1. Activity-Based Costing (ABC)

2. Agenda Introduction A hospice example: Hospice of Central Kentucky
Mechanics of Activity-based costing (ABC)
A manufacturing example: Ross Parts
Takeaway

3. 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

4. Costing Overview

5. 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 The case does not disclose the time period over which the costs were measured (e.g., monthly).

6. Business Model of HCK
Cost
Cost
Cost
Process
Care
Admit
Discharge

7. 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.

8. TOTAL Resource Usage over ALL patients
Resource Resource Supporting Activity Allocation Rate Type Cost Pool Levels over all Patients Prereferral $ 24, referrals* $ per referral Referral $10, referrals* $ per referral Admission $1, admissions $42.61 per admission Post-admission $3, admissions $79.33 per admission Post-death $1, deaths $32.09 per death Bereavement $12, deaths $ per death Med. services $5,588 2,080 service calls $2.69 per service call Reception $8,597 3,200 calls $2.69 per call Acc./Fin $13,566 5,553 patient-days* $2.44 per patient-day Management $17,107 5,553 patient-days* $3.08 per patient-day IT Systems $6,191 5,553 patient-days* $1.11 per patient-day Billing $2, billings $15.10 per billing Volunteer $3, volunteers $45.04 per volunteer Total $112,565

9. 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.

10. A Specific Patient’s Admin. Cost
Prereferral 1 X $ per referral Referral 1 X $ per referral Admission 1 X $42.61 per admission Post-admission 1 X $79.33 per admission Post-death 1 X $32.09 per death Bereavement 1 X $ per death Medical services 0 X $2.69 per service call Reception 1 X $2.69 per call Accounting/finance 2 X $2.44 per patient-day Management 2 X $3.08 per patient-day Information systems 2 X $1.11 per patient-day Billing 4 X $15.10 per billing Volunteer services 5 X $45.04 per volunteer Total: $1,178.43

11. 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 Cost per Patient-Day
Slow decline $27.39
Rapid decline $29.84
Imminent death $62.88
Death $381.57

12. 2012 Insurer operating expenses (in millions)
$1,657
$5,526
$2,655
$8,738
$17,306
$6,876
$23,729
$80,226
$48,213

13. IMPACT OF THE ACA ON HOSPITALS AND INSURERS
Access – particularly expanding Medicaid and creating health insurance exchanges
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
Quality improvement – including reduction in hospital-acquired infections and readmissions, electronic health records, and the establishment of the Patient-Center Outcomes Institute
Prevention – including the coverage of preventive services without co- payments, menu labeling, and employer wellness programs

14. IMPACT OF THE ACA ON HOSPITALS AND INSURERS --- ctd
Workforce – including support for nursing schools and changes in loan forgiveness for physicians entering the National Health Service Corps
Revenue – including device, cosmetic surgery, and tanning salon taxes
Other important odds and ends – including administrative simplification, medical-loss ratio, and transparency of financial relationships between drug companies and physicians
The CLASS Act – that would have created a voluntary long-term insurance program, but it was subsequently repealed

15. 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

16. 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 employer-sponsored health insurance.
2025
End of health care inflation
Health care inflation will be GDP+0%.
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.

17. Activity-Based Costing (ABC)
Activity-Based Costing: Shared resources are mapped to products by analyzing the production processes:
Production
Processes
Shared Resources
Products
Mapping

18. Steps of ABC
Identify key activities that are required to produce the good or service by analyzing the production processes.
Assign the overhead costs to the different activities.
Identify the cost driver (allocation base) for each activity.
Calculate the overhead rate for each activity:
(Rate = Overhead cost ÷ Cost driver volume)
Using the activity rates, charge each product based on the amount of activities it uses as it moves through the production process.

19. Agenda Introduction A hospice example: Hospice of Central Kentucky
Mechanics of Activity-based costing (ABC)
A manufacturing example: Ross Parts
Takeaway

20. Another Example: Ross Parts
Manufacture two (substitutable) parts
D-12 and M-24
Current production information
D-12
M-24
Units produced annually
100,000
25,000
Material costs per unit
$10
$12
Direct labor hours per unit
0.8
Direct labor rate per hour
$20
Machine-hours per unit
2.0
Set-up hours per run (batch)
5.0
Annual production runs
110 10
Wastewater generated per unit (liters)
10.0
0.0

21. Ross Parts Example Overhead cost by department and category
Department/Category
Annual
Budgeted Overhead
Supervision
$ 240,000
Material handling
325,000
Wastewater treatment
250,000
Equipment depreciation
625,000
Setup labor
60,000
Total
$1,500,000

22. 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 ,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)

23. Ross Parts Example Unit product costs under this system D-12 M-24
Direct material
$10.00
$12.00
Direct labor
16.00
Overhead 75% of direct labor)
12.00
Unit cost
$38.00
$40.00
Decision: Only produce D-12

24. 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

25. Two-Stage Cost System Materials Labor Overhead Direct Direct
Wastewater
Treatment
Other
Overhead
Wastewater
Machine hours
D-12
M-24

26. Two-Stage Overhead Rates
The rates for the two overhead pools:
Cost Pool
Costs ÷
Allocation Base =
Overhead rate
Wastewater
$250,000
1,000,000 liters
$0.25/liter
Other overhead
$1,250,000
250,000 machine-hours
$5.00/hour

27. Two-Stage Product Costs
Product costs for the two-stage system
D-12
M-24
Direct material
$10.00
$12.00
Direct labor
16.00
Overhead
Wastewater $0.25 per liter)
2.50
0.00
Other overhead $5 per mh)
10.00
Unit cost
$38.50
$38.00
Decision: Only produce M-24

28. 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

29. 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

30. 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

31. ABC Cost System Diagram
Direct Costs
Overhead
Direct
Supervise
Handle …
Setup
Labor $
Material $
Setup hours
D-12
M-24

32. ABC Overhead Rates There are five overhead pools Cost Pool Costs ÷
Total Activity* =
Overhead rate
Supervise
$240,000
100,000 hours
$2.40/hour
Handle material
$325,000
$1,300,000
25% material $
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
*Total Activity
Supervision (labor hours)
100,000 units x 0.8 hours + 25,000 units x 0.8 hours
Handle material (material dollars)
100,000 units x $ ,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

33. ABC Product Costs Unit product costs for the ABC system D-12 M-24
Direct material
$10.00
$12.00
Direct labor
16.00
Overhead
Supervise $2.40 per hour)
1.92
Handle material material $)
2.50
3.00
Treat wastewater $0.25 per liter)
0.00
Use equipment per machine-hour)
5.00
Setup machines $100 per setup hour)
0.55*
0.20
Unit cost
$38.47
$38.12
*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).

34. 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