The Current Costing Model Has Both Strengths And Weaknesses Accounting Essay

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Executive Summary

Westmount Retirement Residence is involved in giving aged people in London a residence where they have comfort, food services, laundry services and round the clock medical services among other things. It largely concentrates on the elderly who are mostly around the age bracket of 75 years. Helen Roswell who is the administrator of Westmount Retirement Residence is of the opinion that the recent decline in profitability is largely attributable to the current costing system. Westmount needs to change its costing approach to reflect changes in the industry and to become competitive.

Among the strengths of the current costing system are its simplicity and its ability to divide costs among the different departments. Its weaknesses include equal distribution of all expenses among all the departments irrespective of the size of these departments. The biggest weakness is that the current costing approach does not attribute costs to the clients but rather divides the total cost among all the clients irrespective of the consumption by each.

Westmount performed poorly in 2005 because of increased competition. Westmount's costing approach is inadequate because it does not capture costs accurately leading to lower profits.

The new costing system will allocate costs based on the suits available at Westmount and the categories of patients based on their medical needs. All costs, but for supportive costs, will be allocated on the basis of suit size as a percentage of the total area in square feet. Supportive costs on the other hand will be allocated as a percentage of the cost of hiring nurse supervisors, nurse attendants and nurse dieticians taking into consideration the amount of these services consumed by each client. This analysis helps in arriving at the new cost per patient under each option. This information will be useful to Roswell in arriving at a properly computed base cost and setting a pricing structure that will enable Westmount to attain the much desired 15% margin and profitability as a whole.

Strengths and Limitations of the current costing model

The current costing model has both strengths and weaknesses. Among its strengths is its simplicity in arriving at the unit cost. It is however not sufficiently comprehensive. This leads to inaccuracies in costing. Secondly, the current costing method attributes costs into the respective departments. This ensures that the costs are well distributed across all the functional areas and is good in tracking the costs incurred by each department. For instance, from the reports created using this costing approach, we can ascertain that supportive services department incurs the most cost which is as a result of wages and benefits. This is followed by the food service department where the cost is divided almost equally between wages and supplies.

The weaknesses of the current costing system include its equal distribution of the general administration expenses, management fees and fixed operating expenses. This can also be referred to as the absorption costing method. The absorption costing method includes both the variable costs as well as the fixed overhead costs in each product. This is used in allocating costs to the departments. However, these departments are not equal both in terms of their area in square feet or the number of employees present in each department. As such, these expenses, instead of being apportioned equally, should be apportioned according to the area or the number of employees or both (Jamal, Mastor, Saat, Ahmed, & Abdulla, 2007).

The second weakness with the current costing model is the fact that it does not capture the actual cost incurred by each of the home's inhabitant. It is obvious that some of Westmount's residents use some services more than others. For instance, the supportive services which represent the highest costs are classified into residents requiring no medical needs, medium medical needs and high medical needs. This approach does not comprehensively capture the essence of costing which is attributing the total costs in the production of a good or a service. A more elaborate costing model should be developed to capture these varying needs among the residents and develop a corresponding pricing model (Murthy & Gurusamy, 2009).

Westmount's poor results in 2005

Westmount performed dismally in 2005 as a result of a number of factors. First of all, competition increased dramatically between the years. Over 17 retirement homes exist in the London area alone. This has increased competition which in turn has eroded the pricing power. Competition shifted towards the price factor making it increasingly difficult for Westmount to price their products at a premium and thus achieve the required level of return to sustain growth and protect their revenues (Schomair, 2008).

Secondly, pricing highly is sensitive as their clientele comprise of individuals over the age of 75 are individuals with average incomes of between 25,000 dollars and 40,000 dollars. This places a cap on the level of prices that Westmount can institute. This is despite of rising cost of living. For instance, the cost of food and supportive services is very high. This requires an increase in prices to maintain the margins. However this is not possible because too high an increase cannot be born by the clients because of their limited incomes (Schomair, 2008).

Westmount's costing system also posses an internal threat. This is because the costing is not based on usage but rather takes a uniform approach. All costs at Westmount are divided among the clientele equally without consideration of each client's individual consumption. Some of the clients even share rooms with their spouses yet this does not result in extra prices for them. Such instances increase the cost of food and other social amenities. The costing approach should be re-evaluated to take these facts into consideration.

New costing system

The three suites are Studio, one bedroom and two bedrooms. The studio room measures 400 square feet, the one bedrooms measure 500 square feet while the two bedroom measure 600 square feet. The total suites are 125. This can be represented in an excel sheet as shown:

Suites

No. of Suites

Size (Sq. Feet)

Percentage (%) Sq. Feet

Studio

75

400

26.67

One B/Room

35

500

33.33

Two B/Room

15

600

40.00

Total

125

 

100.00

The percentages have been arrived at based on the difference in the sizes of the different rooms. This will form the new basis for costing based on the room sizes as opposed to the traditional method of arbitrary adding 0.25 and 0.5 percent to the base cost. This will be used to allocate costs remaining after supportive services have been allocated. This costs total to $1,917,426 per year ($2,465,999-$548,573). This allocation is illustrated in the excel sheet below:

Actual Remaining Cost Share in ($) per Yr

Suites

Percentage (%)

Cost Amount ($)/Yr

Cost Amount ($)/Yr/Suite

Studio

26.67

511314

6818

One B/Room

33.33

639142

18261

Two B/Room

40.00

766970

51131

Total Cost

100.00

1917426

 

The three patient levels are represented by those with no medical needs, medium medical needs and high medical needs. These three levels consume supportive services differently and thus should be charged according to their usage of these services as opposed to suite size. Supportive services represent the highest costs in Westmount. The excel sheets below indicate the allocation in percentage of the three supportive costs namely nursing supervisors, nursing attendants and dieticians.

Nursing Supervisors

Patient Care

Res. No.

Hrs/Res/Wk

Hrs/T.Res/Wk

Hrs/T.Res/Yr

(%)

No Medical Needs

55

0.25

13.75

660

6.51

Medium Medical Needs

65

1.5

97.5

4680

46.15

High Medical Needs

40

2.5

100

4800

47.34

Total

 

 

211.25

10140

100.00

Nursing Attendants

Patient Care

Res. No.

Hrs/Res/Wk

Hrs/T.Res/Wk

Hrs/T.Res/Yr

(%)

No Medical Needs

55

1.3

71.5

3432

15.66

Medium Medical Needs

65

3

195

9360

42.72

High Medical Needs

40

4.75

190

9120

41.62

Total

 

 

456.5

21912

100.00

Dieticians

Patient Care

Res. No.

Hrs/Res/Wk

Hrs/T.Res/Wk

Hrs/T.Res/Yr

(%)

No Medical Needs

55

0.1

5.5

264

8.15

Medium Medical Needs

65

0.4

26

1248

38.52

High Medical Needs

40

0.9

36

1728

53.33

Total

 

 

67.5

3240

100.00

The above excel sheets illustrate the percentage share of the nursing supervisors, nursing attendants and dietician's costs between the patient classes of no medical needs, medium medical needs and high medical needs. This will be used in apportioning supportive services costs among the three groups; No medical needs, medium medical needs and high medical needs. A summary of this allocation is shown in the excel sheet below. Note that this information has been derived from the tables above and this table forms the summary.

Cost Share in Percentage (%) per Year

 

No Medical Needs

Medium Medical Needs

High Medical Needs

Nurse supervisors

6.51

46.15

47.34

Nurse Attendants

15.66

42.72

41.62

Nurse Dieticians

8.15

38.52

53.33

The cost associated with supportive costs in the year 2005 is $548,573. To allocate this between the nurse supervisors, attendants and dieticians, the ratio of their costs per annum should first be determined using data from the current wages payment information and their working hours. This is illustrated in the excel sheet below.

 

No.

Hrs per Wk

T.Hrs per Wk

Cost per Hr ($)

Wks in Yr

Annual cost ($)

(%)Ann.Cost

Nurse supervisors

5

47

235

18.5

48

208680

38.70

Nurse Attendants

10

50

500

11

48

264000

48.95

Nurse Dieticians

2

37.5

75

18.5

48

66600

12.35

Total

 

134.5

810

 

 

539280

100.00

The percentage annual cost for each of the nurse category from this table can then be used to apportion the supportive cost of $548,573. This is illustrated in the sheet below.

Total cost of Supportive Services

Supervisors

Attendants

Dieticians

100%

38.70

48.95

12.35

548573

212276

268549

67748

This cost figures for each department form the basis through which the table for cost share in percentage is applied to get the exact cost share for the three classes of residents for the year 2005. The table below illustrates the exact costs where each is the percentage share multiplied by the costs incurred for each nurse category as shown in the above table.

 

No. Meds

Medium Meds

High Meds

Total Cost ($)/Yr

Nurse supervisors

13817

97974

100486

212276

Nurse Attendants

42062

114714

111773

268549

Nurse Dieticians

5520

26096

36132

67748

Total Cost ($)/Yr

61399

238783

248391

548573

Therefore, from this analysis, it can be said that individuals requiring no medication take up $61,399 of the supportive costs, those requiring medium medication consume $238,783 while those requiring high medication consume $248,391 per year. This approach takes into consideration both the three levels of patient care that essentially affect the supportive costs exclusively and the three suite options that affect all other costs including overhead costs. A more elaborate costing approach would have considered resident numbers in apportioning costs such as those of food service and laundry while using the three suit option for recreation, facility and housekeeping and the three levels of patients for supportive costs.

The new cost per patient under each of the options

The new cost under this option will be based on the level of medication required and the suit that a resident occupies. This will result in a combination of costs for the different patients residing in different suits. The Sheet below shows the cost allocation of the supportive costs per resident per year for the three medical classes.

 

Total Cost ($)/Yr

Residents

Cost Amount ($)/Yr/Resident

No. Meds

61399

55

1116

Medium Meds

238783

65

3674

High Meds

248391

40

6210

Total Cost ($)/Yr

548573

160

11000

The following sheet indicates the cost allocation of all other costs based on the suit size, per suit per year.

Suites

Percentage (%)

Cost Amount ($)/Yr

Cost Amount ($)/Yr/Suite

Studio

26.67

511314

6818

One B/Room

33.33

639142

18261

Two B/Room

40.00

766970

51131

Total Cost

100.00

1917426

 

The combination of this two costing approaches will give the cost required of every resident per year depending on what suite they reside in and the level of medication required for each resident. The total cost options are thus nine as shown in the excel sheet below.

 

Other residence costs

Supportive costs

Total cost per client

Studio No. Meds

6818

1116

7934

Studio Medium Meds

6818

3674

10491

Studio High Meds

6818

6210

13027

One B/Room No. Meds

18261

1116

19378

One B/Room Medium Meds

18261

3674

21935

One B/Room High Meds

18261

6210

24471

Two B/Room No. Meds

51131

1116

52248

Two B/Room Medium Meds

51131

3674

54805

Two B/Room High Meds

51131

6210

57341

This information can be summarized in matrix form as shown below. All the figures shown are in dollars. They have been computed per suit and not per individuals living in each suit. In bedroom suites with more than one resident, a premium can be added on the prices below to cater for the extra costs.

 

No Medication

Medium Medication

High Medication

Studio

7934

10491

13027

One B/Room

19378

21935

24471

Two B/Room

52248

54805

57341

Usefulness of this new information to Roswell

This information is very useful to Roswell as he will now be in a position to easily arrive at a base cost through which he will be able to objectively price the rooms. Roswell only needs to adjust the above information if costs change and to consider the expected inflation in the coming year. Roswell will also be able to differentiate Westmount's products thus increasing the residence's competitiveness.

Prices that Roswell should recommend

Roswell has indicated that he requires a 15% margin over the cost to cover for replacement of assets and growth as well as the shareholders interests. To achieve this, Roswell will just need to add a premium of 15% on the above cost matrix for the various clients. This is illustrated in the excel sheet below:

 

Total cost per client

15% Margin

Cost Plus 15% Margin

Studio No. Meds

7934

1190

9124

Studio Medium Meds

10491

1574

12065

Studio High Meds

13027

1954

14981

One B/Room No. Meds

19378

2907

22284

One B/Room Medium Meds

21935

3290

25225

One B/Room High Meds

24471

3671

28142

Two B/Room No. Meds

52248

7837

60085

Two B/Room Medium Meds

54805

8221

63026

Two B/Room High Meds

57341

8601

65942

The column cost plus 15% margin represents the new prices. This can be represented in a condensed pricing matrix as shown below.

 

No Medication

Medium Medication

High Medication

Studio

9124

12065

14981

One B/Room

22284

25225

28142

Two B/Room

60085

63026

65942

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