Costing and Managerial Accounting

Costing Practices in Healthcare Organizations: A Look at Adoption of ABC

December 5, 2017 10:05 am

Results of a recent survey point to a rise in interest in activity-based costing techniques among hospitals and other providers.

Amid today’s rapidly increasing healthcare costs, healthcare providers face increased pressures to deliver services more effectively and efficiently to their patients. The challenge also is compounded by the healthcare industry’s ongoing transition toward a value-based payment environment. Providers cannot hope to successfully make this transition if they lack effective managerial costing techniques.

Nonetheless, even as organizations redesign many of their processes to meet the challenges of the value-focused environment, many of them continue to use managerial costing practices that are rapidly becoming obsolete.

As early as the 1980s, managerial accounting thought leaders recognized the need for changes to costing practices in response to ongoing changes in business and its information requirements, and since then, many innovative managerial costing practices have been developed. Pressured by the demands of external financial and regulatory reporting, however, many accountants have been reluctant to promote these new, more appropriate practices within their organizations. Instead, they have computerized their old practices, without alteration.

As a result, healthcare organizations all too often are using oversimplified costing practices that can lead to poor decision making because they in no sense match the operating reality of the business. The experience of one not-for-profit, long-term healthcare provider exemplifies this point. Using its traditional cost-accounting system, the provider was unable to inaccurately measure resident service costs, and because it did not understand its actual costs, the provider accumulated a resident population that it could not financially support, substantially eroding the endowment it required to achieve its mission.

Simply put, to meet the economic challenges faced by the industry, and to provide low-cost high-quality services, healthcare organizations require managerial costing systems that promote efficient and effective operations. Managerial costing systems—as opposed to an organization’s externally oriented financial reporting system—should accomplish three goals:

  • Promote cost efficiency
  • Allow the organization to maximize its resources by managing the services it offers its patients
  • Highlight opportunities for continuous improvement of operations

Traditional costing systems used by healthcare organizations all too often fall short in these areas. However, one costing approach, activity-based costing (ABC), has been widely touted as an effective means for achieving these goals. Adoption of ABC promises to transform healthcare providers’ managerial cost accounting systems in a way that will enable these organizations to keep pace with the changes that are sweeping the industry.

Findings of a recent survey conducted by HFMA in collaboration with the Institute of Management Accountants (IMA), compared with those of two similar surveys conducted in 1994 and 2004, provide insight into the state of the healthcare industry regarding adoption of ABC, and suggest that the such adoption is becoming more widespread. The HFMA-IMA survey also looked at the broader state of cost accounting in general within health care as part of a larger initiative focused on developing a standard approach to cost accounting that can be used to help prepare an organization for success in the evolving healthcare environment. The sidebar below provides additional details about the survey and its broader findings.

Sidebar: Key Findings of the HFMA-IMA Initiative

The remainder of this article focuses on the survey’s findings with respect to ABC, in particular, which suggest this methodology may be poised to eventually supplant traditional costing approaches used across the industry.

Emergence of ABC

First appearing on the management accounting scene in the mid-1980s, ABC promised to revolutionize the way costs were allocated to the products produced and services performed by organizations. Numerous articles have appeared since its introduction, detailing the effectiveness of this technique for a variety of purposes. Activity-based management, which emphasizes managing the activities an organization performs rather than the results of those activities, involves a paradigm shift in management—a move from a functional view of an organization to a cross-functional one. The effectiveness of ABC systems is taken as given by many, and the technique is now routinely covered in managerial and cost accounting textbooks.

Nearly all (98 percent) of respondents to the current survey were familiar or somewhat familiar with ABC. By comparison, respondents to the earlier surveys were much less familiar with this technique (73 percent in 2004; 56 percent in 1994). These findings together reflect how awareness of ABC has grown since its introduction in the healthcare industry in the early 1990s.

This increased awareness of ABC might be expected to translate into greater usage of this tool, and indeed, this is the case. As shown in the exhibit below, the usage of ABC has shown an increase in roughly the past decade. We also see that, although hospitals were early adopters of ABC, their use of this technique has increased more slowly than has the use by other healthcare organizations. The lower rate of usage of ABC by hospitals might be expected, given their greater complexity and, thus, greater cost of implementing an ABC system. However, it is in more complex environments where ABC offers the opportunity for cost savings and operational improvements, so its adoption may increase among  hospitals going forward.

Activity-Based Costing (ABC) Use by Type of Organization

As the exhibit below shows, a significant percentage of respondents that are not currently using ABC are considering adopting this costing methodology. The findings over the three surveys suggest a resurgence in interest in ABC among non-users in 2016 after a decline noted between 1994 and 2004.

Organizations Considering the Use of Activity-Based Costing (ABC)

An interesting related finding is that all the organizations that reported using ABC in 2016 have had these systems for over three years, whereas in the earlier studies, the ages of the systems varied among users. Perhaps renewed interest in this technique has been spurred by the increasingly competitive environment and the belief that improvement in costing information will provide a competitive advantage.

Looking at 2016 findings only, the propensity to use ABC also appears to be affected by an organization’s payer mix. As the exhibit below suggests, organizations that have adopted ABC tend to have a smaller proportion of Medicare patients than do non-adopters. It may be that organizations with a high proportion of Medicare patients—and which thus have a large portion of their revenues paid based on a fixed schedule—feel less compelled to know the precise costs of the activities they perform because there is less of a need for them to set their fee schedules to maximize their profitability. These organizations can still benefit, however, from ABC’s utility as a means to control cost and improve processes, which eventually could heighten their interest in the technique.

Effect of Percentage of Medicare Patients on Use of Activity-Based Costing (ABC)

A similar relationship was noted among 2016 respondents regarding the proportion of uninsured patients and ABC utilization, with organizations having a higher percentage of uninsured patients being generally less likely to use ABC.

Use of Activity-Based Costing (ABC) by Percentage of Patients Uninsured

Similar relationships between percentages of Medicare patients and uninsured patients and ABC utilization were observed in the prior studies.

Perceived Benefits of ABC Systems

Survey respondents were asked to indicate the extent to which they agreed or disagreed with four statements regarding the benefits of ABC systems. (Respondents were asked to use a five-point Likert scale, with a response of 1 indicating strong agreement and a response of 5 indicating strong disagreement.) The exhibit below presents the mean response for these questions.

Perceived Benefits of an Activity-Based Costing (ABC) System 

The potential advantages of an ABC system over a conventional costing system appear to be well accepted and understood—and these perceptions have remained fairly consistent over time. An encouraging finding is that the highest level of agreement is with the statement that ABC systems provide more useful information for process improvement programs than do conventional accounting systems (with 80 percent of respondents agreeing or strongly agreeing), and agreement that ABC does, indeed, provide this benefit appears to have increased over time. Using the information provided by an ABC system to better manage an organization, rather than using it solely to focus on cost control, greatly expands the potential of an ABC system to add value to an organization. However, that benefit appears to be considered secondary to the perceived benefit that ABC systems can be used to effectively control costs. This point raises the concern ABC may be widely seen as simply a costing exercise, which could preclude its use as part of a more pervasive management control system.

Respondents also agreed, on average, that use of an ABC system would enable them to better understand their organization’s operations and would provide more useful product costing information. Given the need, when designing an ABC system, to identify the activities performed by an organization, their related cost drivers, and the consumption of activities by products, this finding is to be expected. In the environment in which most healthcare organizations operate today, these are important benefits, and organizations should seek to obtain them from their managerial costing systems.

Significant differences exist between the responses of organizations that use ABC systems and those that do not. For example, all users of ABC systems (as well as organizations that are considering adopting ABC systems) agree that an ABC system is more effective than a conventional accounting system as a means for understanding their operations, while only 25 percent of those that do not have such a system and are not considering adopting one agree with this point.

Reasons Organizations Have Not Adopted ABC Systems

The 2016 survey found that healthcare organizations are generally dissatisfied with their existing accounting systems. That finding, coupled with the general perception that organizations can benefit from deploying ABC systems, raises the question of why more organizations have declined to implement these systems. Survey respondents whose organizations have not implemented ABC were asked to provide the reasons why they had not adopted this technique. The survey offered respondents a list of 12 possible reasons for non-adoption of ABC, and additional space was provided for write-in answers (although none of these received a significant number of responses). The percentages of non-adopters that selected each response are shown in the following exhibit.

Reasons Organizations Give for Not Adopting Activity-Based Costing (ABC)

Respondents to the 2004 and 2016 surveys were much more likely than respondents to the 1994 survey to give reasons for their decisions not to adopt ABC. However, when the reasons were ranked by how frequently they were cited, there were only minor differences in the order in which they were ranked among the three surveys.

A lack of commitment by senior management was the most commonly cited reason for non-adoption in the 2016. This was also a highly cited reason in the earlier studies and is consistent with the perspective advanced by other research that support of top management is key factor in the successful implementation of a new performance management system. a Clearly, it is important for an accounting and finance team to build a strong business case when proposing the adoption of an ABC system.

Many of the other reasons organizations have declined to adopt ABC relate to the belief that the cost of adopting an ABC system is higher than the benefits derived. For example, the belief that the cost of designing and implementing an ABC system is prohibitive was the second most-cited reason given for non-adoption (and it was the top reason cited in the 2004 study).

Implementation issues can also influence organizations to choose not to adopt ABC systems, including the need to create new systems for data capture and processing (55 percent of non-adopters in 2016), the inability to obtain all the data needed to implement ABC (45 percent), the perceived complexity of ABC systems (36 percent), and the difficulties involved in identifying activity cost pools and drivers (18 percent).

Abandonment of ABC Systems

Although only four of the respondents’ organizations had abandoned their ABC systems, this number nonetheless did constitute 10 percent of the respondents to the survey. The reasons for abandonment were much like those cited by non-adopters: The complexity of the ABC system and the failure of the ABC systems to produce benefits that outweighed system costs were cited by half of those who abandoned their systems. Additional reasons cited included the inability to create new systems for data capture and processing and the inability to obtain all the data necessary to implement ABC. In addition to the reasons just mentioned, half of the group dropping their ABC system reported that system upgrades resulted in the loss of the functionality needed to easily perform ABC costing.

ABC System Implementation

Many decisions must be made when implementing an ABC system, including whether the system should be constructed as a stand-alone system, implemented parallel to a conventional costing system, or integrated into the existing accounting system. Among all respondents to the 2016 survey, there was slight preference for integrated systems, unlike in the prior two studies, where there was a slight preference for stand-alone systems. Among 2016 respondents, a higher percentage of organizations that have ABC systems preferred integrated systems than favored stand-alone ones (38 percent and 15 percent, respectively, with the rest of the respondents not indicating a preference). This trend toward favoring integrated systems may reflect technological advances. It may also reflect the high cost associated with updating and maintaining a stand-alone system.

Another important attribute of an ABC system is the extent to which an organization has adopted it (i.e., fully versus partially). None of the respondents to the 1994 survey had fully implemented ABC, and only one respondent to 2004 survey had done so. Among respondents to the 2016 survey, however, half of organizations with ABC systems had fully adopted this methodology. The greater proportion of organizations fully adopting ABC, combined with the trend towards adopting integrated systems, points toward a more mature implementation of these systems over time. It is also a positive development given the need for these systems to have a positive cost-benefit impact.

Although the earlier surveys provided some evidence that the complexity of ABC implementations was increasing, the current study could not corroborate that finding. The exhibit below indicates that both the number of cost pools and the number of cost drivers employed in ABC systems have largely remained unchanged over the past decade. This is not necessarily a bad thing: Increasing the numbers of costs pools and cost drivers increases the cost of maintaining an ABC model, thereby also increasing the likelihood that an organization will feel the cost outweighs the benefits of the model.

Number of Cost Pools and Drivers Used in Activity-Based Costing (ABC) Systems

With regard to design, most systems (83 percent) were designed by in-house staff, although external consultants also assisted in designing half of the systems. One-third of the systems use commercial packages; the rest use tools developed in-house.

Challenges in Implementing ABC Systems

Given the perception by some organizations that implementing an ABC system can be challenging, it is useful to examine the issues faced by organizations that have already implemented these systems. In each of the studies, ABC systems users were asked what problems they encountered in designing and implementing their systems.

Difficulties Encountered in Designing and Implementing Activity-Based Costing (ABC) Systems


In contrast to the earlier studies, the 2016 study highlighted one issue stands out in particular: the allocation of costs to activities in a way that reflects causation. Although this issue may indeed pose challenges, it goes to the heart of the ABC methodology and, if it is managed effectively, such allocation of costs can yield valuable insights for controlling an organization’s costs overall.

Another significant challenge over the years has been obtaining buy-in to ABC systems from middle managers. This challenge may simply reflect the fact that managers are accustomed to managing using difference costing information and need to be adequately educated on the benefits of using ABC data. Interestingly, getting line employees to accept an ABC system is rarely a problem. The greater use of operational (versus financial) data in an ABC system—resulting in an approach to measuring performance that line employees can more readily relate to and understand—may contribute to this acceptance.

Organizations considering adopting ABC systems should carefully think through the resources needed to implement these systems: “Inadequate computer system support to implement system” and “Lack of adequate resources to effectively implement desired system” were often-cited implementation challenges. As noted previously, it is important when implementing an ABC system not to overdesign it or make it overly complex. Doing so will result in systems that are costly to maintain and likely to be abandoned.

The Way Forward

Managerial costing is about the application and use of sound managerial economics in managing an organization to higher levels of success. b As highlighted in this study, most healthcare organizations’ management accounting systems are inadequate for this purpose because they are based on oversimplified financial models that do not adequately connect to the fundamental economics that underlie organizations’ operation.

These models reflect an out-of-date, rules-and-regulations view of costing. It is critical to recognize that the external financial reporting model has significant flaws when used for internal decision-making that can derail strategies and cripple a business. Effective, value-adding managerial cost information must come from models that reflect the fundamental economics that underlie an organization’s actual operations.

A finance team with courage, will, and strong leadership skills will shift their organization’s management accounting practices from the status quo to progressive practices. They will narrow, and ideally close, the gap between the information currently provided by their externally oriented financial accounting system and the managerial cost information their decision-makers need to obtain the insights required to inform high-quality business decisions. To assist organizations in making this transition, HFMA will be working on developing and disseminating best practices in managerial costing principles and practices.

Raef Lawson, PhD, CFA, CMA, CPA, is vice president, research and policy, professor-in-residence, and editor, IMA Educational Case Journal, Institute of Management Accountants, Montvale, N.J.


a. Lawson, R., Hatch, T., and Desroches, D., Scorecard Best Practices: Design, Implementation and Evaluation , Wiley, 2008.

b. For more information regarding best practices in managerial costing, see the Center for Managerial Costing Quality’s website at


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