Management Accounting

ACCT 2006 Management Accounting Mandy Lim Dialysis Clinic

 

 

 

Introduction

            Costing is one of the biggest challenges facing healthcare providers recently. Majority of healthcare providers use ratio-of-cost-to charges methods in determining their costs.

            However, a new system, activity-based costing (ABC) has helped many manufacturing and services organizations improve their competitiveness by enabling them to make better decisions based on an improved understanding of their product cost behavior. The main premise behind ABC is to classify overhead or indirect costs and to allocate them to end products or services based upon the activities required to produce these products (1999).

            ABC takes a two-stage approach to allocating overhead costs to products based on multiple cost drivers at various levels of activity. In the first stage, overhead costs are assigned to cost pools within an activity center based upon activity-driven cost drivers. There is no equivalent step in traditional costing accounting (TCA).

            In the second stage, overhead costs are allocated from the cost pools to the products based on the product’s consumption of indirect activities. This stage is similar to TCA except that the traditional approach uses a single volume-based cost driver to allocate overhead costs to products without consideration for non-volume-related characteristics.

            ABC was pioneered in the late 1980s by  (1988a, 1988b, 1999a, 1999b),  (1989a, 1989b), and  (1987). Experts believe that ABC can provide more accurate product costing information than TCA when products are diverse in size, complexity, material requirements, and/or setup procedures (1988). A costing system should provide users with relevant and accurate information that will assist them in making decisions such as product pricing, customer and product profitability analysis, and process improvement.

The Current Cost system

            Currently, Mandy Lim Dialysis Clinic is using the ratio-of-cost-to-charges (RCC) method of estimating costs. This method estimates costs from charges using conversion factors from Medicare Cost Report. RCC is the most popular costing method in the healthcare field because it is simple to apply, consistent with Medicare guidelines, and familiar to financial managers.

            According to (1996), the RCC costing method represents the “step-down” indirect cost allocation methodology. This means treatment cost information is estimated within departments by applying the ratio of treatment costs to charges, that is, indirect costs divided by total charges to revenues generated. In addition, by emphasizing the denominator of this ratio, the RCC method encourages the pursuit of highly reimbursed types of treatment and favors revenue optimization strategies resulting from treatment mix decisions.

            With the RCC system, there are three assumptions according to  (1996) that financial managers should accept. These are the following:

1) That indirect costs comprise a single pool, that is, allocated costs are interchangeable,

2) That reimbursement rates reflect service intensity, and

3) That each type of service consumes indirect costs in the same proportion. Controlling costs which would be encouraged by an emphasis on the numerator of the ratio is less important as long as total revenues exceed total costs because every procedure and activity is perceived to be profitable.

            However, RCC method also comprise of problems with it. The problem of this method include the assumption that reimbursement rates accurately reflect the amount of resources consumed, over classification of illnesses resulting from efforts to maximize revenue through management of the RCC denominator, and the lack of emphasis on cost containment (1996).

 

 

 

 

Proposed Changes and remedy of the new ABC system

            The primary objective of an ABC system is to improve the accuracy of estimates of resources consumed (1992). According to  (2003), in ABC, costs of activities are connected to the primary drivers of those activities. The ABC method attempts to link resources consumed to service costs. ABC recognizes that activities and their costs can be driven by either volume-related or nonvolume-related variables (1996). As a result, both types of drivers are used, as appropriate, to determine overhead rates. The expectation is that the overhead costs assigned to products and services will be more representative of the actual overhead consumed. The benefits of ABC for product and service costing are certainly applicable in determining the costs of the departments or other units within an entity when enhanced accuracy is desired (2003).

             According to  (1996), the ABC method, unlike the RCC method, provides decision support information for all three variables: treatment mix, resource cost, and resource consumption. In addition, it accurately reflects resource consumption at the treatment level, and it directly identifies the resources consumed by cost object. Moreover, it can determine which capitates contracts, individual physicians, or patient groups are more profitable. In contrast with the RCC method, the healthcare ABC model provided a better picture of the ways resources actually were consumed.

Table 1. Comparative Income Statement of Mandy Lim Dialysis Clinic using RCC and ABC

Item

Using Ratio of Cost to Charges (RCC)

Using Activity-based Costing (ABC)

 

Total (RCC)

HD (RCC)

PD (RCC)

Total (ABC)

HD (ABC)

PD (ABC)

Revenues

 

 

 

 

 

 

  No. of Patients

164

102

62

164

102

62

  No. of treatments

34,967

14,343

20,624

34,967

14,343

20,624

Total Revenue

,006,775

,860,287

,146,488

,006,775

,860,287

,146,488

 

 

 

 

 

 

 

Supply Cost

 

 

 

 

 

 

  Standard Supplies   (drugs and syringes)

664,900

512,619

152,281

664,900

512,619

152,281

  Episodic supplies (for special conditions)

310, 695

98,680

212,015

310, 695

98,680

212,015

Total Supply costs

5,595

1,299

4,296

5,595

1,299

4,296

 

 

 

 

 

 

 

Service Costs

 

 

 

 

 

 

General overhead

785,825

 

 

 

 

 

  Facility cost

 

 

 

233,100

170,940

62,160

  Administration and      support staff

 

 

 

354,565.38

145,438.02

209,127.36

  Communication system and medical records

 

 

 

157,218.60

97,782.30

59,436.30

  Utilities

 

 

 

39,762

33,797.70

5,964.30

Durable Equipment

137,046

 

 

137,046

102,784.50

34,261.50

Nursing Services

883,280

 

 

 

 

 

  Registered Nurse

 

 

 

239,120

170,800

68,320

  Licensed Practical Nurse

 

 

 

404,064

318,998

85,066

Nursing Administration & support nurse

 

 

 

115,041.43

47,188.47

67,852.96

Dialysis Machine Operators

 

 

 

124,928

124,928

0

Total Service Costs

,806,151

,117,463

8,688

,804,845.41

,212,656.99

2,188.42

 

 

 

 

 

 

 

Total Operating Expenses

,781,746

1,728,762

1,052,984

,780,440.41

,823,955.99

6,484.42

Net Income

5,029

131,525

93,504

6,334.59

36,331.01

190,003.58

 

 

            Table 1 above illustrates how the application of the ABC model affects reported financial performance at the service level. As in the previous analyses with the use of RCC method, revenues, standard supplies, and episodic supplies remained unchanged with the use of ABC method in the total number of dollars and the dollars-per-treatment.

            However, two of the indirect costs categories used with the RCC method were separated into eight separate cost pools: four cost pools each for general overhead and nursing services. Durable equipment is not subjected to an ABC analysis; consequently, the healthcare ABC model identified the resources actually consumed by hemodialysis and peritoneal dialysis which is 75% HD and 25% PD.

            Table 1 also shows that hemodialysis was significantly more costly than peritoneal dialysis, but was still profitable. The table also indicates that peritoneal dialysis was considerably more profitable than hemodialysis.

                In contrast with the RCC method, the healthcare ABC model provided a better picture of the ways resources actually were consumed.

 

Conclusion

            Healthcare executives who have more accurate cost information can make more effective decisions regarding resource allocation, cost containment, capitated contract profitability, and incentives that drive the selection of treatment alternatives.

            ABC method offers financial managers the opportunity to identify procedures or activities that are not cost-effective. The ABC method, in contrast with RCC method which uses expenditure-based aggregate cost accumulations and allocates these costs based upon prescribed reimbursement methods, identifies the cost of resources that have been consumed by different treatments, patient groups, or physicians. In addition, only the ABC model can help executives avoid managed care contracts that ultimately would be unprofitable. To bid appropriately on the long-term capitated contracts required by many managed care plans, the costs associated with providing services to plan members must be understood and managed.

            Increased awareness of resource consumption provides healthcare financial managers with greater opportunities for cost containment. Rather than simply shifting costs, for example, managers may find ways to use fewer resources and identify more cost-effective delivery methods.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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