Strategic Cost Management and Institutional Changes in Hospitals

Abstract

Accounting research raises the concern that firms in the health care and defence contracting industries, when facing a dual payment system with both cost-based and fixed-rate payments, have an incentive to reallocate overhead costs through increasing inputs used in cost-based operations. However, prior literature reports contradictory empirical evidence regarding such real activity manipulation. Drawing on the institutional perspective, we hypothesise that firms' market power and interorganisational dependence affect their cost-management strategies and choice of overhead allocation in response to dual payment systems. Analysing the data of California hospitals from 1980 to 1991, we find that when facing a dual payment system, dominant (strong market position) hospitals adopt a cost-revenue-enhancing strategy, increasing direct costs for cost-based services without containing costs in fixed-rate services. In contrast, nondominant hospitals choose a cost-reduction strategy and improve operation efficiency on fixed-rate services. We also find that nondominant hospitals shift more overhead costs away from fixed-rate services to cost-based services by reclassifying the allocation bases across services; combining this cost shifting with the cost-reduction strategy, nondominant hospitals demonstrate the compliance with the regulation expectation of cost containment.

Acknowledgements

The authors acknowledge the helpful comments of Marcia Annisette, Mark Covaleski, Dean Neu, Alan Richardson, and workshop participants at the Annual Alternative Accounts Workshop in Toronto and the International Symposium of Management Accounting and Controls in Beijing. The authors are especially grateful to two anonymous reviewers for their constructive and insightful comments and suggestions, and for the advice of the editor, Salvador Carmona.

Notes

To increase profitability, a firm with market power might also choose to adopt the cost-reduction strategy by reducing the cost of fixed-based services. However, cost containment is not an easy practice, as it needs time and effort to achieve. If a firm is able to adopt the cost-revenue-enhancing strategy to maintain or even increase its profits, it might have less incentive to minimise costs. We appreciate the suggestion of one of the reviewers.

We examine the intention of firms' strategic reporting of overhead allocation. We exclude overhead costs that are allocated via the allocation base of direct costs because both the cost-revenue-enhancing strategy and the cost-reduction strategy change direct costs used in services and reallocate overhead costs.

Under the PPS, the inpatient fee is computed by multiplying a standard rate by a weight factor that depends on the complexity of the diagnoses and is categorised by DRGs. The standard rate is determined by the average costs of hospitals in the same market, and is revised every year; it includes both labour-related (e.g. wage index) and nonlabour shares (e.g. cost of living adjustment).

California was one of the leaders in implementing selective contracting (Zwanziger et al., 2000).

The cost-revenue-enhancing strategy and the cost-reduction strategy lead to a shift of overhead costs. When using direct costs as an allocation base, both strategies change the ratio of the allocation base among products because of the mechanism of cost allocation, and as a result, reallocate overhead costs. This section examines how market position affects hospitals to reallocate overhead costs that are not allocated on the basis of direct costs.

On 1 January 1986, the California Hospital Commission transferred its functions to the Office of Statewide Health Planning and Development (OSHPD, 2003).

Revenue-producing departments include daily hospital centres, which provide inpatient services with routine nursing care and room accommodation (e.g. intensive care unit and medical acute centre); and ancillary service centres, which perform outpatient services (e.g. clinics) or diagnostic and therapeutic services for both outpatients and inpatients (e.g. diagnostic radiology).

Allocation bases include accumulated costs, costs of supplies, department full-time equivalents (FTE)s, gross patient revenues, number of square feet, etc.

As a sensitivity test, the median of the hospital ratios is used as a cut-off point to define fixed-rate and cost-based departments. The results are quantitatively similar (not reported).

There are three reasons that we choose the patient day of the medical acute centre as the basis of the service unit. First, adjusted patient days are a common measure used in the health economics literature (e.g. Clement, 1997); furthermore, interviews with senior managers in the health care industry indicate that the price per patient day of the medical acute centre is commonly used as a basis for evaluating the prices of other services. Second, services provided in the medical acute centre are relatively consistent over time in comparison with other services (e.g. cardiac catheterisation centre, intensive care centre). Therefore, we can control, at least partly, the effect of technological progress on the costs of services in the years 1980–91. Third, inpatient services of the medical acute centre are provided by all acute care hospitals. Basing the quantity measure on patient days of the medical acute centre allows us to avoid unnecessary deletion of observations due to missing data.

In the ‘Robustness Tests’ section, we examine our hypotheses using different classifications of dominant hospitals.

We use less strict criteria to define a firm with a dominant position; hence, the definition might be against us to find a significant result of dominant hospitals' responses.

We replace year dummies with two dummy variables (early post-PPS and late post-PPS) in Equation (1) and estimate the coefficients of early post-PPS and of late post-PPS. Results are qualitatively similar.

The means of direct cost per adjusted patient day are the unconditional means. Dollar values are deflated using the average consumer price index data from the Bureau of Labor Statistics (http://www.bls.gov) and expressed in 1983 dollars.

We also analyse how hospitals manage their overhead costs. Both dominant and nondominant hospitals reduced hospital overhead costs over the sample period: dominant hospitals spent $71.6 per adjusted patient day in 1980 and $64.9 in 1991; nondominant hospitals spent $75.6 per adjusted patient day in 1980 and $67.9 in 1991.

We choose top two hospitals, instead of the leading one, to increase the number of observations of dominant hospitals. The less strict criteria for defining dominance (moderately concentrated vs. highly concentrated and two vs. one) provide a strong test; we might not find a significant result of dominant hospitals' behaviour when the defined dominant hospitals do not have sufficiently strong power.

This example is to demonstrate the financial outcome of the cost-reduction and cost-revenue-enhancing strategies that are involved in real operation activities and changes in direct costs. Firms might reallocate overhead costs among products by only misclassifying joint costs and not changing direct costs.

This example shows that the profit from the cost-reduction strategy is higher than that from the cost-revenue-enhancing strategy. However, when we modify the assumption of the cost reimbursement rate (e.g. assuming a rate of 200%) and the changes in direct costs of products, the cost-reduction strategy might not obtain a higher profit than the cost-revenue-enhancing strategy. For example, because of the effort and investment needed for controlling costs, the firm adopts the cost-reduction strategy and only reduces $30 of direct costs in the product F; thus, the profit would be only $492.

Additional information

Notes on contributors

Sylvia H. Hsu

Paper accepted by Salvador Carmona.

Sandy Q. Qu

Paper accepted by Salvador Carmona.