Health Care Finance

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Copyright 2013 by FACHE 6/15/12

Case 3

Panhandle Medical Practice

(Activity-Based Costing)

Panhandle Medical Practice is a group practice owned by the area’s leading

hospital, Panhandle Regional Medical Center. The Practice includes both

primary care and specialty physicians, with an emphasis on internal medicine,

obstetrics, pediatrics, and surgery. The Practice has three different

locations, each one staffed with a mix of primary care and specialist

physicians.

Traditionally, ancillary services have been performed at the hospital. Still,

some ancillary services are best performed at the Practice locations for one

or more of the following reasons: lower costs, increased physician

efficiency, and improved patient convenience. For example, one of the

Practice locations now has a diagnostic imaging capability. When the scanner

was moved from the Hospital to the Practice location, volume increased, costs

decreased, and both physician and patient satisfaction improved.

The proposal now being considered is to provide ultrasound services at the

Practice locations. Preliminary analysis indicates that two approaches are

most suitable. Alternative 1 involves the purchase of three ultrasound

machines, one for each of the Practice’s three locations. Patients would

schedule appointments, generally at the location that they are using, during

preset times on particular days of the week. Then, the full-time ultrasound

technician would travel from one location to another to administer the tests

as scheduled.

In Alternative 2, patient scheduling would be the same, but only one

ultrasound machine would be purchased. It would be mounted in a van that the

technician would drive to each of the three Practice locations. Most of the

operating costs of the two alternatives are identical, but Alternative 2 has

the added cost of operating the van and setting up the machine after each

move.

The two alternatives differ substantially in initial costs because

Alternative 1 requires three ultrasound machines, at a cost of $75,000 each,

while Alternative 2 requires only one. However, Alternative 2 requires a van,

which with necessary modifications would cost $40,000. Thus, the start-up

costs for Alternative 1 total 3 × $75,000 = $225,000, while those for

Alternative 2 amount to only $75,000 + $40,000 = $115,000.

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Note, though, that because the two alternatives have different operating

costs, a proper cost analysis of the two alternatives must include both

initial (capital) and operating costs. The Hospital’s financial staff

considered several methods for estimating the operating costs of each

alternative. After much discussion, they decided that the activity-based

costing (ABC) method would be best. Furthermore, an ad hoc task force was

assigned the task of performing the cost analysis.

To begin the ABC analysis, the task force had to develop the activities

involved in the two alternatives. This was accomplished by conducting “walk-

throughs” of the entire process from the standpoints of the patient, the

ultrasound technician, and the billing and collections department. The

results are contained in Table 1. A review of the activities confirms that

all except one--machine setup--are applicable to both alternatives.

The next step in the ABC process is to detail the costs associated with each

activity. This step uses financial, operational, and volume data, along with

the appropriate cost driver for each activity, to estimate resource

consumption. Note that traditional costing, which often focuses on

department-level costs, typically first deals with direct costs and then

allocates indirect (overhead) costs proportionally according to a

predetermined allocation rate.

In ABC, the activities required to produce some service, including both

direct and indirect, are estimated simultaneously. For example, Table 1

contains activities that entail direct costs (such as technician time) and

activities that entail indirect costs (such as billing and collection).

Although the ABC method is more complex and hence costlier than the

traditional method, it is the only way to accurately (more or less) estimate

the costs of individual services.

Activity cost detail on a per procedure basis is contained in Table 2. In

essence, each activity is assigned a cost driver that is most highly

correlated with the actual utilization of resources. Then the number of

driver units, along with the cost per unit, is estimated for each activity.

The product of the number of units multiplied by the cost per unit gives the

cost of each activity. Finally, the activity costs are summed to obtain the

total cost per procedure.

Many of the activity costs cannot be estimated without a volume estimate. The

best estimate is that 50 procedures would be done each week, regardless of

which alternative is chosen. Assuming the technician works 48 weeks per year,

the annual volume estimate is 2,400 procedures. Of course, a much greater

total volume can be accommodated under Alternative 1, with three machines,

than with Alternative 2, with only one machine. However, to keep the initial

analysis manageable, the decision was made to assume the same annual volume

regardless of the alternative chosen.

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In addition to the costs mentioned thus far, some other costs are thought to

be relevant to the decision. First, in addition to the obvious costs of

operating the van (primarily gas expenses), it is estimated that annual

maintenance costs will run about $1,000. Furthermore, annual maintenance

costs on each of the three machines under Alternative 1 are estimated at

$500, while the annual maintenance costs for the single machine under

Alternative 2 are estimated at a higher $1,000 because of added wear and

tear. Also, the manufacturer of the ultrasound machines has indicated that a

5 percent discount may be available if three machines, as opposed to only

one, are purchased.

Finally, to have a rough estimate of total annual costs over the life of the

equipment, it is necessary to make assumptions about the useful life of the

ultrasound machines and the van. Although somewhat controversial, the

decision was made to assume a five-year life for both the ultrasound machines

and the van. Furthermore, the assumption was made that the value of these

assets would be negligible at the end of five years.

Assume that you are the chairperson of the ad hoc task force. Your charge is

to evaluate the two alternatives and to make a recommendation on which one to

accept. Because the revenues are assumed to be identical for the two

alternatives, the decision can be made solely on the basis of costs. As part

of the analysis, it will be necessary to estimate the costs of the two

alternatives on a per procedure and annual basis. In addition, any

qualitative factors that are relevant to the decision must be considered

before the recommendation is made.

To keep the analysis manageable, the task force was instructed to assume that

operating costs remain constant over the useful life of the equipment. For

comparative purposes, this assumption is not too egregious because the

activities are roughly the same for both alternatives, and hence inflation

would have a somewhat neutral impact on costs.

TABLE 1

Panhandle Regional Medical Center

Activities Associated with Alternatives 1 and 2

1. Appointment scheduling

2. Patient check-in

3. Ultrasound testing

4. Patient check-out

5. Film processing

6. Film reading

7. Billing and collection

8. General administration

9. Transportation and setup (Alternative 2 only)

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TABLE 2

Panhandle Regional Medical Center

Activity Cost Detail

Cost

Activity Cost Driver Volume per Unit

Appointment scheduling Receptionist time 3 minutes $ 0.20

Patient check-in Receptionist time 5 minutes 0.20

Ultrasound testing Technician time 45 minutes 0.40

Physician time 1.5 minutes 3.00

Supplies per procedure 1 packet 9.00

Patient check-out Receptionist time 5 minutes 0.20

Film processing Technician time 10 minutes 0.40

Film reading Contract terms per procedure 40.00

Billing and collection Overhead costs per procedure 6.80

General administration Overhead costs per procedure 1.25

Transportation/setup* Technician time 6 minutes 1.00

*Alternative II only.

Notes:

1. Physician time for testing (15 minutes) is needed for one of every ten

patients.

2. Supplies consist of linen, probe cover, gel, film, and print paper.

3. There are no radiologists in the Practice. Films will be read by the

Hospital’s radiologists at a contract fee of $40 per procedure.

4. Billing and collection costs are based on an average cost per medical

services bill.

5. General administration costs are based on an estimate of facilities and

other administrative costs.

6. Transportation and setup is based on ten procedures per day at each

location and includes vehicle operating costs, excluding maintenance.

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QUESTIONS

1. Estimate the base case cost of each alternative regarding the provision of

ultrasound services. (For now, ignore the discount if three units are

purchased.)

2. Which alternative has the lower total cost?

3. What value for travel and set-up costs would make the costs of the two

alternatives the same?

4. Now consider the 5 percent discount. What impact does this have on the

decision? What discount amount would make the two alternatives equal in

costs?

5. What subjective factors would influence the decision as to which alternative

to choose?

6. What is your final decision?