Is it Time for the Healthcare Industry to Make Cost Management a Priority?

Most industries today are faced with a variety of obstacles in achieving or remaining profitable. The healthcare industry is no exception. Profitability is enough of a challenge under normal circumstances, but especially so during fragile economic times. Uncertain revenue streams and rising costs have many healthcare organizations understandably apprehensive.   

Traditionally, hospitals were more focused on managing revenues rather than on costs to insure profitability. But this focus on revenues has become increasingly more difficult to plan, execute and manage due to confusing healthcare reform, complex insurance reimbursements, community perception, government red tape and political concerns. Conversely, cost management has been a topic of discussion for the past decade but has not been a priority due to limited administrative resources.

Cost management
Cost management can be defined as the process of collecting, analyzing, evaluating and reporting of cost information that is used for budgeting, forecasting, pricing, profitability analysis and performance reporting. Accurate cost information affects both financial and non-financial decision making. Inaccurate decisions often result in unprofitable service offerings, incorrect pricing, inefficient allocation of personnel and low return on investment on equipment purchases. In an article, "Analysis of Hospital Costs: A Manual for Managers" (Donald Shepard, 1998), it is stated that “A hospital cannot set rates and charges which are realistically related to costs unless the cost-finding system accurately allocates both direct and indirect costs to the appropriate cost centers.” This statement is as valid today as it was 13 years ago. Healthcare organizations quickly realized that there was limited control over revenue sources, and the costs associated with increasing those revenues only resulted in incremental profits. In comparison, cost management often results in each cost dollar saved contributing directly to net income. Technology and costing techniques have now greatly evolved, so there is a real motivation to shift the focus to cost management.

Activity-based costing
In the past few decades, several significant improvements have occurred in both cost management techniques and with the supporting technology. These improvements focused on the approach and accuracy of the allocation of indirect costs (overheads). In its simplest form, costs consist of direct and indirect (overhead) components. Direct costs are easily identified and assigned to products and services. Examples of healthcare direct costs include: physician and procedure specific staff services (labor), supplies used to deliver services and easily assignable service related equipment costs. Assigning the supporting overhead, or indirect, costs to these same services to arrive at the total cost is far more complex and at times may appear ambiguous. Traditional overhead allocation practices involve allocating overhead costs based on criteria such as square footage, direct labor dollars, labor hours, revenue dollars, units of production, machine hours (manufacturing) and miles (transportation organizations). These traditional practices were, and continue to be, imprecise and inconsistent at best. One technique that was developed in the early 1990’s to more appropriately assign overheads is activity based costing. ABC is an advanced costing technique that is used to address the complex process of assigning indirect costs (overheads) to products, services, customers (cost to serve) and suppliers.  

Costing example
A typical service offered by a healthcare facility is heart surgery. The direct costs would include the cost of the surgeon and procedure specific staff, along with the supplies required for this particular operation. The indirect (overhead) costs would include, but not be limited to, general support staff and related costs, insurance, taxes, floor space, facility and administration. It is estimated that these indirect costs can be as high as sixty percent (60 percent) of the total costs of a hospital service. This is a significant portion of the total cost, so it only takes a slight deviation in such a large component of the cost to paint a startlingly different financial picture. This subsequently leads inaccurate or misguided decision making.

Early versions of ABC focused on developing cost at the activity level and involved performing activity analysis to survey how much of each employee’s time was spent, on average, on each activity. This approach resulted in significantly more accurate overhead assignments, as opposed to the traditional allocations. The downside of this first evolution of ABC was that it had high resource requirements and extensive computer processing to organize the data into useful information. 

Time-driven activity based costing
Within the last several years, a newer evolution of ABC, called time-driven activity based costing, was developed. TDABC is a formula-driven approach that essentially replaces traditional ABC and the time-consuming surveys that go with it. TDABC takes advantage of improved technology capabilities to reduce the manpower and IT resources that are needed. Thousands of transactions can now be processed immediately, and additional information, such as capacity utilization, can be described in detail.

Until recently, hospitals have rarely taken advantage of these advanced costing techniques. There are cases where hospitals have implemented ABC practices, primarily using spreadsheets or custom databases, but at a high resource cost. Now that these newer cost effective tools (such as TDABC) are available, healthcare organizations can improve the quality of their cost information to dramatically reduce the risk of inaccurate financial decisions. This includes the ability to better measure efficiencies and capacity utilization. Better information for all of the key stakeholders, including hospital administrators, physicians, or policy makers, will result in a far more efficient and cost-effective industry.

The bottom line: Increased profitability
The conclusion is that healthcare organizations are finding it increasingly more difficult to improve profitability by focusing on revenues. Refocusing resources on cost management will allow these organizations to achieve increased performance without sacrificing existing service levels.  Understanding the total costs of services will allow the redeployment of resources which provide a higher payback, or will facilitate the elimination of those resources altogether. The bottom line: increased profitability.  

On Target Performance Group is a client-focused, performance-driven, cost-management consulting firm that quickly identifies where profit is earned and where profit is lost by focusing on cost. On Target’s primary objective is to deliver sustainable costing and profitability solutions to our clients.

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