Introduction to Activity-Based Costing

Robert S. Kaplan

Background Note | HBS Case Collection | February 1997 (Revised July 2001)

Introduction to Activity-Based Costing

Abstract

Introduces the fundamental notions of activity-based costing (ABC). Motivates ABC by means of a simple example, a single and a diversified pen factory. Proceeds to show how ABC assigns costs more accurately to products and customers by: 1) identifying the activities being performed by organizational resources; 2) assigning resource costs to the activities; 3) identifying all the products, services, and customers of the organization; and 4) assigning activity costs to these outputs via activity cost drivers. Also covers activity attributes, such as the cost hierarchy, value and non-value added, and business processes, as well as different types of activity cost drivers: transaction, duration, and intensity. Closes with the admonition to balance the benefits from more accurate cost estimates with the cost of developing an appropriate activity-based cost system.

Keywords: Activity Based Costing and Management;

Format: Print

14 pages

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Citation:

Kaplan, Robert S. "Introduction to Activity-Based Costing." Harvard Business School Background Note 197-076, February 1997. (Revised July 2001.)

A gerontologist in Kaiser Permanente’s Colorado region is concerned with the high and growing cost of treating the elderly population. She introduces a new care model, Primary Care Plus, using an interdisciplinary team of a primary care doctor, palliative care specialist, nurse coordinator, clinical pharmacy specialist, and behavioral and social service specialists. The team focuses on the highest-risk patients to see if the new, pro-active care model can improve patient, family, and provider satisfaction and lower Kaiser Permanente’s total cost of care for this patient segment.

The federal government mandated adoption of certified electronic health record systems (EHR), at least in part, to reduce administrative costs for physicians. This study used time-driven activity-based costing to determine the administrative costs associated with billing and insurance activities at a large academic health care center that had a certified EHR system. The center enjoyed economies of scale by concentrating its bill paying functions within a single, dedicated unit. The study found that costs for processing a single bill ranged from $20 for a primary care visit, about 20% of revenues, up to $215 for an inpatient surgical procedure. The high costs were not caused by wasteful, inefficient processes, duplicate or redundant tasks, or the inappropriate use of high-wage personnel to perform low-skilled tasks. Rather, they were driven by the heterogeneous payment requirements across the multiple payers and health plans contracting with the academic health center.

Partners in Health, a global NGO focused on delivering health care to residents of rural underserved communities, conducts a project on the cost of primary care at five sites in the Central Highlands of Haiti. It devises a simple approach for tracking the resources used by patients being treated for diverse medical conditions, as an input to a time-driven activity-based costing model. The results show considerable cost diversity across the five sites, but organizational leaders differ on the interpretation and action implications of the findings.

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Introduction to Activity-Based Costing

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