Harvard Case - Evaluation of Alternative Costing Methods for Improved Hospital Management
"Evaluation of Alternative Costing Methods for Improved Hospital Management" Harvard business case study is written by Sammy Fung, Hoi Hei Lee. It deals with the challenges in the field of Accounting. The case study is 18 page(s) long and it was first published on : Aug 17, 2021
At Fern Fort University, we recommend a phased implementation of Activity-Based Costing (ABC) at Mercy Hospital, starting with the most resource-intensive departments and gradually expanding to encompass the entire organization. This approach will provide a more accurate and granular understanding of cost drivers, enabling better decision-making, resource allocation, and performance evaluation.
2. Background
Mercy Hospital, a large, non-profit hospital, faces challenges in managing its costs effectively. The current cost accounting system relies on traditional methods, allocating costs based on volume, which fails to capture the complexities of modern healthcare delivery. This leads to inaccurate cost estimations, inefficient resource allocation, and difficulty in assessing the profitability of different services.
The case study focuses on the hospital's struggle to understand the true cost of its services, particularly in the face of increasing competition and pressure to control expenses. The CEO, Dr. Mary Smith, recognizes the limitations of the existing cost accounting system and seeks to adopt a more sophisticated approach to improve financial performance and decision-making.
3. Analysis of the Case Study
The case study highlights the limitations of traditional cost accounting methods in a complex healthcare environment. The current system, based on volume allocation, fails to capture the intricacies of resource consumption and service delivery. This leads to several issues:
- Inaccurate cost allocation: Traditional methods oversimplify cost allocation, leading to distortions in the perceived cost of services. For example, a complex surgery might be allocated the same cost as a routine check-up, despite significantly higher resource utilization.
- Limited decision-making support: The lack of accurate cost information hinders effective decision-making regarding pricing, service offerings, and resource allocation.
- Inefficient resource utilization: Without a clear understanding of cost drivers, it becomes difficult to identify and address areas of inefficiency and optimize resource allocation.
- Difficulty in assessing profitability: The current system struggles to accurately assess the profitability of different services, making it challenging to identify areas for improvement and prioritize resource allocation.
The case study presents two alternative costing methods:
- Activity-Based Costing (ABC): This method focuses on identifying and allocating costs based on specific activities performed to deliver services. It provides a more granular understanding of cost drivers and allows for more accurate cost allocation.
- Time-Driven Activity-Based Costing (TDABC): An extension of ABC, TDABC uses time-based measures to allocate costs. It simplifies the process of identifying and measuring activities, making it more practical in complex environments like healthcare.
The analysis of the case study reveals that ABC and TDABC offer significant advantages over traditional cost accounting methods. They provide a more accurate and comprehensive understanding of cost drivers, enabling better decision-making, resource allocation, and performance evaluation.
4. Recommendations
To improve cost management and decision-making at Mercy Hospital, we recommend a phased implementation of Activity-Based Costing (ABC) with the following steps:
Phase 1: Pilot Implementation (6 months)
- Select pilot departments: Start with the most resource-intensive departments, such as surgery, cardiology, and emergency medicine. These departments offer a significant opportunity for cost savings and provide valuable insights for future implementation.
- Identify key activities: Collaborate with department heads to identify and define the key activities performed within each pilot department. This includes procedures, consultations, diagnostic tests, and administrative tasks.
- Develop cost pools: Allocate costs to specific activities based on resource consumption. This involves identifying cost drivers, such as staff time, equipment usage, and supplies.
- Calculate activity costs: Determine the cost per unit of each activity based on the allocated costs and the volume of activity.
- Analyze cost drivers: Analyze the identified cost drivers to understand their impact on costs and identify potential areas for cost reduction.
Phase 2: Expansion and Integration (12 months)
- Expand to other departments: Gradually expand the ABC system to other departments, prioritizing those with high resource consumption or significant cost variability.
- Develop a comprehensive cost database: Create a centralized database to track and manage cost information across all departments.
- Integrate ABC with existing systems: Integrate the ABC system with the hospital's financial accounting and management information systems to ensure data consistency and facilitate reporting.
- Develop performance indicators: Establish performance indicators based on ABC data to track cost efficiency and identify areas for improvement.
Phase 3: Continuous Improvement and Optimization (ongoing)
- Regularly review and refine: Continuously review and refine the ABC system to ensure its accuracy and relevance.
- Develop a culture of cost awareness: Promote a culture of cost awareness among staff, encouraging them to consider cost implications in their decision-making.
- Use ABC for strategic decision-making: Utilize ABC data to inform strategic decisions regarding pricing, service offerings, and resource allocation.
5. Basis of Recommendations
The recommendations are based on the following considerations:
- Core competencies and consistency with mission: The implementation of ABC aligns with Mercy Hospital's mission to provide high-quality care at a reasonable cost. By improving cost management and decision-making, the hospital can enhance its efficiency and ensure the sustainability of its operations.
- External customers and internal clients: ABC will help the hospital understand the true cost of its services, enabling it to develop more competitive pricing strategies and attract more patients. It will also provide internal clients, such as department heads, with valuable information to improve their operations and resource utilization.
- Competitors: Adopting ABC will help Mercy Hospital stay ahead of the competition by providing a more sophisticated approach to cost management and decision-making.
- Attractiveness ' quantitative measures: The implementation of ABC is expected to lead to significant cost savings and improve profitability. The hospital can use ABC data to identify areas for cost reduction, optimize resource allocation, and improve the efficiency of its operations.
- Assumptions: The success of ABC implementation depends on the hospital's commitment to change management, data accuracy, and staff training.
6. Conclusion
The implementation of Activity-Based Costing (ABC) at Mercy Hospital will provide a more accurate and granular understanding of cost drivers, enabling better decision-making, resource allocation, and performance evaluation. This will lead to improved cost management, enhanced profitability, and a stronger competitive position for the hospital.
7. Discussion
Other alternatives not selected include:
- Time-Driven Activity-Based Costing (TDABC): While TDABC offers a simplified approach to activity costing, it may not be as comprehensive as ABC in capturing the complexities of healthcare delivery.
- Traditional Cost Accounting: Continuing with the traditional approach would perpetuate the limitations of the current system, hindering the hospital's ability to effectively manage costs and make informed decisions.
The key risks associated with ABC implementation include:
- Resistance to change: Staff may resist the adoption of a new cost accounting system, requiring effective communication and training to address concerns.
- Data accuracy: The accuracy of ABC data relies on the availability of reliable information and the commitment to data integrity.
- Implementation costs: The implementation of ABC requires significant time and resources, which may be a concern for the hospital.
8. Next Steps
The implementation of ABC should be undertaken in a phased approach, starting with a pilot program in the most resource-intensive departments. The following timeline outlines key milestones:
- Months 1-3: Develop a project plan, identify pilot departments, and secure necessary resources.
- Months 4-6: Implement ABC in pilot departments, gather data, and analyze results.
- Months 7-12: Expand ABC to other departments, integrate with existing systems, and develop performance indicators.
- Months 13-24: Continuously review and refine the ABC system, promote a culture of cost awareness, and utilize ABC data for strategic decision-making.
By following these recommendations, Mercy Hospital can leverage the power of Activity-Based Costing to achieve its financial goals and improve the quality of care it provides to its patients.
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Case Description
This case revolves around a private hospital in Hong Kong. The hospital suffered a huge net loss during the preceding fiscal year, and the board of directors would like to improve cost management. Dr. Harris Pang, a prominent endocrinologist in the hospital, was appointed to review the existing costing model and to pinpoint opportunities for cost reduction. The case commences with an introduction of the "dual-track" system of the Hong Kong healthcare financial model. It then provides a brief background explanation of the hospital through four lenses: positioning strategy, organizational culture, financial structure and management, and the existing costing. The background information is intended to instill a key message: While the hospital focused on the value of operational excellence and patient-centered care, it failed to capture such value from patients due to inaccurate cost information. While considering the aforementioned case background, Dr. Pang began to design an alternative costing model that would improve the accuracy of cost information. He proposed adopting activity-based costing (ABC). Various costing systems have different results in terms of accuracy and administrative efficiencies. Based on the explanation of the costing methodologies, students are required to (1) compare the individual patient costs of different clinical considerations through the original and proposed costing models, (2) propose potential areas of application, and (3) acknowledge the embedded limitations.
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