Historical Perspective
Activity
Based Costing
In
1989, a Harvard University professor coined the phrase
“Activity Based Costing”. The ensuing
worldwide hype of a “new” cost accounting system called
ABC eventually died out about 6 years later.
In
order to understand what exactly activity based costing
is and how it has been applied in hospitals, one must
first understand the differences between Cost
Determination and Cost Accounting.
Cost Determination
Methods
When the cost of an activity or
item is resolved, this is called “cost
determination”. A cost accounting system is used
to combine the costs of many activities so that the sum
defines the cost of a product or an
output.
To resolve the cost of an
activity or item, one of three direct cost determination
methods or one of the two indirect methods are
applied. The three direct cost determination
methods are:
-
Barter (10,000 BC) – when two
beings decide to exchange one thing(s) for something
else, then the cost of the things on both side of the
transaction is resolved. Note that physical
intimidation can be a factor in the resolution of costs
using this method.
-
Job Costing(2500 BC) – when the
discipline of recording the resources used to complete a
single project (also known as “bookkeeping”) is applied,
the resulting sum of the resources is the cost of the
project.
-
Microcosting (1500 AD) – this is
the reverse of job costing. A single cost object
is reverse engineered to determine the resources that
had to be committed to create the cost
object.
The two major indirect cost
determination methods are:
-
Relative Value Proration (1960
AD) – a mathematical process wherein the total resources
used in the series of operations are allocated to each
operation using an assigned relative value for each
operation. The relative values are typically
created using microcosting and the spreading is
computerized.
-
Ratio of Cost To Price (1975 AD)
– this technique is limited to hospitals in the United
States and is the result of the calculation of the Ratio
of Cost To Charges required in the hospital’s annual
report to the federal government related to the Medicare
insurance program.
Cost Accounting
Systems
A system that is used for the
valuation of outputs or products is referred to as a
“cost accounting system”. There are three major
systems. They are:
-
Project Accounting (2500 BC) –
this is both a cost determination method and a cost
accounting system.
-
Standard Costing (1900 AD) – a
system for checking for waste or valuing inventory in a
manufacturing process. First, the standard costs of each
activity are determined. Then these standards are
multiplied by the total number of products
assembled. To uncover waste, the totals are
compared to the gross amount of resources
purchased.
-
Directed Expense Costing (1964
AD) – a computer software system that determines the
standard cost of a series of activities involved in a
particular form of work for each accounting
period. The system uses thousands of expense
directing commands stored on a computer disk each of
which were created to define a beneficial relationship
between an activity and the expense dollars that funded
that activity. The costing process first subtracts
the direct expenses from the actual expenses and directs
these to the activities. Relative value proration
is then used to apply all remaining expenses to the
activities as either direct or overhead costs. The
millions of calculations involved in this costing
process can only be completed using a
computer.
Activity Based
Costing
Activity Based Costing is not a
“system” in itself but rather a philosophy of
costing. This philosophy promotes the treatment of
overhead as direct costs when ever possible.
The textbooks presenting
activity based costing define cost drivers, resource
drivers, activities, and outputs. They specify
that resources are consumed by activities and the
outputs are a sum of the activities. But all this
dilutes the real message activity based costing – that
of treating what is normally allocated to overhead
expenses as direct product
costs.
While the ABC textbooks
logically define drivers, resources, and outputs, the
books do not contain a description of how this treatment
of overhead expense as direct costs is to be
accomplished. A system such as the Directed
Expense Costing system mentioned above must be
employed.
Hospital Claims
Denials – An Example of Activity Based
Costing
Using the hospital business
office as an example, the expenses in this cost center
are normally treated as an indirect overhead cost and
allocated to patients based on a statistic such as
length of stay, total charges, cumulative direct costs,
or equally to all.
However, a majority of the
salary expenses in the business office are consumed
dealing with problem insurance companies that routinely
refuse to pay certain claims, or short pay claims, or
delay paying claims by asking for more records and
documentation associated with the hospitalization.
The business office staff must
investigate the denials, write appeal letters, find and
copy original documents and records, contact the
patient, and perhaps prepare to sue for the outstanding
money. Using the activity based costing
philosophy, these salary dollars would be applied so as
to increase the cost of the patients involved rather
than have the salary expenses allocated to all patients
as an overhead cost.
