Activity-Based Costing (ABC)

1. Activity-Based Costing (ABC)

2. Agenda • Introduction to course • Shared resources • Strategy and costing • A hospice example: Hospice of Central Kentucky • Mechanics of Activity-based costing (ABC) • A manufacturing example: Ross Parts • Forrest Gump case • Takeaway

3. Mapping Resources to Products • Product costs arise from products’ use of resources • Dedicated Resources • Shared Resources • More accurate costing systems • Better track the products’ use of shared resources • Design of more accurate costing systems • 2 stage-costing systems

4. Traditional Cost Systems Overhead Labor Materials Direct Direct % Labor Cost Doors Mufflers Manifolds

5. Two Stage Cost Systems • Traditional Systems • Assumes that all shared resources exist to support direct labor • Modern Manufacturing and Service Technologies • Shared resources could include • Machines and Technical Personnel • Product and Service Designers • Two Stage Costing Systems • A more sophisticated method of mapping shared resources to individual products

6. Example: Detroit Lofts, Inc. • A small loft at 3930 Cass Ave. in Detroit • Originally a VFW bar • Now houses two office spaces A and B of 600 sq. ft. and 400 sq. ft. respectively • Each office space is used by one person • The joint utility bill is $800, of which $500 is for heat, and $300 is for water • Electricity and Comcast are billed individually • What is the utility cost of each office space?

7. Traditional System • Use square footage as the allocation basis • Both offices together have 1,000 sq. ft. • So each sq. ft. costs $800 ÷ 1000 = $0.80 • Office costs • A: $0.80 x 600 = $480 • B: $0.80 x 400 = $320 • Do the costs properly reflect resource use by the two offices?

8. Two-Stage Costing System • One approach is to adopt a “two-stage” cost system • First stage • Split overhead into the two departments (heat and water) • Second stage • Calculate separate overhead rates using different allocation bases (cost drivers) Note: use allocation base levels that combine all offices’ usage • Calculate individual office costs using the new rates

9. Two-Stage Cost System Comcast Internet Electricity Overhead Direct Direct Heat Water Square feet Headcount Office A Office B

10. Detroit Lofts: Resource Usage • First stage • Total utilities bill is $800 = $500 (heat) + $300 (water) • Second stage • Heat allocated by square footage (allocation base) • Heat rate = $500 ÷ (600 + 400) = $0.50 per sq.ft. • Water allocated by headcount (allocation base) • Water rate = $300 ÷ (1 + 1) = $150 per person • Office A cost = $0.50 x 600 + $150 = $450 (down from $480) • Office B cost = $0.50 x 400 + $150 = $350 (up from $320) • A better reflection of the offices’ true usage of shared resources

11. Strategy and Costing • Why care about efficiencies? • Monopoly (utilities and solar power) • Healthcare

12. Some Facts (from Ezekiel Emanuel’s books) • Medicare • Federal government (HHS) prohibited from negotiating drug prices with pharma companies • Only private insurers can • Medicaid and VA already negotiate directly • Will Warren Buffett/Jeff Bezos/Jamie Dimon negotiate with pharma? • What does that mean for the rest of us?

13. IMPACT OF THE ACA ON HOSPITALS AND INSURERS (from “Reinventing Healthcare” by Ezekiel Emanuel) Access – particularly expanding Medicaid and creating health insurance exchanges Cost control – including accountable care organizations (ACOs) bundled payments, the “Cadillac” tax, the Center for Medicare and Medicaid Innovation, and the Independent Payment Advisory Board Quality improvement – including reduction in hospital-acquired infections and readmissions, electronic health records, and the establishment of the Patient-Center Outcomes Institute Prevention – including the coverage of preventive services without co-payments, menu labeling, and employer wellness programs

14. IMPACT OF THE ACA ON HOSPITALS AND INSURERS --- ctd Workforce – including support for nursing schools and changes in loan forgiveness for physicians entering the National Health Service Corps Revenue – including device, cosmetic surgery, and tanning salon taxes Other important odds and ends – including administrative simplification, medical-loss ratio, and transparency of financial relationships between drug companies and physicians The CLASS Act – that would have created a voluntary long-term insurance program, but it was subsequently repealed

15. IMPACT OF THE ACA ON HOSPITALS AND INSURERS --- ctd Blue states starting their own ACA with individual mandate (California, Connecticut, Hawaii, Rhode Island, Washington, Minnesota, New Jersey and Vermont, as well as the District of Columbia); red states scrapping the individual mandate Will this cause old and young people to move? Alibaba using AI in Chinese healthcare

16. Six megatrends by Ezekiel Emanuel

18. Two-Stage Cost Systems • Recall the two-stage cost system • Stage 1: Partition shared resources into pools • Move “BIG and DIFFERENT” resource to a separate pool • Stage 2: Allocate each pool using the relevant allocation base • How to design two-stage cost systems for any given company? • Activity Based Costing (ABC) provides a systematic approach • It relies on a thorough understanding of the production process

19. HCK Example • The Hospice of Central Kentucky (HCK) traditional cost system computed administrative cost per patient-day by dividing total administrative cost by total patient-days. • Reported administrative cost per patient day • $112,565 ÷ 3,593 patient-days = $31.33. • How accurately does this cost number track the costs of servicing patients using the modern technologies of terminal care? Source: Sidney J. Baxendale and Victoria Dornbusch, “Activity-Based Costing for a Hospice,” Strategic Finance, March 2000, pp. 65-70. www.imanet.org. The case does not disclose the time period over which the costs were measured (e.g., monthly).

20. Business Model of HCK Cost Cost Cost Process Care Discharge Admit

21. Activity Levels over ALL Patients at HCK 74 referrals* 46 admissions 46 deaths 2,080 service calls 3,200 calls 5,553 patient-days* 192 billings 75 volunteers _______ * Referrals and patient-days are weighted by the stage of the disease. For example, the actual number of patient-days is 3,593, but a day for a patient whose death is imminent is counted as equivalent to three patient-days for a patient in slow decline due to the more intensive care such patients receive.

22. TOTAL Resource Usage over ALL patients Resource Resource Supporting Activity Allocation Rate Type Cost Pool Levels over all Patients Prereferral $ 24,611 74 referrals* $332.58 per referral Referral $10,873 74 referrals* $146.93 per referral Admission $1,960 46 admissions $42.61 per admission Post-admission $3,649 46 admissions $79.33 per admission Post-death $1,476 46 deaths $32.09 per death Bereavement $12,670 46 deaths $275.43 per death Med. services $5,588 2,080 service calls $2.69 per service call Reception $8,597 3,200 calls $2.69 per call Acc./Fin $13,566 5,553 patient-days* $2.44 per patient-day Management $17,107 5,553 patient-days* $3.08 per patient-day IT Systems $6,191 5,553 patient-days* $1.11 per patient-day Billing $2,899 192 billings $15.10 per billing Volunteer $3,378 75 volunteers $45.04 per volunteer Total $112,565

23. Questions • How to get the data? • What do you think of the cost pools? • What do you think of the drivers? • What new insights does the costing system give?

24. True cost of an INDIVIDUAL Patient • A patient’s administrative cost is that patient’s use of administrative resources times the usage charge • Consider a patient who had one referral, one admission, one call, no service call, 4 billings, 5 volunteers, stayed for two days and died.

25. A Specific Patient’s Admin. Cost Prereferral 1 X $332.58 per referral Referral 1 X $146.93 per referral Admission 1 X $42.61 per admission Post-admission 1 X $79.33 per admission Post-death 1 X $32.09 per death Bereavement 1 X $275.43 per death Medical services 0 X $2.69 per service call Reception 1 X $2.69 per call Accounting/finance 2 X $2.44 per patient-day Management 2 X $3.08 per patient-day Information systems 2 X $1.11 per patient-day Billing 4 X $15.10 per billing Volunteer services 5 X $45.04 per volunteer Total: $1,178.43 • What cost figure will you arrive at when you add up over all patients?

26. Summary of Cost Analyses at HCK • Traditional cost data • $112,565 ÷ 3,593 patient-days = $31.33 • The management then measured the levels of resource consumption by various categories of patients. The estimates of the average cost per patient-day for patients in various stages of their diseases are: • Stage of Disease Cost per Patient-Day Slow decline $27.39 Rapid decline $29.84 Imminent death $62.88 Death $381.57

27. Why should HCK do the costing exercise? • Why not just charge everyone $31 plus some markup?

28. Activity-Based Costing (ABC) • Activity-Based Costing: Shared resources are mapped to products by analyzing the production processes: Production Processes Shared Resources Products Mapping

29. Steps of ABC • Identify key activities that are required to produce the good or service by analyzing the production processes. • Assign the overhead costs to the different activities. • Identify the cost driver (allocation base) for each activity. • Calculate the overhead rate for each activity: (Rate = Overhead cost ÷ Cost driver volume) • Using the activity rates, charge each product based on the amount of activities it uses as it moves through the production process.

30. Takeaway • Resource level • ABC assumes resources arise from activities • ABC then divides each resource’s cost by the total level of activities it supports • This division calculation yields a activity charge for each activity • Product level • As the product progresses through the production process, it accumulates costs based on how much activities it uses • The product cost thus more accurately reflects its true use of shared resources

31. Costing Overview

32. Another Example: Ross Parts • Manufacture two (substitutable) parts • D-12 and M-24 • Current production information

33. Ross Parts Example • Overhead cost by department and category

34. Ross Parts Example • Company uses a single overhead pool • Allocation base is direct-labor cost • Which product is less costly to produce? • Total labor hours = 100,000 (= 100,000 x 0.8 + 25,000 x 0.8) • Total labor cost = $2,000,000 (= 100,000 hours x $20/hour) • Overhead rate = 75% (= $1,500,000 ÷ $2,000,000)

35. Ross Parts Example • Unit product costs under this system Decision: Only produce D-12

36. What’s “Wrong” With the Decision? • Only D-12 uses the wastewater treatment • The wastewater treatment costs are “spread” between both products • This is the result of using a single cost pool • Tendency to “overcost” products making less use of overhead resources • One solution might be a two-stage cost system

37. Two-Stage Cost System Materials Overhead Labor Direct Direct Other Overhead Wastewater Treatment Wastewater Machine hours D-12 M-24

38. Two-Stage Overhead Rates • The rates for the two overhead pools:

39. Two-Stage Product Costs • Product costs for the two-stage system Decision: Only produce M-24

40. What’s “Wrong” Now? • Company produces M-24 in “longer” runs, requiring fewer set-ups • But, M-24 uses more expensive material, which might require different handling • However, the overhead costs are based entirely on volumes produced

41. A Thought Experiment • Two production areas (buildings) within a single plant that produce identical numbers (volumes) of markers • One building only produces black markers (by far the most popular model) • The second produces all the other colors • Both buildings use the same amount of direct labor, machine hours, and material cost

42. A Thought Experiment • What do you observe in the multi-color building relative to the black marker building? • More machine set-ups • More material handling • To and from the production line • More inventory movement • More orders • In general, a lot more activity

43. ABC Cost System Diagram Direct Costs Overhead Direct … Handle Supervise Setup Labor $ Setup hours Material $ D-12 M-24

44. ABC Overhead Rates • There are five overhead pools

45. ABC Product Costs • Unit product costs for the ABC system *Because these are unit costs, we need to first determine cost of setups and then divide by the number of units produced (e.g., 0.55 = [110 x 5 x $100] ÷ 100,000).