The ABC's of Smart Accounting


The ABC's of Smart Accounting by Tom Pryor Has this ever happened to you? You go to dinner with three other people, all of whom eat more than you. At the end of the meal the waiter hands the check to one of your dinner companions who proceeds to say, "Let's make this easy and split the check four ways." You end up paying more than you ate while your friends just got something for free. You sit there telling yourself, why didn't I ask for separate checks? It would be prudent and smart for home medical equipment (HME) providers to create "separate checks" for their products, services and customers. Traditionally, HME owners have assumed that all overhead expenses apply equally to all products and customers. As an example in Table 1, this business owner would be led to assume that every dollar of revenue consumes 27 ½ cents of overhead expense. Intuitively, business owners recognize that certain sales transactions consume more overhead cost than others, e.g. a delivered order consumes more cost than a customer pick-up. But monthly accounting reports don't report the "facts" to confirm these "feelings" (see Table 2). To address the need for financial facts, home care firms are using Activity Based Costing (ABC) to create "separate overhead cost checks" for their different types of customers, services and product lines. What is ABC? Activity Based Costing is based on a simple principle … activities consume resources and customers consume activities. Associating the labor and overhead expenses of the business with the activities that consume those resources provides valuable facts. Financial facts that can be used to improve decision-making and identify cost improvement opportunities. The basic building blocks for ABC are activity accounting spreadsheets for each group of employees in the business. Typical groups in a home care company would be Delivery, Billing, Customer Service, Therapy, Repair, Sales & Marketing, Accounting, Purchasing and General Administration. Table 3 shows an activity accounting report for a typical home care billing department ... the columns are the activities and the rows are the resources. The workload of each activity is measured resulting in a cost per output. As is often the case, the average cost of re-submitting a claim is more expensive than the initial submission. Steps to Implement ABC Implementing ABC is a Five-Step Process: Step 1: Create an activity accounting spreadsheet (like the one in Table 3) for each group of employees in your company. To define the columns, ask each group of employees to list their 5 to 10 time-consuming activities. Most home care firms have less than fifty (50) activities. Step 2: To fill in the rows on the activity accounting spreadsheet, estimate the amount of wages, fringes and other overhead cost consumed by each activity. Be sure to include space cost and depreciation. I recommend that you use twelve-month actual cost for this step, not budget. Step 3: Ask each group of employees to collect their output measure (workload) quantities for the past year. Divide each activity's total cost by its output quantity to calculate cost per output. For example, the average cost to submit a claim in Table 3 is $75.40. Therefore, you know that you're losing money on any claim submitted for less than $75.40 of revenue. Evaluate the cost per outputs for reasonableness before proceeding to the next step. Step 4: Select one high-volume and one low-volume customer to analyze. For example, you may want to analyze the profitability of a customer that requires daily or weekly nursing visits versus one that comes in once a month to pickup a replacement oxygen bottle. Step 5: Determine the gross margin (revenue minus cost of goods sold = gross margin) for each of the two customers. Then subtract the cost of activities consumed by each customer from the gross margin. Is each customer profitable or not? If not, does the list of activities consumed by the customer provide you insight as to how you could make them profitable? NOTE: There will be some business sustaining activities that will not be directly traceable to customers, e.g. Issue Purchase Orders, Do Housekeeping, Attend Meetings, etc. I recommend that you add up the total non-traceable cost and then allocate based on each customer's percent of total sales dollars, e.g. if a high volume customer provides 5% of total revenue they would get allocated 5% of non-traceable costs. If non-traceable activities consume more than 25% of total overhead cost, you will likely find it very difficult to be a profitable company. The reason is that non-traceable activities rarely create revenue or customer satisfaction! Uses of ABC I have heard it said that the lottery is God's way of punishing people who are bad at math skills. I believe the same can be said for the use of 1940's-style accounting reports (Table 1) in 2000's home care. The management of gross margin percentages is simple. But in today's competitive marketplace, a focus on gross margin is simplistic. Traditional accounting reports are formatted for external compliance reporting, e.g. I.R.S., banks, etc. ABC is formatted for internal decision-making. HME owners are increasingly discarding their monthly focus on traditional accounting reports and periodically using ABC to help make many types of decisions: Setting minimum order quantities. Setting prices. Analyzing customer profitability Analyzing service profitability Analyzing product line profitability Analyzing retail versus delivery profitability Analyzing payer profitability Analyzing branch profitability Bidding and/or quoting prices Target costing new services Here are some examples of "how to use" ABC: Fire customers that consume more activities than their gross margin will cover! But before you "fire" any customer, add to the decision their accounts receivable balances and payment histories. What you will often find is that not only are you not making money on their orders, but you are also banking for them with your accounts receivable as well. ABC customer profitability analysis not only identifies profitable and unprofitable customers, ABC also provides methods to turn losers into winners: Make losers cash-only customers. Eliminate billing and accounts receivable activities. Use activities to create menu-based pricing, e.g. charge for delivery, charge for returned goods, etc. Do not allow losers to consume your value-added services for free. Many HME owners need more shelf-control when it comes to which products and services they should offer customers. Published gross margins can be misleading. For example, one home care firm met with a sales rep that wanted to demonstrate a useful new product. The new product had a recommended list sales price that results in a 20% gross margin. Normally the home care owner would not have carried the product because overhead costs are 27.5%, resulting in a pre-tax loss of 7.5%. But the business owner, using the principles of ABC, realized that many of the home care overhead activities would not be incurred with the sale of this new product. With this ABC knowledge, the owner decided to add the new product to the sales shelf. The product became a big seller for all the branches, adding significant profits to the company. ABC helped the owner make a good shelf decision. Menu-based pricing is another popular use of ABC. The most costly activities of a home care company are typically services that are being performed for the customer. The higher cost, higher volume activities of the home care firm serve as a basis for a menu of services and prices, e.g. Make Delivery, Process Return Goods, etc. If customers are not charged for costly activities, they may incorrectly assume that you're providing the service for free! Creating an ABC Bill of Activities will alert home care managers if they can afford to sell what they are currently offering customers on the firm's menu of services. A recent personal experience highlights the importance of using ABC to set policies. My 79-year old father recently had successful triple bypass surgery. The doctor prescribed an oxygen concentrator on the Sunday my dad was released from the hospital. Someone on the hospital staff selected a home care firm to make the delivery. If the selected home care owner subtracted the cost of the activities consumed in the two-hour roundtrip delivery and subsequent return two weeks later, I seriously doubt that any profit would be left from the $228 fee. Apparently the home care owner had a policy of accepting any business, no matter the distance from the store. While noble, it makes little or no sense. Repeat Steps 3, 4 and 5 for product lines, service types, branches or any cost object needing analysis. ABC provides insight as to where you're making money and where you're not in your business. Cost versus Benefit Implementing ABC can provide significant benefits … improved pricing, better marketing strategies and more profits despite lower reimbursement rates. But there is a cost of implementing ABC. There are three basic implementation options that vary in cost: Option 1: Self-implement ABC using one of your existing staff, a spreadsheet and a book. While project length depends on the size of the business, most small to medium home care firms can implement ABC in 60 to 90 days with a staff member dedicating 30-60% of their time to the project. If there is no available staff member for an ABC project, don't overlook local university or college professors and students. Many are looking for ABC experience and will do the work for little or no money. Excellent books are available on the topic of ABC. Probably the most relevant for home care is "Activity-Based Management: A Healthcare Industry Primer". It is available for $40.00 from the American Association for Homecare, Association for Healthcare Resource & Materials Management or from ICMS, Inc. Option 2: Self-implement ABC with the aid of a Homecare Toolkit. Each toolkit contains a homecare activity dictionary, PC-based ABC software, step-by-step instructions, aforementioned primer and homecare case study. Toolkits can be purchased on the www.ICMS.net web site for $3,995.00. Other ABC software products to consider include OROS from ABC Technologies, Metify from Armstrong Laing and Activa from Oracle. Option 3: Hire a consultant to implement ABC. While this is the most expensive option, it will be the quickest path to success. If your organization is in dire need of improved cost management, hiring an ABC consultant may be the best option. Average fees of consultants with home care ABC experience vary from $1,500 to $2,500 per day. The amount of consultant work typically varies from five to twenty-five days, based on the size and complexity of the project. After the ABC software model has been created, most small home care companies update the numbers once or twice a year. Medium to large firms will typically update the model quarterly. The activities rarely change but the cost and workloads do. Conclusion Zig Ziglar defines disappointment as the gap between expectation and delivery. Many home care business owners expecting a reasonable return on their investment are disappointed with their current financial condition. And while they may get some temporary pleasure in blaming others … such as Medicare, Medicaid, HMO's, Health Care Financing Administration … for current financial problems, it is up to every business owner to close the gap of disappointment. In the newly published "17 Lies that are Holding You Back & the Truth that will set You Free", author Steve Chandler lists number 8 as "I worry because I care. We worry because worrying is what we do all day to avoid taking action." Worrying will not improve your home care company. Action will! Implement ABC. Create "separate checks" for your products, services and customers. Convert your profitability "feelings" into "facts". Use ABC as the basis for a fresh start to your firm's improved financial future. Send comments on this article to Tom Pryor at TomPryor@icms.net. 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