Thursday, May 31, 2012

abc costing

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The last 10 years have brought substantial changes to the health care

industry. Managed care fee reimbursement structures have many physicians

working harder, but earning less. Costs for providing medical services have

increased, while payments for those services have decreased. Capitation has

shifted insurance risk to the medical practice, and many physicians and

administrators do not know how to adequately evaluate the performance of

their managed care contracts. To remain profitable in this environment, a

physician needs accurate cost information from which informed business

decisions can be made.

The health care industry can use techniques developed by manufacturing

companies to help them remain profitable, eliminate unnecessary costs and

plan for change. The growing demand for high-quality, low-cost products

led manufacturers to develop a methodology called activity-based costing,

or ABC. This technique identifies the relationship between an activity and

the resources needed to complete it. It then assigns costs to the resources

consumed by the activity. This technique can be effectively applied to a

medical practice. When a practice knows how much it costs to provide a

specific service, informed managed care decisions can be made.

Actuarial data can be used to predict procedure utilization, and through these

data, the number of procedures the practice will perform under the contract

can be estimated. Cost figures can be applied to these estimates for a

projection of how much it will cost the medical practice. The amount the

practice will receive can be compared with what the practice anticipates it

will cost to provide services . The difference will be profit or loss. Any

profitability estimate is a guess, but accurate cost information can make that

guess an educated one.

Activity Based Costing (ABC) is an accounting technique that

allows an organization to determine the actual cost associated with each

product and service produced by the organization. Activities can be defined

as a named process, function, or task that occurs over time and has

recognized results.

Activities use up assigned resources to produce products and

services. Inputs are transformed into outputs under the perimeters set by

controls performed by the organizations employees and their tools.

Activities can be perceived as consumers of resources in production of

materials, services, events, or information. Activities are the common

denominator between business process improvement and information

improvement. Documenting and understanding activities is necessary in

order to improve the business process, since activities are the building

blocks of business processes.

When employees understand the activities they perform, they

can better understand costs based on the activities. Traditional financial

information is reorganized by ABC into a form that makes sense to the

casual functional user; in addition to the usual information that tells them

how they spend money, it also tells them what to do with the money. This

ability to place costs on activities and their outputs provides a clear metric

for improvement, whether for determining improvement priorities in the

long-term or for measuring near-term success. ABC allows functional users

to characterizethe value of, or need for, each activity, getting rid of the waste

before automating (or reautomating) activities.

Activity-Based Costing (ABC) arose in the 180s from the

increasing lack of relevance of traditional cost accounting methods. The

traditional cost accounting methods were designed around 1870 - 10 and

in those days industry was labor intensive, there was no automation, the

product variety was small and the overhead costs in companies were

generally very low compared to today. However, from the 160s �

particularly 180s - this changed rapidly. For these reasons, and more,

traditional cost accounting has been called everything from number 1 enemy

of production and questions whether it is an asset or a liability have been


The question of course is whether ABC has overcome these deficiencies or

not? It has. In fact, ABC has been called one of the most important

management innovations the last hundred years.

So what is really the difference between ABC and traditional cost

accounting methods? Despite the enormous difference in performance, there

is only three major differences

In traditional cost accounting it is assumed that cost objects consume

resources whereas in ABC it is assumed that cost objects consume


Traditional cost accounting mostly utilizes volume related allocation

bases while ABC uses drivers at various levels.

Traditional cost accounting is structure-oriented whereas ABC is


This is discussed in more detail in the subsequent sections and illustrated


But first, the directions of the arrows are different because ABC brings

detailed information from the processes up to assess costs and manage

capacity on many levels whereas traditional cost accounting methods simply

allocate costs, or capacity to be correct, down onto the cost objects without

considering any cause and effect relations.

Consumption of resources versus consumption of activities

ABC acknowledges that you cannot manage costs, you can only manage

what is being done and then costs will change as a consequence. In

traditional cost accounting, however, the underlying assumption is that costs

can be managed, but as most managers have found out the hard way �

managing costs is almost impossible.

The benefit of the ABC mindset is that it opens up for a much wider

array of measures when it comes to improving productivity. By investigating

systematically what is being done, i.e. the activities, one will not only be

able to identify surplus capacity if it occurs, but also lack of capacity and

misallocation of capacity. A result of this might be that costs are cut the

traditional way, but it might as well lead to a reallocation of capacity to

where it is most needed which will yield high productivity more effectively

than the traditional way.

Volume related allocation bases versus drivers at many levels

Due to the historic background of traditional cost accounting methods, they

tend to use direct labor - or other volume related allocation bases - for cost

assignment purposes. But as overhead has grown and new technologies have

come, it goes without saying that assigning costs based on only 5 - 15% (in

most companies) of total costs is highly risky. In fact, the incurred errors are

up to several hundred percent!

In ABC, however, costs are assigned according to the cause and effect

relationship between activities (the actual process) and cost objects, which is

captured using drivers. The drivers are therefore not allocation bases in the

traditional sense, although they work the same way mathematically - drivers

are estimates of actual cost behavior and can therefore also be used to

identify, or they are themselves, the critical cost factors. Because the drivers

are related to the actual processes, they occur on several levels. The four

most common levels are;

Unit level. Unit level drivers are triggered for every unit that is being

produced. For example, for a man and a machine that produces one

unit at a time, the associated direct labor will be a unit level cost

driver. This is therefore a volume related driver similar to the

traditional allocation bases.

Batch level. Batch level drivers are triggered for every batch

produced. A good example of that is production planning, because the

planning is done for each and every batch regardless of the size of the

batch. Here, number of batches can be a good driver.

Product level. Product level drivers are triggered for every product

regardless of the number of units and batches produced. These drivers

occur by the sole existence of a product. A good example of a driver

is the number of product development hours per product so that the

more product development hours a product triggers, the more product

development costs should be assigned to that product.

Facility level. Facility level driver are drivers that are not related to

the products at all. Costs that are traced by such drivers will therefore

be allocated to products and not traced. The difference between

allocation and tracing is that allocation is quite arbitrary whereas

tracing is based on cause and effect relations.

Hence, we see that the traditional usage of fixed and variable

costs is totally meaningless. In ABC, all costs are included. While we

discuss drivers it is important to mention that in ABC there are two types of

drivers w.r.t. cost assignment;

Activity drivers that keep track of how cost object behavior

influences activity levels, i.e., the level of activity for each activity.

Resource drivers that keep track of how the subsequent activity level

affects the resource consumption.

Before we continue it is important to mention that in early terminology

activity drivers were referred to as second stage cost drivers whereas

resource drivers were denoted first stage cost drivers. But it is evident that

the word cost driver is misleading in this context because activity- and

resource drivers do not tell what drives costs in the general case.

Therefore, in Activity-Based Management (ABM) a third type of drivers is

employed in addition to the two aforementioned drivers. This type of drivers

is called cost drivers and they are the underlying causes of costs of activities

and measured by non-financial performance measures. Today, the most

important of these measures can be presented in a Balanced Scorecard and

they represent the process view in ABM.

Structure-orientation versus process-orientation

Traditional costing systems are more concerned about the organizational

charts than the actual process. Traditional cost accounting systems are

therefore structurally oriented and the process view is completely missing

The result is that one cannot ask what needs to be done?, because the

process is unknown. The only questions such costing systems can give

answers to, although often off the mark, is what do we have at our disposal

to do the job?.

The latter question is a question of capacity, that is, how capacity is

managed. Capacity is measured as an expense and found easily in the

accounting system. The first question is a question of resource management,

because resources is what you need in order to do a job and measured as a

cost, but the resource measures can only be found by investigating the


Thus, because ABC is process-oriented and gathers information

from the processes it can be used to identify both what needs to be done?

and how to allocate resources most productively. ABC can therefore give

managers the ability to match the resource needs with the available capacity

as closely as possible, and hence improving productivity. From this we

understand that the structure oriented approach of traditional costing systems

gives no decision support in allocating capacity to match resource needs.

Over time this leads to cost inefficient organizations and poor profitability.

There is also another aspect to process-orientation; how ABC is used

and implemented. Because ABC can direct attention towards the causes of

costs (critical success factors) related to both cost objects and processes and

not to mention the cost of quality, ABC is viewed as more than a method for

cost accounting - it invites to a whole new way of management, such as;

The identification of critical success factors that enables continuous improvement of product- and process design.

The link between cost information and other information enables a much wider array of improvement strategies than traditionally acknowledged.

The identification of the cost of quality and the process-orientation in ABC open up for a very powerful link to Total Quality Management (TQM) where both ABC and TQM can realize their fullest potential.

From the above discussion it should be evident that not only is ABC useful

and powerful to any organization, but a need for companies that want to

excel, and efficiently and effectively increase their Sustainable Competitive Advantage (SCA). As one marketing executive said This is revolutionary!.

Components of ABC

Before performing ABC, a baseline or a starting point is needed for

business process improvement , and a baseline can be expressed in some

form of model. A baseline is a documentation of the organizations or

agencys policies, practices, methods, measures, costs and their

interrelationships at a particular location at a particular point in time.

Through baselining, activity inputs and outputs across functional lines of

business can be identified. ABC is the only improvement methodology that

provides output or unit costs.

An important function of ABC is for the organizations activities to be

defined as value added or non-value added. Value added activities are those

for which the customers are usually willing to pay (in some way) for the

service. Non-value added are activities that create waste, result in delay of

some sort, add costs to the product/s, or for which the customer is not

willing to pay.

Resources are assigned to activities to allow them to be conducted;

performing the activity results in a cost that can be priced, which can be

assigned to the primary output. It is through ABC, that an organization can

begin to see actual dollar costs against individual activities, and find

opportunities to streamline or reduce the costs, or eliminate the entire

activity, especially if there is no value added.

Steps for Performing ABC

Functional Managers identifies five activities that need to occur in order to

determine activity costs

Analyze Activities

. Gather Costs

Trace Costs to Activities

4.Establish Output Measures

5. Analyze Costs

Analyze Activities

First the scope of the activities to be analyzed must be identified. A

determination then is made if an activity is value or non-value added; also if

the activity is primary or secondary, and required or not needed. Value

added is determined if the output of the activity is directly related to

customer requirements, service or product, as opposed to an administrative

or logistical outcome that services the providing organization. For instance,

if the output of an activity were an inventory report or update for products

(for which there are customers), the output would be non-value added, but

necessary to the organization, i.e., overhead. A major goal of

reengineering is to reduce non-value added activities and eliminate those

that are not necessary. Primary activities directly support the organizations

mission while secondary activities support primary activities. Required

activities are those that must always be performed while discretionary

activities are performed only when allowed by the operating management.

Gather Costs

In this step costs are gathered for the activity producing the products or

services provided as the outcome. These costs can be salaries, expenditures

for research, machinery, office furniture, etc. These costs are used as the

baseline activity costs. When documents for the costs incurred are not

available, cost assignment formulas may be used.

Trace Costs to Activities

In this step the results of analyzing activities and the gathered organizational

inputs and costs are brought together, which produces the total input cost for

each activity. A simple formula for costs is provided - outputs consume

activities that in turn have consumed costs associated with resources. This

leads to a simple method to calculate total costs consumed by an activity �

multiply the percent of time expended by an organizational unit, e.g.,

branch, division, on each activity by the total input cost for that entity. Here

we are not calculating costs, just finding where they come from.

Establish Output Measures

In this step the actual activity unit cost is calculated. Even

though activities may have multiple outputs, only one is identified as the

primary output. Activity unit cost is calculated by dividing the total input

cost, including assigned costs from secondary activities, by the primary

activity output volume; the primary output must be measurable and its

volume or quantity obtainable. From this, a bill of activities can then be

calculated which contains or lists a set of activities and the amount of each

activity consumed. The amount of each activity consumed is extended by the

activity unit cost and is added up as a total cost for the bill of activity.

Analyze Costs

In the final step, the calculated activity unit costs and bills of

activity are used to identify candidates for improving the business processes.

Managers can use the information by stratifying the activity costs and

identifying a certain percentage of activities that consume the majority of

costs. The thing to keep in mind is that the identification of non-value added

activities occurs through this process with a clarity that allows us to

eliminate them, and at the same time permits the product or service to be

provided to the customer with greater efficiency.


Established in the year 188, Sri Ramachandra Medical Centre

now has 1050 beds with a full spectrum of clinical activities providing hi-

tech and comprehensive medical care. This ten lakh sq. ft hospital building

has been planned to include all services to patients under one roof and to

serve the cross section of the community. There is a good distribution of free

patients, heavily subsidised ones and the ones who will pay for the services

in full. The medical care itself is uniformly monitored to establish

predictable levels of care that will reach every patient

In general Out patient services are provided in a wide spread area

with all the facilities supervised and managed by consultants. Close to ,000

out-patient visits are recorded everyday. Where free medical consultations,

prescriptions medicines and laboratory service are given free.

In addition to the OP services, Ambulatory private clinic is available for

consultants to see private patients or patients referred by industries and

affiliate organisations. Here patients are seen by consultants and when

necessary admitted to the private wards. The services are offered on a fee for

service basis.

Quality health care is being provided by a team of committed,

highly qualified, experienced consultants. The daily charges are affordable

and a wide choice by way of room rent from Rs. 150 per day to Rs.1500 is

available. These charges include the room charges and nursing care. Special

arrangements have been made for nutritious food to be served hygienically

at bed side.

The hospital offers full range of surgical services with qualified

consultants addresses a variety of emergency and elective problems.

Specialists in surgery in every area like hepatobiliary, pancreas, liver and

intestine including surgical oncology are available on a full time basis.

Minimally invasive laparoscopic surgery has gained a special reputation in

this institution. The department of general surgery is organized into seven

clinical units, each unit having one chief, two assistants and one registrar.

The blalock OT is assigned to the general surgery units for all five days from

Monday to Friday.

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