Norton, 1992).
In a traditional (pre-ABC) approach, costs are allocated to revenue centers (as
above, and the allocation process stops). If a revenue center has more than one
service line (as is usually the case), costs are simply divided among those service
lines, often on a "per visit" or "per bed day" basis. The similarity to spreading
peanut butter evenly on a slice of bread has given this process the derogatory
name "peanut butter costing." Peanut butter costing can lead to overestimation of
the costs of some services and underestimation of the costs of others.
ABC seeks to improve on the shortcomings of peanut butter costing by identify-
ing the cost drivers that use resources within a revenue center. Consider a clinical
laboratory. A hemoglobin Al-c test uses more resources than a simple serum glu-
cose measurement (both are used in the assessment of diabetic control). Peanut
butter costing allocates the same cost to each. ABC costing identifies the drivers
that move cost, such as set-up time, and allocates the laboratory's cost based on
each test's use of those drivers. The result is that the cost object, or cost pool, is the
service, not the center. In a system in which the costs of specific diagnoses, and,
therefore, specific product lines, are important inputs into decisions, ABC has
become an important tool, indeed.

Just as finding the total (direct plus indirect) cost of a service or of a revenue center
is essential to good budgeting and decision making, so is separating fixed from
variable cost. A service that at least meets its variable cost of production makes a
contribution to meeting the organization's fixed cost and ought, at least in the
CHAPTER 7 Cost Behavior · 137

short-run, to be continued. Decisions as to which services to keep, which to termi-
nate, and which to subject to flexible budgeting (discussed in Chapter 8) require
that one be able to separate the fixed and variable components of costs.
Unfortunately, costs rarely come with their fixed and variable components bro-
ken down. Rather, one is usually faced with data on the total costs of operating a
responsibility center, if one has cost data at all. Also, whereas some costs are
clearly fixed (depreciation, for example) and others are clearly variable (vials of
vaccine for a public health clinic), others cannot be identified as fixed or variable
before the fact. The fixed / variable distinction is, ultimately, an empirical question.
Two methods are widely used for separating fixed and variable costs: the high-
low method and least squares regression analysis. The latter has become, with
advances in spreadsheet software, so easily applied that it has largely replaced the
former. Table 7--2 extends the cost analysis of fictitious Sample Clinic's pediatric
revenue center. The allocated overhead cost column reflects the amount of indirect
costs that are allocated to pediatrics each month. Overhead is only another way of
expressing fixed costs. Various numbers of visits are recorded for each month in a
sample year. Figure 7--7 shows the cost data graphically. The figure reveals data on
direct fixed and variable costs that would not be available to a decision maker
without detailed analysis. The reader can easily verify that variable costs per unit
are $30. The director of the pediatric center does not yet know that. What the clinic
director knows is revealed in Table 7-3.

High-Low Method
The high-low method is very simple, easy to apply, and accurate over small ranges
of output. The method is shown in Table 7-4. In the high-low method, one selects
one high-volume month (it need not be the month with the highest volume) and
one low-volume month (it need not be the month with the lowest volume).
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Subtracting the low volume from the high volume and the associated low cost
from the associated high cost, one determines how much total costs will change for
a given change in volume. In Table 7--4 a change of 325 visits per month causes a
change of $9,750 in total cost.
All of the change in total cost associated with the change in total volume must
be variable cost. Fixed costs, by definition, don't change as volume changes.
CHAPTER 7 Cost Behavior · 139

Dividing the total change in cost by the change in volume, then, yields variable
cost per unit ($9750/325 = $30).
Remember that total cost is equal to fixed cost plus the product of variable cost
per unit and quantity of units. In equation form:

Using the high-volume month, one knows that fixed cost is equal to total cost
minus variable cost per unit times the number of units (quantity). Subtracting vari-
able cost per unit ($30) times quantity (715) from total cost, one finds that monthly
fixed cost is $128,000. Because $83,000 of that fixed cost is allocated overhead, it
follows that $45,000 must be the monthly direct fixed cost of the pediatric clinic.
These results are consistent with the data in Table 7-2.
The high-low method works well when variable cost per unit is constant and
when fixed costs do not change over the time period used. When fixed costs vary
widely (for example, when utility bills are very different in the summer and winter
months, or when a new facility has been opened between the high-volume and
low-volume months), the high-low method is less reliable.

Least Squares Regression Analysis
An alternative to the high-low method is the use of ordinary least squares regres-
sion analysis to separate fixed and variable costs. Regression analysis, properly
employed, is a powerful, flexible tool. Contemporary students and financial ana-
lysts are fortunate in that regression analysis is now a standard feature of spread-
sheet software. Readers unfamiliar with the method should consult a textbook on
econometrics (Lardaro, 1993, especially chapters 4 and 5; Maddala, 1992, especially
chapter 3).
To use the linear regression model to separate fixed and variable costs, one spec-
ifies a model of the form

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Total cost = Fixed cost + (Variable cost per unit x Quantity)
That is, total cost is specified as determined by a causal relationship in the form of
a straight line. Total cost is the dependent variable, fixed cost is the estimated
intercept term (what total cost would equal were volume equal to zero), and vari-
able cost per unit is the estimated coefficient (fi) of quantity (the independent vari-
able). In the language of spreadsheets, the column labeled Total Cost in Table 7--3
is the Y-range (the dependent variable) and the column labeled Visits is the X-
range (the independent variables).
Table 7--5 shows the Output Range from a spreadsheet regression, estimating
the fixed and variable cost components from Table 7--3. The constant" ($128,000)
is the estimated value for fixed cost. The estimated X coefficient shows variable
cost per unit, how much the dependent variable (total cost) changes with a one
unit change in the independent variable (service volume or quantity). That esti-
mated variable cost per unit is $30. As was the case for the high-low method, the
regression model yields an estimated fixed cost per month of $128,000.
R-squared indicates the proportion of the total variation in the dependent vari-
able that is explained by the model. In this case, but seldom in real life, the rela-
tionship is exact and R squared is at its maximum value, 1.00. Because the
relationship estimated is exact, the test for the statistical significance of the esti-
mated coefficient is trivial, the standard error of the coefficient is 0.00. In most
cases, one would need to divide the estimated coefficient by its standard error. The
resulting t-statistic should then be subjected to a significance test to determine
whether variable cost per unit is, in fact, significantly different from zero.
What is the advantage of using statistical cost analysis rather than the high-low
method? Regression is a more "robust" method. It works even if fixed costs are
nonconstant (so long as the analyst can model the causes of the change in fixed
cost). Linear regression is also, in the age of desktop computing, easy. With only a
spreadsheet, one can run regressions instantly, at the touch of a button
Finally, the use of linear regressing allows the development of richer models of
more complex cost behavior. For example, a clinic offering both vaccinations (X 1 )
and well-baby visits (X 2 ) might specify and estimate a cost function of the form:
CHAPTER 7 Cost Behavior · 141

where a is estimated fixed cost, 13 1 is estimated variable cost per unit for vaccina-
tions, and (3 2 is estimated variable cost per unit for well-baby visits.
Sometimes, fixed costs change within a data collection period. Consider the case
of moving to a new facility and wanting to know the effect of the move on costs.
Our clinic could model:

where the initial variables are interpreted as above, and X 3 = 1 for months in the
new facility and X 3 = 0 otherwise. 13 3 , then, is the estimated effect of the new facil-
ity on fixed costs.

The previous sections showed how costs will behave as volume changes and how
to separate fixed from variable costs. The cost-volume-profit (CVP) analysis
model is a useful framework for analyzing that information (Cleverly, 1979).
Consider Sample Clinic's pediatric unit once again. No matter what its monthly
volume, it generates $45,000 in direct fixed cost and is assigned $83,000 in over-
head costs. Each visit generates $30 in variable cost (variable cost per unit, VC, A ).
Suppose the pediatric clinic charges $50 per visit. The $50 is the price of a visit, or
revenue per unit (R,). Each visit, then, contributes $50--$30 toward meeting
Sample Clinic's fixed cost. That amount is the per-unit contribution margin of a
pediatric visit. It represents what each pediatric visit contributes toward meeting
the clinic's fixed costs.
To find how many visits would be necessary for the pediatric unit to break
even, begin with the formula:

Breakeven quantity = Fixed cost/per-unit contribution margin
For the case at hand, breakeven quantity in the pediatric unit is $128,000/$20, or
visits per month. Does that mean that the pediatric unit should be shut
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down? Not necessarily. Note that $83,000 of Pediatrics' fixed cost is allocated over-
head, costs that Sample Clinic would incur even if there were no pediatric unit. If
the unit covers its direct costs (fixed and variable) and makes any contribution to
overhead, it is worth keeping, even in the long run. Further, in the short run,
Pediatrics cannot eliminate its own fixed cost ($45,000). In the short run, if the unit
has a positive contribution margin (as it does), it should continue to operate to
make a contribution to its own fixed costs. In the long run, if the unit cannot meet
its own (direct) total costs, it should be eliminated, unless some outside entity or
another revenue center is to subsidize it.

The discussion above assumed that the provider is paid for each unit of service
provided. Many health care providers face the situation in which total revenue per
period is fixed, based on the receipt of per-member-per-month (PMPM) payments
for an enrolled population. The fixed total revenue model is familiar in many set-
tings: veterans' medical centers, Indian health service hospitals, primary care
physicians' practices in the British National Health Service, hospitals and polyclin-
ics in the countries of the former Soviet Union, as well as in pure health mainte-
nance organizations in the U.S.
Let toal revenue be fixed: TR. Total cost is still given by

Setting the two equal and solving yields a breakeven quantity of

If we call (TR ­ FC) our "monthly cushion," then each unit of service eats away
VCu of that cushion. At service levels above Q*, the provider suffers a loss. Boles
and Fleming (1996) provide an interesting discussion of capitated providers' incen-
tives to control enrollees' utilization of services.

The cost of a health care service is the market value of the real resources used to
produce that service. Knowledge of costs is important for budgeting, planning,
and evaluating the adequacy of pricing structures.
Young and Pearlman (1993) have proposed that every health care organization
implement a four-step process that integrates cost finding with managerial decision
making. In the first stage, the organization would improve its systems for collecting
cost data (its cost accounting systems). In the second stage, the organization would
separate fixed from variable costs (determine its cost behavior patterns). In the third
stage, the organization would identify its "cost drivers" and look for ways to con-
trol its costs (engage in feedback and managerial cost control). In the fourth stage,
cost information is used as input into redesigning the organization and its tasks.
That process, and the four stages that it incorporates, provides a way to use cost in-
formation to enhance organizational performance.
CHAPTER 7 Cost Behavior · 143

Modern computing equipment and relatively elementary statistical analysis
make identification of costs possible for every health care organization. When costs
are known, they can be controlled. With knowledge of costs, one can employ other
models, such as cost/volume/profit analysis, that enable one to make better decisions.

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