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?

Some Financial Distress Is Self-Inflicted

Sure, there are many sophisticated and technical processes that can be applied to deal with cost management. Toyota's Lean or Six Sigma can be utilized to reduce variances in processes. Benchmarking the right indicators can identify areas of opportunity. Technology can be simply tweaked, or major EMR initiatives pursued. Clinical protocols can be established. I could go on, but you get the idea. And these steps will need to be taken to overcome the fiscal crisis faced by many hospitals (and, I would add, other industries). A good discussion of these and other techniques can be found in an article entitled Taking On the Cost Drivers, on the Health leaders media website.

But I maintain, as financial distress mounts, organizations can become so absorbed in mounting such initiatives, or perhaps are so beaten down, they fail to see opportunities that can be easily addressed by looking carefully for simple, even silly, problems. Here are two examples from my own experience, where I was involved with turnaround situations.

Let's start with a silly example. In the first week I was engaged as a CFO at a large urban hospital with a 40% Medicaid payor population, I happened to be standing near the reception desk when a FedEx courier arrived with a package. I saw the courier speaking with the receptionist for a few minutes, whereupon he turned on his heels and left with the package. I asked the receptionist what happened. Turned out the hospital had not paid it's outstanding FedEx bill, so the package was delivered COD. The receptionist had no money, so the package was not handed over. When I researched the matter, I found FedEx was owed about $125. What was in the package? A Medicaid check for $1.8 million! If someone was paying attention, the FedEx bill would have been timely paid, and the hospital, which was suffering severe cash flow problems would have received it's Medicaid funds on time.

This one is not silly, but shows how some creativity can be applied to a situation. A hospital system, again with a severe cash shortfall, could not pay it's Workers Compensation insurance premiums. As a result, the State had declined to renew several large grants, as one of the eligibility requirements was to carry Workers Compensation insurance. I spoke to the State, and indicated if they would renew the grants, we could utilize a portion of the funds to participate in a State-sponsored self-insurance fund. They agreed. The hospital obtained its insurance and obtained the grants.

This is not rocket science. Sometimes, when you're under the gun, its easy to miss the obvious. Don't let the pressures of a distressed situation keep you from scrutinizing the basics and looking for the low-hanging fruit.

I would be interested in any similar anecdotes that support this thesis.

Staff Reductions? Maybe, But How Best To Proceed?

I came across a blog entitled "Ignore Your People at Your Own Peril" by a Canadian blogger, Geoff Crane. It dealt with the problems caused by a hospital's reduction of nursing staff as a result of a non-collaborative staffing reduction on the part of management. Anyone can cut costs, and salaries & benefits are generally around 60% of a hospital's costs. No one wants to cut staff if they can help it, although the current fiscal state of many hospitals can make it unavoidable. But I agree with the author, adjustments in staffing must be done carefully. This would seem to be a no-brainer, but ill-conceived staffing cuts are not rare.

So, what's the approach to be taken? Foregive me if I'm preaching to the choir, but you've got to look at processes and responsibilities across all functions. Are there processes that can be streamlined or otherwise improved? What are the likely consequences of reducing staff in a particular department? I'm a big believer in metrics and benchmarks, They can give you a 10,000 foot look at areas of opportunity. So, bear with me as I bore through some numbers.

For example, if a hospital has 6 Full-Time Equivalent employees per adjusted patient day (a ratio of staffing compared to patient volume) and the benchmark for a hospital of equivalent size, geography, acuity, etc. is 4.7, chances are you have an opportunity to reduce staff somewhere in the facility. But where? Let's look at a single department next. Say environmental services expends 3 hours per 1,000 square feet versus a benchmark of 2. OK, maybe this an area for further exploration. Now, we get to the important part. What do the housekeepers do, and how do they do it, compared to the benchmark you're measuring against? For example, if your hospital has housekeepers changing bed linens while another hospital uses nurse aides you're not comparing apples to apples.

I don't want to run on forever here, so let me get to the key points. Involve as many functional area leaders as possible in evaluating opportunities for staff reductions. Start with metrics, benchmarks, key performance indicators or whatever, as a starting point. But examine processes carefully to identify where the reductions should occur.

Hospital CFO Priorities Shift in 2010

According to the finance component of HealthLeaders Media Industry Survey 2010, quality was moved down as a priority in favor of physician recruitment and cost reduction. No surprise, as financial results suffer the effects of the recession, and healthcare reform has raised the specter of further pressures. The survey is robust and quite comprehensive. I recommend it to you, for a detailed view of CFO's concerns and thoughts.

In an April 15th article by the same organization, entitled Moody's: Health Reform Will Drive Consolidation, Hinder Credit for Nonprofit Hospitals, Moody's Investors Services is quoted as saying healthcare reform will have a long-term negative credit effect on not-for-profit hospitals, even though it will reduce bad debt expenses and charity care. "The key longer-term challenge for the not-for-profit hospital sector is the reform's reliance on extracting long-term cost efficiencies from hospitals, probably resulting in diminished hospital revenues," said Moody's Vice President Mark Pascaris, author of the report, Long-term Credit Challenges of Healthcare Reform Outweigh Benefits for Not-for-Profit Hospitals.
In the Media Industry Survey, financial leaders ranked their top three priorities for the next three years as:

• Physician recruitment and retention (37.50%)
• Cost reduction (35.53%)
• Patient experience/patient satisfaction (33.55%)

Last year's ranking was:
• Quality/patient safety (68%)
• Physician recruitment and
  retention (38%)
• Reimbursement (31%)

During a down economy, recruitment and retention is just one avenue to get a hospital’s finances in shape, revenue management is another big area. The big question to me is, what will the hospital of the future look like, given the far-reaching changes contemplated in the Healthcare Reform Act, and what should the resultant long-term strategies be to prepare for that future? That will shape the priorities for CFOs, going forward.