Activity-based costing and balanced scorecard: a comparative case study

¶ … Healthcare Industry

Activity-Based Costing in the Health Care Industry vs. Patient Safety

Activity-Based Costing (ABC) allocates the costs of production to specific products or services. It is more precise than older methods of accounting that involved adding a broad percentage of expenditures to direct and indirect costs. The definitions of direct and indirect costs varied and were often a judgement call on the part of the accountant. ABC allowed accountants to obtain a more precise view of the costs associated with specific products or services.

ABC developed as rising overhead costs (indirect costs) made it more difficult to forecast. The technique began in the manufacturing sector, but was later adopted in other sectors such as banking and health care. Until the development of these techniques, it was difficult to predict future costs associated with products or services. The industry needed a more precise method for determining future costs associated with production. Kaplan and Brun (1987) first clearly defined activity-based costing in relation to the manufacturing industry.

Activity-based costing seeks to identify the causal relationships between expenditures and the profit realized from a product or service. ABC can identify specific areas of high overhead so that methods can be devised either to reduce costs to charge more for that product or service. The cost of an activity will be attributed to a product or service to the extent that the product or service actually uses that activity. For instance, the cost of electricity will be divided among the units that are produced. Each unity will have a cost associated with it that reflects the amount of electricity that was needed to produce that product. The amount used by each unit may be small, but collectively, this accounting method allows better cost control than assigning a general percentage to the entirety of the units produced.

Objective of the paper

ABC was developed to meet the needs of the manufacturing sector. Therefore, much of the terminology used is borrowed from the manufacturing sector. However, this technique can be applied other sectors, but it requires a change in the way one thinks about these industries. For instance, in the health case field, a "unit" might represent one procedure, or part of the procedure. Each surgical procedure on each individual patient has certain costs associated with it. Therefore, from an accounting perspective, it can be thought of as a "unit" for accounting purposes.

Costs of healthcare continue to rise on a global basis. There are many reasons for this phenomenon. However, as costs for procedures rise, it places a strain on insurance companies and individuals. As health care providers struggle to make ends meet, the patients are the ones that suffer the most. Many may not be able to afford necessary procedures due to the costs involved. Finding more efficient ways to manage costs in the healthcare industry is imperative, if industrialized countries wish to be able to meet the health needs of their citizens.

The objective of this research will be to explore how ABC can be applied to the health care industry. There are certain limitations in this method that apply to the healthcare industry, but that do not apply to the manufacturing industry. Patient safety is the most important factor in the healthcare industry. There are limitations as to costs reductions, when it would involve placing patients at greater risk. One can only go so low before cost becomes a safety issue in the healthcare industry. However, ABC can help to identify less critical areas where costs can be reduced without placing the patient at greater risk during a procedure. The following will examine this issue by case analysis to illustrate how ABC can help to achieve greater cost effectiveness.

Analysis, Findings & Discussion

ABC is similar traditional cost accounting in that it divides expenditures into direct and indirect costs. Direct costs are easily attributable to a certain activity. For instance, one can count the number of bandages, drugs, and other equipment that is needed for a procedure. As in the manufacturing industry, these items are easy to attribute to the unit costs. In the healthcare industry, as in the manufacturing industry, direct costs cannot often be reduced. One must weigh the costs and benefits of reducing costs. One might be able to find a cheaper supplier for oxygen equipment or drug, but this is not a realistic option if cheaper means inferior quality. There are some direct costs that are more critical than others in this respect. In many cases, there is no way to reduce direct costs in the healthcare industry without compromising patient safety. Therefore, direct costs will be the primary focus of cost reduction in the healthcare field.

Although there is little that can be done in the healthcare field to reduce direct costs associated with a procedure, there are many ways to reduce indirect costs. This is where ABC becomes an important tool in the healthcare industry. Certain indirect costs (overhead) are more difficult to attribute to each unit. In order to attribute these costs to their assigned unit, some type of weight must be assigned to them.

A key case for the use of ABC can be found in the healthcare sector that encompasses blood transfusion services in the UK (Lapsley, 2005). Services in the UK are similar to those in the United States and in other industrialized nations. This is a global problem and is not restricted by region or locale. As in the U.S., blood is collected and distributed by regional centers. In the UK, there are four centers, but in the U.S. there are more (Lapsley, 2005). Volunteers donate blood at these centers. The raw material (blood) is free. However, before it becomes the final product used in transfusions, it must go through a long line of processes to assure its safety. It must be collected, processed, tested, packaged, and then delivered to the final location. These processes must occur on a daily basis (Lapsley, 2005).

This process is an excellent example of how the healthcare industry can have a low direct cost, but can incur mounting indirect costs that must be attributed to the final product. The final recipient of the "free" blood must pay for it in some manner, either by insurance or self-pay. Therefore, there must be an elaborate system for assigning indirect costs that are associated with each phase of the process from volunteer donation to final product delivery.

There have been several recent events that effect direct costs in many phases of blood processing services. For instance, higher fuel costs effect delivery. The discovery of HIV and Creutsfeldt-Jacob Disease (vCJD) have meant higher costs of collection and testing to improve safety of workers and patients alike (Lapsley, 2005). More steps had to be included in the process from volunteer blood donor to final delivery to the patient. These are still considered to be indirect costs and must be attributed to each final unit of blood delivered.

Many of these processes are accomplished through batch processing, but the end patient is the one that pays for the units of blood needed. The patient is billed for the units of blood needed as if blood is a direct costs. A unit of blood represents a product that can be assigned and billed to a particular customer (patient). However, unlike the production of a manufactured good, there is no direct cost associated with it, because the raw material is "free." Indirect costs account for almost 100% of the price associated with a unit of blood delivered to a patient. This case study illustrates how indirect costs have a more direct impact on the final costs of service in the healthcare industry than in any other sector of the economy. ABC is an effective method for assigning indirect costs in the healthcare industry.

Suggestions, Recommendations & Conclusions (2 pages)

ABC method is not perfect and there are some limitations that cannot be overcome by this method. It can be argued that ABC cannot be applied to the healthcare industry due to the limitations imposed by patient safety. One must be careful to keep the mission and objectives of the facility in mind. While it is important to reduce costs, it is important to make certain that the safety of the patient are not sacrificed for the sake of the bottom line. For this reason, it can be argued that ABC should not be applied to the healthcare industry, but rather it should rely on traditional accounting methods.

There are some overhead costs that are more difficult to attribute to a unit. This is true in any industry, not just the healthcare industry. Executive salaries are one example of this. This expenditure is difficult to assign to a specific patient. However, this is a necessary expense for the healthcare facility. These types of costs are treated as "business sustaining" and are not assigned to a particular patient, as there is no effective means of doing so. However, ABC does not allow for costs to be unattributable to an end product. Therefore, although executive salaries and other similar costs are difficult to assign, a method must be developed for doing so, if the accounting is to be the most effective. One method might be to divide the executive salaries by the average number of patients seen in the facility over the year, or some similar method. This is only one example of how an indirect expense can become a direct expense using ABC methodology.