Explore the advantages of activity-based costing in the healthcare setting.

This is the second article in our “10 in 12” series, examining how hospitals can strategically reduce operating costs by 10% in 12 months.

Strategically reducing operating cost by 10% in order to improve margins is something that many hospitals hope to accomplish over the next 12 months. But hope is not a strategy. Real strategies need to be created and the first steps involve gathering information and assessing current conditions. With cost reduction as the primary objective of “10 in 12”, gathering cost information is a critical first step. Do you have the resources and experience required to efficiently accomplish this first step? What is your confidence level in the accuracy of your information? Read on to see how Harris Affinity can mentor you through the intelligence gathering and strategic planning process.

What is the basis of your current cost valuation and assignment process?

There are a multitude of costing theories and methodologies to choose from and no one methodology is perfect in and of itself. Each has its strengths and weaknesses with specific applications related to the characteristics of your organization. The ability to apply multiple methods in concert as they best suit your organization is the ideal approach. A sample list of costing methodologies includes:

  • Activity-based costing
  • Environmental accounting
  • Project accounting
  • Resource consumption accounting
  • Standard cost accounting
  • Target costing
  • Throughput accounting
  • Life-cycle costing

Which costing method is most advantageous to your organization?

Activity-based costing is currently considered one of the most precise costing methods available in the industry today. There is a great deal of easy-to-access information that supports this claim as it relates to healthcare and hospital administration. Accomplishing a solid understanding of this information requires a clear definition of what ABC is. It is good to know what you are investing in before you make the purchase.

What is activity-based costing (ABC)?

Activity-based costing is a concept that was introduced in 1971 by George J. Staubus of the Haas School of Business at the University of California, Berkeley. It was not until 1986 when Robert S. Kaplan and William J. Bruns of the Harvard Business School published a definition for ABC. There is consensus among costing professionals regarding value related to the accuracy of information that the ABC method provides. However, considering it took about 15 years to establish a definition of activity-based costing underscores the complexity and varied perspectives associated with this costing method.

From the manufacturing perspective, where activity-based costing was first developed and applied, it is defined as a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore, this model assigns more indirect costs into direct costs when compared to conventional costing.

Specifically defined for healthcare as an approach to determining the costs associated with providing patient care (case costing) or clinical service lines (groups of similar patients). The approach improves the accuracy of costing different services and service lines by accurately assigning costs on a cause-and-effect basis. This is accomplished by using a multitude of specific activity metrics and their assignment to services and supplies utilized to provide patient care.

What are some of the advantages associated with activity-based costing in healthcare?

Please keep in mind that the level to which a value can be realized and a risk managed is predicated on the knowledge, skills and experience that are applied to the design, implementation and support. Harris Affinity is a valued partner who has been successfully involved with supporting ABC methodologies for more than 35 years. ABC costing methods are part of the architectural foundation of our system. ABC provides:

  • Enhanced understanding of overhead costs with detailed insights to cost drivers
  • Benchmarking for your facility and service lines
  • Improved performance management and balanced scorecards using detailed information
  • Precise activity tracking to explain cost behavior
  • Integration with Six Sigma and other continuous improvement programs
  • Strategic cost management by applying capacity and utilization metrics

Does your hospital currently use activity-based costing?

If you answered yes, then you already understand the value of the information it can provide, as well as the resources required to support the process. But are you aware of some risks that are not always visible? For example, your system may be reconciling appropriately but not revealing hidden issues related to data validation, inappropriate activity and cost relationships. When activity-based costing is first implemented, these issues are low risk; however, over time as your healthcare organization adapts to market conditions, the process requires monitoring to ensure that the information provided is accurately correlated with the current state of your organization’s operational activity.

If you answered no, then the confidence level of the information you are currently using to make operational decisions is of a low to moderate degree. Even when applying the best decision-making methods possible, the accuracy of the information being used will have a direct impact on the outcomes. You may not perceive ABC as a perfect fit for your organization, but keep in mind that successful leadership will always consider all options and resources available before making final decisions. ABC is a valuable resource.

Adopting activity-based costing in healthcare is not difficult. Most EHR systems have the utilization and clinical information needed for activity-based costing. This information combined with financial data from any healthcare financial system provides the time-driven data needed to calculate the cost detail including direct and indirect costs.

So what’s the difference between using a traditional “Ratio of Cost to Charge” (RCC) method instead of “Activity Based Costing” (ABC)?

A picture paints a thousand words. Charge-based costing vs. activity-based costing: The chart below provides a visual example of the informational disparity between results of the two methods. With revenue as the constant, differences in cost assignment details beyond the financial statements can cause major profitability and cost reporting swings between service lines and other defined reporting groups. Some may argue that charge masters can be adjusted to reduce the disparity. However, that approach can require more resources to implement and maintain than the costing method. It may also have an adverse effect on billing, charge reporting and revenue realization. Accurate information supports good decisions and ABC provides accurate information; that’s the difference.

ABC to RCC Variance by Cost Type

Click the image above to view larger. The chart above shows the result variances of calculated cost between activity-based costing and charge-based costing in a healthcare setting. It focuses on the relationship of “cost type” to “service line.” These variances are amplified in areas of greater spend, e.g. labor, supplies and drugs, as well as indirect cost. For example, in the surgical orthopedics service line ABC allocates $12M more in supply cost than RCC and conversely allocates $6M less than RCC for the other surgery service line. The allocation variances can be bidirectional and illustrate the risk of erroneous insights that charge-based costing can yield.

ABC & RCC Comparison by Cost Type

Click the image above to view larger. The first chart is a macro view. This chart is a micro view. It is a single patient encounter with a side-by-side comparison of the results for the two costing methods. It demonstrates the precision and accuracy of activity-based costing at a granular level. Together, these two charts emphasize the value and confidence that ABC provides for both summary (high-level organizational) and detailed (granular-level operational) analyses that provide value to all decision-making processes.

Precision in costing provides evidence-based information for decision making. It is also a valuable resource for budgeting, forecasting and the management of healthcare services. Knowing the cost of care relationship of price or payor rates provides a deep understanding of profitability at all levels. For example, service lines, physician practices, third party contracts, clinical services and surgical procedures. Insights to the value and risk associated with decisions that will affect your organization.

How does ABC support 10 in 12?

ABC provides the detailed insights necessary to identify costs that can be reduced without adverse effects on clinical operations and quality of care. ABC produces accurate costing of services by converting broad indirect costs into direct costs. It determines the various sources of indirect costs and allocates these expenses to specific activities, aligning costs to utilization.

As with all decision support and cost accounting systems, ABC requires a defined commitment of resources to implement, which is why you need a valued partner that can provide the experience and resources necessary to effectively implement and maintain the system, including knowledge transfer. In return, activity-based costing provides relevant information for improving the efficiency of hospital processes and strategic cost management to increase financial margins.

ABC provides detailed insights to cost that directly support initiatives focused on strategic cost management in a way that can accomplish 10% in cost reductions over a period of 12 months.

Harris Affinity is uniquely positioned to provide value beyond the ABC method because we support multiple costing methods and are experienced in implementing them to work in concert with each other. We are a valuable partner in the strategic planning process and delivery of innovative solutions for complex challenges.

Harris Affinity has been implementing and supporting ABC for more than 35 years. It was embedded in the very first release of our software. We understand value and risks related to ABC in ways that very few can. We are here to work with you as a valued partner in exploring how activity-based costing can benefit your healthcare organization. We look forward to talking with you.

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