Activity Based Costing & Activity Based Management in Hospitals

The following article was written by a colleague, John P. Ortiz.
John is a partner in Tatum’s Healthcare Services practice.
I want to express my gratitude for John's contribution to Arnie's CFO Spot, as this is an important and timely topic for the industry.

Healthcare Looks to Other Industries for Cost Management


Historically, the healthcare industry has not been faced with overwhelming pressure to know, understand and manage costs. Some services have been and are still reimbursed based on cost actually incurred. Cost-plus revenue arrangements have historically left little incentive for managing those costs.

Times have changed. Today, more pressure exists to manage healthcare costs: Medicare at-risk, Medicaid at-risk, Pay-for-Performance, Accountable Healthcare Organizations, managed care and the rising cost of caring for the indigent. Effective operational management has never been more crucial to the success of a healthcare organization. Just as global competition has driven manufacturers to better understand and manage costs, today’s pressures are providing the same impetus in healthcare. Savvy healthcare managers are beginning to take notice of the powerful tool used in other industries, cost management through activity-based information techniques. Activity-based information techniques have the potential to be the business weapon of this century and beyond for healthcare.

Tools for Different Needs

Activity-based information techniques include two powerful components: activity based costing (ABC) an accounting tool and activity based management (ABM) a management tool. Activity-based costing looks at cost from a strategic point of view to answer the question, how much does a service or procedure cost?” It’s a way to maintain and process financial and operating data on resources, activities, the things that drive cost, cost objects (e.g. the organization’s patients, service lines, payers, physicians and network facilities), and activity performance measures. It also assigns cost to activities and cost objects.

Activity-based management takes an operational point of view to answer the question, “What makes costs occur?” It studies the things that drive costs and the activities that go into processes, and helps measure performance. ABM relies heavily on ABC information.

Not your Father’s Cost Vehicle

Organizations that calculate profitability by service line or patient usually rely on traditional cost allocation accounting. For example, a material burden charge might be allocated to the surgical services department. This method helps executives understand cost according to the revenue that’s generated.

Cost allocation is a straightforward idea for healthcare executives, but it has inherent problems for operations managers. An administrative overhead charge doesn’t reflect the diversity of the real work that goes on in the various overhead departments and it doesn’t give management the tools to manage costs. So to answer the question, “What do things cost?” healthcare financial officers have started to look at techniques used in other industries including ABC.

Traditional Cost Cutting Failures

When an organization uses traditional methods of cost accounting and want to trim expenses, cuts may be made in the wrong places. For example, executives may call for across-the-board cuts. The tactics commonly used include hiring or wage freezes, or eliminating entire portions of a budget which may improve expenses in the short term but be harmful in the long run. The organization might try benchmarking, though most benchmarking projects don’t shed light on the processes that lead to excellent results. The organization might focus on trimming the highest cost areas. But resource costs don’t provide information on activities or their value to the organization. For example, knowing someone’s salary doesn’t shed light on that person’s activities or the value they add. If managing costs in a business were as easy as saying just cut 10% across the board, then why not cut 20%. What about 50%? What the heck, cut 100% of the cost. That will really trim expenses. The obvious reason executives in healthcare have historically not specified large cuts is because they know they have no idea what effect an across the board reduction will have on their organization. So the smaller the reduction, the less likely it is for major problems to crop up.
ABM can bridge the gaps. Using activity cost as the starting point, ABM helps managers find out if those activities add value. To determine this, it provides a platform for analyzing, ‘What causes costs to occur?” In taking this approach, ABM focuses on “cost drivers” and performance measures. A Cost driver is any factor which causes a change in the cost to be incurred. There are multiple cost drivers for any activity. Understanding the significance of cost drivers, both individually and in combination with each other, is the key to both understanding what causes costs to occur and how to reduce costs.
Performance measures are used to measure the output of activities. They include not only measures, but also non financial measures such as quality, cycle time, and customer satisfaction. Understanding the impact that activities have on key performance measures is critical to achieving the optimal answer, not just the lowest cost. If the lowest cost is the only objective, simply eliminate the activity. Eliminating an activity yields no cost, however, it also eliminates any benefit the activity was providing which may have included reducing costs in other areas such as preventative maintenance.

To illustrate the power of activity-based information techniques consider the following scenario: Hospital management has dictated a 10% reduction in costs. Which expense statement below would be the most helpful in achieving the goal?

Medical/Surgical Unit                                         Medical/Surgical Unit
Labor                               $525,000                  Deliver Care                        $225,000
Benefits/Payroll Taxes          90,000                  Document Care                      115,000
Supplies                              60,000                   Process Patient Orders           110,000
Depreciation                       60,000                   Transport patients                   75,000
Other Costs                         40,000                   Obtain Test Results                 70,000
  Total                             $775,000                 Admit Patients                        50,000
                                                                        Process Transfers/Discharges 30,000 
                                                                        Develop Care Plan                25,000
                                                                        Perform General Admin.        75,000
                                                                          Total                              $775,000 
Obviously focusing on Processing Patient Orders and Documentation of Care would be a good starting point that traditional cost measures would not have surfaced as a problem.
Understanding activity-based techniques can dramatically improve healthcare management’s ability to make wise cost reduction decisions that are based in fact, sustainable over the long haul, and not at the expense of quality.

ABM is becoming widely recognized as an effective tool to manage costs in healthcare. The Healthcare Financial Management Association in conjunction with Tatum, one of the leaders in ABM, has teamed up recently to develop courses to train healthcare executives on ABM. Courses are being scheduled for the fall of 2010 and the spring of 2011.
For further information on ABM, contact John Ortiz at Tatum, at 678-637-4823.

Once again, my thanks to John. What is your facility doing with respect to managing cost?