Direct, Indirect and Overhead Costs of NHS Trust

3487 words (14 pages) Business Assignment

27th Feb 2020 Business Assignment Reference this

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  1. Introduction…………………………………………………………………………………………………
  1. The direct costs and indirect costs of the departments in each hospital……………..
  1. Traditional absorption costing, relating it to the hospital environment………………
  1. Activity Based costing and how it may be implemented in the hospital………………
  1. The strengths and weaknesses of the Activity Based Costing approach………………
  1. A development that has been suggested in recent journal articles that aims to overcome (at least some of) the weaknesses of traditional ABC)………………………………………….
  1. References…………………………………………………………………………………………………………


I am going to write a business report to the Senior manager to the NHS Trust explaining the direct, indirect and overhead costs of the trust, How traditional absorption costing relates to hospital environment, what is ABC and how it can be implemented in the hospital, the strengths and weakness of activity based costing approach and a development that has been suggested in a recent journal article that aims to overcome some of the weaknesses of traditional ABC relating them to some of the hospital departments like cardiology, paediatrics, maternity and Accident and Emergency department.

Direct and Indirect Costs of the Departments in Hospital

Hospital costs can be incurred directly or indirectly in providing health care treatments and facilities for its service users and staff. Firstly, I would like to define what is cost, direct and indirect costs and over heads are and explain how these costs are incurred in hospital environment or context.

Costs: In a hospital context, NHS costs are the amount of payments incurred in providing health care treatments or facilities for its service users such as patients.

Costs can be classified as either fixed such as rent, rates.

Semi fixed such as the number of staff at shifts and variable costs such as medications.

Direct costs: Direct costs are costs which are incurred directly in providing and delivering of care or treatment to patients which are driven by patients to provide care that meets the individual needs of each patient. Costs that are incurred directly as materials, labour , expenses example: medications given orally or intervenes, salary of staff such as surgeons, doctors, nurses, midwives, nutritionist for patients requiring special/ specific diets.

Indirect costs: Indirect costs which are incurred indirectly in providing and delivering of patient care or treatments such as indirect materials, labour and expenses example: receptionists, security, chefs, cleaners, porters, laundry entertainments on children ward. Indirect costs are allocated to different cost centres and the number of patients does not determine the indirect costs.

Overhead costs: overhead costs are apportioned and reapportioned by service cost centre and are not driven by the level of parents’ activity. Overhead costs are the costs of supported services that contribute to the efficient running of an NHS provider for example the salary of the chief executive . Overhead costs are apportioned on a logical and consistent basis, care must be taken to indicate the relevant costs are identified and allocated in the right service and should be annually reviewed as the utilisation of these services will vary.

(Demeere et Al 2009)

Example of directs cost of various departments wards such as cardiology, maternity, Accident and emergency , paediatrics ward can be  medications and surgical supply if the need arises to carry out an operation, Salaries and wages of surgeons, doctors and nurses who works directly in providing the care or treatments needed and also other materials needed in providing direct care to patients example transporting of medications / drugs or patients in ambulances or Air ambulance .

Indirect costs incurred by fees from supervision, suppliers, chefs, cleaners, receptionist, entertainers in paediatric ward that’s contributes indirectly to the patients and over heads can be rent, rates, repairs, electricity for the space occupied.


NHS Costing Manual…/dh_132398.pdf

Traditional Absorption Costing Relating to the Hospital Environment

What is Traditional Absorption Costing?

“ The allocation of manufacturing overhead ( indirect manufacturing costs) to produce  on an basis of a volume metric such as direct labour hours or production machine hours. As manufacturing becomes more sophisticated the manufacturing overhead costs usually increases whiles the direct labour hours or production machine hours decreases. Hence, the direct labour or machine hours are unlikely to be the root cause of the manufacturing overhead”

In traditional costing, allocations of overhead costs are based on single predetermined rates. If the overhead expense is attributable to other service providers then apportionment is used to distribute the overheads. This works fine in manufacturing process where direct labour is major part of the costs.

Traditional absorption costing system apply indirect costs to product based on a predetermined overhead rate, traditional costing treats overhead costs as a single pool of indirect costs.

These are steps in traditional costing and how its related in hospital environment.

Example in a cardiology ward, A 65 years old man was pre-assessed for open heart surgery for 8 hours and was expected to breath for himself after he gain consciousness,  but during the surgery he suffered complications and the surgery lasted for 14 hours and was also given breathing mask to support him.

Firstly, the indirect costs are to be identified: indirect costs such as supervision, supplies, cleaners/ receptionists fees are to be identified.

The costs for the period are to be estimated monthly, annually: An estimation of these costs incurred are to be made either quarterly, half a year or per annum so that the approximate costs incurred for that period of time can be known.

Cost are to be linked to their cost drivers such as labour or machine hours: with reference to the above example, costs increases because the surgery lasted longer than anticipated , therefore the cost driver which in this case is labour and machine  hours influences the increase of cost.

An estimation of the amount of the cost driver for the appropriate period of time such as labour hours per quarter: cost drivers estimations are to be made for either quarterly, half year or annually. For instance, if every quarterly, an estimation of 500 cardio surgeries are performed and about 120 surgeries are influence by cost drivers, so am estimation of the total cost can be made.

A calculation of the predetermined  overhead rate are to be made and using the predetermined overhead rate to apply overhead such as rent and rates, electricity are to be applied using their appropriate rates.

Activity Based Costing and How it may be Implemented in the Hospital

What is Activity Based Costing?

“ ABC is a costing method that identifies activities in an organisation and assign the cost of each activity to all products and services according to the actual consumption by each. This method assigns more indirect costs/overhead in to direct costs compared to conventional costing”

The goals of the NHS are to promote, provide and deliver high level of care quality but at a minimum costs level. In hospitals there are revenue and supports centres in which hospitals generates parts of their income from profits/revenue centres.

The reason for activity based costing in hospital is to understand and streamline the activity. In activity based costing the overhead costs are allocated to cost pools which are similar to departments and can be driven by cost centres. The number of activities performed in Hospital are vast; the collecting, counting, classifying of the data is going to be time consuming and expensive.

To implements ABC in hospital environment steps should be followed.:

Example: Two men was brought in to the accident and emergency department for surgeries due to bike accident, if possible you need to find out the costs per patient for the surgery.

The first step is to identify the cost objects.

Identify and define activities and activity cost pools based on costs allocation: Identifying the direct cost associated per patient such as the costs of medications/injections provided per patient, the surgeon fee depending on how many hours worked, the medical suppliers costs used such as dressings or cast.

Directly trace costs to cost activities and costs objects such as patient admission process like check in and discharged, surgery and the post-surgery care for the patient.

Assign costs to activity cost pool base on cost allocation: In activity based costing systems, activity pools are connecting costs that relates to a single measured activity. Cost pools can be identified and grouped.

For instance, Patient admission cost pool in a ward like cost of staff associated with admission activity, cost of depreciation or rent, electricity of the occupied space or costs of the telephone calls.

Emergency room cost pool such as cost of staff associated with cardiology activity such as scans, depreciation of medical equipment required for cardiology, electricity and rent of the occupied space.

Calculate activity rates: Identifying the rate per unit of cost allocation base, for each activity cost pool identified will be allocated based on cost allocation basics or cost driver which increases the total costs linked to activity pool.

For instance with reference to the above example for surgery, lets assumed the indirect costs incurred is £250,000, cost drivers of patient-days, the quality of cost drivers is 100 patients per day, therefore the rate of cost driver per patient is £2500 per patient..

Assign costs to cost object using the activity rates and activity measures: With reference to the above example for instance, One of the men the diagnosis lasted one hour, 8 hours in  surgery , 3 days of post-surgery care so the indirect costs will be calculated appropriately.

Finally prepare reports per patient of the total direct costs including the direct material, direct labour and direct expenses and the allocated indirect costs.

Strengths and Weaknesses of the Acitivty Based Costing Approach

Strengths of ABC

ABC enables accuracy of overhead costs been charged appropriately for health care service, example rent is charge to the space occupied, canteen to the number of employees.

ABC ensures and encourage interdepartmental relationships, for example accounting department relates well with other departments within the hospital environment

Identification and reduction of idle time at work, ABC enable to identify the amount of idle time in hours cost incurred, therefore enables the implementation of strategies to reduce those idle time costs.

ABC provides accurate insight in to what drives overhead cost.

ABC can be applied to all overhead costs in health care settings, not just sales or production cost

ABC recognises the activity that cause costs and the health care service that uses it, because it provide more accurate costs per department.

ABC has been useful in an health care setting and allows the use of multiple cost drivers to trace cost to health care environment.

Weaknesses of ABC

ABC gives less attention to behavioural and organisation factors, therefore ABC was treated  by many organisations as a technical innovation.

It is not possible to allocate all overheads to specific activity, because some overheads will be difficult to allocate specifically.

Accuracy of costs under ABC was question because of the processes involved in the system, because when production volume increases, ABC cannot predict profits, hence it is not accurate for decision makings.

Other systems may need to change, such as the calculation of variances.

(Demeere et Al 2009)

Relevance Lost - The Rise and Fall of Activity Based Costing.pdfRelevance Lost – The Rise and Fall of Activity Based Costing.pdf

A Development that has been suggested in Recent Journal Articles that aims to Overcome the Weaknesses of Traditional ABC

Development of relevant and accurate cost information remained one of the key challenges faced by traditional absorption costing. The major issue with the traditional ABC was that people argued that a potential draw back of the system lies in the time and resource consumption associated with the development and management of these systems” ( Demeere et Al 2009). Therefore many managers who have implemented the system started to withdraw from it and later abandoned it.

In order to overcome these issues of traditional absorption costing, Kaplan and Anderson introduced a new solution to activity based costing called time driven ABC.

There are two parameters to which the new system could work.

Firstly, the unit cost of supplying capacity, this represents the unit costs of the activity or cost item. Secondly, time requires to complete a transaction or activity.

This system allows the use of multiple cost drivers which enables complex activities in organisations to be solved.

Time-Driven ActivityBased Costing in Service Industries.


Drury, c. (2005) Management and cost accounting, 9th ed. china RR Donnelley.

[PDF] Specifics of the activity-based applications in hospital management

Activity Based Management in Healthcare Industry – Cost to serve a patient

[PDF] Application of ABC method in hospital management

Time-Driven ActivityBased Costing in Service Industries.


[PDF] NHS Costing Manual…/dh_132398.pdf

  2-activity based costing for hospitals.pdf2-activity based costing for hospitals.pdf
  Relevance Lost - The Rise and Fall of Activity Based Costing.pdfRelevance Lost – The Rise and Fall of Activity Based Costing.pdf

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