Feature Story

Bean counting basicsfor laboratories

Using ABC to show cost savings

June 2001
Anne Paxton

For American industry in the 1980s, the question was a provocative one: How can German auto workers earn three times as much as Americans and get six-week holidays, yet still produce high-quality cars that don’t cost that much more? When U.S. auto manufacturers investigated, they discovered the Germans were indeed innovative. But it wasn’t a magic elixir that made workers more productive; it was a new method of cost accounting.

The auto industry was one of the first in the U.S. to embrace new accounting techniques that have won favor in Europe; banks, insurers, and energy companies followed, but hospitals and other health care entities have only recently started to show interest. Now, in the hotly competitive arena that health care has become, many laboratories are wondering if improved cost accounting can also give them the edge they need.

Eleanor M. Travers, MD, MHA, a senior physician executive with the U.S. Department of Veterans Affairs and author of the textbook Clinical Laboratory Management (Lippincott Williams & Wilkins, 1997), believes it can—if laboratories are willing to devote the necessary resources. Labs are overwhelmed, she notes, and it may be that such burdens as coding and compliance, Stark regulations, and ambulatory patient classifications prevent them from doing cost accounting. But cost accounting is crucial to their survival, she warns.

There’s often a missing piece when people talk about cost accounting, suggests Al Lui, MD, member of Affiliated Pathologists Medical Group and CEOof Pathology Inc., a Medical Corporation, Torrance, Calif., and formerly medical director, president, and CEO of Bio-Diagnostics Laboratories. (The clinical part of Bio-Diagnostics, of Torrance, was sold to Laboratory Corporation of America last year.) Dr. Lui says Bio-Diagnostics weathered the most difficult years, the ‘80s and ‘90s, by paying close attention to finances. In southern California, he notes, "capitated managed care contracts with no exclusions, including anatomic pathology, were being bid in the $.40 per member-per month range by the big clinical laboratories."

"Most people will say cost accounting is very important, it’s vital, you must know your costs to make intelligent decisions. I don’t disagree," he says, "but until you know what you’re trying to analyze when you’re doing it, you can get very badly misled. The most important thing is understanding what questions you’re trying to answer."

He distinguishes between the kind of cost accounting done for financial reporting purposes and the kind that’s conducted to help make management decisions. What should the budget be? Should we do a test ourselves or refer it out? What should we bid on that capitated contract? What price should we set on this test? Laboratories’ use of financial data to address these issues, he says, is often not as helpful as one would hope.

Indeed, financial reports don’t give managers the information they need to change daily operations. Jackie McDowell, director of sales and marketing at TISMO Inc., a Swiss firm that provides costing and productivity solutions to hospitals, laboratories, diagnostics vendors, and other companies, points out that many lab managers in North America see the six-inch stacks of paper sent to them every month by the finance department and they rarely have the time or energy to look at them closely. Even if they did, "those stacks of paper don’t give them a good understanding of whether to buy or not to buy, whether to outsource, whether a customer is profitable or not. All they give you is financial, not operational data."

Oddly enough, the financial tail frequently ends up wagging the operational dog. For example, says Dr. Lui, budgeting can be a process that is only marginally grounded in actual cost accounting. "It’s a necessary tool, and it does force you to think about what your costs are and to look at projections and so forth. But in many organizations, there’s somebody who’s boss, and they have in their minds that you’re going to have to earn eight percent of some number in order for performance to be satisfactory this year. So the managers are asked to give realistic numbers of what they can produce, and everyone comes up with what is realizable, and it’s four percent. So the budget is rejected, everybody goes back and changes their projections, and then it’s six percent."

"We all know what happens next. We need another $200,000 from sales or another $100,000 from decreasing expenses, and in the end you get eight percent and the budget is accepted. But everybody knows there’s not a chance it’s going to happen." When the monthly variance reports come in, they show how far off the lab is from the budgeted numbers. "And somebody’s going to grill you about why you have an unfavorable variance of 11 percent, which everybody knew you were going to have in the first place. So there’s an immense amount of time wasted."

Like most independent laboratories, Bio-Diagnostics had regular monthly generated reports that tracked various financial ratios, Dr. Lui notes. "For example, among many items, we tracked net revenue per requisition and the number of requisitions per working day, so you know if you have a rate of 1,000 per working day one month and 1,100 the next, then
you’re growing."

But not everybody does it this way, he adds; many labs track requisitions per month. "Then you’re always trying to figure out did we have a good month or just 23 working days. You want to analyze things you can actually control. You don’t want to spend all your time on the fact that the Fourth of July fell on a Saturday instead of a Tuesday."

Bidding on contracts is a task that highlights well the difficulties of correctly accounting for overhead. "Probably the biggest area in which labs diverge in cost accounting is whether they are doing incremental cost analysis or fully loaded cost accounting—whether they are allocating a portion of the overhead expenses of the lab (which tend to be fixed) to a particular item, or clearly identifying just what expenses will increase with a particular test or contract. The differences between the two methodologies, of course, are huge," says Dr. Lui.

For example, "Let’s say we’re running a lab and we’re looking at a contract to do 1,000 glucoses every week for the next year. You can fairly easily calculate the additional reagent, supply, and labor costs for performing each additional glucose under these circumstances. And that’s incremental cost."

"But let’s say you were doing financial reporting on what a glucose cost in 2001. If you go back and retroactively analyze it, you’ll find it’s considerably more than the add-on cost of doing one additional glucose, because it includes the rent, electricity, and so on," he explains. "For financial reporting purposes, you almost invariably want to know the entire fully loaded cost. But if you’re going to decide on a potential new contract, most people find if they use the fully loaded cost of doing a glucose, they’ll never get any contracts." In practical terms, he sums up, "Especially for capitated contracts, the analyses are of interest—but they’ll probably only tell you more precisely how much money you’re going to lose."

Unfortunately, numbers can’t tell the whole story. Complicating the accounting picture are myriad intangible and nonquantifiable factors, especially apparent when—as occurs with most bidding on capitated contracts—at least on paper, losses are almost a certainty. No matter how definitively cost accounting can predict the value of a contract, the numbers often end up being ignored in favor of sales predictions, guesswork, and instinct. Laboratories frequently do accept an expected loss on a capitated contract, because they hope other factors will balance out the losses.

Economies of scale, for example, can result if the additional tests the lab decides to perform can be automated. "Up to some limit of the equipment’s handling ability, it’s almost certainly true that the higher the volume, the less your cost per unit will be, and yes, that is analyzable," Dr. Lui says.

"The phrase ’incremental costing’ often has a negative connotation in the laboratory business, because it means you didn’t think about all the overhead. But while people sneer at incremental costing, they use it because intuitively they understand that even if you’re not accounting for overhead, you are in some measure making things better all around because added volume helps to support your operations." Staff at his company, he notes, viewed these expectations skeptically. Their joke: "What is the optimum volume of testing required for a laboratory to maximize profit? Ten percent more than you have."

Gaining noncapitated business from the capitation clients, or "pull-through," is another means by which losses can be neutralized, but it’s a nebulous item, Dr. Lui says. "Pull-through was an important factor the first few years of the mid-’80s when there were many exclusive managed care contracts in California, but once we were past that stage, being the exclusive lab for a managed care entity didn’t matter that much, because most physicians had contracts with multiple clinical labs."

"If you’re going to lose money on a contract—and everybody did, big to small—why do it? You did it pretty much for two reasons. One, people used it as a loss leader to enter a new market. If you had no clientele in a geographic area, you could use it as a way to get them, to penetrate a new region. If you got an IPA contract, you were the exclusive lab and you suddenly had absolute access to all the physician offices signed up with the IPA." The second major reason is a defensive strategy, he says: to protect a market from competition. "If you own part of the geography in your region, you might very well agree to lose money just to keep out another lab."

A variation on this strategy would be to keep accepting money-losing capitated contracts in hopes of simply increasing revenue and just being one of the last players left alive, Dr. Lui says. "At that point, the lab may say it will raise its rates or get acquired by someone else with more money. When that happens, the size of the business you bring in is often more important than whether or not you’re profitable."

In strategies like these, the demands of competition have led laboratories to ignore the messages they get from their cost accounting efforts. But Dr. Travers argues that for most laboratories, competition today is doing the reverse: It is making better cost accounting critical. To cope with intense competition and inadequate reimbursement, she has long advocated that laboratories use some form of cost analysis that allows them to control their cost "drivers." She recommends that they follow the lead of European companies like the German automakers and employ a microcosting method advanced fairly recently, called activity-based costing, or ABC.

Although it was developed in the United States by Harvard economists Robert Cooper and Robin Kaplan in 1988, ABC was adopted more aggressively and earlier in Europe. ABC starts with the notion that traditional accounting is geared mainly toward satisfying auditors or other outsiders interested in evidence of financial accountability—not toward providing accurate cost information that will aid strategic and management decision-making. "ABC is an information system that ties costs to their true causes, the drivers of cost," Dr. Travers says.

A process like ABC is needed to understand costs in complex industries, such as clinical laboratories, she says. As the production processes of an industry become more complex over time, an ever greater proportion of total production costs are lumped together as overhead and allocated arbitrarily to output. This practice leads to distortions in production cost estimates—specifically, the attribution of too much overhead to high-volume, less-complex products and too little to low-volume, highly complex products
and services.

TISMO’s McDowell calls this the "bucket" problem. "When you volume-allocate, you tend to dump too many costs on simple tests and you undercost high-complexity tests. A bilirubin may take a minute, while a PCR may take three hours, yet the laboratory may spread the cost out over all the tests. That’s how a traditional cost spreadsheet works; it doesn’t have the ability to allocate cost accurately based on how many resources are used."

Activity-based costing, however, views the production process as a set of activities. "ABC identifies the activities performed, traces costs to these activities, and uses cost drivers to allocate those costs to a final product or service," Dr. Travers explains. Its main value: "It reduces the risk of bad decisions when laboratories are installing new methods, purchasing new equipment, setting prices, charges, or fees, and expanding or contracting operations."

Cost drivers are measurable factors that create or influence cost, or reflect the consumption of activities by the product or service. They may be discrete factors such as the presence or absence of a piece of equipment, or continuous factors such as the number of specimens processed. Each facility must determine what its own unique cost drivers are, but once they are developed, they can prove extremely revealing in analyzing how a company’s resources are being used.

For example, Laporte, a British specialty chemicals and materials producer, used ABC to find out if it was assuming correctly that big-name customers such as large food and drink producers were more profitable to the company than smaller ones such as farmers. It had its sales staff track cost drivers such as the product they were selling, the type of customer, the likely number of support visits required, and the free on-loan equipment that the customer needed.

The company was surprised to learn that the margins on farmers’ business were actually bigger than those on sales to the food companies. Analysis of the cost drivers showed that, unlike the larger clients, farmers placed orders by telephone, rarely required technical support, and did not demand loaner equipment.

Similar surprises are in store for laboratories that adopt ABC accounting, Dr. Travers predicts. "Overhead costs are what make you need ABC," she notes. "And overhead is so much greater in all the laboratory tests that are new and not automated, especially the molecular biology, the genome tests, the very sophisticated endocrinology and immunology tests. These high-cost/low-volume tests now constitute a much larger part of a laboratory’s test menu."

Nevertheless, says TISMO’s McDowell, although the laboratory is "probably one of the most complex manufacturing environments you’ll find, I would say health care as a whole is one of the last areas to look at itself in that way."

TISMO, whose founder was an American with a laboratory background, has been established worldwide since 1998, but three quarters of its software is sold in Europe and only about 15 percent in North America. It moved to the United States a year ago. The company uses ABC in its CostCrusher LabAudit Software because it believes ABC can refocus laboratories on business strategies that will help. "If you understand what’s driving costs, you can hone in on your processes, streamline, standardize, and improve them," McDowell says.

Although she says U.S. manufacturers who have adopted ABC usually get a return of three to five times their investment, U.S. laboratories have been slower to see the benefits of the cost-accounting method. "One of our first hurdles is helping people understand that a costing system is really valuable," she notes. "If you ask laboratories what is the most important thing to them, they’ll say ’understanding cost.’ Yet they’ll invest millions in an LIS and not even consider a costing system as a tool to make more money.

"Many laboratories say, ’If we had more money, we could do better.’ But often it’s not true. Often labs will build on a bad process by changing the workflow, buying new instrumentation, or automating. They think those steps will fix the problem, versus looking at a process as something they can eliminate or reduce depending on whether it adds value."

Says Dr. Travers: "We know reimbursement has been inequitable. But how do you know what fair reimbursement is—unless you’ve been able to calculate the actual costs of what you’re providing to the customer? One has to very carefully understand workflow, instrumentation, the grade level of people operating the equipment, and the cost of supplies, reagents, or materials before you can truly say you’re cost-effective."

The cost of one test is never the same in two locations, even in the same city, Dr. Travers warns. Alluding to former Speaker of the House Tip O’Neill’s famous assertion that "All politics is local," she contends: "All cost accounting is local. In the U.S. if you look at every single laboratory, group practice, hospital, or clinic, there absolutely is no uniformity. Even in the U.S. government, in the Army, the Navy, the Air Force, and the VA, we’re not forced to use the same instruments, we don’t have the same grade levels for pay, we don’t use the same reagents or have doctors ordering the same tests." All of these variables, she continues, make the cost drivers different in each laboratory and require custom-designed activity-based costing.

With the right cost drivers, though, users of ABC are able to "drill down" to the most useful details, says Kathryn Kendall, formerly general manager of Tri-State Laboratory Network in Illinois, Wisconsin, and Indiana and now executive vice president of Retail Health Network, an Internet-enabled health screening company with business-to-business data-mining services. "In outreach, for example, you can identify who is calling the most, look at what they’re asking, see if there’s something that can be done with this customer to reduce the calls. Do you need training on requisitions to alleviate the demands on customer support? Or if your courier is picking up a sample, maybe you need to call on other doctors in the building to penetrate it more so the courier costs less—instead of asking why your courier is costing so much."

When manufacturers demonstrate instruments, she notes, it’s usually in a nice room where the technologist can determine the workflow and see that there’s 10 percent waste, 10 percent repeats, and work out the cost. "But what’s really interesting is you can have two instruments in the laboratory and set up ABC, and find out that one is costing you more in maintenance parts. ABC makes it transparent because of the level of detail it analyzes."

One audit, she recalls, found that the instrument located close to the telephone was used most often and was wearing through parts much faster, so the laboratory changed the instrument’s location to make the parts last longer. Similarly, "You can actually ask, what does it cost me to run a TSH on first shift versus third shift, or on Wednesday versus Thursday. You can actually see that different days are going to cost you differently."

TISMO, which designs its software to work both top-down and bottom-up, also promotes ABC as a means of improving personal productivity on the job—a goal that countries like Sweden believe is integral to managing costs. "There are virtually no other tools out there that can go down to the level of personal productivity, that is, what do I do as an individual and what are the cost implications?" McDowell points out. "I think often we feel the financial people and managers, the rulers of the numbers, are the only ones who understand costs. But what drives those numbers is actually what people do, how they manage different processes."

Another benefit derived from ABC is the ability to educate physicians who order tests but have no idea what they cost, Dr. Travers says. "Once the laboratory finds out how much a test costs, it can send feedback to providers ordering the tests and say, ’Do you really need it? Because we’re only being reimbursed a certain amount.’" This reality check is particularly important for microbiology, molecular pathology, genomics, surgical pathology, and other highly intensive manual procedures, she adds.

Kendall points out that ABC challenges the widespread assumption that labor is the biggest cost laboratories face. Once the real cost drivers are known, Kendall says, "You could say, ’I’m going back and giving the techs a 20 percent raise,’ and you know what it does to the end product? Practically nothing, because labor is not driving it as much as some other things. When I was doing consulting, the first thing my clients wanted to do was look at labor and supplies. But ABC will show that’s not where you’re going to get your bang."

In fact, using a real-life example, she found that an across-the-board raise made only pennies of difference in actual costs. "It would be very powerful for lab managers to be able to show that to administrators, and use it to defend or propose outreach or another program, or look at new profit centers for the laboratory."

Findings like these tend to be counterintuitive, and proponents of ABC admit that philosophically it is very different from the way people in the U.S. do costing today, and that it requires a lot of time and effort. "Cost accounting is not a quick fix," Dr. Travers emphasizes. "It’s not easier; it’s harder to add cost accounting to your tool basket for management. But those patient and brave enough to add it will get a great reward in the long run."

Anne Paxton is a freelance writer in Seattle. For information on the CAP’s Laboratory Management Index Program, which can simplify cost accounting, call CAP’s customer service at 800-323-4040 (option No. 1).