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Application of ABC Method in Hospital Management
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2. Application of ABC Method in Hospital Management
BORIS POPESKO
Department of Enterprise Economics
Tomas Bata University in Zlín
nám. T. G. Masaryka 5555, 760 01 Zlín
CZECH REPUBLIC
popesko@fame.utb.cz
PETR NOVÁK
Department of Enterprise Economics
Tomas Bata University in Zlín
nám. T. G. Masaryka 5555, 760 01 Zlín
CZECH REPUBLIC
pnovak@fame.utb.cz
Abstract: - Paper analyses the present situation in application of Activity-Based Costing method in hospital
management. Primary objective of the paper is to analyze the worldwide use of this method in healthcare sector
and predict the possibilities of application of hospital wide ABC system. First part of the paper analyzes the
ways of ABC implementation in published foreign studies. Second part outlines the individual steps in ABC
application a discusses the differences in the application procedures in different ABC applications. Primary
objective of the paper is to outline the general methodology of the ABC application in hospitals.
Key-Words: - Healthcare management, hospital management, cost management, Activity-based costing,
variable costing, process.
1 Introduction
Hospital organizations have been facing difficulties
and challenges in balancing limited resources and
costs to provide their demand for services. Medical
research has the effect in introduction of modern
medical techniques and medicines, which usually
causes the increase of consumed costs. Increasing
costs of healthcare systems have the growing
demands on the public budgets, and also the patients
expenditures. Many countries start to seek the
alternative sources of financing of healthcare
systems, because the traditional systems of
healthcare insurances are no more sufficient for
covering of expansive healthcare services costs.
In face of these tendencies, many hospitals are
under pressure to become more cost efficient. In this
situation, attention to the acceptable accounting and
costing systems is paid, in order to improve the
efficiency of existing operations. [11] comments,
that healthcare organizations use cost accounting to
estimate the unit cost of services they
provide. Such information helps establish a realistic
budget; prices, identify inefficiencies and project the
effect that changes in demand would have on
resource requirement.
As in the case of manufacturing organizations,
one of the key factors of effective company
management is ability of accurate estimation of the
cost of products. Product costing is an essential
economic tool used to quantify the cost of individual
interventions carried out.
[7] states, that most hospitals with costs
management systems, use the absorption method.
Traditional costs methods have caused distortions in
indirect costs and financial reports normally do not
provide the managers’ interpretations and actions
for the control of deviations related to specific
problems; also, their actions are rarely reflected in
accounting reports, [2, 3, 21, 28] leading to
frustration.
The difficulty inherent in choosing a proper and
accurate product costing method for manufacturing
enterprises has been widely discussed by academics
and practitioners [9, 20]. The important limitation of
traditional (absorption) costing methods had been
also deeply discussed along with advantages of
other costing method as Variable costing or
Activity-based costing (ABC) [15].
Non-manufacturing sector [29] and the current
complexity of cost structure and outputs of
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3. organizations lead to frequent preference for modern
costing methods (Variable costing method and
Activity-based costing) over traditional absorption
costing.
[6] states that more developed cost systems such
as activity-based costing (ABC), may facilitate
strive for cost efficiency. ABC provides more
detailed cost information on the activities of the
hospital, which could typically result into better cost
reduction and cost management.
[7] supports the use of ABC in hospitals with
statement, that information generated by ABC
significantly contribute to hospital management in
planning and managerial control, as they enable
organizational behavioral changes by enhancing the
attention focus for activities due to volumes.
Application of the ABC in healthcare institution
entails a number of predictable benefits, especially
the ability to quantify the actual costs of activities,
to identify the relationship between the costs and
means of carrying out these activities, to identify
capacity influences on the overall costs of the
organization and in the assessment of legislative
issues regarding the reimbursement of particular
performances to also measure the “profitability” of
provided operations. It is necessary to view
profitability in this case as an identified discrepancy
between the amount of reimbursement for a certain
performance and the actual (full) cost after taking
into account all overhead costs [23].
Despite the fact that Activity-based costing
methods had been originally developed for the use
in the manufacturing organizations, use of the
method in non-manufacturing sectors, such as
services or healthcare is not unique, but relative
frequent. ABC applications in manufacturing
organizations have remained the focal point of
interest for academics and practitioners during the
1990´s, but in the middle of the decade, we can
identify the early applications of the method in
healthcare institutions incurred.
2 Problem Description
Despite the proved advantages of the ABC
applications in manufacturing and non-
manufacturing sectors, such as: better understanding
of process and activity costs correctly quantifying
the costs of distinct production/service activities,
some authors [8] points at the number of
disadvantages, such as high complexity of the
system or large amount of non-financial data
requirements.
[30] states, that the most of the early applications
of the ABC method in healthcare organizations
focus on a narrow application of the method to a
department in the healthcare organization. For
instance [14] examines the application of the ABC
to the costing of laboratory tests, [24] examines the
application of ABC in hospital’s radiology
department and a nursing station and finally [4]
publicised the application of ABC in X-Ray
department of the hospital. Similar narrow
applications of the Activity-based costing are
frequent also recently. For instance, [13] examines
the use of the ABC in hematopathology laboratory,
[7] report about ABC application in central
sterilizing services and [25] examined the
application of the method in heart centre.
These partial application of the Activity-based
costing could effective solve any specific problems
of the department management or support the
managerial decisions on the department level, but
are usually unusable for the overall hospital
management.
One of the earliest studies, examining the
organization wide application of ABC in hospital,
was published by [30]. His study examines the
hospital inpatient services. He states that outpatient
care generally involves the much larger number of
units of service with relatively small cost per unit.
ABC can nonetheless be applied to a few selected
high-volume and high-cost-low-profit outpatient
services. Some of the more recent studies focus on
more detail features of ABC in hospitals [19, 27],
and connections of ABC with other managerial
techniques such as benchmarking [12], process
management [25] or management systems [26]. No
relevant regional specifics of ABC application in
hospitals could be identified. The published studies
reports about successful applications in USA [30],
Sweden [25], Belgium [27], Turkey [1], Japan [5],
Taiwan [19], India [13], Spain [12] or Brazil [7].
As stated above, most of the studies focus on
specific parts of the healthcare organizations or
individual departments. Most important reason for
those partial applications is high difference between
the activity, product and cost structure in specific
parts of organizations. ABC application in
individual parts of the hospital could also lead to
different managerial objectives.
Despite the relatively high number of existing
applications use of the Activity-based costing
method in hospital management still entails a
number of issues related to the practical
applicability of costing for the health organization
environment, and its further practical usefulness for
decision-making bodies and characteristics of
specific information outputs of such methods
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4. especially for the specific conditions of national
legislative environment.
As stated above, application of the ABC method
in healthcare service provider could bring a lot of
benefits for an organization, but brings also large
number of risks related to bad system construction
and utilization.
[27] states that while several articles have
advocated the use of ABC by service organizations
in general and healthcare organizations in particular,
there is, nevertheless, need for some degree of
caution. [17, 18] argue that a potential drawback of
ABC systems lies in the time and resource
consumption associated with the development and
management of these systems. [16] note that the
high time and cost to estimate an ABC model and to
maintain it through re-interviews and re-surveys –
has been a major barrier to widespread ABC
adoption. In a similar vein, [10] claim that many
managers who have tried to implement ABC in their
organizations, including healthcare managers, have
abandoned the attempt in the face of rising costs and
employee irritation.
3 Problem Solution
Together with the emergence of ABC methodology
in 1980´s, issues relating to the practical application
in different types of organizations have been
presented by both academics and practitioners. [9]
defined the necessary steps to set up an ABC system
as follows:
1. Identifying the major activities taking place
in an organization
2. Assigning costs to cost pools/cost centers
for each activity
3. Determining the cost driver for every
activity
4. Assigning the costs of activities to products
according to their individual demands on
activities
It is obvious that the application of the ABC in
healthcare institution will have a lot of specifics
especially in the first step of application, where the
individual activities are defined. Despite the fact,
that the healthcare institution provides the
oppositely different activities and tasks, logically
the system construction could be similar to the
manufacturing organization.
[30] defines the seven steps in ABC application
in hospital management, which focuses more on
practical application procedure of the system than
on the system structure:
1. Form a cross functional steering committee
2. Identify case types/DRGs1
for analysis
3. Profile the health care delivery system
4. Aggregate activities
5. Analyze cost flow using cost drivers
6. Educate hospital staff about ABC
7. Evaluate and analyze data and results
Interesting issue of this application is the fact
that cost object definition is made before the activity
analysis. Udpa´s study [30] results showed the
several important characteristics of ABC application
in healthcare institutions:
• Key cost object, which is used for cost
allocation are DRGs. In some situations use
of the DRGs as the cost object could lead into
distortions when DRGs are broad based and
includes case types that are non-homogenous.
• Number of performed actions is too detailed
for effective use in ABC system. Performed
actions had to be aggregated.
Different approach to ABC application was
published by [19] who used the following steps:
1. Activity analysis
2. Cost structure analysis
3. Identification of cost object
4. Data collection for activity analysis
5. Data collection of cost assignment
Specific of the Lin´s study [19] was use of the
individual patient as the cost object. Study uses also
strict separation of the defined activities into
primary and secondary (support).
Primary activities might relate to actions which
the organization performs to satisfy external
demands, while secondary refers to those performed
to serve the needs of internal “customers”. This
classification is essential for cost allocation
procedures. In healthcare organizations, we can
identify the higher importance of support activities,
which could consume also the higher volumes of
costs, than in manufacturing organizations [23].
[7] use the application procedure, which is very
similar to traditional procedure presented by [9].
The study defined the following steps:
1. Institutional and analysis unit diagnosis
1
Diagnosis-related group (DRG) is a system to classify
hospital cases into one of originally 467 groups. The 467th was
"Ungroupable." The system of classication was developed as a
collaborative project by Robert B Fetter, PhD of the Yale
School of Management, and John D Thompson, MPH of the
Yale School of Public Health. The system is also referred to as
"the DRGs," and its intent was to identify the "products" that a
hospital provides.
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5. 2. Processes mapping and activities
identification
3. Activities and resource drivers cost
4. The cost of cost objects and activity drivers
Costs objects or costs objectives in their study
are costing sterilization and disinfection by
cycle/load and by the groups of products performed
in this CSS. They were grouped considering the
type of processing; physical chemical disinfection
and pressurized and LTSF steam sterilization.
Based on the other published studies, there is
possible to define the general specifics of the ABC
application in healthcare institutions:
Identifying the major activities
Most of the studies define the activity definition as
the default step of application. Activities form the
basis of measurement of all relevant information in
an ABC system. Several procedures defining
activities may be used [22]:
• Analysis of the organizational structure of
an enterprise
• Analysis of the workplace
• Analysis of personnel costs
Applying all three ensures that no activity is
overlooked.
Generally the principles of activity definition in
healthcare organizations are similar to the
manufacturing organizations. Number of activities
or level of detail of the system is the optional issue.
In case of organization wide application, there is
important to keep the limited number of activities in
order to avoid the data overload. Partial applications
could work with more detailed structure of
activities.
Assigning costs to cost pools/cost centers for each
activity
Second step in ABC application is the assigning
costs to cost pools/cost centres for each activity.
Assigning costs to activities represents the first
stage of the allocation process within the ABC
system. Cost allocation to defined activities might
prove very complicated in practice and eventually
take up an important amount of the implementation
process time. The reason is that the structure of
activities and structure of a company’s department
usually clash somehow. The activity cost matrix
could be invaluable for assigning company costs
classified in company cost centres to activities. Very
often it is necessary to define a resource cost driver
in order to effectively allocate such costs. Resource
cost drivers help to assign costs to a specific
activity, when the cost in evidence is aggregated in
general book entries. The following resource cost
drivers were used in the case studies:
• Personnel workload – for allocating
personnel costs to activities
• Square meters – for allocating rent,
premises depreciation, heating, and indirect
electricity to activities
• The quantity of machines, tools, etc.
• Estimation
Accurate allocation of the costs to defined
activities is the one of the crucial points of ABC
application.
Definition of activity cost drivers
Third step of the ABC application is the determining
the cost driver for every activity [9]. Within this step
of the application it is necessary to calculate the
primary rates of individual activities. Following
steps have to be done:
Calculating the primary rates of individual activities
can be conducted in four steps [22]:
1. Setting appropriate activity cost drivers for
individual activities
2. Determining the output measures of
individual activities
3. Calculating the primary rates of individual
activities
4. Assigning the costs of support activities to
primary activities
Performing of this step of ABC application in
healthcare institutions could have a lot of specifics.
The setting the appropriate cost drivers may be
questionable and the measuring the output rates
could also be complicated.
Many studies of ABC application in hospitals
deal with the problem of selecting the appropriate
cost drivers, and collection of data about volumes of
each activity output which is defined as output
measures. [5] states, that the workload for collecting
data of cost drivers is not easy, even if integrated
hospital information systems are introduced; labour
hours for which hospital staffs are engaged in some
medical services are generally difficult to collect.
[5] further states that the resolution for simple
and accurate cost accounting is to reduce the
number of cost drivers based on logical procedure.
These cost drivers are often selected based on
experiences and recommendations of experts of
hospital management. Some cost drivers have very
high correlation with each other, and therefore one
cost driver among them may be used for these
activities. Cao´s study [5] is then focused on cost
drivers reducing.
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6. [27] describes in detail obstacles existing in
procedures of accurate cost driver selection and the
data collection. The possible way of the
simplification of the system is the application of
time-driven activity-based costing system
(TDABC).
Assigning the costs of activities to products
Final step in ABC application is the assigning the
cost of activities to products according to their
individual demands on activities. In case of ABC
implementation in healthcare institution this step
could be crucial, because the management have to
decide, what the final product is or cost object of the
healthcare institution. Is it the patient as the
customer or the type of diagnosis?
As mentioned above different published studies
on ABC application uses various types of cost
objects. It starts with types of diagnosis or
individual patients and finishes with the specific
cost objects in the narrow applications of ABC, in
specific healthcare areas. Cost object definition is
based on managerial requirements of the system.
Another important issue is to collect the accurate
information about the volume of activities
consumed by the cost objects.
4 Conclusion
When we analyse studies of ABC applications in
healthcare, we can observe that they differ a great
deal in methodology, data collection technique and
the setting. There are many studies focusing on just
one treatment procedure and there are also studies
focusing on departments. Because of the important
differences between the individual procedures and
departments in hospitals, the complex applications
of ABC, which could replace the obsolete costing
and accounting systems are very unique.
Hospital managers, who consider the ABC
utilization as the support tool for more effective
operation of hospitals, have to face a number of
obstacles. Hospital as the object of ABC application
has usually much more complex structure of outputs
(products), customers, performed activities and
financial flows, than an ordinary manufacturing
enterprise. The setting the appropriate cost objects,
suitable structure of activities and relevant and
simple cost drivers requires the detailed future
studies. Ultimate objective of the research in this
area should be defining the general methodology for
the ABC application on the organization wide level.
Deeper level of knowledge in the area could
facilitate the hospital managers to use the limited
resources more effectively and save the increasing
costs of healthcare services.
Acknowledgment
This paper is one of the research outputs of the
project NT 12235-3/2011 “Application of modern
calculation methods for optimization of costs in
health care” registered at Internal grant agency of
Ministry of Health Czech Republic (IGA MZ ČR).
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