Activity Based Costing Model in Laboratory of Care Hospital

Ali Habibi*

Dr. Kamal Javanmard**

Ravi Kumar Tati***

The study explores the relation between Activity Based Costing (ABC) and the

measures of hospital performance-profitability revenue and cost containment in a corporate

hospital-Care Hospital in Hyderabad, India. A Comparative analysis is attempted to check the

benefits offered by the ABC in comparison to traditional costing system.

Activity Based Costing is a process by which the cost of individual products and

services are estimated based on the activities in the process of producing and delivering those

goods and services so that unprofitable products are identified and eliminated. It is a tool used

for understanding product and customer cost and profitability. It identifies activities in an

organization and assigns the cost of each activity resource to all products and services. The

total cost of production is computed as the sum of the total cost of all the activities

performed. Activity Based Costing relates to the overhead costs to the forces behind them.

Contrary to traditional cost-accounting systems, ABC systems accumulate overhead costs for

each activity, and then assign the costs of the activities to the products, services, or

customers. Hence the focus shifts from managing costs to managing activities.____________

* Ali Habibi, Researcher & Faculty of Accounting, Kanooj University, Iran.

**Dr. Kamal Javanmard, Principal of Islamic Azad University, Kanooj, Iran.
*** Ravi Kumar Tati, Associate Professor, Sujana School of Business, Hyderabad, India.
Initially, ABC was applied to factory overhead (Berliner and Brimson, 1988), but soon

managers recognized that traditional methods for allocating overhead to products or services

were too arbitrary and did not necessarily reflect the specific resources used in producing

diverse outputs (Cooper and Kaplan, 1988). ABC is a remedy for the organisations suffering

from cost distortions. Some of the important factors in determining cost under ABC different

from VBC.

1). Inventory valuation

An ABC cost system values inventories on a total cost basis absorbing all costs. Costs

therefore include items such as interest and certain other marketing and administrative costs.

Overhead is added to components and materials on issue to work-in-progress, parts being

either front flushed or back flushed from the systems record of materials in store.

2). Service Pricing

ABC by bringing together product attribute costing and market share forecasts provide a

powerful approach to new product and product improvement decisions in both short term and

long-term planning. It provides more factual basis for decisions involving charging the

service options offered.

3). Cost Responsibility

The underlying philosophy of ABC is that the cost responsibility should be shared by all

functions of an organisation. The technique gives the visibility to costs by detailing

organizations activities and their inter relationships.

4). New Service Design

Establishing a service/product design calls for crucial choices- about materials made or

bought. A high percentage of final manufacturing cost is determined in the design stage

(Whitney 1998).

ABC in Service Industry

Service companies have had problems coming up with decent cost accounting systems

because they have been modeling them after systems found in manufacturing firms. The

problems that manufacturing firms place emphasis on valuing inventory, which service firms

do not even have, and use standard costs calculated for direct materials and labor. Direct

materials and direct labor costs are not major in service firms and it is hard to calculate

standard costs in that setting. Nonetheless, service firms do need to know accurate costs for

product profitability analysis. The methodology for making cost allocations involves two

separate issues:

1. The pools or categories of indirect costs that should be identified aggregated and allocated

together.

2. The basis over which the costs in any given pool should be allocated.

The most acceptable method of assigning costs to a product or service is to select

drivers that approximate the underlying behavior of the costs to be allocated. This causal

relationship is generally regarded as the best method for allocating indirect costs. A cost

driver is used to allocate costs based on a common measure of the quantity of the resource

used by the product (or service, department, contract or unit). Cost drivers are key to the

value based costing and can be identified as.

1). Volume based cost drivers

2). Transaction based costing

 Volume based cost drivers those drivers that drive all short term variable costs and

overhead comprising of these short term variable costs. While on the other hand the costs are

driven by complexities and diversities and not by volume. Determining the number of cost

drivers depend on product diversity, relative cost of the activities and volume diversity. The

Volume based Costing (VBC) is the popular cost accounting method under which the indirect

costs are allocated to each cost object using a single indicator called driver. The VBC offers

the merit of simplicity through rough and inaccurate results. In mid 1990s the ABC method

was introduced in the health care industry. Under ABC all events and transactions that cause

costs are recognized as ‘activities’ and a specific cost driver is prepared whereby indirect cost

costs are allocated to each activity. ABC provides more accurate results.

Health Care Industry in India

People are healthier, wealthier with a longer life span today than 30 years ago. There

have also been significant improvements in access to water, sanitation and antenatal care.

This shows that progress is possible and can be accelerated. According to the ‘Indian

healthcare trends report published by Technopak, Indian healthcare industry is growing at

over 18% making it the fastest growing in the world and highest growing sectors in India. As

per the report, the industry is currently valued at US $ 35 billion and is expected to reach over

US$ 75 billion by 2012 and US $ 150 billion by 2017. During the last one decade the health

care sector in India has undergone tremendous changes offering opportunities and posing

challenges and Andhra Pradesh in particular. India presents a unique opportunity for

healthcare providers, policy makers and service providers alike. With 16% of the world

population and 21% of total global diseases, Indian healthcare is not only grossly under-

staffed, with a doctor to thousand population ratio of 0.5 as against 1.5 of comparable

emerging economies, but also faces ever widening gaps in physical infrastructure. The
healthcare industry in India, which comprises hospital and allied sectors, registered a growth

of 9.3 per cent between 2000 and 2009. According to the report, the growth in the sector

would be driven by healthcare facilities - private and public, medical diagnostic and path labs

as well as the medical insurance sector.

ABC in Health Care Industry

Healthcare organization can identify non-value-added activities, which consume

resources without adding value to patient services by applying ABC. The price for the health

care services provided is defined in terms of the volume of services provided, bed-days,

surgical procedures and out-patient days. No-medical professionals lack technical skills

necessary skills to manage the cost effectively while medical professionals lack appropriate

knowledge to design an effective cost system (Cooper-2006). The environment is becoming

more competitive and less forthcoming with the resources required. The Hospital

Administrator’s responsibility is driven by organizational maintenance rather than customer

needs (Udpa 96). Activity based management information empowers the management to take

better decision (Mishra and Vaysman 2001). Different hospitals espouse different objectives

in different countries and the varied ownership structures. The profit seekers

(Administrators) try to maximize the shareholders’ wealth thereby attempts to reduce the cost

of the service (Mark 1999).

Period of the Study

The study takes in to account only one year i.e 2009-10data of the care hospital,

Hyderabad. The data related to previous years (prior to 2009) also is being used.
Limitations

Since the data collected was through cost sheets of the hospital, the errors if any might

have peeped into our analysis. The Analysis presented the study may not give accurate

picture as the data might suffer from congenital defect.

Research Approach

Hospitals in Hyderabad feel pressure from customers and regulators to provide high

quality service at a lowest possible cost. In this study we investigate whether the hospitals

enjoy incremental benefits with the adoption of activity based costing beyond what is being

provided by the traditional costing system. We propose a method which provides a

convenient method ABC in comparison to VBC with reduced number of cost drivers. The

total cost for each object is divided into direct and indirect costs; direct costs include direct

labour costs, direct material cost and direct equipment cost which can be obtained from the

hospital information system. Under ABC indirect activity costs are attributed each cost

object. The cost function under ABC can be given as follows:

C =ax+by+cz+S

Where:

C= Total cost

a= Variable cost per unit

x= Number of patients served

b= Cost per activity

y= Number of activities

c= cost per service line

z= Number of services offered in the hospital

 We assume that there are various indirect activities in physiological laboratory with a

corresponding total cost as presented in Table 1. We have categorized all the activities in the

department under three broad tests namely Bio-Chemical Test denoted with ‘A’,

Hematological Test denoted with ‘B’, Immunological Test denoted with ‘C’, SLAX

(Equipment require for vacuum preparation) maintenance and STS (Equipment for sample

transfer). The cost drivers identified were Number of Orders Received, Number of Tests

Requires Vacuum Tubes, Number of HIS terminals, Time required, Number of Bills and

Number of Tests by Transfer in the study. Indirect cost were allocated to each test and the

total indirect cost of each of the three tests. There were 940198 drivers involved in test A,

similarly 84963 drivers in Test B and 61,266 drivers in test C in the laboratory during 2009-

10 financial year. The total costs involved for test A were Rs.84482, test B Rs.25664 and test

C Rs.256568. The total number of drivers in the laboratory was 1086427 and corresponding

cost was Rs.256568. The cost per order received was lowest of Re.0.08, while the cost per

terminal was at Rs.3739. The cost saving can be seen in table 2 that test A gives a saving of

3.77 per cent , test B 10.31 and test C 40.52. The total saving offered by the activity based

costing over the volume based costing was 11.38 per cent.

Conclusion
With the identification of the cost drivers, the cost accountant can also make out the

drivers and centres responsible for the cumbersome activities and heavy costs. Hence there

can be a check on the ballooning costs and elimination of unwanted costs. None the less due

to enormity of the data, large number of cost drivers and complexity of data collection under

ABC calls for a concern. The strict application of ABC in usual cost estimation is un-

pragmatic in service sector and health care sector in particulars. To get the advantage of the

ABC the number of cost drivers had to be reduced as proposed by Penygu Cao et.al (2006).

They suggested that once the number of cost drivers is reduced by applying the cost driver
selection method to the data for the ABC, then we can use a simplified ABC method that can

easily perform the data collection and cost accounting.

 Table 2

Cost Accounting under Activity Based Cost Accounting Method

  Total  
  Volume of Cost Drivers Volume of Indirect Cost Total Cost
Drivers   In Rs. Lakhs
Activity Cost Driver A Test B Test C Test   A Test B Test C Test  
Number of orders
Receiving test orders received 211461 8500  6724  226685   12600 4200  1700  18500
Number of test require
Taking blood samples vacuum tubes 258007  4260  3600  265867  42600  58900  14562 116062
Transferring reports Number of his terminals 2  1  1  4  5600  7800  1558 14958
Claiming remuneration Time required 216  6  4  226  2800  1600 3546 7946
Supplying materials Number of bills 960  14  9  983  21000  1800  658 23458
supplying reagents Number of bills 84  16  18  118  25014  9815  2589 37418
Number of test require
Maintaining SLAX vacuum tubes 211461  72166  29256  312883  11156  367  426 11949
Number of tests by
Maintaining STS transfer 258007  0  21654  279661  25652  0  625 26277
Total   940198 84963 61266 1086427 146422 84482 25664 256568

A= Bio-chemical test
B=Hematological test
C= Immunological test
SLAX= Equipment require for vacuum preparation
STS= Equipment for sample transfer
 Table 2

Comparative Cost Analysis of Activity Based Costing and Volume Based Cost Accounting

  Total  
  Volume of Cost Drivers Volume of Indirect Cost
Drivers   Total Cost
Types of Costing A Test B Test C Test   A Test B Test C Test  
ABC 211461 8500  6724  226685  146422 84482 25664 256568
218518
VBC 211461 8500  6724  226685  152168 94200 43150
Cost Saving 5746 9718 17486 32950
Cost Saving( in per cent) 3.77 10.31 40.52 11.38
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