Activity Based Costing And Hospital Cost Efficiency Accounting Essay


While many hospitals are under pressure to become more cost efficient, new costing systems such as Activity-based costing (ABC) may form a solution. However, the factors that may facilitate (or inhibit) cost system changes towards ABC have not yet been disentangled in a specific hospital context. (Greene 2001) Via a survey study of hospitals, we discovered that cost system development in hospitals could largely be explained by hospital specific factors. Issues such as the support of the medical parties towards cost system use, the awareness of problems with the existing legal cost system, the way hospitals and physicians arrange reimbursements, should be considered if hospitals refine their cost system. Conversely, ABC-adoption issues that were found to be crucial in other industries are less important. Apparently, installing a cost system requires a different approach in hospital settings. Especially, results suggest that hospital management should not underestimate the interest of the physician in the process of redesigning cost systems. (Eldenburg 1997)


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With margins on the decline, more restrictive reimbursement schemes based on diagnostic-related groups (DRGs), increasing complexity and rising costs, the health care sector faces a new challenge of becoming more cost efficient to survive in this changing environment. More developed cost systems such as Activity Based Costing (ABC), may facilitate this strive for cost efficiency. ABC provides more detailed cost information on the activities of the hospital, which could typically result in better cost reduction and cost management. (Udpa 1996)

In other industries, it has proven to be successful since firms that extensively use ABC outperform similar matched firms that do not adopt ABC, mainly through more efficient cost control efforts. However, while there are different levels of cost system design, it seems remarkable that the number of hospitals collecting cost on a more detailed basis remains limited as a starting point we look at ABC-adoption in other industries. (Greene 2001)

The results of our survey, conducted in the hospital sector, show that cost system improvement in hospitals, is largely determined by health care specific factors such as the dissatisfaction with the legal system, the support of medical staff to cost system use, the way the reimbursements between hospitals and their physicians are arranged etc ... This seems to suggest that health care management should focus on hospital specific elements in order to facilitate ABC adoption. (Eldenburg 1997)

Literature Review

In many countries hospitals are legally required for refunding purposes to have a predefined cost allocation scheme. This makes them unique to other industries where such a legal obligation does not exist. The legal system mostly takes the form of a step-down allocation of costs from service departments (e.g. administration, cafeteria, laundry, etc.) to revenue generating departments such as acute care, surgery and laboratory. (Hill 1994)

Drivers of Activity Cost Base System

General drivers of cost system development

There only exist a limited number of studies that identified some general drivers of cost system improvement for firms in other industries.

Cost variability.

Firms with a higher level of indirect overhead and greater heterogeneity in the way products make use of the firm's resources are expected to introduce more refined costing systems. This issue may playa role in a hospital. (Greene 2001)

Cost importance.

This issue mainly captures the way firms in other industries perceive cost data as crucial for their decisions and their competitive position. (Hill 1994)

Quality link.

Firms that focus on quality often link their formal quality programs with more accurate ABC-systems. Hospitals initiating programs to improve the quality of the care processes may be more in need of a cost system that accurately captures the cost of this different care process. (Hill 1994)

System State.

This issue concerns the general elaboration of the IT -system within a firm. The more elaborated and integrated the system and the more performance measures it gathers, the easier it is to introduce ABC-systems that make use of IT systems and their information. (Ittner 2002)

Perceived complexity.

This issue in fact captures whether the firm's operational environment is perceived as complex.

Research Method

The survey was conducted on a sample of hospitals, located in Flemish part of Belgium. Similar to most other countries, all hospitals in our sample are required to issue a legal cost report based on an elaborated set of drivers in a step-down allocation scheme from service to revenue generating departments. In addition, these hospitals also agree on various reimbursement schemes with their physicians. A total of 120 questionnaires were issued to either general hospitals, academic hospitals, psychiatric hospitals or specialized hospitals. The survey administered questions to identify the stage of cost system development and the hospital specific and general drivers that are possibly linked with the level of cost system design.

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The survey was either addressed to the chief executive officer of the hospital facilities or the chief of the administration and financial department. These respondents are most likely to be informed about the design and the use of cost systems in their hospital. Of the 120 questionnaires, we received 50 valid responses. This corresponds to a response rate of about 42%. Of the 50 valid replies, 48% came from general private 8 hospitals, 10% from general public hospitals, 38% from psychiatric facilities and the remaining 4% from either academic or specialized private hospitals. It is important to note that the sample's distribution is not significantly different from the distribution within the total population of 120 Flemish hospitals (Chi-square: 2.3; p = 0.13). In terms of size our sample counted 20% small facilities with less then 200 beds, 56% intermediate-sized hospitals with 200 to 499 beds and 24% large hospitals with over 500 beds. (Eldenburg 1997)

Dependent variable

The primary dependent variable for our study is the stage of cost system development. Via our survey study we were able to identify three possible levels of cost system design. A first group of hospitals only installed the legal system. A second group of hospitals is in the process of changing their cost system. Either they started with small adjustments to their legal system by introducing more specific drivers and cost objects (e.g. patient-levels, DRG-levels) or they were in the process of considering ABC. This group may be situated on a sort of 'intermediate level' in the process of change towards more refined costing systems. The last group is on a more advanced level of cost system refinement. They actually indicated to be experimenting with ABC and as a result of this exercise they developed an adapted cost system. The sample of 50 hospitals is distributed across these three possible development stages of cost system design. One should further note that hospitals in phase 1 are somehow distinct from the two other groups. Unlike hospitals in phase 2 and 3, these hospitals do nothing in terms of cost system refinement.

Independent variables

The general drivers and most of the hospital specific elements, except for the type of reimbursement scheme, were measured via multiple (e.g. two or more) items that were in fact based on our arguments of the literature review. Respondents indicated the relevance for each item on a five-point Likert-scale (1= strongly disagree; 5= strongly agree). A first set contains items for the general drivers such as cost variability, cost importance, quality link, system state and perceived complexity. The next set focuses on the remaining hospital specific issues such as organizational support, satisfaction with and the use of the legal system and the level of conflict between management and physicians. However to test whether our items actually capture the presumed construct, factor analyses were performed on both the sets of general drivers and hospital specific factors. (Udpa 1996)


As hospitals' income is under pressure as a result of rising health care costs and more restrictive budget constraints, hospitals are looking for options to become more cost efficient. For assisting their strive for cost efficiency, health care organizations may want to adopt more refined costing techniques, such as activity based costing (ABC) as they have proven to be successful in other industries. However the factors that facilitate (or inhibit) this change towards ABC have not yet been investigated in hospital settings. Via a survey we single out factors that explain further cost system development in a health care context. First of all, the survey shows that similar to other industries cost system change in hospitals gradually happens in different stages. (Hill 1994)

However and more importantly, results indicate that the general drivers of ABC adoption from other industries are less crucial for promoting cost system change in hospitals. Apparently, typical features of the health care sector such as the satisfaction with and the use of the existing legal system, the support of the medical team, the level of conflict with and the way in which physicians are reimbursed seem to explain variations in cost system development among hospitals. Hospitals are quite unique settings in a sense that they have to work with highly autonomous groups of physicians. While cost system changes normally flow from top management, our results suggest that in hospitals physicians and other medical parties are apparently powerful coalitions when it comes to redesigning cost systems. Not only the support of the medical team towards cost system change, but also a minimal level of conflict with the physician, make cost system change towards ABC more likely. (Eldenburg 1997)

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The way hospitals arrange their reimbursement with the physicians may also require reassessment. If refunds depend on cost allocations, there may be endless debates over which cost to include in the analysis. Furthermore, physicians are not likely to go along with cost system changes as new cost systems such as ABC may give hospitals more discretion to maximize the cost reimbursement streams from the physician. Conversely changing to ABC is easier if reimbursements are not physician cost based. In sum, it is important for hospitals to consider the stakes of the physician and their support towards cost systems in the process of cost system refinement. (Eldenburg 1997)

The fact that specific issues of the sector are more crucial for promoting cost system change may explain why hospitals typically lag behind other firms. Installing ABC apparently requires a different approach in hospitals. For example, the change of attitude of the physician, installing new reimbursement schemes may require time that can slow down the process of changing towards ABC. We however do not depict factors of other industries as not important. Hospital specific factors may be the first steps of cost system change, while general drivers may become highly important in later stages (e.g. this applied to a certain extent for the general driver cost variability). (Eldenburg 1997)

The quality of IT -systems, top management support, the link with performance and quality measures, and the perceived complexity may all be crucial factors in the process of ABC to grow to a fully operational system. Unfortunately, we only had a limited number of hospitals that adapted their cost system via ABC. Therefore, it is difficult to recognize further divisions in the type and the level of ABC-systems within this group. We however leave this fascinating conjecture for future research.