In today’s continually evolving healthcare environment, independent practices, hospices, clinics, private therapy offices, and other such businesses are all facing mounting financial pressures. Why? First, rising operational costs due to ongoing sticky inflation, a tight labor market which keeps employee salaries on the high end, complex insurance reimbursement structures that are often changing and/or confusing, coupled with the imperative to deliver high-quality patient care amidst heavy competitive pressures, all come together to make financial management decisions more challenging than ever.
To navigate this complexity, healthcare providers are turning to one financial method for help. Activity-Based Costing (ABC) is a strategic tool for businesses to gain deeper insights into their cost structures which helps to offer guidance for strengthening financial performance.
An Introduction to Activity-Based Costing
So, what is Activity-Based Costing? This novel approach to allocating costs focuses on identifying and analyzing activities within an organization. By tracing and linking resource consumption to specific activities, and, ultimately to specific services or products, ABC can give users a more accurate picture of where and how resources are being used within a business. Unlike traditional costing methods which typically distribute overhead costs evenly across services, ABC instead assigns costs based on their actual usage, giving users a more nuanced understanding of cost drivers.
For instance, think of an example such as a physical therapy clinic. In traditional costing methods, administrative expenses in such a business would likely be equally spread across all therapy sessions. However, some sessions, such as specialized treatments, may require more administrative support than the standard ones. When using ABC, this alternatively recognizes these differences and instead connects each service to the cost to reflects the actual resources consumed.
Understanding Healthcare Costs and Challenges
Let’s broaden our thinking about how healthcare organizations, particularly smaller entities like independent practices and clinics, face challenges in managing their costs:
- Indirect Costs: Expenses such as facility maintenance, administrative salaries, and utilities that are not directly tied to patient care but are indeed essential for operations are major challenges. Managers handling such cost tracking, analysis, and strategies must accurately allocate these costs to specific services. This can be a complex process.
- Rising Healthcare Costs: Another challenge is the continuous and, at times, sharp increases in costs for medical supplies, new technology, and labor, and contribute to financial strain. Without a clear understanding of cost drivers, managing these escalating expenses may not only be daunting, but may also be impossible.
- Inadequate Traditional Costing Methods: And third, and to the point of this article, conventional costing approaches such as using Relative Value Units (RVUs), often fail to capture the true resource consumption of services provided, and can lead to skewed profitability analyses and, subsequently, misguided strategic decisions.
To emphasize the point, a study done by the National Institutes of Health, highlighted that poor costing systems can have serious consequences, as healthcare providers may misunderstand their costs and be unable to link cost to process improvements or patient outcomes.
Implementing Activity-Based Costing
So how do businesses begin the process of implementing ABC in a healthcare setting? It involves several critical steps:
- Identify Activities: First, users must catalog all activities that are involved in patient care and administrative functions. Sounds like an onerous process, but a first necessary step. For example, using a hospice care facility to illustrate activities that need to be considered and might be included in an ABC process would start with all steps involved with patient intake. Other costs to be included in the activities identification may vary widely and include medication administration, ongoing counseling sessions for hospice clients, and even critical family support services offered by the clinic.
- Assign Costs to Activities: Next is the important and challenging step of determining the resources each activity actually consumes. These activities need to have costs assigned to them. And what could this entail? Items such as staff time on particular tasks, all supplies needed for a medical intervention, as well as quantifying equipment usage. Needless to say, this key step in the process requires meticulous data collection so that accurate results can be derived.
- Determine Cost Drivers: Third would be identifying the ancillary factors that influence the cost of each of these activities. Take, for example, a psychological therapy office. Cost drivers that might be considered for individual counseling sessions might be the duration of each session, while in group therapy situations, a driver could be the number of participants in the group setting.
- Allocate Costs to Services: Lastly, by using the information gathered as noted above, the user employing ABC would then assign the costs of activities to specific services based on the actual consumption of the business’s resources.
Case Scenario: Consider a community health clinic. After their typical annual financial audit, the internal accounting department started to notice that even though they were experiencing a steady increase in patient volume, their financial margins were actually shrinking. It just didn’t make sense. But, by implementing ABC, they were able to dig deeper into the numbers to discover that their extended patient consultations were consuming a lot more resources than their standard appointments. At first, they were under the belief that these extended sessions were going to offer better margins. Yet, it wasn’t the case. Instead through activity-based costing, they gained the insights that allowed them to adjust their scheduling practices (basically a resource allocation), which led to better margins and overall improved financial performance. Lessons learned? For one, accurate data entered is essential for successful ABC implementation; and verification of that data is crucial for accuracy purposes.
Service Line Management with ABC
Another element to consider in this cost method is what’s called service line management. This involves overseeing “specific categories” of services that are offered by a healthcare provider. So, ABC improves service line management by:
- Clarifying Cost Structures: By assigning precise costs to each service line, healthcare providers can spot which services are actually profitable and which are not.
- Informing Pricing Strategies: Understandably, by knowing what the true cost of services are, providers are then able to set pricing that reflects their resource utilization. Again, competitiveness is bettered, financial viability is extended, and long-term sustainability ensured.
- Enhancing Resource Allocation: Insights from ABC will allow for the redistribution of resources to service lines with higher demand or profitability. It’s this kind of smart business decision-making ability (and agility) that helps healthcare entities survive and thrive.
Case Scenario: A multi-specialty physical therapy clinic offered service to a wide range of age groups. Their business model included both a younger demographic (think athletes) as well as PT services for geriatric clients. But only after implementing the ABC method, did they realize that their geriatric care actually required a lot more resources (and time), yet it was priced similarly to younger client care. By adjusting their scheduling and resource allocation, the business was able to improve the sustainability of their geriatric services, a service line they felt vital to their business, and an important service to their community.
Time-Driven Activity-Based Costing
Time-Driven Activity-Based Costing (TDABC) refines the ABC approach further by focusing on the time needed to perform activities being measured. This method also involves several steps:
- Estimating Time: First, users must calculate the time healthcare employees spend on each activity, from initial patient consultations, to procedures, to the associated administrative tasks.
- Assigning Costs Based on Time: Costs are then allocated based on the time each activity takes. This allows for a more robust and accurate burden of each activity.
Why would this be a useful technique? Assigning cost by time can be particularly beneficial in environments where time is a critical factor such as in outpatient clinics or therapy offices. By understanding “the expenditure of time,” providers can streamline operations and reduce inefficiencies.
Case Scenario: A dialysis treatment center implemented TDABC and found that their initial patient assessments were taking much longer than necessary. This ultimately led to scheduling bottlenecks and frustrated customers and staff. But after their cost analysis (based on time) they were able to standardize their procedures and reduce the time spent per assessment. This in turn allowed them to accommodate many more patients without compromising the quality of care.
Overcoming Implementation Challenges
So, as nothing is typically straightforward when it comes to healthcare (and the operational and financial processes involved) it’s appropriate to discuss what are some implementation challenges in using ABC systems. These can include:
- Resistance to Change: One of the biggest obstacles is that staff usually is accustomed to traditional costing methods and reluctant to adopt new ways. Change can be painful. But clear communication about the benefits of ABC (with showing actual examples of how it helps a business), employees are often more open to adjusting. Importantly, involving team members early in the process can also mitigate resistance and is a time-honored technique (getting buy-in) in implementing all sorts of change management.
- Resource Investment: Implementing ABC requires time and financial investment in training, data collection, and system integration. Management needs to allow for this. The long-term gains in financial insights and efficiencies often far outweigh any initial upfront costs.
- Data Accuracy: We at Walters Accounting always emphasize this key point. “Clean data in” is the only way to get useful business insights out. The effectiveness of ABC hinges on precise data. Healthcare staff must make sure that their data collection methods are systematic, logical, and repeatable. They also need to ensure that their data is regularly updated so as to reflect their current operation status.
Case Scenario: A hospice care provider realized they needed assistance in better understanding their cost structure. They partnered with Walters to implement a new ABC system. While there were initial misgivings about the changes to their procedures, coupled with an attitude that their previous methods were “always the way things were done,” the hospice indeed successfully integrated ABC into their financial practices. It’s been a fruitful collaboration which has led to more accurate cost assessments for the business, better informed strategic planning, and opportunities for Walters as well to suggest ways to optimize their resource allocation strategies ever further.
Future Directions and Innovations
As with most things in the healthcare space, the use of ABC continues to evolve. To conclude this piece, we want to share with you some emerging trends that are shaping this cost method’s future. First, there is an ever-increasing integration of ABC systems with technology. For instance, advances in healthcare analytics and information systems are creating a more seamless connection with ABC and business’s processes. This is giving users real-time cost monitoring and better up-to-date decision-making options.
Next is a shift toward increasing alignment with value-based care (basically outcome-based). As the industry moves towards theses value-based care models, ABC can offer granular cost data that is necessary to assess the “value” of the services relative to the outcomes. Last but not least, another ABC trend is with the customization within diverse healthcare entity settings. Healthcare entities range a wide range of businesses, and customization in the cost analysis process can be critical to ensure the most accurate analyses and reporting.
These and other topics are likely to be the subject of future articles that we at Walters Accounting offer our readers. We look forward to keeping on top of the newest innovations in accounting practices and sharing these with our clients and other readers alike.
