How Activity based costing is used

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This report illustrates the Activity based costing (ABC), how it emerged, how it is used, what are the benefits of ABC. Also keeping in view the statement of Gordon Brown that unit cost variation in hospitals is because of poor management but actually there are different causes of variation in unit cost which are discussed in this report. In this report it is explained why ABC method gives the best possible result in providing services and gives the desired outcome which is required. How the cost is calculated and identified for maximizing profit and reducing overhead cost.


First it should be known that from where activity based costing emerged, why organisations and companies thought of using ABC.

Back in 1960 General Electric (GE) finance and accounting department senior representative started trying to get the accurate information about the indirect cost and exploring the ideas to control this indirect cost. The GE staff noted that indirect costs are often the result of upstream decisions that are made well before the costs are actually incurred. Some of financial investor and companies after 1970 and in early 1980 worked on product cost improvement and back pricing and mix decision of product.(Latshaw , Danile,2002).

Cooper and Kaplan introduced ABC accounting approach in which overheads cost is correlated to products and calculating the cost of product (Drury, 1998).

Activity based costing (ABC) traces operating cost to products by focusing on the activities that drive costs (Weetman,2006,P-488).

Activity based costing is the link of cost drivers and activity performed (Baker, 1998).

ABC is principally used to make or finalizing tactical decisions which include outsourcing, costing, pricing and planning activities.ABC is a process of accounting, with this method of accounting various information's and data are considered to find out operative cost. This method of accounting is involved in finding the cost and profit of particular service or business. ABC is very useful methodology in taking or finalizing any decision in terms of accounts and finance.ABC is based on causes, output and outcomes and its effects. Drivers that causes and making sure the activity performed and then the activity which is performed gives the outcome.

ABC generally focus on two main segments that how to measure the cost and cost on the particular activity and examine and calculate the performance of that particular activity. ABC is the method in which input is given to the activity is performed and measured its cost and that input is than interrelated with the object of cost which is involved in that activity to acquire output, so calculating the resources used, tracing out cost of resources used, identifying the non value-added cost and the manageable way to eliminate that overhead cost is what we call ABC.

By using ABC we can examine the resource which is allocated or budget which is allocated to the particular task or project and it is harmonized with the scope of work or target, correlated with time consumed in completing that particular project.ABC method gives clear and better idea that how overhead cost is associated to product or service.

ABC system can be understood by four stages,

Activities which are taking place in providing any services like in hospitals equipments which are in service in treatment of patients. The equipments which are being used are consider to be in cost centres and direct cost which are the resources used in providing treatment and operating that equipments.

After knowing the major activities which are taking place, setup to be made to calculate the total cost which are involved in that activities which are taking place that is called cost pool.

Cost which influence the activities are consider in third stage, in this stage we determine the forces or events which have affects on that particular activities. Term cost driver is used to determine the forces and determinants of the cost of activities. Behaviour of cost can be dictated by cost driver and by identifying the cost behaviour accurate overhead cost can be calculated accurately. Cost driver which is used in ABC accounting system can be best understood by taking example that when unit which takes orders receives orders for production of items and manufacturing unit which produce items and then the supply unit supplies those manufactured items, cost driver indicates the accurate cost in production, so cost behaviour of particular activity must be known to indentify the overhead cost which are likely to be occurred during completion of different task in different phases.

Receiving order unit the labour hours are the main cost driver, in production phase the cost is related with the labour and machine or power hours, these are resources which are used in production phase and then supply phase utilize both labour and transportation to complete the required activity, so in this phase both machine and labour cost are involved so these are called cost driver of this phase.

Through ABC methodology cost is allocated to the each unit of the company or organisation which is called cost center, like the delivery vans budget or cost is allocated to the delivery department and the salaries of drivers and all cost is calculated with the particular department cost center. There are two kinds of cost, fixed and variable cost, fixed cost is predefined and that cost is independent of the services and to the production of items and variable cost is calculated with the items that are produced or to the services which are provided so variable cost is dependent on the services and number of items which are produced (Drury,1998).



Variation in unit cost depends upon the size and location of hospital. Hospital in much advance and bigger city results more cost than hospital in smaller and rural area. Hospital covered area also influenced the unit cost, larger the covered area and size of hospital more will be cost because bigger the covered area of the hospital more expenses are needed to maintain and run that hospital.


Unit cost varies with services high level of services. If some extra and advance services are provided to the patients that affects the cost as well as varies the unit cost. Proper cooling and heating service, 24 hours security service in order to make sure the safety, Proper hygienic food for patients, Clean and hygiene environment for patients, staff and visitors increase the unit cost.


In order to maintain the good level of services there will be a need of more doctors and nurses, like there will be increase in number of Pre- registration house officer, senior house officer, specialist registrar, surgeons and general physicians, like wise there will be need of extra nurses in order to make sure that each patient is attended by nurses, so nurse team manager, nurse team leader, nurse day, nurse night ward, nurse 24 hours ward so increase in these kind of services increase unit cost.


Unit cost varies with number of ambulances and paramedic staff hired by the hospital, more the number of ambulances and paramedic staff more will be the unit cost.


Using more advance medical instruments and equipments affects the unit cost, to keep the high and advance standard equipments and instruments have to upgraded and by doing this unit cost varies, also maintenance of more advance equipments are expensive than those equipments which are not that much advance. Making sure the 24/7 services these equipments must have backup equipments if something goes wrong with running equipments. For maintenance purpose and in order to continue the full flow of operation there will be a team of expert technicians for repairing the damaged equipments and making sure to run the backup instruments on time without any delay in operation.


In order to maintain the high level of standard of doctors and nurses trainings and seminars are arranged and by establishing the library for doctors and nurses, and maintaining that library with research paper and advance books varies unit cost.


Facilities and services other than medical also contribute a lot in unit cost variation, like additional heating system to patient, individual alarm system, new level bath, stair lift, cafe, restaurants, car park, wireless internet facility and phone booths increase unit cost.

Keeping in mind about the facilities to staff like doctors and nurses and other informal staff keep them happy and make them work hard for hospital so by investing on facilities for staff vary in unit cost as well.


Different type of costing and accounting methods also varies unit cost. If accounting to be done on day by day basis than proper team of accounting is required to do this task so it increases the unit cost. Also if to make sure the finance and accounts of organisation is running to the mark than quarterly or yearly basis accounting and finance check which is called audit can result in variation of unit cost. Type of management that is implemented in hospital by management also the reason for cost variation, if extra facilities or service provided which are not needed they can cause main variation in unit cost because those non useable service and facility is non profitable and increases the overhead cost.


Main disadvantage of ABC is that this system gives very clear image of the cost and profit to the owners and heads of organisation. In order to gather and calculate the accurate cost, overhead cost and profit of the activity takes long time and expert resource is required to get the precise result.


It is extracted from the report that unit cost variation is not only because of poor management of NHS hospitals but there are many other reason behind that variation Also it is concluded that much more accurate result can be taken from activity based costing, with ABC accounting approach it is very easy in managing activity with respect to cost. Through ABC we can indentify product or service which are giving less profit or overpriced and so we can decrease or do away with those cost.


It is recommended to control the overhead cost and unit variation in different NHS hospitals, Activity based costing should be implemented to figure out the accurate cost of the particular activity or services and minimizing the unwanted and non profitable services so that cost variation can be minimized to maintain the same level of services in NHS hospitals on same cost.