Activity-based costing may reduce cost, aid planning - information system management helps hospitals' financial management

Healthcare Financial Management, Nov, 1991 by Medhat A. Helmi, Murat N. Tanju

An information system management approach developed by manufacturing companies may help ease hospitals' financial pressures. Activity-based costing (ABC), a system for collecting information related to an organization's significant activities, has helped many manufacturers improve the quality of their goods and services provided and, at the same time, reduce costs.

Applying ABC could benefit healthcare organizations in several ways. Along with providing realistic cost information, ABC can be used to study trends and compare costs by diagnosis, by attending physician, or by patients under different payment plans.

To benefit from ABC, hospitals must redesign their cost accounting systems to provide relevant cost information. Cost accountants must be able to go beyond average costs to study the basic factors affecting hospital costs and the controlling forces behind these factors.

Waste reduction. An important factor in applying ABC is searching for ways to avoid product cost distortions. Cost distortions result from using simple allocation bases in multi-product or multi-service organization. These organizations face a challenge in allocating common costs, especially if common costs represent a significant portion of their total costs.

To avoid distortion in product costs, ABC requires that an organization trace costs to products or services using cause and effect relationships. Consequently, it draws attention to cost drivers--activities that generate costs, such as respirator hours used or number of X-rays taken. Knowledge of activities and cost drivers enables administrators to better understand factors affecting costs. This understanding can lead to improvements in managerial decision making.

By applying ABC, a healthcare organization can identify non-value-added activities, which consume resources without adding value to patient services. To closely monitor and eliminate these activities with ABC, a hospital must develop non-financial measures. For example, an information system that keeps track of patients' time waiting in hallways for X-rays or other procedures can focus administrator's attention on the problem and help find a solution. While eliminating waste may not reduce hospital costs in every case, it can improve the quality of services provided.

In a hospital setting, where the emphasis is on patient care, the term cost can have a bad connotation. By emphasizing management of acitivities rather than managing costs, however, ABC may stand an increased chance of success in its implementation.

Pilot study. Because implementing ABC is time- and effort-consuming, it should be done in stages to guarantee its success. In the initial phase, a department is selected for a pilot study. During the study, potential problems can be identified and methods for solving them can be developed. Successful application of ABC in a pilot department creates a model for other departments to follow.

A healthcare organization's administrative and general service costs can be classified into two categories: costs that can be traced directly to individual patients and costs that cannot.

Medical record costs, for instance, can be traced to patients using a suitable measurement, such as length of stay. The more costs are traced directly to patients, the more accurate the resulting cost. Every effort should be made to trace as many costs as feasible.

Using suitable cost drivers, a hospital should allocate all other costs first to departments. It then can classify departmental costs into direct and indirect costs, then allocate them to patients.

Applying ABC in a selected department involves the following steps:

* Step 1: Identify all significant activities of the department. Arrange with the director of the department to conduct interviews with staff members responsible for key activities;

* Step 2: Create a flow chart of key activities to identify which activities provide value-added services. Nonvalue-added activities should be eliminated or at least significantly reduced. Develop non-financial measures as needed to monitor nonvalue-added activities;

* Step 3: Determine cost categories for allocating activities identified in Step 1. Some costs are directly traceable to activities, while other costs are allocated using suitable bases. The resulting cost figures represent the cost of a department's activities;

* Step 4: Trace the costs of the department's activities to patients. Respiratory therapy, for example, is traceable to patients by the number of hook-ups, and medical records maintenance can be traced by number of treatments.

* Step 5: Allocate the costs of activities not directly traceable to patients. Supervision costs, for example, must be allocated by the most logical basis, such as hours of treatment received, number of patient days, or as a percentage of direct cost.

Cost tracing. Exhibit 1 shows cost tracing for three activities of a nursing station, assuming that:

* The annual costs of the station (mainly personnel costs) are $166,000;