Activity-Based Costing

A costing method that assigns overhead and indirect costs to services based on the actual activities that consume resources, rather than a simple volume measure.

Source: Cooper & Kaplan 1988

Traditional costing spreads overhead across services in proportion to a single volume measure such as direct labour hours or patient numbers, which is accurate only where every service consumes overhead in the same proportion to that measure. Where services differ in complexity, the method systematically overstates the cost of simple high volume work and understates the cost of complex low volume work, because the complex work consumes setup, scheduling, quality control and support activity out of proportion to its volume. The resulting cross-subsidy is invisible in the accounts and distorts decisions about which services to expand or withdraw.

Source: Cooper & Kaplan 1988

Costs are assigned in two stages. Resource costs are first collected into pools corresponding to the activities that consume them, such as admitting a patient, preparing a theatre, processing a specimen or arranging a follow up. Each activity is then given a driver measuring how much of it a service consumes, and costs are assigned to services in proportion to their consumption of that driver. The effect is that overhead follows the work actually done rather than being spread evenly, so two services with the same volume can carry very different costs.

Source: Horngren, Datar & Rajan 2015

It underlies patient-level costing, which builds the cost of an episode from the specific activities a patient received rather than applying a departmental average, and it supports service line reporting comparing the cost of a pathway against the income it attracts. National tariff and reference cost construction relies on the same logic, since a price intended to reflect typical resource use must be built from the activities that consume it. It is also used to identify where cost is actually incurred within a pathway, which is frequently not where clinical attention is concentrated.

Source: Kaplan & Porter 2011

It is a simplification developed because maintaining a full activity model proved too burdensome for many organisations. Rather than surveying how effort is divided between activities, it requires only two estimates: the cost of supplying capacity for a unit of time, obtained by dividing the cost of a resource by the time it is practically available, and the time each activity takes. Costs then follow from time consumed. The approach also makes unused capacity visible as a separate figure rather than burying it in the cost of the work performed.

Source: Kaplan & Anderson 2004

Building and maintaining the model is demanding, since activities must be defined, drivers measured and estimates refreshed as practice changes, and the effort is regularly underestimated. Choosing drivers is a matter of judgement, and a driver that correlates with cost without causing it produces figures that look precise and mislead. The method also assigns costs that do not vary in the short run, including buildings and established staffing, to activities as though they did, so a projected saving from reducing volume will not be realised unless the underlying capacity is actually removed.

Source: healtheconomics.wiki