The University has a medical school that operates a large teaching hospital. Other small...

The University has a medical school that operates a large teaching hospital. Other smaller hospitals in the region are independent of University Hospital in the sense that they are owned and operated by unaffiliated not-for-profit corporations.

University Hospital has a Medical Laboratory Department (MLD) that provides a wide range of medical tests including hematology, biopsies, electron microscopy, immunology, toxicology, and virology. Few of the other independent hospitals in the region have the scale to provide the same comprehensive range of tests that MLD provides. Consequently, other hospitals rely on MLD for some of their lab tests.

For quality assurance and billing purposes, MLD tracks how much time laboratory technicians spend on each test performed. Based on these time sheets and the salaries of the technicians, 70 percent of MLD’s lab technician salary expense (direct labor cost) is incurred performing lab tests for patients at University Hospital. The remaining 30 percent of MLD’s lab technician direct labor cost is incurred performing tests for patients at the other nonaffiliated hospitals. Direct labor cost consists of the salaries and benefits of the lab technicians while they are performing test procedures.

MLD charges other departments at University Hospital the variable cost of performing the tests where variable cost is the actual direct labor cost of the lab technician (salary and benefits) plus direct materials. Direct materials (laboratory materials, supplies, chemicals, and other consumables) are 40 percent of direct labor. So, if the direct labor of a lab technician for a particular test is $120, the University Hospital department requesting the test is charged $168 ($120 + 40% X $120).

The reason for charging University Hospital departments requesting lab work only the variable (direct) cost of the tests is to keep the cost of lab work down. The vast majority of patients at University Hospital have HMO or other third-party insurance providers that pay University Hospital for providing care to their clients. Before University Hospital can get reimbursed from these third-party providers, the insurance provider must preapprove the treatment plan (including lab tests). If the Hospital does not get permission, the insurance provider might deny the charge. Since insurance providers base their approval decisions to some extent on the estimated cost of the treatment (including lab work), the Hospital wants to reduce the cost of lab tests to encourage the performance of adequate test procedures.

Outside, unaffiliated hospitals are charged 200 percent of the direct cost of performing a test. So, if an outside (unaffiliated) hospital sends a specimen to MLD and requests a test that has a direct labor cost of $120, it is charged $336 ([$120 + 40% X $120] X 2).

The following table lists the expenses incurred by MLD in the most recent fiscal year

Fixed overhead cost of $900,000 consists of supervision and administrative costs, occupancy costs, depreciation and leases of equipment, training, and so forth.

Required:

a. Based on the existing pricing arrangements for inside and outside users, prepare an income statement for MLD for the most recent fiscal year.

b. Given the income statement you prepared in part (a), discuss the financial condition of MLD and the reasons for MLD’s financial condition for the last fiscal year.

c. The manager of MLD believes that University Hospital departments sending specimens to his department for testing are not paying their fair share of the costs of his department under the current pricing arrangement. The MLD manager is proposing that inside users of MLD be charged the full cost that his department incurs to provide testing services (direct labor plus direct material plus fixed overhead). The manager proposes that since MLD’s fixed costs are $900,000 and the direct labor costs are $1,400,000, then for every $1 of direct labor cost in each lab test, that lab test (for inside University Hospital departments) should be charged $0.6429 ($900,000/$1,400,000) of fixed overhead (in addition to the direct material charge of $0.40 and the direct labor charge of $1). The pricing of lab tests for outside users will not change. Prepare an income statement for MLD for the most recent fiscal year assuming the MLD manager’s proposal is accepted.

d. Explain briefly why the net income figures computed in parts (a) and (c) differ.

e. Describe the likely consequences for MLD if its manager’s suggestion described in part (c) is implemented.