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September 23, 2015
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David W. Johnson
Economics Outcomes System Dynamics

The Tyranny of Average Costing: Profit and COST in Value-Based Delivery

Market Corner Commentary for September 23rd-The Tyranny of Average Costing: Profit and COST in Value-Based Delivery

costMichael Porter, the eminent Harvard Business School professor, defines “value” in healthcare as “achieving the best outcomes at the lowest cost.”[1]

Through evidenced-based protocols, health companies have invested substantial resources to deliver and document improved care outcomes, the first component of Porter’s equation.

By contrast, health companies exhibit marginal understanding of their costs, the second element of Porter’s equation.  Porter characterizes the current state of healthcare cost management harshly,

For a field in which high cost is an overarching problem, the absence of accurate cost information in health care is nothing short of astounding.”[2]

Outcomes and costs should go together like love and marriage.  Given their “distant” relationship within most health companies, making outcomes and costs compatible will require serious intervention.

The Tyranny of Average Costing

costMost hospitals use either Ratio of Costs to Charges (RCC) or Relative-Value Units (RVUs) methodology for allocating costs.These methodologies blend direct and indirect costs into average cost units (e.g. one cost for knee implants).  Finance applies these cost units to treatment codes for billing third-party payors.

RCC and RVUs are pure allocation methodologies that rely on broad assumptions and are easy to implement.  Neither RCC nor RVUs incorporate rigorous activity or resource-use analysis.  Instead, they generate high-level cost data to support revenue collection (“Job 1 at most hospitals) and produce departmental-level income statements.

Here’s where “the tyranny of average costing” raises its ugly head.  The system oppresses performance improvement in two important ways:

  • The gross cost allocations mask the actual profitability and loss performance of individual procedures, clinicians and units.  Overall profitability is accurate at the departmental level.  Component profitability within departments homogenizes and is often wrong.  Significant resource allocation mistakes happen.


  • RCC and RVU cost allocations support billing, not clinical improvement.  Clinicians have little understanding of cost allocations and their relationships to outcomes.  They cannot combine their clinical knowledge with meaningful cost data to exploit opportunities for better outcomes at lower costs.  Productivity improvement sputters.

Wrong-Headed Cost-Cutting

It gets worse.  RCC and RVUs blind health companies to informed process improvement that reduces costs while maintaining or improving quality.  Under financial pressure, companies adjust P&L expense categories (e.g. payroll) without understanding how line-item cuts will affect care productivity and outcomes.  Too often, this approach to expense reduction leads to lower productivity and higher costs.

An insightful article in Harvard Business Review by Robert Kaplan and Derek Haas illustrates five common cost-cutting mistakes that health companies make: [3]

  1. Cutting Back on Support Staff: sub-optimal reduction in support staff can make front-line caregivers less productive and increase treatment costs.  Forcing clinicians to complete routine support functions prevents them from operating “at the top of their license.”  Far better to integrate lower-cost staff into more efficient care delivery that doesn’t compromise quality.


  1. Underinvesting in Space and Equipment: “idle” space and equipment are less expensive than idle medical personnel, particularly high-cost specialists.  Investing in facilities and equipment that increase caregiver productivity reduces overall costs.


  1. Focusing Narrowly on Procurement Prices: supply prices are only one component of supply cost.  Supply choice and use patterns often exert more influence on a procedure’s total cost.  Cutting supply prices feels good, but frequently doesn’t improve productivity or reduce costs.


  1. Maximizing Patient Throughput: increasing clinician patient loads only works if shorter-duration interactions do not worsen outcomes.  This tactic often backfires.  Less time with patients means less time to discover and implement better and less-costly care strategies.   Alternatively, spending more time with patients often improves engagement and leads to better outcomes at lower total cost.


  1. Failing to Benchmark and Standardize: variance in procedure performance, protocols and costs is evidence of sub-optimal performance.  Reducing variance requires constant process improvement that eliminates waste and inefficiency.  The result is better outcomes, higher quality and lower costs.

Effective cost reduction occurs in pursuit of higher-quality outcomes.  “Mistakes” happen when health companies adjust expenses in isolation.  With understanding of an entire care episode’s costs, clinicians and administrators “can work together to deliver the same or better outcome with an overall lower-cost mix of personnel, purchased materials and equipment.”[4]

Hi-Yo Silver: Better Costing to the Rescue

costAll is not lost.  Superior methodologies exist to pinpoint costs, optimize resources and boost productivity.

Measuring the costs and outcomes of care episodes is not rocket science.  It’s the logical response to marketplace demands for better, more affordable and personalized healthcare.  The “art” of costing is balancing the precision of desired data with the effort required to retrieve the data.

Ideal solutions combine actionable cost data for “objects” (products and services) generated systematically and efficiently.  Two methodologies stand out:

Time-Driven, Activity-Based Costing (TDABC)

RCC and RVU are gross methodologies for allocating resources to “objects” (products and services).  By necessity, these measures incorporate “paid for but not used” capacity which distorts measurement of actual activities and resources required to create objects.

To overcome this bias, TDABC measures the specific activities that occur and the resources consumed to create objects.  Specifically, TDABC determines a “cost per unit of time” for a resource (e.g. a minute of a surgeon’s time).  It multiplies that unit cost times the number of units required to create an object (e.g. a tonsillectomy) to estimate the total cost for that resource (e.g. the surgeon) for that activity (the tonsillectomy).

By “mapping” the relationships between resources, activities and objects, TDABC assigns real costs to a company’s products and services.  In doing this, TDABC enables productivity measurement and facilitates performance improvement.

Natural Flow Costing (NFC)

NFC accumulates and assesses enterprise-wide financial and clinical data to replicate the “natural flow” of costs within a hospital.  It employs big data analytics and TDABC methodology to measure the activities and resources required to create specific objects at multiple “levels”.  For example, it details revenues and costs at the department level (pediatrics), the specialty level (neurosurgery), the procedure level (surgical puncture), the ancillary level (pathology), the physician level, the diagnostics level and so on.

Aggregating data (usually from existing data sources) at multiple execution levels clarifies operating performance and facilitates targeted outlier analysis.  It also enables cross-referencing by payor and outcomes.  NFC provides real-cost and outcome data for entire care episodes (the best metric for measuring performance).  Consequently, NFC promotes efficient resource allocation, productivity improvement and profitability.

The University of Utah Embraces Costing


  A recent New York Times article explored how the University of   Utah has engineered 0.5 percent annual cost declines in recent   years.  During the same period, academic centers nationally       have experienced 2.9 percent annual increases.

Utah’s secret?  They’ve developed powerful cost-accounting and decision-support software that calculate treatment costs to the penny –  the per-minute cost for ER time is 82 cents.

The software incorporates over 200 million cost elements and correlates with outcome measures, such as readmissions and procedure complications.  It reveals opportunities for improving outcomes at lower costs.  For example, Utah discovered rampant lab test ordering by residents.  Excessive blood tests were making some patients anemic.  Requiring residents to justify lab orders now saves $200,000 annually.  Somewhere, Michael Porter is smiling

If Not Now…

America already spends enough on healthcare.  Like Utah, organizations can reduce costs and deliver better healthcare.

Fawn Weaver, the founder of “The Happy Wives Club,” observed, “Happily ever-after isn’t a fairy tale.  It’s a choice.”  Marrying costs with outcomes enables better medical decision-making, reduces errors, improves health outcomes and turbocharges productivity.  It seems almost too good to be true.  It’s not.  It’s a choice.

A version of this commentary appeared in “Academy 360” on September 17th

[1] Michael E. Porter and Thomas H. Lee, The Strategy That Will Fix Health Care, Harvard Business Review, October 23, 2013

[2] ibid

[3] “How Not to Cut Health Care Costs” by Robert S. Kaplan and Derek A. Hass, Harvard Business Review, November 2014.
[4] Ibid

About the Author

David W. Johnson

David Johnson is the CEO of 4sight Health, an advisory company working at the intersection of healthcare strategy, economics, innovation. Johnson is a healthcare thought leader, keynote speaker, and strategic advisor to organizations busting the status-quo to reform our healthcare system. He is the author of Market vs. Medicine: America’s Epic Fight for Better, Affordable Healthcare, and his second book, The Customer Revolution in Healthcare: Delivering Kinder, Smarter, Affordable Care for All (McGraw-Hill 2019). As a speaker, Dave plays the role of rebel, challenger, industry historian, investor and company evaluator to push audiences forward. (Watch bio video.) Johnson applies his 25+ years of investment banking in healthcare to identify ways the healthcare industry must change to deliver better care. He received a Masters in Public Policy from Harvard Kennedy School, an English degree from Colgate University, and served in the African Peace Corp service. Join over 10k+ healthcare executives who read our weekly insights and commentary on www.4sighthealth.com. His third book, Less Healthcare, More Health: The Prescription for a Happier, More Equitable and Productive America, will publish in 2024.

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