Activity-Based Costing (ABC)
Agenda
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•
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Introduction
A hospice example: Hospice of Central Kentucky
Mechanics of Activity-based costing (ABC)
A manufacturing example: Ross Parts
Takeaway
Two-Stage Cost Systems
• Recall the two-stage cost system
– Stage 1: Partition shared resources into pools
• Move “BIG and DIFFERENT” resource to a separate pool
– Stage 2: Allocate each pool using the relevant allocation base
• How to design two-stage cost systems for any given company?
• Activity Based Costing (ABC) provides a systematic approach
– It relies on a thorough understanding of the production process
Costing
Overview
HCK Example
• The Hospice of Central Kentucky (HCK) traditional cost system computed
administrative cost per patient-day by dividing total administrative cost by
total patient-days.
•
Reported administrative cost per patient day
• $112,565 ÷ 3,593 patient-days = $31.33.
• How accurately does this cost number track the costs of servicing patients
using the modern technologies of terminal care?
Source: Sidney J. Baxendale and Victoria Dornbusch, “Activity-Based Costing for a
Hospice,” Strategic Finance, March 2000, pp. 65-70. www.imanet.org. The case does
not disclose the time period over which the costs were measured (e.g., monthly).
Business Model of HCK
Cost
Cost
Cost
Admit
Process
Care
Discharge
Activity Levels over ALL Patients at HCK
74
referrals*
46
admissions
46
deaths
2,080 service calls
3,200 calls
5,553 patient-days*
192
billings
75
volunteers
_______
* Referrals and patient-days are weighted by the stage of the disease. For
example, the actual number of patient-days is 3,593, but a day for a patient
whose death is imminent is counted as equivalent to three patient-days for a
patient in slow decline due to the more intensive care such patients receive.
TOTAL Resource Usage over ALL patients
Resource
Type
Resource
Cost Pool
Supporting Activity
Levels over all Patients
Allocation Rate
Prereferral
Referral
Admission
Post-admission
Post-death
Bereavement
Med. services
Reception
Acc./Fin
Management
IT Systems
Billing
Volunteer
Total
$ 24,611
$10,873
$1,960
$3,649
$1,476
$12,670
$5,588
$8,597
$13,566
$17,107
$6,191
$2,899
$3,378
$112,565
74 referrals*
74 referrals*
46 admissions
46 admissions
46 deaths
46 deaths
2,080 service calls
3,200 calls
5,553 patient-days*
5,553 patient-days*
5,553 patient-days*
192 billings
75 volunteers
$332.58 per referral
$146.93 per referral
$42.61 per admission
$79.33 per admission
$32.09 per death
$275.43 per death
$2.69 per service call
$2.69 per call
$2.44 per patient-day
$3.08 per patient-day
$1.11 per patient-day
$15.10 per billing
$45.04 per volunteer
True cost of an INDIVIDUAL Patient
• A patient’s administrative cost is that patient’s use of
administrative resources times the usage charge
• Consider a patient who had one referral, one admission, one
call, no service call, 4 billings, 5 volunteers, stayed for two
days and died.
A Specific Patient’s Admin. Cost
Prereferral
Referral
Admission
Post-admission
Post-death
Bereavement
Medical services
Reception
Accounting/finance
Management
Information systems
Billing
Volunteer services
Total:
1 X $332.58 per referral
1 X $146.93 per referral
1 X $42.61 per admission
1 X $79.33 per admission
1 X $32.09 per death
1 X $275.43 per death
0 X $2.69 per service call
1 X $2.69 per call
2 X $2.44 per patient-day
2 X $3.08 per patient-day
2 X $1.11 per patient-day
4 X $15.10 per billing
5 X $45.04 per volunteer
$1,178.43
Summary of Cost Analyses at HCK
• Traditional cost data
• $112,565 ÷ 3,593 patient-days = $31.33
• The management then measured the levels of resource consumption by
various categories of patients. The estimates of the average cost per
patient-day for patients in various stages of their diseases are:
• Stage of Disease
Slow decline
Rapid decline
Imminent death
Death
Cost per Patient-Day
$27.39
$29.84
$62.88
$381.57
2012 Insurer operating expenses (in millions)
100%
$1,657
$5,526
$2,655
$6,876
$17,306
$8,738
$23,729
$80,226
$48,213
Aetna
UnitedHealth
Wellpoint
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Medical Costs
Administrative Costs
Net Profit (after taxes)
IMPACT OF THE ACA ON HOSPITALS AND INSURERS
1) Access – particularly expanding Medicaid and creating health
insurance exchanges
2) Cost control – including accountable care organizations (ACOs)
bundled payments, the “Cadillac” tax, the Center for Medicare and
Medicaid Innovation, and the Independent Payment Advisory Board
3) Quality improvement – including reduction in hospital-acquired
infections and readmissions, electronic health records, and the
establishment of the Patient-Center Outcomes Institute
4) Prevention – including the coverage of preventive services without copayments, menu labeling, and employer wellness programs
IMPACT OF THE ACA ON HOSPITALS AND INSURERS --- ctd
5) Workforce – including support for nursing schools and changes in loan
forgiveness for physicians entering the National Health Service Corps
6) Revenue – including device, cosmetic surgery, and tanning salon taxes
7) Other important odds and ends – including administrative
simplification, medical-loss ratio, and transparency of financial
relationships between drug companies and physicians
8) The CLASS Act – that would have created a voluntary long-term
insurance program, but it was subsequently repealed
Six megatrends
MEGATREND
CHANGE
EFFECTIVE
DATE
End of insurance companies
as we know them
Insurance companies will either become
purveyors of management, analytics, and
actuarial services or integrated delivery
systems actually employing (or contracting
with) hospitals, physicians, and other
providers to render patient care.
2025
VIP care for the chronically
and mentally ill
Physicians and hospitals will focus on keeping
patients with chronic illnesses healthy and
out of the emergency room and hospital,
thereby decreasing the frequency of
avoidable complications and rate of
hospitalization. Then they will begin
routinely screening for depression and other
mental health problems and develop
standardized rapid interventions.
2020
MEGATREND
CHANGE
EFFECTIVE
DATE
The emergence of digital
medicine and closure of
hospitals
Over 1,000 acute-care hospitals will close.
We will see a slew of new technologies for
remote monitoring, testing, and treating
patients in real time outside of the hospital
and physician’s offices.
2020
End of employer-sponsored
health insurance
Fewer than 20% of workers in the private
sector will receive traditional employersponsored health insurance.
2025
End of health care inflation
Health care inflation will be GDP+0%.
2020
Transformation of medical
education
Medical education will be transformed in 4
fundamental ways: (1) three-year medical
schools and shorter residencies; (2) half of
medical school clinical training will be outside
of hospitals; (3) integration of nurses,
pharmacists, social workers with medical
students in multi-professional team training;
and (4) formal incorporation of population
health and management skills in training.
2025
Activity-Based Costing (ABC)
• Activity-Based Costing: Shared resources are mapped to products
by analyzing the production processes:
Production
Processes
Shared Resources
Mapping
Products
Steps of ABC
1. Identify key activities that are required to produce the good or
service by analyzing the production processes.
2. Assign the overhead costs to the different activities.
3. Identify the cost driver (allocation base) for each activity.
4. Calculate the overhead rate for each activity:
(Rate = Overhead cost ÷ Cost driver volume)
5. Using the activity rates, charge each product based on the amount
of activities it uses as it moves through the production process.
Agenda
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Introduction
A hospice example: Hospice of Central Kentucky
Mechanics of Activity-based costing (ABC)
A manufacturing example: Ross Parts
Takeaway
Another Example: Ross Parts
• Manufacture two (substitutable) parts
– D-12 and M-24
• Current production information
D-12
Units produced annually
M-24
100,000
25,000
Material costs per unit
$10
$12
Direct labor hours per unit
0.8
0.8
Direct labor rate per hour
$20
$20
Machine-hours per unit
2.0
2.0
Set-up hours per run (batch)
5.0
5.0
Annual production runs
110
10
Wastewater generated per unit (liters)
10.0
0.0
Ross Parts Example
• Overhead cost by department and category
Department/Category
Supervision
Annual
Budgeted Overhead
$ 240,000
Material handling
325,000
Wastewater treatment
250,000
Equipment depreciation
625,000
Setup labor
Total
60,000
$1,500,000
Ross Parts Example
• Company uses a single overhead pool
– Allocation base is direct-labor cost
• Which product is less costly to produce?
– Total labor hours = 100,000
(= 100,000 x 0.8 + 25,000 x 0.8)
– Total labor cost = $2,000,000
(= 100,000 hours x $20/hour)
– Overhead rate = 75% (= $1,500,000 ÷ $2,000,000)
Ross Parts Example
• Unit product costs under this system
D-12
Direct material
M-24
$10.00
$12.00
Direct labor
16.00
16.00
Overhead (@ 75% of direct labor)
12.00
12.00
$38.00
$40.00
Unit cost
Decision: Only produce D-12
What’s “Wrong” With the Decision?
• Only D-12 uses the wastewater treatment
– The wastewater treatment costs are “spread” between both
products
– This is the result of using a single cost pool
• Tendency to “overcost” products making less use of overhead
resources
• One solution might be a two-stage cost system
Two-Stage Cost System
Materials
Direct
Overhead
Labor
Direct
Wastewater
Treatment
Wastewater
D-12
M-24
Other
Overhead
Machine hours
Two-Stage Overhead Rates
• The rates for the two overhead pools:
Cost Pool
Wastewater
Other overhead
Costs
÷
Allocation Base = Overhead rate
$250,000
÷
1,000,000 liters =
$0.25/liter
$1,250,000
÷
250,000
machine-hours
$5.00/hour
=
Two-Stage Product Costs
• Product costs for the two-stage system
D-12
Direct material
M-24
$10.00
$12.00
16.00
16.00
Wastewater (@ $0.25 per liter)
2.50
0.00
Other overhead (@ $5 per mh)
10.00
10.00
$38.50
$38.00
Direct labor
Overhead
Unit cost
Decision: Only produce M-24
What’s “Wrong” Now?
• Company produces M-24 in “longer” runs, requiring fewer set-ups
• But, M-24 uses more expensive material, which might require
different handling
• However, the overhead costs are based entirely on volumes
produced
A Thought Experiment
• Two production areas (buildings) within a single plant that produce
identical numbers (volumes) of markers
• One building only produces black markers (by far the most popular
model)
• The second produces all the other colors
• Both buildings use the same amount of direct labor, machine hours,
and material cost
A Thought Experiment
• What do you observe in the multi-color building relative to the
black marker building?
– More machine set-ups
– More material handling
• To and from the production line
– More inventory movement
– More orders
– In general, a lot more activity
ABC Cost System Diagram
Direct Costs
Overhead
Direct
Supervise
Labor $
D-12
Handle
…
Material $
M-24
Setup
Setup hours
ABC Overhead Rates
• There are five overhead pools
Cost Pool
Costs
÷
Total Activity*
= Overhead rate
Supervise
$240,000
÷
100,000 hours
=
Handle material
$325,000
÷
$1,300,000
Treat wastewater
$250,000
÷
1,000,000 liters =
$0.25/liter
Use equipment
$625,000
÷
250,000 hours
=
$2.50/hour
Setup
$60,000
÷
600 hours
=
$100/hour
Cost Pool
Supervision (labor hours)
Handle material (material dollars)
$2.40/hour
= 25% material $
*Total Activity
100,000 units x 0.8 hours + 25,000 units x 0.8 hours
100,000 units x $10 + 25,000 units x $12
Treat wastewater (wastewater)
100,000 units x 10 liters + 25,000 units x 0 liters
Use equipment (machine hours)
100,000 units x 2 hours + 25,000 units x 2 hours
Setup machines (setup hours)
110 runs x 5 hours + 10 runs x 5 hours
ABC Product Costs
• Unit product costs for the ABC system
D-12
Direct material
M-24
$10.00
$12.00
16.00
16.00
Supervise (@ $2.40 per hour)
1.92
1.92
Handle material (@25% material $)
2.50
3.00
Treat wastewater (@ $0.25 per liter)
2.50
0.00
Use equipment (@2.50 per machine-hour)
5.00
5.00
Setup machines (@ $100 per setup hour)
0.55*
0.20
$38.47
$38.12
Direct labor
Overhead
Unit cost
*Because these are unit costs, we need to first determine cost of setups and
then divide by the number of units produced (e.g., 0.55 = [110 x 5 x $100] ÷ 100,000).
Takeaway
• Resource level
– ABC assumes resources exist to support activities
– ABC then divides each resource’s cost by the total level of
activities it supports
– This division calculation yields a activity charge for each activity
• Product level
– As the product progresses through the production process, it
accumulates costs based on how much activities it uses
• The product cost thus more accurately reflects its true use of
shared resources