Like most businesses, health care organizations prosper or fail on their ability to be profitable and reinvest in their mission and vision. However, unlike other businesses, quality of care and patient safety at a reasonable cost are the major objectives of health care delivery.

Rising competition and dwindling reimbursement for our health care services require us to look for other ways to shore up our business's profitability. At the same time, providers are being asked to offer more health care service options using the latest, more expensive technology.

In addition, patients are being asked to take on a larger portion of their health care costs via higher deductible health plans augmented with health savings accounts (HSAs). To successfully lead these businesses through these challenging times, health care managers will need to continually improve business processes, and most effectively and efficiently use the limited resources of people, equipment, supplies, and space.  To ensure a positive bottom line, health care providers must manage the costs of care delivery.

This article introduces the concept of “activity-based costing” (ABC).  ABC is rapidly becoming an effective tool in many industries to help manage costs on a product-line basis and gain insight into how to more efficiently deliver services.

Why Activity-Based Costing?

Now more than ever before, managers need accurate, timely information about the cost and profitability of services to patients.  This would be easy to do if most of the resources used in providing health care services to patients were direct labor and direct supplies used in a static, easily determined amount. Costs could be quickly traced and profitability very simply determined.

Unfortunately, in a service business, we know that even the same product (e.g., an established patient office visit) has high variability in direct time spent and direct materials used. Even more problematic, the great majority of the costs involved are indirect costs that do not vary in amount with volume but are fixed in amount within a specific range of productivity over a fixed period.

Very high fixed costs within health care organizations make cost management through volume control only partially effective in providing a solution to reductions in the breakeven point. Only sound management decisions, over time, can affect the fixed costs of operating a health care business.

In addition, general overhead expenses cannot be directly traced to services rendered. Both of these attributes -- indirect and fixed -- make it essential that a logical cause-and-effect relationship be used in allocating these expenses to our services for meaningful effect.

Understanding Why You Make or Lose Money

The concept of cost accounting is not new to us in health care.  Sophisticated health care managers have been determining department-level or procedure-level costs for years. Historically, we have been using various methods of cost accounting such as ad hoc cost analysis, ratio of cost-to-charges (RCC), standard costing, and the relative value unit (RVU) method.

It is easy for us to trace the direct labor and direct supplies costs to specific services or responsibility centers. However, the majority (60 percent or more) of the total costs in most health care settings are general overhead costs and indirect costs. These indirect or overhead costs need to be allocated in some reasonable manner to departments or procedures to determine costs.

Traditional methods of cost allocation do not logically connect the cause-and-effect relationship of resources used to the activities performed. When a substantial portion of the total costs are being allocated to departments or procedures using a methodology that does not accurately link the true costs to the proper activities, the financial control information we obtain and use as health care managers is misleading, if not financially damaging.

For example, RCC is used with Medicare cost reporting, so this cost allocation methodology is prevalent in many health care systems. However, inaccurate procedure-level cost information is often produced because the RCC cost allocation methodology divides costs based upon the charges for a procedure, and resources are not always used in this manner.

Likewise, although the RVU method actually weighs the relative resources consumed by each procedure, its key weakness is the assumption that each RVU consumes the same set of resources in similar proportions, producing an “indexed” cost per procedure, not the actual cost per procedure.     

How Does ABC Create an Advantage Over Other Methods?

Like other cost-accounting methods, activity-based costing is not new. ABC became popular in the mid-1980s with manufacturing companies. As the direct costs of labor and supplies became a lesser portion of the total costs of production and indirect, support, or overhead costs increased as a percentage of total costs, manufacturing managers needed more accurate information about production costs than provided by historic costing methods.

With ABC, costs are traced by activities, across departments or cost centers, allocating actual direct costs based on actual usage in performing an activity, when possible.

An activity can be defined as any work that causes costs to be incurred. For example, if we are interested in allocating costs for general surgery, all salaries and supply expenses associated with the operating room and nursing and physician care are direct “activities."

The remaining costs, the indirect costs, are allocated through a logical cause-and-effect relationship with activities. This is the heart and the primary difference in cost allocation methodology with ABC, making it the most comprehensive methodology for allocating costs and providing more accurate and reliable cost information.

Generally, ABC will cost out low-volume services at a higher cost than traditional costing methods because any activity, regardless of volume, has a certain amount of basic activity, and ABC allocates this cost in a more accurate cause-and-effect manner than traditional costing methods do.

Applying ABC to the Health Care Industry

Though ABC evolved in the manufacturing setting, its emphasis on activities and the more accurate allocation of overhead costs lends itself very easily to service-oriented businesses, such as health care. With ABC, we have the appropriate tool to provide the accurate, timely management information needed to find answers regarding the cost and profitability of our services.

Because direct materials are such a small portion of costs and because so much of the labor costs are supportive instead of direct, most operating expenses in the health care setting have been committed before any services are performed. This makes a large portion of total health care costs fixed in nature. This means that managers in health care organizations need the costing information provided by ABC more than manufacturing companies.

ABC lets health care managers see the actual costs of activities and processes, makes the basic causes of costs clear, and highlights the main important costs involved.  Better cost information allows managers to better determine profitable and unprofitable services, improve pricing and contracting strategies, determine and manage required controllable costs, and cut non-value-added costs. In essence, we can make better managerial decisions with better information.  

With all of the benefits of activity-based costing, the health care industry has been slow in adopting it as a management tool.  Clearly, the up-front cost of providing better cost information is more. However, is it worth it?

There is a saying something like “don’t climb the hill if the view isn’t worth it.” In relation to activity-based costing, this means that you will only want to cost those activities you believe will provide you with more benefits than the costs of measurement. Early attempts by large companies to produce meaningful management information from ABC projects were often unsuccessful and of questionable value because the scope of their ABC projects was too broad.

Perhaps it is time for us in health care to give activity-based costing a closer look. In doing so, keep the following in mind:  

• Activity-based costing does not replace the current general ledger system. There is no need to completely restructure your financial reporting system to accommodate ABC or to gain its information benefits. It uses the accounting information provided by your current financial reporting system, as well as other nonfinancial information, to help you understand the cost of operations, understand and improve work processes, and make better business decisions. It merely translates what is being spent by your organization into what is being done in your organization. The result:  communication that both financial and operations people can understand and use effectively. 
  
• ABC use can be phased in. It is not necessary to have a fully developed activity-based costing system covering all of the activities of your organization to benefit from its use. Benefits can appear quickly in key or significant business activities. In fact, the first step in ABC methodology is to identify which services would be most affected by a cost-benefit analysis. One of the main reasons ABC projects fail is because the scope or size of the undertaking is too large.
  
• The system does not have to produce exact answers to be meaningful. Estimates can provide useful results and foster good business decisions.  In fact, smaller amounts of detail and the use of cost estimates help facilitate the goal of ABC, which is to provide useful financial insights into your operations. Many ABC projects have been unsuccessful because they have gotten bogged down in too much detail.

The simple illustration in Figure 1 allows us to see how ABC can help in viewing business operations more clearly.

In the Medical/Surgical Unit example, ABC allows the organization to break out cost on a more detailed basis and gain an in-depth understanding of where the “true” cost of providing the service lies.

ABC also resolves cost misallocations by using activities that capture unique, actual resource consumption and logically link a cause-and-effect relationship to the cost-assignment (allocation) process.  After the department’s general ledger costs are allocated to concrete activities as provided by the ABC methodology, the financial numbers come to life for operations performance management.

In the example above, activities all involve an action verb.  For operational (non-financial) managers, this ABC management financial information speaks to them in understandable and concrete terms.

The Benefits of ABC

This information not only shows us what the department costs are by regular general ledger expense categories but also clearly identifies for us:

• The specific activities performed within the department
• The steps taken in performing these activities
• The makeup of resources (costs) used to perform each required activity
• The total cost to perform each activity

Documenting the Process:  An Added Benefit

Knowing which activities are performed -- and how they are accomplished -- makes it easy for you to determine if any procedure has been missed and if any effort is being spent on non-value-added services.  Measuring actual activity with written operating procedures allows managers to understand if people are being trained adequately and if they are using their training to properly perform their duties. By identifying the costs to perform functions, managers gain a better understanding of how costs are affected by what people do.   

• Who performed the activity?
• How much time is spent on the activity?
• What equipment and supplies are used?

Having this information, along with appropriate performance standards, makes it possible to answer such questions as:

• Is the right person doing the job or, in broader terms, are we staffed properly?
• Do they spend too much time on a specific activity?
• Do they have idle time?

Using Standards to Grade Performance

Inevitably, success is measured by how efficiently and profitably we are operating. Because current efficiency and profitability might be unacceptable, using historical performance will not necessarily provide a good standard or measuring bar from which to judge performance.

However, measuring current performance also allows us to gain a currently attainable standard. For example, by measuring the time each nurse in the clinic takes in completing a patient’s history or by measuring the total face-to-face nurse/patient time per visit categorized by patient risk, the low, high, and average time actually spent on these activities would be known.  A currently attainable standard can be set from these actual results.

Using internal benchmarks based on a current performance standard creates an achievable goal rather than a theoretical benchmark that staff think is unrealistic. Since the ultimate goal is continuous improvement of current performance, managers should be most concerned with how are we doing “in the future” rather than how we performed “historically”. ABC provides substantial information concerning current activities and costs within the organization and matches costs to performance standards. The results identify areas where the most positive effect in efficiency improvement/cost reduction can be achieved

Realistically Allocating Costs across Multiple Departments

Figure 2 illustrates how ABC provides a clearer understanding of the costs associated with a service department.  In this example, the maintenance department, whose activities help other departments (in this case, the pharmacy department) is shown.

The manager of the pharmacy department believes that since the pharmacy experiences few equipment breakdowns, its allocation of maintenance department costs under current allocation methods results in an erroneously high maintenance cost to his department.  Currently, all maintenance department costs are allocated on departmental square feet.

• Current allocation is determined as follows: Total maintenance costs of $307,000 divided by 100,000 square feet equals $3.07 per square foot; allocated pharmacy department costs equal $3.07 times 2,000 square feet, or $6,140.
  
• Under ABC methodology, the allocation could be as follows: The pharmacy directly used six labor hours at $18, for a total of $108, while all other departments used the remaining $71,892 of direct repairs labor costs.  Again, without any better logical basis, the $120,000 in routine maintenance labor cost is allocated based upon square footage.  The pharmacy is allocated 2%, or $2,400.  Total pharmacy department labor cost equals $2,508.

In summary, total pharmacy, department maintenance costs under an ABC methodology are as follows.

Under the ABC methodology, the costs for the pharmacy are about $3,329 or one-half of the cost allocation of $6,140 made under the traditional cost allocation approach. This small cost allocation change made regarding the total $307,000 in maintenance costs is not only more realistic, it more accurately reflects what it costs to operate the pharmacy department.

Final Thoughts

In summary, it is important to remember that activity-based costing concerns activities. It is a methodology for determining the most accurate costs of the activities performed to produce the services we provide in our businesses. However, activity-based costing is not a cure-all for other financial problems.

ABC can be a powerful performance improvement tool for identifying key activities that are operating inefficiently. Ultimately, it is management’s responsibility to determine what, if any, corrective steps are needed to be taken to alter inefficient operations.

Continuing tight reimbursement policies and the intense competition within the health care industry, along with ever-growing expenses, force us to not focus on the top line --revenues -- but to understand and manage our middle lines -- costs.  Activity-based costing can be a valuable tool for controlling costs and making strategic choices.

Lloyd A. Froelich (651-636-6468) is a partner in Wipfli's health care division.