the significance of indirect application to clinical...

Journal of Automatic Chemistry Vol. 11, No. 4 (July-August 1989), pp. 174-178

The significance of indirect costs-application to clinical laboratory testeconomics using computer facilities

F. R. Hindriks*Central Laboratory for Clinical Chemistry, University Hospital Groningen,Groningen, The Netherlands

A. Bosman and P. F. RademakerDepartment ofManagement Science and Business Administration ofthe EconomicFaculty, University of Groningen, The Netherlands

The significance of indirect costs in the cost price calculation ofclinical chemistry laboratory tests.by way of the production centresmethod has been investigated. A cost structure model based on the’production centres’ method, the Academisch Ziekenhuis Groningen(AZG) 1-2-3 model, is usedfor the calculation of cost and costprices as an add-in tool to the spreadsheet program Lotus 1-2-3.The system specifications of the AZG 1-2-3 cost structure modelhave been extended with facilities to impute all relevant indirectcosts to cost centres by aid ofallocation rules, which can be chosenfreely. The inference is made that as indirect costs play a moreimportant part in decision-making processes concerning planningand control, the specification of the relation to the cost centresshould be determined in a more detailed way. The AZG 1-2-3 coststructure model has therefore been extended in order to increase thesignificance as a management toolfor laboratory.management.

Introduction

The registration of costs and the calculation of cost pricesin health care, especially for laboratory tests, are increas-ingly important [1-3]. Among other things, interest isfocused on computer systems with which all relevantcosts, both direct and indirect, can be registered. Bymeans of databases, the costs of the activities oforganiza-tional units can be determined beforehand and the costprices of services to be rendered and the consequences ofpolicy decisions can be judged.

Recently, the Academisch Ziekenhuis Groningen (AZG)1-2-3 cost structure model has been developed by us as a

support for the decision-making concerning the allocationof production factors [4]. In principle, direct costs inaddition to indirect costs can be fed into the model. Thistakes place through an addition method with which theindirect costs are transformed into direct costs. Ineveryday practice it often appears to be a problem todetermine the relation between indirect and direct costsunambiguously.

In this paper, the significance of indirect costs in theoverall costs of clinical chemistry tests is examined. Herethe question is raised of the way in which the AZG 1-2-3

cost structure model should possibly be adjusted in orderto allocate the relevant indirect costs according to theactivities, taking into account the nature of the variousindirect costs.

Costs in an organization

In any organization costs are incurred. Costs are definedas an aggregate ofapplied quantities ofproduction factorsmultiplied by their prices per unit. Usually costs aresubdivided into categories. Thus direct and indirect costsare distinguished in addition to fixed and variable costs.The distinction between direct and indirect costs is verysignificant for an organization, as thereby a specificationis given of the coherence between products, functions andactivities existing in any organization. This is a specifica-tion that is especially significant for management makingdecisions on matters of planning and control.

Direct costs are costs that can be directly related to aparticular product on the basis of a technical andorganizational relationship. Indirect costs do not havethis characteristic and usually they can be imputeddirectly to functions and activities only. They can beimputed (in commercial economics the term used is’allocated’) to products on the basis of allocations whichare often arbitrary. The distinction between direct andindirect is first of all dependent on the definition of theterm product. Strictly, in cost-price calculation a productis defined as the final products (services) which aremarketed by an organization and for which a price is paidand/or for which a remuneration is obtained (e.g. from agiver of grants). In order to effect a good balance of theexchange process possible, the price will have to becompared with the cost-price of the final product. It isobvious that the indirect costs will have been included inthe cost-price in one way or another.

In a hospital organization, the diagnoses and therapiesare the final products, which are compensated by returnsin the form of rates for days of treatment, consultationsand operations. The costs which show a direct relation tothese final products are direct in nature and those whichdo not show this characteristic are indirect. Strictly, thismeans that all costs of departments such as the labora-tory, technical department and civil department, areconsidered to be indirect by the organization of thehospital. This is one of the reasons why the costs andachievements of the laboratory are registered in oneauxiliary cost centre in hospital administration.

* To whom correspondence should be addressed.From the point of view of planning and control, thevarious services and departments of larger organizations

1740309-1902/89 $3.00 I) 1989 Taylor & Francis Ltd.

F. R. Hindriks et al. Indirect costs in clinical laboratory tests

are split into sub-systems, so that each sub-system can bestudied separately. The products ofmost sub-systems arethen regarded as achievements (intermediate products),for which there is no direct relation to the return of theorganization. In fact, the products of most sub-systemsare achievements which contribute to the realization ofthe quality of the final products of the organization. Inorder to judge the control of a department or service inhospital organization, it is necessary that beforehandstatements can be made on the cost and return to beexpected (planning) and that afterwards it can bechecked whether the control was either good or bad.Therefore, figures on the total cost and return perdepartment or service beforehand and afterwards arenecessary. The mutual supplies of achievements amongthe sub-systems of an organization should therefore beregistered by means of internal imputation systems. Theway in which this takes place, particularly the extent ofspecification, determines the way in which control can bejudged.

Allocation of costs

By means of the costs a cost-price per product, service orachievement can be calculated. By cost-price, the amountof direct and indirect costs per product unit is meant.

There are various methods for the cost-price calculationof final products. Two examples, of which the second issuitable for planning, are the following.

Primitive addition method. The indirect costs are imputed tothe separate products in the form of an addition to (partof) the direct costs.

Production centres method. According to this method, thevarious costs are imputed to the various products on thebasis of the relation of the application of productionfactors which caused the costs for the realization of theproducts. It should be investigated how far achievements,coming from different organizational sub-systems, were

necessary for each product and therefore have to beconsidered as an indispendable ’derived’ productionfactor. With this information, allocations can be deter-mined.

The allocation of costs through the production centresmethod assumes an organization in which variousfunctions with the costs connected to them are dis-tinguished, which can be imputed to other functions orproducts. These functions are called cost centres and thefinal products are called cost bearers.

Auxiliary cost centres are cost centres that supplyachievements, not final products. The costs of auxiliarycost centres are imputed to other auxiliary or main costcentres.

Main cost centres are the cost centres of which theachievements directly benefit the final products, the costbearers. The production centres method, which forms thebasis for the AZG 1-2-3 cost structure model, is themethod of cost price calculation in which the coherence

Table 1. Supplies ofservices to and within our laboratory entailingindirect costs and stating the share in the total cost of laboratorytests.

Share (%)

1. Sample collection2. Sample transportation3. Preparation ofwork and distribution4. General services5. Service and maintenance6. Computer system7. Management and supervision8. Administration9. Training, education and research

10. Housing11. Scientific staff12. Laundry

Total share ofindirect costs

5<1

336542652

<l

40

Note: one part of the indirect costs has not been included in this

set-up, i.e. hospital management, and another part, housingand scientific staff, is probably too low in this estimation.

between the achievements and final products are expli-citly laid down. This coherence in a way represents theproduction structure of an organization and it is essen-tially important in judging the control.

Indirect costs

Many mutual supplies of both external and internalachievements to which indirect costs are entailed can bedistinguished in the clinical chemistry laboratory. Aninventory of services and the indirect costs entailed in ourlaboratory are stated in table 1.

The question to be asked now is which indirect costs arerelevant to be involved in the cost price calculation. Forthis purpose the relation to the products, the results oflaboratory analysis should be determined. Cost-pricecalculation is applied in organizations to support themany decisions that are made, where costs and cost-

prices are used as a criterion.

The need to consider indirect costs in cost price calcula-tion is based on a number of reasons"

1. From the planning point of view, it is necessary to

judge alternative application possibilities of productionfactors through which changes in the conduct of businessand organization of the mutual supplies result. In theclinical laboratory the sample collection, transportation,reception and preparation of work come into considera-tion here. However, the organization of the warehouse,the cleaning room and the administration are alsoimportant.

2. Costs are used to make statements on the efficiency ofan organization and as a means to control efficiency, e.g.by budgetting. By efficiency is meant the extent to whichan organization is capable to achieve a certain goal with

175


the given means, this goal often being a certain rate ofproduction. In order to make statements on this, the costfunction will have to be divided into the productionfunctions lying behind it. As achievements to whichindirect costs are entailed contribute considerably to therealization and quality of the products, it is important toinclude the indirect costs in the calculation of cost,especially in order to be able to determine if the supplymeets the desired specifications of efficiency and quality,and if the compensation obtained for it is sufficient.

3. In the development ot tianctional budgetting, thesignificance of know-how concerning the cost of labora-tory tests is increasing because alternative applicationpossibilities of the clinical laboratory can favourablyaffect the allocation of the budgetted production factorswithin the hospital organisation. In the near future theclinical laboratories will be faced more emphatically withthe question of utilization of analytical equipment andstaff. Considerations of the capacity to be put into serviceare affected by the possibilities of having activitiesexecuted by external laboratories or by attractingresearch from outside the organization in order to realizea more favourable rate of utilization. For both situationsit is important to know all relevant costs for laboratorytests.

For ajudgement by the management, these three reasonshave to be stated with the relevant arguments, which iswhy indirect costs cannot be excluded from considera-tion.

Usually it is difficult to transform indirect costs into directcosts, as a direct relation with the results of analysiscannot be derived. The indirect costs specified in tablecomprise a considerable part of the total costs of ourlaboratory (at least 40%). With this the ratio of directand indirect costs is 3:2.

The AZG 1-2-3 cost structure model and indirectcosts

In the original version of the AZG 1-2-3 cost structuremodel, indirect costs, in as far as this is relevant andrealizable, can be transformed into direct costs or beimputed to the main cost centres by way ofa variant oftheprimitive addition method. This method is based on theassumption that the ratio of indirect costs (overhead) tothe total cost is equal for every sort of activity, andcorresponds to the ratio oftotal indirect costs to total cost.In everyday practice, it can be questioned whether thisassumption is correct. Should this not be the case, the ruleused in the primitive addition method has to be specifiedfurther. Such rules are called allocstion rules.

An allocation rule consists of quantities or factors bymeans of which indirect costs can be split up. They arerules that specit/the relations between the achievementswhich were made and the production of final products orachievements. The factors included in these rules willdiffer according to the nature of the existing relations andthe desired accuracy with which they are described.These factors are expressed in physical units of the

176

achievement to be made (e.g. the number of kilowatthours in electricity). Some examples of these factors arethe number of tests, direct costs per activity, surfacemeasure and number of employees.

Per auxiliary cost centre, one or more allocation rules arespecified by which the costs can be allocated. Then anallocation will result.

The indirect costs are imputed by way of the followingequation:

k Kj.[xo/Y(x Xim)]

where kij the indirect costs of the auxiliary cost centrewhich is imputed to the productj; iij 1... m; Kji thetotal cost of the achievement i; and Xim the technicalfactor of achievement for the specified products fromup to and including m series.

The distribution of indirect costs into the variousactivities by means ofallocations have thus been includedin the AZG 1-2-3 cost structure model.

The AZG 1-2-3 application program, based on the Lotus1-2-3 program, has been extended with facilities todistribute indirect costs over various activities by alloca-tions known or to be chosen. The program can be appliedon any IBM-compatible microcomputer with an internalmemory of at least 384 kB, DOS operating system andusing the Lotus 1-2-3 program.

Examples of application

To illustrate the allocation of indirect costs, the cost ofhousing and computer usage will serve as examples.

Housing

As a rule it is generally accepted that the cost ofhousing isallocated by the ratio of the number ofnet square metres.The price per square metre is determined by

Pji Kji/total number of square metres

where Pji the cost-price of achievement (in this casehousing).

For the calculation of the contribution of indirect costs ofhousing to a certain achievement j, the number of netsquare metres that has to be hired for the production ofjshould be determined. A relation between the productionofj and the number ofachievements of/in the case ofcostof housing usually does not exist. In order to produce theachievement, j square metres are needed. This numberwill not flucutuate with the real production ofj. Mostly anamount is calculated that consists ofpji times the numberof square metres needed.

Computer costs

An example showing detailed figures of the imputation ofindirect costs of computer usage to the achievements ofthe SMAC automated analyser (Technicon Instruments,


Table 2. Source data with relation to the achievements of the hospital computer.

Hospital computer achievements

CKCL* shareTotal (%)

Costs according tosystem oftariffs]"

CPU time 468 037 437 15"2Disc

accesses 568 052 673 17.9SPOOL

records 163 760612 19"

Total

x Dfl l’E-4 Dfl 78 256

X Dfl 35.E-4 Dfl 928 385

x Dfl 30.E-4 Dfl 93 835

Dfl 154 476

* Abbreviation of our laboratory.

" Dfl Dutch guilders.

Table 3. Source data with relation the achievements ofthe SMACanalyser.

CKCL achievements

Total SMAC share (%)

Tests 2 895 314 55"3Requests 425681 31"3Direct costs (Dfl) 8 285 600 11-3

Table 4. Results of imputing costs of hospital computer to theSMAC analyser in three different ways (all amounts in guilders).

Production centres method

Addition Allocation Technicalmethod rule coefficient

Per request 0-98 2" 71 2"93Per test 0"08 0"40 0"24Imputation 130 456 361 350 390 944

Tarrytown, NY, USA) illustrates the significance of theimputation of indirect costs in case there exists a directrelation between the production ofj and the number ofachievements of i.

It can easily be seen that there is a relation between theSMAC production (number of tests or requests) and theapplication of the hospital computer (in the form ofCPUtime, disc accesses, SPOOL records) as a productionfactor. It is relatively easy (though time consuming) todetermine the amount taken up by SMAC through theaccount data of the computer system (see table 2). It willbe more difficult to define the achievement unit of thecomputer system, the system second, and to calculate a

price per unit for it, as the specifications lying behind itare very arbitrary.

In practice, computer costs are often allocated through atariff system, for which it is not clear in what way it wasspecified, as a result of which gross inaccuracies canresult. As the decisions that are made partly on the basisof the results of allocation of costs are considered moreimportant, the imputation of costs should take place in amore detailed (and hence more accurate) way. In such acase an application of the indirect costs on the basis of asimple addition method will not suffice; instead, takinginto consideration the relation with the production ofj,the application of the computer will have to be deter-mined as a technical coefficient, and the costs entailed tobe considered direct.

In tables 2 and 3, the source data with respect of theachievements of the hospital computer and the SMACanalyser in our laboratory are stated. In various ways the

indirect costs for the use of the hospital computer can beimputed, the results of which are stated in table 4. Thecalculations are given in the Appendix. Note that 1corresponds with about Dfl 3.70.

The results show that large differences in the imputationarise and that it is essential to recognize them as such andto realize that these differences are strongly dependent onthe chosen (arbitrary) rules lying behind it. In practice, itis often chosen as a starting point to impute indirect costson a high aggregation level as the difficult specification isnot always necessary. As the decisions based on that areconsidered more important, the necessity of specifyingthe relations concerned in more detail will increase.

The primitive addition method takes these computercosts as fixed and distributes these costs to the laboratoryproducts (requests, tests) randomly, not based on anyspecification of the relation between computer achieve-ments and laboratory products. The method can imputethese costs after they have been made.

The production centres method imputes costs accordingto the specification of the relation between the computerachievements and the laboratory production process,which gives results closer to reality than the primitiveaddition method.

The imputation through technical coefficients is timeconsuming because of the detailed specification of theworkload, i.e. the definition of the unit of computerachievement, the system second and the relation betweenthe system second and the laboratory products. A great

177


advantage for reasons of planning and control, is to usethis method beforehand. This method can be consideredas a reference method.

The use of allocation rules is simple and quick to perform.It seems to be the second-best method and for manyapplications gives relevant information sufficient to makethe right decisions.

List of definitions

Activity: A description of a technical transformationprocess that for certain reasons can be considered as aunit and that results in the production offinal products orintermediate products.

Allocation: Allocation of the indirect costs which anauxiliary cost centre imputes to a number of main costcentres.

Allocation rule: An allocation rule consists of quantities orfactors by means of which the indirect costs of an

auxiliary cost centre can be allocated to specifiedactivities.

Cost: Aggregate of production factors used multiplied bytheir prices per unit to produce a certain productionquantity.

Cost centre: An organization unit, in which all costs, withreference to certain activities, are specified. See alsoActivity.

Direct and indirect costs: Direct costs are costs that can berelated directly to a particular final product on the basisof a technical and organizational relation. Indirect costsdo not have this characteristic, but they can usually bedirectly imputed to functions and activities on the basis ofcausal relations.

Finalproduct: The output ofan activity which is sold by theorganization and to which the revenues are directlyrelated.

Intermediate product (achievement): Intermediates or inter-mediate products are the output of these activities thatare not sold by the organization but which are necessaryto produce the final products.

Occupancy: Indicates which portion of the availabilitycapacity of production factors is utilized.

Production factor: Is applied for the sake of activities inrealizing (final) products.

Production quantity: Number of units of an activity pro-duced in a certain time period.

Rate ofapplication: The use of a production factor per unittime in order to achieve a certain rate of production.

Acknowledgement

The authors are grateful to W. Liet for his investigation ofthe relation between the costs of using the hospital

178

computer and the activities of the laboratory. Some ofhisfindings have been used in this study.

Appendix

Imputing the costs ofthe hospital computer to the SMACanalyser in three different ways:

1. The primitive addition method

The share ofSMAC in the total CKCL costs is 11"3%; intotal Dfl 154476 is imputed to the laboratory. Theaddition for SMAC is then 11"3% ofDfl 154476 or intotal Dfl 130 456, i.e. Dfl 0"98 per request or Dfl 0"08 pertest.

2. Allocation through allocation rules (production centres method)

The indirect costs of computer usage are allocated by theratio of the number of tests or in a given case the numberof requests into the activities of SMAC. The share ofSMAC in the total number of CKCL tests or requests is55"3% and 31-3%, respectively. Imputation to SMACthrough 55"3% ofDfl 154476 over 601 136 tests willthen result in an addition of Dfl 0"40 per test or through31"3% ofDfl 154476 over 133428 requests in Dfl 2"71per request.

3. Through technical coefficients roduction centres method)There is a relation between the production of the SMACactivity and the achievements of the hospital informationsystem, which can be indicated by the determination ofatechnical coefficient.

The hospital computer production factor is expressed inthe physical unit of the system second (syssec) and hasbeen defined as follows:

unit 0"222 CPU time + 0-688 disc access +0"09 SPOOL record

The price per unit of the syssec amounts to Dfl 29.E-4according to the system of tariffs.

The technical coefficient of the hospital computer pro-duction factor for SMAC activity amounts to 1005 syssec,i.e. dealing with (producing) one request by SMAC takesup 1005 syssec of the hospital information system.

Because of the relation between production and suppliedachievement, the costs of hospital computer usage areconsidered direct by the SMAC analyser. The eventualaddition will result in Dfl 2"93 per request or Dfl 0"24 pertest.

References

1. KRIEG, A. F., ISRAEL, M., FINK, R. and SHEARER, K. L.,American Journal of Clinical Pathology, 69 (1978), 525.

2. BROUGHTON, P. M. G. and HOGAN, T. C., Annals of ClinicalBiochemistry, 1 1981), 330.

3. STILwELL, J. A., Journal of Clinical Pathology, 34 (1981), 589.4. HINDRIKS, F. R., VAN DER SLIK, W., BOSMAN, A., FROWEIN,

CHR. and KAMPS, H.,Journal ofAutomatic Chemistry, 4 (1986),178.

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