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INTRODUCTION
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
raised.
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
activities.
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
process-oriented.
This is discussed in more detail in the subsequent sections and illustrated
below.
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
processes.
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.
ORGANISATION PROFILE
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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