UMHS-LDP 1 Friday, November 14, 2003 Evolution of Cost Measurement and Control Systems in...

UMHS-LDP1

Friday, November 14, 2003

Evolution of Cost Measurement and Control Systems in Organizations

Category

Stage 1Broken

Stage 2Financial/regulatory

reporting driven

Stage 3Customized, stand-

alone

Stage 4Integrated

Data quality • Many errors• Large variances

• No surprise• Meets audit standards

• Shared database• Stand-alone systems• Informal linkages

• Fully linked databases and systems

External financial reporting

• Inadequate • Tailored to external and regulatory reporting needs

• Stage 2 system maintained for financial transactions and periodic external reporting

• Financial reporting systems

Product/service or procedure costs

• Inadequate • Inaccurate• Hidden costs and profits

• PC-based ABC for costing activities, products, and cost to serve customers

• Integrated cost and clinical data systems

Operational and strategic control

• Inadequate • Financial feedback only; variances

• Delayed, aggregated

• Kaizen costing, Pseudo profit centers; timely non-linear feedback

• Operational and strategic performance measurement systems

Typical accounting system installed

• Traditional • Standard • ABC-like • Strategic ABM, ERP

Stages of Excellence

International best practice UMHS (maybe?)

UMHS-LDP2


What is so special about health centers / medical care?Impact on cost measurement and control

Manufacturing / Industrial Sector Health services / products

Conventional economic analyses apply; firm versus consumer.

Regulation affects some industries but not most.

Focused set of offerings / product lines.

Important components of costs (e.g., materials, labor) can be traced to products

Revenues associated with selling products largely linked with decision to incur costs

Non-standard services, multiple constituencies and customers.

“Highly” regulated.

A diverse set of offerings / services.

Almost complete separation between decisions by customers that generate revenues and decisions to incur costs.

Virtually all costs are “indirect” and appear to be “fixed.” Most resources (expenditures) provided in advance – adding operating room capacity. Marginal costs (as conventionally defined) close to zero.

UMHS-LDP3


Need for Measurement and Control Systemssimilar to industrial sector

Control and Evaluation Product / service decisions

Like most organizations, need to address “coordination” and “motivation” problems.

Focus on Departmental, cost center, or “operational management” level ( e.g., budget responsibility by department heads).

Charges by revenue-producing departments may be tracked; perhaps matched with expenses to compute a departmental contribution. Departmental information aggregated at a higher level. Hospital overhead may or may not be allocated (via elaborate service dept. allocation methods like medicare step-down, reciprocal etc.) to revenue-producing departments.

Measure and analyze “relevant” cost and profitability information.

Focus on product/service level (DRGs, major diagnostic categories, medical specialties, an HMO population, etc.,).

Evolution of reimbursement methods towards managed care highlights the importance of this role for measurement systems (e.g., negotiating with insurers, decisions on new or existing services).

Requires “better” data on resource consumption by product or procedure (that may cut across various departments).

UMHS-LDP4


Need for Measurement and Control Systemssimilar to industrial sector

Control and Evaluation Product / service decisions

Like most organizations, need to address “coordination” and “motivation” problems.

Focus on Departmental, cost center, or “operational management” level ( e.g., budget responsibility by department heads).

Charges by revenue-producing departments may be tracked; perhaps matched with expenses to compute a departmental contribution. Departmental information aggregated at a higher level. Hospital overhead may or may not be allocated (via elaborate service dept. allocation methods like medicare step-down, reciprocal etc.) to revenue-producing departments.

Measure and analyze “relevant” cost and profitability information.

Focus on product/service level (DRGs, major diagnostic categories, medical specialties, an HMO population, etc.,).

Evolution of reimbursement methods towards managed care highlights the importance of this role for measurement systems (e.g., negotiating with insurers, decisions on new or existing services).

Requires “better” data on resource consumption by product or procedure (that may cut across various departments).

UMHS-LDP5


A UMHS example (data provided by Dave Butz and Paul Taheri from TSI system)

Is EAAA (Endovascular Abdominal Aortic Aneurism) more or less “profitable” than Open AAA?

Endovascular AAA Open AAA

Fiscal year 2002 2003 2002 2003

Number of patients 21 13 66 36

Mean LOS (in days) 2.8 1.9 10.0 10.9

Mean net revenue $28,722 $30,989 $34,440 $43,369

Mean variable cost 18,064 16,673 12,229 16,166

Mean contribution margin 10,658 14,316 22,211 27,202

Mean overhead costs (??) 15,888 16,732 16,477 20,870

Mean Profit (5,230) (2,416) 5,734 6,332

Mean contribution margin /day $3,793 $7,456 $2,232 $2,486

UMHS-LDP6


The Quest to Cut Inpatient Care

Cost Management based on Average Length of Stay

Mantra: “Hospitals are expensive” Best practice = lowest rate of inpatient day.

Focus on cost management and profitability analysis based on ALOS driven by insurers? Per-diem reimbursement methodologies?

A conjecture:

• Health Systems provides a variety of services and procedures with different degrees of complexity (e.g., severity of illness) for a diverse clientele. Resource utilization by different clientele groups is unlikely to be proportional to length of stay.

• Implications of overemphasis on ALOS: Rampant cross-subsidization across patients and payor groups? Capacity utilization problems (are there more empty beds?) Emergence of competing “alternative” care facilities?

Relevance of ALOS - Fact or fiction? A testable hypothesis?

UMHS-LDP7


Example of a research study of hospital overhead costs MacArthur and Stranahan (Journal of Management Accounting Research, 1998)

Data: 5,306 hospitals obtained from HCFA (R-squared 91%)

Dependent Variable Log Overhead Costs

Independent Variable Parameter Significant

Intercept 6.08 yes (< 1%)

Volume Log Patient Days 0.29 yes (< 1%)

Log Discharges 0.53 yes (< 1%)

Capacity Beds Available 0.06 yes (< 5%)

Complexity Number of services (breadth) 0.07 yes (< 5%)

Intensity of services (depth) 0.004 yes (< 1%)

Interaction (breadth x hospital size) -0.008 yes (< 1%)

Other North Central -0.12 yes (< 1%) South Central -0.12 yes (< 1%) Mountain -0.05 No Pacific 0.15 yes (< 1%) Non-profit -0.19 yes (< 1%) Government -0.29 yes (< 1%) Medicare Intensity -0.001 yes (< 5%) Medicaid Intensity -0.0007 No Education Intensity 0.02 yes (< 1%)

UMHS-LDP8


Understanding “Relevant” Costs

What decisions do you (or your department) make that require you to

know costs?

What drives costs of services? For example, what are the “relevant” costs

for a second or third day stay in maternity relative to the first day? Are

costs linear or nonlinear in length of stay? Does the measurement system at

UMHS give the “relevant” costs to make the “right” decisions? (Not

necessarily the “costs” to support the decision you want to make).

What are direct costs (variable or fixed), incremental costs (short-run

variable) opportunity costs (profit foregone for a constrained resource),

indirect (fixed) costs? Should we ignore fixed costs – why or why not?

UMHS-LDP9


Understanding “Relevant” Costs

What decisions do you (or your department) make that require you to know costs?

What drives costs of services? For example, what are the “relevant” costs for a second or third day stay in maternity relative to the first day? Are costs linear or nonlinear in length of stay? Does the measurement system at UMHS give the “relevant” costs to make the “right” decisions? (Not necessarily the “costs” to support the decision you want to make).

What are direct costs (variable or fixed), incremental costs (short-run variable) opportunity costs (profit foregone for a constrained resource), indirect (fixed) costs? Should we ignore fixed costs – why or why not?

UMHS-LDP10


Schematic of a typical cost measurementand control system

INDIRECT COSTS

allocations allocations

allocations

Product / Service costing DIRECT COSTS for decision making

Support Departments

Revenue-Producing or “Production” Departments

Responsibiltyreporting for control and evaluation

UMHS-LDP11


Cambridge Hospital – Primary Care Unit

Why do the ABC Study?

1) Help Network reduce costs while maintaining quality.

2) Provide “new” information to effectively “price” managed care services.

3) Determine profitability of mini, short, routine, extended, complex, comprehensive, and hospital-employee visits; Why? Because payer reimbursements are based on these categories.

Is the PCU a good place to do the ABC study? Criteria?

• High and/or rising indirect and support costs (>20% of PCU costs not including the step-down costs are support services)

• High diversity – high level of variability in services (mini, complex, extended, routine, interpreted, use of doctor vs. nurse practitioner vs. intern, etc.,)

UMHS-LDP12


Common Distortions in Cost Measurement SystemsThe real “economic” costs vs. what is measured

Over-aggregation (or under-aggregation) of costs of services / products

Measurement of costs of “unutilized” resources – down time, waiting time, idle capacity, excess capacity

Inappropriate allocations (arbitrary, incorrect drivers)

Highly inaccurate cost and profitability information particularly in settings where there is a lot of services / products and a lot of diversity in resource consumption.

Do you know how the cost of the services you deliver are computed?

UMHS-LDP13


• Develop an “Activity Dictionary” that lists and defines all major activities performed in the facility

• Often 10-30 activities – can be up to several hundred, depending on how complex a model is needed

• Identify activity attributes• Cost hierarchy

• Unit, Batch, Product • Business process• Value added, non-value added• Primary/secondary

• ID resource costs linked to activities

• Build activity-cost drivers to link activity costs to cost objects

• Transaction drivers• # of setups, receipts, tests

• Duration drivers• Setup, inspection hours

• Intensity drivers

2. Determine The Cost Of Performing These Activities And Business Processes

3. Determine How Much Of The Output Of Each Activity Is

Required For The Products, Services, And Customers

1. Identify The Activities Performed By The Organizational Resources

Activity Based Costingaddresses situations where many indirect and support resources in an organization are not consumed by products or services in proportion to volume (such as length of stay)

• Help make product / service decisions where expenditures for indirect and support resources are high and/or rising.• Help make product / service decisions in settings where products and services are many and varied.

• Example: airlines have cost increases not seemingly tied to flight hours or other metrics -- want to understand root causes. • Example: hospitals treating diverse patient populations with varying needs and degrees of complexity.• Example: major chemical manufacturer offers commodity chemicals (high volume, low price) and specialty chemicals (low volume,

high price) and wants to ensure that it is allocating costs correctly to these two types of products

Applications

UMHS-LDP14


Cambridge Hospital – Primary Care Unit

Why do the ABC Study?

Is the PCU a good place to do the ABC study? Criteria?

UMHS-LDP15


Cambridge Hospital – ABC mechanics

Details in exhibits 4 – 9:

• Define a set of activities and sub-activities.

• Group (regroup, reclassify, allocate) resource costs – usually taken from the cost categories in the accounting system – into activity pools (see exhibits 4 through 7 in case)

— Why allocate portion of provider’s salary (e.g., $50,702 from physicians’ salaries and $29,555 from I/R salaries) to Interpretive services?

— What are the medicare step-down costs and how/why are they allocated to the activity pools?

• Define and measure driver units – usually determined through interviews (in manufacturing; process studies, time and motion studies) – see exhibit 8 in case.

• Determine activity driver rate; Divide the cost of activity pool by the total number of driver units (note: assumes linearity) – see exhibit 9 in case.

UMHS-LDP16


Cambridge Hospital – Profitability analysis based on ABC costs

Routine visit Extended visit /new/interpreted

Medicare reimbursement $89 $127

Units Costs Units Costs

Nurse practitioner – exam time @$3.39 22.50 $76.28 37.50 $127.13

Nurse practitioner – wait time @$1.65 45.00 74.25

On call Special Language @0.27 45.00 12.15

Clerical support – patient visit @14.07 1 14.07 1 14.07

Clerical support – new patient @7.03 1 7.03

Billing @1.65 1 1.65 1 1.65

$92.00 $236.28

Now what?

UMHS-LDP17


An Analysis of time spent at PCU (using exhibit 8 and assuming 50 weeks/yr 36 hrs per week)

Category Nurse - practitioner Interns / residents Physician

Examination time outside patients 8.7% 10.7% 27.3%

Waiting for interpretation time for outside patients

1% 1.3% 3.2%

Examination time employee-patients 17% -- 3.5%

Time assisting nurse-practitioner -- -- 1.8%

Time assisting interns and residents -- -- 17.9%

“Idle” time 73.3% 88% 46.3%

100% 100% 100%

Why is there idle time? Are the costs associated with idle time “relevant?” Why?

UMHS-LDP18


Costs of “idle” capacity – another example

Seasonal Underutilization and cost of providing capacity to serve

Alternative SolutionsApproach 1: Dividing monthly costs by monthly production volumes

Approach 2: Dividing annual costs by annual production volume

Approach 3: Dividing annual costs by annual potential production volumes

Approach 4: Charging all capacity costs to units in peak season

Approach 5: Charging the costs caused by unused capacity to peak months

Preferred Solution:

• Approach 5

Economic Implications• Excess capacity installed

was caused by peak season production requirements

• Charge more to the customers at peak season is reasonable

• Charge less in the slack season would be helpful to increase the purchase

Example

Peak seasonSlack season Slack season

Who should be responsible for

excess capacity?

UMHS-LDP19


Cambridge Hospital – Profitability analysis based on ABC costs – based on new (“marginal”) rates

Routine visit Extended visit /new/interpreted

Medicare reimbursement $89 $127

Units Costs Units Costs

Nurse practitioner – exam time @$0.91 22.50 $20.48 37.50 $34.13

Nurse practitioner – wait time @$0.42 45.00 18.90

On call Special Language @0.27 45.00 12.15

Clerical support – patient visit @14.07 1 14.07 1 14.07

Clerical support – new patient @7.03 1 7.03

Billing @1.65 1 1.65 1 1.65

$36.20 $87.93

UMHS-LDP20


ABC system is best fit for allocating non-volume driven diverse overhead costs

Category Standard Cost SystemABC System

(Activity-Based Costing)

Definition • Standard costing, assign indirect and supports costs to products and services with volume-based cost drivers

• Link resources expenses to the variety and complexity of services produced.

Best fit for • Volume-driven business• Simple operations• Very very long run – aggregate data

and grand averages are sufficient.

• Non-volume-driven operations• In mid- to long-term horizon (all cost items are

variable)• Product/process diversity, various materials /

labor / machine mix, different overhead / setup requirements

Key applications

• In complex situation, cost structure provided by standard costing may be misleading

• Process reengineering• Outsourcing• Product pricing and profitability analysis, etc

• Little systematic evidence of financial benefits of ABC.

Comparison between Standard and ABC Cost Systems

UMHS-LDP 1 Friday, November 14, 2003 Evolution of Cost Measurement and Control Systems in...

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