Master the ‘ABCs’ of Activity-Based Costing

Pam Schuneman, C.P.A., M.B.A.
How do you find out whether a given capitation rate will be profitable for your practice? Activity-based cost accounting is one tool that can help. An accountant explains how it works.

The last 10 years have brought substantial changes to the health care industry. Managed care fee reimbursement structures have many physicians working harder, but earning less. Costs for providing medical services have increased, while payments for those services have decreased. Capitation has shifted insurance risk to the medical practice, and many physicians and administrators do not know how to adequately evaluate the performance of their managed care contracts. To remain profitable in this environment, a physician needs accurate cost information from which informed business decisions can be made.

The health care industry can use techniques developed by manufacturing companies to help them remain profitable, eliminate unnecessary costs and plan for change. The growing demand for high-quality, low-cost products led manufacturers to develop a methodology called activity-based costing, or “ABC.” This technique identifies the relationship between an activity and the resources needed to complete it. It then assigns costs to the resources consumed by the activity. This technique can be effectively applied to a medical practice.

When a practice knows how much it costs to provide a specific service, informed managed care decisions can be made. Actuarial data can be used to predict procedure utilization, and through these data, the number of procedures the practice will perform under the contract can be estimated. Cost figures can be applied to these estimates for a projection of how much a managed care contract will cost the medical practice. The amount the practice will receive under the managed care contract can be compared with what the practice anticipates it will cost to provide services under the contract. The difference will be profit or loss. Any managed care profitability estimate is a guess, but accurate cost information can make that guess an educated one.

A cost accounting system utilizing ABC techniques will provide a medical practice with cost information. The three basic steps in the development of a cost accounting system are:

  1. Conversion of books to an accrual basis of accounting;
  2. Defining cost centers and cost allocation, and
  3. Determining procedure costs.

A new way to keep books

Most medical practices keep their books on the cash basis of accounting, which recognizes income when received and expenses when actually paid. While this method will adequately reflect profit or loss over time, differences will appear if there is a lag between the performance of services and collection of payment. Most practices will pay expenses currently and receive insurance reimbursements two to three months later. The cash-basis financial statements for a discrete period, such as a month, will report revenues and expenses that are not related to each other. The revenue is from services performed two to three months previously, and expenses are for services performed during the month.

The accrual basis of accounting will record revenues when earned and expenses when incurred. A monthly financial statement on the accrual basis of accounting will better match revenues with the expenses incurred to produce the revenues. Because this is the accounting information needed for cost computations, it is necessary to convert a cash-basis financial statement to the accrual basis of accounting.

All medical practices should have a computerized billing system with practice analysis capabilities. The revenues earned can be easily obtained from this system. Any current expenses paid in a subsequent month should be included in the financial statements, and expenses paid for costs incurred in previous months should be removed.

The accrual-basis income statement is the foundation of the cost system. The numbers presented by this statement will be assigned to the various procedures performed by the practice during this period.

Cost centers are identifiable units through which a medical practice operates. Examples include administration, surgery, pathology and laboratory. It’s up to each practice to define its own cost centers. A multispecialty practice will usually have more cost centers than a single-specialty practice, and a group practice may also view each physician as a cost center. The determination of cost centers will be dependent on how a particular practice operates.

For illustration, let’s say the Metropolis Medical Clinic includes Drs. Kent, Olson and Lane. The clinic has an in-house laboratory and radiology department. All direct revenues and expenses are allocated to the physician who performs the service or incurs the expense. Indirect variable overhead costs are allocated to each physician based on the ratio of revenues earned by physician to total revenues earned during the period. Fixed overhead costs are divided equally among physicians. Because of the separateness of their income and expense allocations, separate cost centers should be used for each physician.

For this medical practice, the costs centers would be administration, laboratory, radiology and each individual physician. When cost centers are defined, they will further be classified as support centers or patient service centers. In our example, administration is a support center and laboratory, radiology and each individual physician are patient service centers.

The medical practice’s chart of accounts will be modified to track specific costs by cost center. This is easily done by adding a modifier to the chart of accounts, and it will enable the accounting system to produce departmental statements. If accrual adjustments are being made, these will also need to be done by cost center.

Once costs are tracked to cost centers, all support costs will be allocated to patient service centers. This can be done by different methods with various degrees of accuracy. The more detailed the cost analysis, the greater the accuracy of the data. As the detail increases, so does the time and expense required to generate the information. Before undertaking the implementation of a cost system, the expense required to establish and maintain a cost system should be weighed with the information required of the system. A practice should examine the commitment of physician and staff to the development of the system, and determine what level of accuracy will be acceptable. Without commitment by all physicians and staff, a detailed cost system will fail.

The option of time studies

The cost allocation that produces the highest degree of accuracy involves time studies and direct expense allocation. If this method is chosen, several months of data collection must be completed to generate data necessary to establish the personnel component of each procedure cost. Time studies will differentiate between used and unused personnel resources and will alert a practice to possible over- or understaffing. This type of analysis will provide information on trends within the practice and will allow a comparison of practice procedure costs to industry averages.

The administrative support costs include direct administrative labor, rent, utilities, building insurance, office supplies, advertising, telephone expense and equipment costs related to the administrative function. Rent, utilities and building insurance were allocated to the administrative cost center on the basis of square footage of the building. These expenses can further be broken down into direct and indirect patient expenses.

Direct patient expenses include activities that occur with each office visit. For each visit, administrative time can be divided as follows:

  • making the patient’s appointment,
  • pulling and refiling the patient’s file,
  • preparing the superbill,
  • verifying the patient’s insurance,
  • collecting applicable copayments,
  • writing patients’ receipts,
  • scheduling follow-up appointments,
  • billing insurance companies, and
  • recording and depositing insurance reimbursement checks.

These expenses will be allocated to each cost center based on number of office visits. All visits to the laboratory and radiology departments are through a clinic physician, so these patient service centers will not be allocated any of the direct administrative costs.

Indirect administrative expenses include advertising, rent, utilities, building insurance, office supplies, bookkeeping, payroll, personnel administration and administrative supervision. Payroll, personnel administration and administrative supervision expense are allocated based on total personnel cost. Rent, utilities and building insurance are allocated based on square footage occupied. Office supplies, office equipment costs and advertising are allocated equally among the patient service centers.

Allocation of employee-related expense can be done based on time studies. The time it takes to complete each task will be monitored and compiled. The average time to complete each task will then be computed. This employee resource will be costed using a payroll factor, which includes salary and fringe benefit components. Only resources actually used will factor into the cost computation, and unused resources will be reported separately. The knowledge of how much of the practice’s personnel is unused is of great managerial value for purposes of planning and cost containment. A large amount of unused administrative labor indicates that a practice is overstaffed. These data will also apprise the practice manager when new employees should be hired. Controlling unused resources is synonymous with controlling costs. Payroll is the number one cost of most medical practices, and the more efficiently a practice uses its personnel, the more profitable it will be.

If time studies are not desired, all direct administrative personnel costs can be allocated based on patient office visits. This method produces a higher administrative cost per visit and does not differentiate between used and unused personnel resources. A general time estimate is still required to allocate administrative time between direct and indirect patient expense costs. The advantage of this method is less time spent compiling data for use in the cost system.

Determining procedure costs

We have now allocated accounting information to the various cost centers, and support costs have been analyzed and allocated to the patient service centers. The next step is to determine the cost of specific medical procedures. There are different ways to accomplish this.

One is to use the resource-based relative value scales (RBRVS) developed for use in the Medicare program. These scales apply to procedures classified by the Physicians’ Current Procedural Terminology, Fourth Edition. They consist of three components: professional time, practice time and malpractice expense. Costs can be assigned to procedures based on the relative value unit (RVU) assigned to the specific procedure. This method allocates total costs of a defined cost center to procedures performed in that cost center based on the relative weight assigned to the procedures.

The advantages of using the RVU method of cost allocation are low cost and ease of implementation. This method does not require time studies or direct cost allocation of resources to specific procedures. The drawback is a lack of accuracy. All medical practices operate differently, and the RVU assigned to specific procedures may not reflect precisely the costs that occur in a specific medical practice. The data produced will not provide information on unused capacity or trends in procedure costs.

If greater accuracy is desired, costs can be directly allocated to specific procedures. This can be done in a way similar to the allocation of direct administration costs. For each procedure performed, time studies should be undertaken for all personnel involved. Supplies used in the procedure are inventoried, and specific equipment use is recorded. The average cost per procedure is then derived.

Uses of cost data

Cost data have value as a management tool only if they are analyzed and used. The primary uses of these data are managed care negotiation, strategic planning and quality improvement.

Managed care contract negotiation: Accurate cost data can be a key tool in evaluating a managed care contract. The cost of providing services is compared with the amount received under the managed care contract. The excess received over the cost of providing the services is the income derived from the contract.

Managed care cost allocation: Cost data also can be used for the allocation of HMO-related expenses. In our fictitious family practice clinic, each doctor operates independently, and indirect expense allocation is based on revenues earned. Revenues from HMOs can be split on the basis of the primary care physician, but the allocation of expenses presents a difficulty. If the current allocation is used, revenues earned will be the basis of expense allocation.

Equipment acquisitions: The cost of acquiring equipment can also be evaluated through the cost system. Equipment costs and their effect on professional time requirements should be examined on a procedure level. The projected procedure cost information for the new equipment can be compared to the existing procedure cost to make an estimate of the anticipated benefit to be derived from the equipment addition.

Industry cost comparisons: Industry cost-per-procedure information can be contrasted with a practice’s cost data to ascertain areas of strength and weakness. If practice costs seem out of line compared with the industry average, the practice will want to review its internal procedures.

Trend analysis: A cost accounting system is not static. Once it is established, it needs to be maintained and updated as medical procedures change. Continual monitoring, with an emphasis on cost containment, will improve a medical practice’s profitability.

Activity-based cost accounting is a powerful managerial tool for today’s medical practice. No one can accurately predict the future of the health care industry, but the physicians and administrators who understand the business of their medical practices will be able to react most intelligently as circumstances change.

The author is an accountant in Oklahoma City who specializes in the tax, accounting and practice management problems of physicians.

Activity-based costing can generate useful reports such as this one showing the allocation of administrative overhead costs to “patient “service centers.”