3.3 The ‘third stage’ (Dyson, 2001: 294) is to identify the factors that influence the costs of a particular activity, for example the costs of a hip replacement operation ranges from £480.00 to £9,337, depending on the hospital. The variations in costs could depend on the size of the hospital, the number of patients, the funding received and the reputation of the hospital in terms of the surgeon’s credibility.
3.31 The term cost driver is used to describe the ‘events or forces that are significant
determinants’ (Hussey & Hussey, 1999: 214) of the costs of the activities. In other words, cost drivers represent those factors whose occurrence creates the costs. For example, if for a bypass operation a heart-monitoring machine were required, it would represent the cost driver for a heart bypass operation.
- The final stage is to ‘trace the cost of the activities to the products’ (Dyson, 2001: 296) according to a products demand for the activities. The number of transactions it generates for the cost driver measures a products demand for the activities. If we assume, for example, that the total costs traced to the cost centre for a particular operation was a £100,000 and that there were 100 operations during the period. The charging out rate would be £1000 per operation. ABC would trace the costs of other activities using a similar approach.
Possible causes for the variations (in reference to a CIMA study of Accountants and Finance Directors)
A CIMA study was carried out to ‘examine the challenges faced by NHS cost accountants’ (Northcott & Llewellyn, 2001) to explore the cost variations between hospitals for healthcare cost information to be useful for ‘benchmarking and decision-making’ (Northcott & Llewellyn, 2001).
- Possible causes for the variations could be the following:
- The Costing approach used in each hospital could be different in terms of
allocating ‘indirect and overhead costs’ (Northcott & Llewellyn, 2001). Certain trusts could be using unreliable costing methods, as only minimum standards are required by the guidelines that therefore allow room for these methods.
- Costs may not be directly comparable as cost accountants find it difficult to decide which is the best allocation approach to use.
- As it is impossible to measure the actual cost for every procedure that is performed in a hospital to construct efficient ‘costed care profiles’ (Northcott & Llewellyn, 2001), which are used to identify a standard cost for healthcare procedures, this causes variations in the costs. The CIMA report identified how hospitals achieved different levels of accuracy in tracking cost-driving activities within costed care profiles. These differences were seen as a barrier to producing systematic and comparable cost information.
- Healthcare resource groups (HRG) are the cost objects to which hospital costs must be attributed. They are assumed to represent clinically similar treatments, to consume similar quantities of resources, and to incur similar costs across all trusts. However the ‘make-up of HRGs’ (Northcott & Llewellyn, 2001) may differ between hospitals due to the nature and complexity of the hospitals. For example a ‘specialist or teaching hospital’ (Northcott & Llewellyn, 2001) may take on a more complex case than a local general hospital in the same HRG.
- Another aspect of costing HRGs is the time that patients spend in hospitals. A patient’s length of stay in a hospital bed is usually related to the severity of their condition or the complexity of their treatment. Length of stay varies widely between trusts causing variances in costs in different hospitals.
- There could be variations in hospitals information systems which are needed to collect the information needed to cost healthcare activities. Systems for gathering information on patient admissions, theatre information and general ledger records can be inefficient to capture and report reliable and complete information for the costing exercise. The problems, which could occur, are: costs data from the general ledger could be incomplete; activity data could be inconsistent and incomplete; and measures of cost-driving activities within hospitals could rely on poor information systems.
5 Advantages and Disadvantages of activity-based costing
5.1 The main advantages of activity-based costing are as follows:
- A ‘more equitable method of charging costs to products’ (Bendry, Hussey & West, 2001: 447) – The products that use the activities, which cause the costs to be incurred bear, those costs associated with those activities in a more equitable manner. This overcomes the drawback in absorption costing where general overheads are spread over the product range in using methods largely unrelated to the way costs are generated.
- Takes into consideration product complexity – ‘The costs charged to products relate to the production circumstances’ (Glautier & Underdown, 2001: 525) in which those products are produced, Under ABC, short runs and complex products might attract consequently higher levels of unit cost compared to long runs and simple products. This aspect would have considerable impact, therefore, in the measurement of relative product profitability compared to the absorption costing approach.
- Costs are more closely related to activity levels – Those costs, which under absorption and marginal costing approaches are traditionally regarded as fixed in total, ‘may be treated as variable in the longer term under ABC’ (Atrill & Mclaney, 2001:223). As a consequence ABC encourages the measurement of efficiency levels of administrative functions.
- Improves cost control – ABC reflects more closely what is happening in the production environment and ‘identifies those elements which should be subject to managerial control’ (Hussey & Hussey, 1999: 302). It recognises that cost management can be best achieved through the management of those activities which cause costs to be incurred.
5.2 The Disadvantages of activity-based costing are as follows:
- More detail analysis required – A more ‘detailed analysis of cost pools and cost drivers’ (Atrill & Mclaney, 2001:223) than necessary for absorption costing is usually required for an effective ABC system, with the consequent increase in the cost of administration of the accounting system.
- ‘Does not always conform to SSAP 9’ (Hussey & Hussey, 1999: 312) –The ABC system encourages all costs, including selling and distribution costs, to be charged to work-in-progress and finished goods as product costs. This cuts across the normal basis for valuing stocks for financial accounting purposes. ‘SSAP No.9 requires stocks and work-in-progress to be valued at total production cost up to the stage of production reached’ (Hussey & Hussey, 1999: 313), which would normally exclude selling and distribution costs.
- A more complex system of absorption costing – ABC is regarded by some as not so very different from absorption costing in that absorption rates for each driver are still required.
6 The Traditional Costing Approach – Absorption Costing
Absorption costing is a method, which ‘gathers together all the direct costs and the indirect costs’ (Dyson, 2001: 428) to arrive at a total cost for a product. The indirect costs comprise the production, selling, distribution and administration overheads. In many businesses the overheads are extremely high and therefore it is essential to find a suitable method for charging them to each unit cost.
6.1 Techniques for measuring production
In absorption costing there are a ‘number of ways of measuring production’ (Glautier & Underdown, 2001: 415). This is because a single measure would not be appropriate to all the cost centres, because not only do the production methods vary but also the types of products being produced. There are ‘six ways in which production can be measured’ (Fleming & McKinstry, 1998:206) in order to calculate an overhead cost absorption rate.
6.2 Drawbacks of absorption costing:
- The encouragement of production for finished stock – As overhead absorption rates are based on budgeted projections, provided actual costs do not exceed budgeted levels, when actual production exceeds budgeted production levels an ‘over-recovery of fixed production overheads results’ (Glautier & Underdown, 2001: 402).
- Costs are not incurred solely on a direct labour basis – ‘Absorption costing uses direct labour as a basis for absorbing production overhead costs’ (Dyson, 2001:282) by the product in spite of the fact that many of the overhead costs are fixed and not incurred on the same basis as, or are driven by, direct labour.
- Fixed costs tend to be independent of production levels – Absorption costing often ‘charges fixed costs to products based on production volumes’ (Drury, C, 1999: 298) a basis which fails to recognise that fixed costs tend to be incurred independent of production levels. This approach fails to recognise the activities or cost drivers, which cause such fixed costs to be incurred.
- Absorption costing and variance analysis – The usual variance analysis associated with absorption costing and standard costing is often meaningless.
7 Illustrating the cost effectiveness of using ABC in Hospitals
A Hospital’s product can be defined as a patient’s stay and treatment. To illustrate the effectiveness of ABC I will concentrate on one type of service provided to each patient, which is ‘Daily Care’ (Hussey & Hussey, 1999: 423). Daily care involves three activities, which are hospitalisation (admission and discharge), hotel services (accommodation and food) and nursing care. Patient days are classified as Output. Traditionally, hospitals have assigned the cost of daily care by using a daily rate (a rate per patient day), which is computed by dividing the annual cost of hospitalisation, hotel services and nursing care by the unit’s capacity expressed in patient days.
7.1 Within each unit (for example intensive care unit and obstetrics unit) all patients are charged the same daily rate. However, ‘the traditional method does not take account of the fact that the three activities may be consumed in different proportions by patients’ (Hussey & Hussey, 1999: 423). This would imply product diversity and a possible requirement to use more than one activity driver to assign daily care costs accurately to patients.
7.2 An illustration of a ‘private maternity unit’ provided by Hansen & Moven, (1995) for which the following activity and cost information applies:
The activity pool rates are £100 per patient day and £20 per nursing hour.
The traditional approach for charging daily care would produce a rate of £200 per patient day (£2,200,000 / 11,000). Every maternity patient, regardless of type, would pay the daily rate of £200. However assuming that within the maternity unit there are three levels of increasing severity: ‘normal patients, caesarean patients with complications’ (Hansen & Moven, 1995), and that they have the following annual demands:
(Hansen & Moven, 1995)
Using the pool rates for each activity, a different daily rate is produced for each patient, which reflects the different demands for nursing services:
(Hansen & Moven, 1995)
This shows Activity Based Costing can produce considerable product costing improvements in hospitals as they experience product diversity.
8 Conclusion
From a managerial perspective an ABC system offers more than just more accurate cost information. It also provides information about the cost and performance of activities and resources. Knowing the cost of activities, their importance to the organisation and how efficiently they are performed allows you to focus on those activities that might offer opportunities for cost savings. If activities are linked across departments forming ‘cross-functional processes’ (Fleming & McKinstry, 2001: 205), the model structure of an organisation is simplified and powerful information results.
8.1 These are the Health Business Issues – For a costing system which is not activity
based:
- Lack of good information
- Requirement to understand costs
- Requirement to satisfy ever-changing statutory information demands
8.2 The Business Benefits achieved by Activity Based Management include the
following:
- Identifies full costs of organisation
- Identifies value-adding and non-value-adding processes and activities
- Improved information to support decision making
- Supports internal and external benchmarking.
8.3 It is recognised that absorption-costing systems suffer from a number of drawbacks, particularly when applied to modern service systems. The development of the activity-based costing approaches in the service sectors have gone some way to overcoming the drawbacks associated with absorption costing.
8.4 Activity Based costing is the most appropriate costing approach to use for efficient results and to reduce costs in hospitals. If adopted by all hospitals, the variables acknowledged in the views of Gordon Brown will be diminished.
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