The continuous increase in the cost of providing health care has resulted in additional pressure on the health care providers to extend their services to their patients in a more cost-effective manner to meet the challenges of retaining the patients as well as maintaining the revenues. To meet these economic challenges the health care institutions are constantly on the lookout for new and improved methods of managerial accounting concepts to provide them adequate information on financial and non-financial metrics of the performance of their respective organizations.
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For this purpose, health care organizations cannot depend on traditional costing systems which suffer many shortcomings. For instance, in the manufacturing industry costs are based on the number of units produced and the cost allocation to production units is done based on direct labor hours or machine hours. Such allocation of costs sometimes may turn out inappropriate depending on the nature of the industry. Hence this system of allocation of costs may not apply to the healthcare industry (Shank et al 1989). To facilitate an efficient allocation of costs in a health care organization, the concept of Activity Based Costing (ABC) is an efficient managerial accounting tool. ABC system can distribute the cost more efficiently by distributing the indirect costs by choosing more appropriate bases for cost allocation. Further, it allows for more than one base to serve as an element that influences cost (Cooper et al 1991). This paper details the application of Activity Based Costing, a managerial accounting in a health care setting.
Basics of Activity Based Costing
Brimson (1991) describes activities to include the accumulation of technology, people, raw materials, and skill that are being used in providing health care. The activities tend to detail the actions of an enterprise, how the enterprise uses its time, and the outcome of such utilization. A health care organization may adopt the Activity Based Cost management system by localizing its main activities in the total operations. The process of adoption may include the identification of main activities, processes, or cost centers like outpatient nursing, pharmacy, etc. A health care organization may use different approaches to build and apply an ABC model.
Adoption of ABC Model in the Health Care Industry
With the mounting pressure on the healthcare industry to have tighter control over costs and the limited nature of the resources available with the health care industry, the ABC model is in more favor with the health care industry. There have been several pieces of literature detailing the potential benefits of adopting the ABC system by healthcare organizations. Chan (1993) advocates combining the ABC system with standard costing for the efficient planning and control of their services by the hospitals. Udpa (1995) observed that the increased need for controlling the price by the healthcare organizations to enable them to compete with large organizations necessitate accurate costing information. This has increased the need for a new costing system to be installed in the hospitals urgently. Ross (2004) has identified the following potential advantages of adopting the ABC model:
- Achieving cost reduction
- Managing customer demand efficiently and
- Optimizing the product/service line
King et al (1994) have identified the use of the ABC model as an efficient performance measurement tool.
Process of Adopting ABC Management System
The process of adopting the ABC management system in a health care organization may take the following steps:
- Activity mapping involves the identification of different activities involved in the total operation of the health care organization
- Activity analysis encompasses predefining and assigning a time value to the different activities identified and
- Bill of activities which is an important step in the whole process that involves the generation of cost for each main activity
On the completion of the above basic steps relating to the main activities, the overhead and secondary activities are identified and cost generated. Finally, the process of adoption of the ABC management system is completed by constructing a cost schedule to define the flow of costs throughout a healthcare activity.
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Example of the use of ABC Model
By way of illustration, this paper presents the use of the ABC model in a medium-sized outpatient clinic in the determination of the cost of a simple process involved in the operation of the clinic namely the X-ray process.
Activity mapping is considered an important step in the ABC system since it enables the managers to understand the intensity of the relationship between activities. Activity mapping involves a graphical portrayal of the relationship between the activities. It becomes possible to determine the productivity level of a healthcare organization once the operations of the organization are broken down into different associations of links between such activities.
In the mapping phase, the processes of a health care organization are converted into a network of activities with a flow chart constructed therefrom. One activity may begin with a starting event like ‘receptionist greets patient’s and may end with an event like ‘the patient departs’.
The objective of activity mapping is to fully describe the sequence of activities that are undertaken to accomplish the goals of the respective work center.
In the ABC model, the activities are classified into either primary activities or secondary activities. While the function of primary activities is to contribute to the achievement of the functional objective of a particular cost center or department, the secondary activities take a supporting role to the primary activities. Personnel training may be cited as an example of secondary activity.
The development of activity mapping for the X-ray process may be broken down into:
- Administrative checking-in of the patient
- Exposure of the patient to the X-ray
- Patient return and
- Processing of the films
The same activity sequence may be followed in respect of all X-rays irrespective of the parts of the body X-rayed.
There may be secondary activities like answering the telephone queries, forwarding the films to the patient or another department, receiving films, and training of staff.
This process involves further analysis of the activities identified to assign a time value in respect of each identified activity. The assigning of time value is considered essential from the point of view of measurement of productivity. In the example of the X-ray process, the time taken for performing each activity may be determined by observing the practices of the staff involved, by conducting interviews with the clinicians, and also by reviewing the historical records. (Brimson, 1991))
For example, the time taken for administrative checking-in of the patients with a customary greeting of the patient and completing the prescribed paperwork may first be determined. The next step is to arrive at the time required for exposure. This may vary according to the complexity of the X-raying involved and the parts to be exposed. Similarly, the time spent on performing each secondary activity may also be determined for evaluating the performance of the individual actors.
Bill of Activities
The purpose of the bill of activities is to estimate the cost of each primary activity involved and to arrive at the total cost of performing the activity. For the X-ray department, the cost of primary activities is assessed based on the type of X-ray procedures involved.
Since the provision of healthcare is much labor-oriented, the cost of each primary activity is largely dependent on the labor costs involved. For example, the cost of checking in a patient may be determined by multiplying the time taken for performing that activity by staff wages. These labor costs will increase while processing the film due to the use of sophisticated technologies.
It is important to take into account the cost of supplies also. For instance, the cost of film processing should normally include the cost of chemicals and this cost needs to be added to the labor cost. This figure then is to be multiplied by the number of films to be processed, which again varies with the type of x-ray procedures performed. The cost of X-ray film is another category that needs to be added to the total costs at actual.
Secondary activities and overhead
After the completion of the costing of the primary activities, the secondary activities need to be taken into consideration for arriving at the total cost of the activity. In our example of the X-ray process, the secondary activities may include the answering of telephone queries, forwarding and receiving of the X-ray films. There may be included another category of secondary activity representing idle time or time spent on miscellaneous activities of negligible importance.
For the overheads, they are to be treated as allocable expenses over all the work centers involved. The watch and ward expenses for the X-ray department may be allocated based on the proportion of the area of the floor space. Heating and electricity costs may also follow the same procedure.
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Interpretation of Results
By adopting the ABC model it is possible to accurately estimate the costs than with the use of a traditional costing system. Thus ABC model acts as a tool to the management for making comparative cost analysis over the periods in respect of the same department or for making inter-departmental comparisons. For example, the costs incurred for different X-ray procedures in the department may be compared for analyzing the cost of film processing or the cost of exposures. Similarly, the analysis of the cost of secondary level activities enables the management to understand how efficiently a work center has performed. For example in the case of the X-ray department, it may be possible to ascertain the time spent by the staff on different activities like greeting patients, using the telephones, or doing something in connection with the filing of the films. By allocating the costs to the secondary activities it may become possible for the manager to exactly arrive at the cost of the unproductive activities of the staff.
Limitations of ABC System
It should be understood that the adoption of the ABC model cannot be construed as a management philosophy that will work on its own. It is a time-consuming and labor-intensive process. The success of the model depends largely on the total participation of the organization which is a tough task for the senior management. It involves the total commitment of the top management. Any organization that adopts the system without the total commitment of the organization would experience very disastrous results. Similarly, the levels of measurement of the costs may significantly affect the investment of time and labor in installing and pursuing the ABC management system. “The level of accuracy in an accounting system depends on a management decision that the organization must focus on. However, concentrating too much on levels of measurement can cause an organization to lose sight of ABC goals”. ABC model also requires a periodic review of the system.
Health care activities are more competitive and market-driven. In addition, there is some legislation that monitors the activities of health care organizations. This may put a restriction on the use of available resources that are very limited in the hands of the health care organizations. Therefore it becomes important that the management identify and make a proper allocation of overheads. This would promote the economic use of the limited resources available to the organization. In this direction, the ABC model provides a meaningful and accurate cost information system towards the elimination of wastage.
Brimson, James A. (1991) ‘Activity Accounting: An Activity Based Costing Approach’, John Wiley & Sons, Inc., New York.
Chan, Lee-Ching Lilian, (1993) ‘Improving Hospital Cost Accounting with Activity Based Costing,’ Health Care Management Review, Vol. 18(1), p. 72.
Cooper, Robin and Kaplan, Robert S (1991) ‘Profit Priorities from Activity-Based Costing,’ Harvard Business Review, p. 130.
King, M., Lapsley, I., Mitchell, F., & Myes, J. (1994) Costing needs and practices in a changing environment: The potential for ABC in the NHS. Financial Accountability & Management, 10(2): 143-160.
Ross, T. (2004) ‘Analyzing health care operations using ABC’ Journal of Health Care Finance, 30(3): 1-20.
Shank, John K. and Govindarajan, Vijay, (1989) ‘Strategic Cost Analysis, the Evolution from Managerial to Strategic Accounting’, Richard D. Irwin, Inc., Boston, p. 73.
Udpa, S. (1996) ‘Activity-based costing for hospitals’ Health Care Management Review, 21 (3): 82-96.