7-51 Departmental Cost Allocation; Insurance Company CareMark Insurance Company has two service lines, health insurance and auto insurance. The two product lines are served by three operating depart- ments which are necessary for providing the two types of services: claims processing, administration, and sales. These three operating departments are supported by two departments: information technol- ogy and facilities. The support provided by information technology and facilities to the other depart- ments is shown below.
Support Departments Operating Departments
Information Technology Facilities Claims Processing Administration Sales Information technology Facilities — 10% 30% — 30% 20 20% 40 20% 30 The total costs incurred in the five departments are: Information technology $ 600,000 Facilities 1,800,000 Claims processing 345,000 Administration 875,000 Sales 555,000 Total costs $4,175,000 Required Allocate the $4,175,000 total departmental costs to the three operating departments using (a) the direct method, (b) the step method (for both information technology and facilities going first in the alloca- tion), and (c) the reciprocal method. 42 7-52 Cost Allocation and Legal Disputes Cost allocation is often the centerpiece of conflict that is resolved in court cases. The litigation usually involves the dispute over how costs are allocated to a product or product line that is of interest to the plaintiff. This is particularly an issue when a company produces some products or services for a price-competitive market while other products or services are produced for a governmental unit on a cost-plus or reimbursement basis. The following cost allocation disputes involve an organization (Nursing Care Inc, or NCI) that operates both a nursing home and an apartment building for retirees (retirement home). A single kitchen is used to provide meals to both the nursing home and retirement home. Also, certain labor costs and utilities costs of the kitchen are shared by the two homes. Many of those living in the nurs- ing home are indigent and are on Medicaid. The state Department of Health and Family Services (DHFS) reimburses NCI at Medicaid approved cost reimbursement rates. The Medicaid reimburse- ment rates are based on cost information supplied by the organization, in this case NCI, and are assumed to be accurate; cost allocations are assumed to be reasonable. DHFS has examined the cost report of NCI and has raised the following issues which are now being litigated. Required (The above is based upon an actual case, with names disguised.) For each issue, consider whether you think the defendant (NCI) or the plaintiff (DHFS) has the valid posi- tion, based on your understanding of cost allocation. 1. DHFS alleges that NCI charged specific milk, condiments, and paper products to the nursing home, without following the usual 60 percent (nursing home) and 40 percent (retirement home) sharing for food costs. NCI asserts that these items are used in the nursing home to counteract the greater danger of spread of disease in the nursing home. DHFS claims that NCI’s documentation to support charging these costs directly to the nursing home is inadequate 2. DHFS alleges that nourishments (liquid supplements, cookies, and some puree foods) that are consumed by nursing home residents at bedtime for their special health needs are akin to “seconds” at meals and should be allocated to both the nursing home and the retirement home 3. Three kitchen employees not involved in meal preparation are involved in service to both the nursing home and the retirement home; NCI asks the three employees to keep track of how much time they spend on the nursing home versus the retirement home. These time reports are then sent to management and are used as a basis for allocating the cost of the employees to the two homes. DHFS alleges that the practice is not sufficiently accurate, and relies largely on unsupported, self-reported information. 4. NCI allocates utility costs to the two homes using an industrial engineering study performed by the power company on five days in June four years ago. DHFS disputes that this allocation base is valid and says that NCI must use a square footage base rate.