Healthcare financial managers use financial resources and cost classifications to allocate indirect
costs to direct costs when determining patient charges. This is achieved using cost accounting
methods. Cost accounting methods involve estimating and classifying costs incurred by an
organization, and is a crucial process needed for organizational success (Carroll & Lord, 2016). The
five most common cost accounting techniques seen in the healthcare environment include traditional
costing, activity-based costing, time-driven activity-based costing, performance-focused activity-
based costing, and the ratio of costs to charges (Carroll & Lord, 2016). To this discussion post I will
be discussing traditional costing and Performance-focused activity-based costing (PFABC).
“Traditional Costing is a cost accounting methodology that allocates organizational overhead to a
specific output based on a predetermined cost driver or by using a pre-determined percentage rate”
(Carroll & Lord, 2016). This method is widely used and accepted, however unrealistically depicts a
product or service’s true cost (Carroll & Lord, 2016).
Performance-focused activity-based costing (PFABC) (AKA value-based purchasing) examines
organizational performance to properly allocate indirect expenses (Carroll & Lord, 2016). I believe
this method of classifying costs would be most effective. Financial success is dependent on
performance and quality. This method reallocates funds to the highest performing hospitals, with
consideration of the quality of care delivered at the organization, and overall patient outcomes
(Patterson, 2017). PFABC involves collection, analysis, and reporting of information pertaining to
performance of the organization. This method allows organizations to see what has been achieved, or
should have been achieved.
Furthermore, utilization rates are related to volumes and revenue generation. “Having a thorough
understanding of the organization's current positioning and the likely impact of healthcare reform and
market forces is essential if a provider is to project utilization to support an accurate multiyear
financial plan” (Samaris, 2013). To determine profit or loss, managers must review costs in relation
to associated volumes and revenues. According to the literature, revenue minus total expenses will
depict organizations profit gain or loss (Nowicki, 2022). Simply, more consumers mean more
volume, however this also means more support, and both must be taken into consideration to
determine volume.
Unlike direct costs, those costs that can be traced directly to a service, product, or department,
indirect costs (overhead) cannot be linked in a direct way (Nowicki, 2022).
Carroll & Lord (2016) as well as our text, describe five cost accounting techniques to allocate indirect
costs to direct costs.
Traditional Costing is a method that allocates overhead to direct costs by using an easy-to-understand
and apply formula involving a pre-determined percentage rate. While it is a simplistic approach, it
has been criticized for producing unrealistic and incorrect depictions of a service or product’s true
cost (Carroll & Lord, 2016).
Activity-Based Costing uses cost drivers or activity measures to allocate indirect costs to products
(Nowicki, 2022). This method takes a more rational approach to product and service costing (Carroll
& Lord, 2016).
This method of allocating indirect costs can quickly become outdated if cost driver assumptions,
which are subjective and sometimes related to manager preference, are not updated to reflect changes
in the organization (Carroll & Lord, 2016).
Job Order Costing is a method of determining product costs by taking a sampling of the product's
direct costs and creating a relative value unit (RVU) which is a measure of what resources are used
by each product. Total indirect and direct costs are then assigned to the product based on the
relationship set by RVU (Nowicki, 2022).
Interestingly, I use RVUs when determining which surgical procedure is the primary (more complex)
procedure in the surgical data abstraction work that I do. There is an RVU calculator found online
that I use as a tool.
Ratio of cost to charges (RCC) explained by Carroll & Lord (2016) is a method of costing that is
specific to the healthcare industry and uses traditional costing methods to allocate indirect costs to
clinical departments in the creation of a cost report. This report allows hospitals to estimate the total
cost of each revenue-producing department. The Centers for Medicare and Medicaid Services (CMS)
require hospitals to file Medicare Cost Reports annually (Carroll & Lord, 2016).
Nowicki (2022) further explains that this method involves “determining product cost by relating its
cost to its charge” by dividing the total operating expenses of an organization by gross patient
revenue (p. 202). This percentage is then applied to any organization’s product charge to get the
product cost (Nowicki, 2022).
Nowicki (2022) points out a serious flaw with this method and that is that it assumes a non-changing
relationship between cost and charge, and this is simply not correct.
Process Costing determines the product cost during a given accounting period. This method divides
the full costs of a department or organization divided by the number of services or products produced
or provided during that period and is not appropriate for all situations (Nowicki, 2022).
Utilization rates as they relate to volume and revenue
According to the London School of Hygiene and Tropical Medicine, utilization rates can be
calculated by taking the total number of new patient consultations or healthcare visits of all
healthcare sites of a population in a given time period and dividing it by the total population. This
figure is then multiplied by what is referred to as a correction figure, say 12 as in 12 months to get the
utilization rate (London School of Hygiene and Tropical Medicine, n.d.).
The resulting figure lets financial managers know what portion of the population is seeking medical
care and perhaps how accessible healthcare is and how they may increase volume. If the population
of an urban city is 100,000 people, but only 3,000 sought healthcare consultations in a 12-month
period, then with a utilization rate of 0.36, financial managers might need to ask themselves what
barriers to healthcare exist in this area (London School of Hygiene and Tropical Medicine, n.d.)?
Why is the volume of new consultations not greater? How can we reduce barriers to healthcare and
increase volume as well as increase revenue?
According to a study by The National Academies of Sciences, Engineering, and Medicine (NASEM)
in 2018, the availability of healthcare services does not necessarily mean that they are equally
accessible to all people within a population. Healthcare utilization is determined by not only the need
for care but also whether that care can be accessed (NASEM, 2018).
Health status and the need for ongoing healthcare services to maintain or improve health are
significant determinants of healthcare utilization (NASEM, 2018). This means if a population of an
area has relatively equal access to healthcare but this population of people has more co-morbidities,
say in a predominant minority community, then the utilization rate will be higher than that of a
community where access to healthy food and exercise are prevalent (Risa et al, 2021). To increase
volume in some areas, then improve access to healthcare services. By increasing volume, gains in
revenue will necessarily follow (all things being equal).
Healthcare managers need to understand all costs (fixed/variable, direct/indirect) of services provided
in order to determine program profitability.Direct costs are costs that can be traced directly to a
department, product, or service while indirect cost indirect costs cannot be traced directly to a
department, product, or service. Examples of direct cost are such as labor and supplies and examples
of indirect cost can be costs associated with heating and cooling. To allocate costs healthcare
financial managers don’t directly send bill for everything they did. Healthcare managers instead of
sending bill to patients for cooling and heating which consider an indirect cost, they assign the cost
another department that make patient bills such as lab and radiology. (Nowicki, 2018).
To determine profit and losses, financial managers evaluate the costs in comparison to volume and
revenue. They subtract the expenses from the revenue. (Nowicki, 2018). In deciding how to
determine patient charges financial managers measure the indirect and direct cost of operations by
first understanding the relationship between costs and expenses through a process called cost
analysis. Direct cost are such things as consumable supplies and materials, sales commission or any
cost that can be directly traced to the organization, while indirect cost is those than cannot be traced
back to the organization such as overhead cost as rent, utilities, salaries and administration cost
(Nowicki, 2018).
Utilization rates are related to both volume and generated revenues. A study done in the United States
about hospitals that routinely keep utilization relatively high to maximize profit found out that
increasing the volume of the patients result in increased utilization rate. The implication is to increase
patient volume, most hospitals signed a discount contract which can have affect revenue. The study
concluded that “for hospitals with a relatively high operating room utilization (e.g., 90%), computer
simulations predict that increasing patient volume by the amount expected to "fill" the operating
room can have the net effect of decreasing contribution margin (i.e., profitability)”. (Dexter &
Macario, 2001).
"To realize an effective cost control, a practical and accurate cost accounting system is indispensable
in hospitals." (Cao et al., 2006). Healthcare financial managers use financial resources and cost
clarifications to allocate indirect costs to direct costs when determining patient charges by splitting up
the charges into individual categories. Direct costs are costs that can be traced back to a specific
department, product, service, or supply (Nowicki, 2018). Indirect costs cannot be traced to a specific
department or back to the patient, and are considered "overhead costs". It is important that their is
separation of these costs so that the patient is in turn only being billed for services rendered.
Unfortunately, "the hospital production process is complex and even the normally simple process of
defining what outcome is being costed is difficult in the context of hospital operations." (Carroll and
Lord, 2013). Traditional based costing "is a cost accounting methodology that allocates
organizational overhead to a specific output based on a predetermined cost driver or by using a pre-
determined percentage rate (Paulus, van Raak, & Keijzer, 2002). This method however, doesn't
differentiate between product & service lines and marketing channels, rendering it unreliable.
Activity based costing is "widely used in the preparation of budgets as it serves as a planning
mechanism that shows the relationship between goal achievement and resource intensity" (Namazi,
2009; Turney, 2010). Time driven activity-based costing (TDABC) "is an attempt to overcome some
of the weaknesses associated with ABC. TDABC differs from traditional ABC, in that time is used as
the primary cost driver. The assumption underlying the TDABC method is that most resources (i.e.
manpower, equipment, and facilities) have capacities that can be measured in terms of time"
(Namazi, 2009) Performance-based activity-based costing (PBABC) is different from TABC and
ABC in that "the actual resources for each activity can be assessed in a variety of ways, including
interviews, surveys, or based on actual utilization of time, materials or other resources" (Namazi,
2009).
Hospitals typically like to keep utilization high in order to attract more revenue. Unfortunately, this
typically has a reverse effect, as and increase in hospital utilization accounts for an increase in wait
times for procedures or beds in a hospital. In regards to increasing utilization in a surgical suite to
attract more revenue, "With a 15% reduction in payment for the new patients, the increase in volume
may not increase revenue and can even decrease the contribution margin for the hospital surgical
suite." (Dexter et al., 2001). Although higher volume of patients equals more revenue for the hospital,
it is not without repercussions.
References
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https://doi.org/10.1620/tjem.208.213
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London School of Hygiene and Tropical Medicine. (n.d.). Health service utilization.
http://conflict.lshtm.ac.uk/page_145.htm#:~:text=Health%20service%20utilization%20can%20be,to%
20calculate%20the%20annual%20number.
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