As the Management Accountant of a local NHS hospital I am going to write a report for the senior management team at the hospital that analyses the issues raised in the view attributed to Gordon Brown. It is difficult to assume which allocation approach the hospitals have used, but I am going to describe the Traditional Costing approach and the Activity Based Costing approach, which I will describe in more detail. 2. The Definition of Activity Based Costing
Activity Based Costing (ABC) is a ‘costing method’ (Fleming & McKinstry, 1998: 216), which recognises that costs are incurred by the activities, which take place within the organisation, and for each activity a cost driver may be identified. Those costs, which are incurred or driven by the same cost drivers, are grouped together into cost pools and the cost drivers are then used as a basis for changing the costs of each activity to the product. 2. 1 Cost Pools A cost pool is a collection of costs, which maybe ‘charged to products’ (Bendry, Hussey & West, 2001: 465) by the use of a common cost driver.
Examples of costs pools are the power, material handling, material receipt, and production planning, sales administration, get-up cost and buying. 2. 2 Cost Drivers A cost driver is any activity or series of activities, which take place within an organisation, which cause costs to be incurred. Costs drivers are not restricted to departments or sections, as more than one activity may be identified within a department. Examples of cost drivers are the ‘volume of raw materials handled in the organisation, the number of orders placed by customers or the number of machine hours’ (Glautier & Underdown, 2001: 468).
Understanding ABC in terms of overhead costs ABC emphasises the need to obtain a better understanding of the behaviour of overhead costs, and thus ascertains what causes overhead costs and how they relate to products. ABC recognises that in the long run most costs are not fixed, and it seeks to understand the ‘forces that cause the overhead costs to change over time’ (Fleming & McKinstry, 1998: 224). ABC Systems ABC systems assume that cash outflows are incurred to acquire a supply of resources, which are then consumed by activities.
In other words, it is assumed that ‘activities cause costs and also that products (or services) create demand for activities’ (Drury, C, 1999: 713). A link is made between activities and products by assigning costs of activities to products based on an individual product’s consumption or demand for each activity. ABC systems simply recognise that businesses must understand the factors that drive each major activity, the cost of activities and how activities relate to products.
Activity Based Costing -Possible causes for the variations Gordon Brown believes that much of the variation in the unit costs of operations is down to ‘poor management’ (Smith ; Cracknell, 2/11/01) but there are other possible reasons to explain the variations in the activities in the local hospitals differentiating. 3. 1 The design of ABC systems involves four stages. The ‘first stage’ (Hussey ; Hussey, 1999: 213) is to identify the major activities in the organisation.
Examples of activities include machine related activities (e. g. for operations and monitoring patients); direct labour related activities (e. g. doctors and nurses) and various support activities. 3. 2 The ‘second stage’ (Hussey ; Hussey, 1999: 213) requires that a cost centre be created for each activity for example; the total costs of all set-ups might constitute one cost centre for all set-up related costs. 3. 3 The ‘third stage’ (Dyson, 2001: 294) is to identify the factors that influence the costs of a particular activity, for example the costs of a hip replacement operation ranges from 9,337, depending on the hospital.
The variations in costs could depend on the size of the hospital, the number of patients, the funding received and the reputation of the hospital in terms of the surgeon’s credibility. 3. 31 The term cost driver is used to describe the ‘events or forces that are significant determinants’ (Hussey & Hussey, 1999: 214) of the costs of the activities. In other words, cost drivers represent those factors whose occurrence creates the costs.
For example, if for a bypass operation a heart-monitoring machine were required, it would represent the cost driver for a heart bypass operation. 3. 4 The final stage is to ‘trace the cost of the activities to the products’ (Dyson, 2001: 296) according to a products demand for the activities. The number of transactions it generates for the cost driver measures a products demand for the activities. If we assume, for example, that the total costs traced to the cost centre for a particular operation was a 100,000 and that there were 100 operations during the period.
The charging out rate would be 1000 per operation. ABC would trace the costs of other activities using a similar approach. 4 Possible causes for the variations (in reference to a CIMA study of Accountants and Finance Directors) A CIMA study was carried out to ‘examine the challenges faced by NHS cost accountants’ (Northcott & Llewellyn, 2001) to explore the cost variations between hospitals for healthcare cost information to be useful for ‘benchmarking and decision-making’ (Northcott & Llewellyn, 2001).