Cost

Definition

Cost is the amount of resources used for something which must be measured in
terms of money. Costing is the techniques and processes of determining costs. Cost
of quality refers to the sum of costs incurred to prevent non-conformance from
happening in products and system which is commonly known as cost of poor
quality.

Why do we need to know cost of quality?

 It shows that cost of poor quality can range from 15 % to 40 % costs.

 It shows how profit is affected by quality.
 It can prioritize quality improvement actions.
 It helps identify the redundant or unnecessary activities.

Why measure cost of quality?

You cannot manage what you cannot measure.

 Motivational purpose.
 Comparing the success of projects.
 Identify quality improvement candidates.

Benefit of minimizing cost of quality

Decreases

o Defects
o Returned goods
o Legal costs
o Overall costs
o Customer complaints
 Increases

o Sales
o Profit
o Market share
o Capacity
o Competitive edge
o Customer and employee satisfaction

Categories or components of quality cost

Cost of quality as defined by Philip B. Crosby has two main components:

the cost of good quality (cost of conformance) and the cost of poor quality (cost of
non-conformance).

I. Cost of good quality (cost of non-conformance): The cost of good quality

includes prevention costs for non-conformance in products and services and
appraisal costs for conformance in products and services.

1. Prevention costs: Funds expended to minimize failure costs are prevention costs.
These costs include:

 Quality Planning: The wide range of activities that collectively create the overall
quality plan and specialized plans, plus the full communication of these plans to all
parties involved.

 Process Planning: Process capability studies, inspection planning, and other

activities associated with the manufacturing and service processes.
 Quality Audits: Evaluating the execution of activities in the overall quality plan.

 Supplier Quality Evaluation: Evaluating supplier quality activities prior to

selection during the contract period.

 Education and Training: Preparing and conducting quality-related employee

training programs.

 New Products Review: Including quality-related activities associated with the

launching of new products or designs (design review, risk assessment, Failure Mode
and Effects Analysis (FMEA).

2. Appraisal costs: Sometimes called inspection costs related to evaluating quality

levels in all stages of production. These costs include:

 Inbound Goods and Services Evaluation: Making sure that the materials you
receive meet your requirements.

 In-Process and Outbound Inspection: Testing product throughout the

manufacturing process to assure that it meets specifications prior to being released.

 Field Testing: Pulling product after it enters the market place and evaluating it.

 Process and System Audits: Formal evaluation of the infrastructure behind your
products and services.

 Calibration of Measurement and Test Equipment: Maintaining the accuracy of

the tools used in the product testing process.

II. Cost of poor quality (cost of non-conformance): The cost of poor quality includes
internal and external failure costs that resulting from failing to meet requirements.

1. Internal failure costs – a defective product or service that are found before delivery
to external customers – are caused by products or services not conforming to
requirements or customer/user needs. Internal failure costs are caused both by errors
in products and by inefficiencies in processes. These costs include:
 Scrap: The labor and material that created the defective product.

 Rework: The cost to correct the defective material.

 Re-testing: The cost to retest products after rework.

 Downtime: The loss of effective capacity caused by the quality problems.

 Failure analysis: The cost of analyzing non-conforming goods or services to

determine root causes.

 Changing processes: The cost of modifying the manufacturing or service processes

to correct the deficiencies.

 Downgrading: The cost difference between the normal selling price and the
reduced price due to quality reasons.

 Backorders: The loss of revenue from not fulfilling current orders and losing future
orders due to backorder situations.

2. External failure costs – a defective product or service that are found after delivery
to external customers – because the defect was not caught before shipping. These
costs include:

 Complaints: The costs of investigation and adjustment of justified complaints from

the defective product.

 Warranties: The costs involved in replacing or making repairs to products that are
still within the warranty period.

 Repairing returns: The costs associated with the receipt, repair, and replacement of
defective product.

 Allowances: The costs of concessions made to customers in exchange for an

agreement to use a substandard product “as is.”

 Penalties: The costs involved with violations in service level agreements.

 Lost opportunities: Future profits lost due to customers switching for reasons of
quality.

 Company’s brand and image: While this cost is hard to measure, it has the
potential to be the most damaging to a company.

Purpose of a quality cost system

Provide systematic means of planning and controlling quality costs.

It provides some enlightenment to management as to the magnitude of their quality

costs.

A change needs to be made due to a mal distribution of quality costs.

Budgets can be made once the quality cost information has been accumulated over
several periods.

Establishment of goals for the reduction of quality costs.

Ten steps implementing a quality cost system

1.Obtain management commitment and support.

2.Establish a quality cost team.
3. Obtain the cooperation and support of users and information sources.
4.Operationally define quality costs (to limit the scope of the system).
5.Identify specific quality costs.
6.Determine sources of quality cost information.
7.Set up a code system and forms to accumulate information.
8.Design quality cost reports.
9.Accumulate information.
10. Distribute reports.
 Elements of cost:

1. Material: The cost incurred for physical substance. E.g. Medical devices, beds.

2. Labor: The cost incurred for human efforts. E.g. Salary, wages, bonus.

3. Expenses: The cost incurred for services. E.g. Electricity, Rent, telephone.

Classifications of cost:

1. By nature or Element: The costs are divided into three categories, Materials,
Labor and Expenses. Materials can be further classified as raw material, spare
parts, consumable stores, packing material etc.

2. By Functions: The costs are divided on the basis of managerial activities

involved in the operation of a business undertaking. Eg; Production,
Administration, Selling and Distribution.

3. As Direct or Indirect Total cost is divided into direct costs and indirect costs.

o Direct costs: are those costs which are incurred for and may be conveniently
identified with a particular cost center or cost unit.

o Indirect costs: are those costs which are incurred for the benefit of number of
cost center or cost units and cannot be conveniently identified with a particular
cost center or cost unit eg: rent of building, management salaries.

4. By variability cost: classified according to their behavior in relation to changes

in the level of activity or volume of production. On this basis, costs are
classified into three groups namely, Fixed, variable and semi-variable

o Fixed costs: Those which remain fixed in total amount with increase or decrease
in the volume of output or productive activity for a given period of time eg; rent,
insurance. Fixed cost per unit decreases as production increases and increases as
production declines.
o Variable costs: Costs which vary in total relatively constant with changes in
production. They are also known as product costs as they depend on the
quantum of output rather than time. .Eg: Direct material, direct labor, power,
repaired indirect proportion to the volume of output. These costs per unit
remain.

o Semi variable: costs: Costs which are partly fixed and partly variable .Eg:
Telephone expenses include a fixed portion of annual charge plus variable
charge according to calls.

5. By controllability: The costs are classified according to whether or not they are
influenced by the actions of a given member of the under taking. On this it is
classified as controllable costs and uncontrollable costs.

o Controllable costs: Costs which can be influenced by the action of a specified

member of an undertaking. i.e. costs which are at least partly within the control
of management.

o Uncontrollable costs: costs which cannot be influenced by the action of a

specified member of an undertaking.

6. By normality: Costs are classified according to whether these are costs which
are normally incurred at a given level of output in the conditions in which that
level of activity is normally attained.

On this basis costs are classified as

o Normal cost and Abnormal cost. Abnormal costs are not a part of cost of
production and are charged to costing.
7. By Capital and Revenue (Financial Accounting Classification): The costs
which are incurred in purchasing assets used to generate income or to increase
 income earning capacity is called capital cost. The benefit of such costs is spread
over a number of years.
8. By time: Costs are classified as

o Historical costs: The costs which are ascertained after their incurrence are
called historical costs. The basic characteristics of such costs are (a) they are
based on recorded facts. (b) They can be verified (c) They are mostly objective.

o Predetermined costs: Costs are estimated costs. Computed in advance of

production taking into consideration the previous periods‘costs and the factors
affecting such costs. Such costs determined on scientific methods become
standard cost.

9. According to planning and control:

a) Budgeted costs: An estimate of expenditure for different phases of business

operations, coordinated in a well-conceived framework for a period of time in
future which becomes a managerial targets to achieve.

b) Standard costs: It is the predetermined cost based on a technical estimate for

materials, labor and overhead for as elected period of time and for a prescribed
set of working conditions.

c) For managerial decisions: On this basis costs are classified as

o Marginal costs: It is the total of variable costs. i.e., prime cost plus variable
overheads. It is based on the distinction between fixed and variable cost.
o Out of pocket costs: It is that portion of the cost which involves payment to
outsiders.

o Differential costs: The change in cost due to change in level of activity or

pattern or method of production.
o Sunk costs: It is an irrecoverable cost and is caused by complete abandonment
of a plant. i.e., costs which are not relevant for decision making.

o Imputed costs: Costs which appear in cost accounts only. These costs are also
known as notional costs, which are considered for decision making.

o Opportunity cost: It is the advantage, in measurable terms, which has been

foregone due to not using the facility in the manner originally planned.

o Replacement cost: It is the cost at which an asset or material identical to that

which is being replaced or revalued, can be purchased.

10.Avoidable and unavoidable cost:

o Avoidable costs are those which can be eliminated if a particular product or

department with which they are directly related is discontinued.

o Unavoidable costs are those which cannot be eliminated with the

discontinuation of a product or department.

Cost effectiveness:

Effectiveness: In nursing is primarily relates to quality outcomes being

achieved. Is concerned with doing the right things in provide the patients care.
Adequate to accomplish a purpose; producing the intended or expected result.

Cost effectiveness:

 It does not mean cheap. It means getting the most for money or that product is
worth the price
 Buying a very expensive equipment may be cost effective if it can be shown that
sufficient needs exists for the equipment and that it was the best purchase to
meet the needs at the time.
 Cost effectiveness takes into account the following factors:

1. Anticipated length of services.

2. Needs for such services.
3. Availability of other alternatives

In order to reduce cost, nursing administration needs to look at factors that affect
cost and effectiveness of nursing care.

Several aspects of nursing that show lack of cost effectiveness:

1. High turnover rate.

2. Short job retention.
3. Nursing care delivery system utilized.
4. Control of allocation.
5. Utilization of resources

Cost efficiency

 The cost efficiency: Is a state in which the inputs and methods used to produce
a product or service result in the maximum feasible outcome. It is the
accomplishment of objectives with the lowest expenditure of resources.

 Performing or functioning in the best possible manner with the least waste of
time and effort.

Principle of efficiency (Emerson, 1910)

5 related to interpersonal relationship and seven related to management

system
 Related to interpersonal relationship:

1. Goals and ideas should be clear, well defined.

2. Component counsel is essential.
3. Changes should be evaluated.
4. Management can strength "disciplines" or adherence to
rules.
5. Justice, or equal reinforcement on all dealing

Efficiency indicators:

1. Records should including adequate reliable and immediate information about

expenses of equipment and personnel.

2. Dispatching or production scheduling is recommended.

3. Standardized schedules.

4. Standardized conditions.

5. Standardized operation.

6. Written instructions.

7. Reward for efficiency.

N.B. The efficiency of particular nursing intervention is determined by

competing the intervention, cost benefit ratio or the relationship between
monetary value of resources expended and monetary value or result achieved.

Implications of cost effectiveness and efficiency in nursing

administration:

1. Budgetary planning should be the responsibility of nursing services department.

2. Establishing valid and reliable PCs must be introduced to the Egyptian hospitals.
3. Increase the number of trained auxiliary personnel.
4. Choice of the most method of assignment in the unit (alternative methods).
5. Supervision and follow up of nursing personnel.
6. Innovative programs to slow absenteeism and abuse sick times.
7. Develop cost awareness for health care provider.
8. Improve managerial function by applying the (14) points of Deming.
9. Bridge authority power gab leads to little productivity.
10.Staff can participate in cost control programs.
11.Employee orientation.
12.Set goals and priorities.
13.Time planning.
14.Sound decision making (quick, inexpensive).
15.Conflict resolution.
16.Applying safety programs and incident reports.
17.The use of prospective payment.
18.Collaborate with non-nursing administrators.
19.Accurate performance appraisal system.
20.Accurately financial management (Task by nurse executive).
21.Develop the capacity for dealing with cost effectiveness in health care.

o Promoting the role of nursing as core resources in cost effective care.

o Promoting and supporting research and evaluation.
o Supporting leadership and management development.
o Promoting equity in terms and condition of service for nurses.
o Offering nurses educational opportunities with staff development programs.
o Encouraging the development of data base systems.
o Facilitates information dissemination and interactive networking.
o Establishing professional networks with relevant stakeholders.

Cost containment
 Cost containment: is process of maintaining organizational costs within a
specified budget; restraining expenditures (fiscal resources) to meet
organizational financial targets.

Methods of cost containment

1. Decrease overtime expenses.

2. Decrease sick time expenses.
3. Decreases the inventory of supplies are not used.
4. Prevent costly expenses for repair of equipment.
5. Prevent employee accidents.
6. Use supplies wisely.
7. Adjusting staffing.
8. Use methods to improve staffing decisions.
9. No filling empty positions.
10.Maintain productivity standards.

Cost containment strategies

1. Cost awareness: cost awareness focuses on what costs are? How can be
managed?

2. Cost monitoring: cost monitoring focuses on how much will be spent, where,
when, and why?

3. Cost management: cost management focuses on what can be done, by whom to

contain cost? (Programs, plans, objectives, strategies are important).

4. Cost incentives: cost incentives focuses on motivate cost containment and

reward desired behavior.

5. Cost avoidance: cost avoidance focuses on not buying (avoided) supplies,

technology or services are expensive costs and less effective.
6. Cost reduction: cost reduction focuses on spending less for goods and services
(safety programs lead to reduce cost of workers compensations, absenteeism
program leads to reduce sick time, and turnover leads to reduce costs).

7. Cost Control: Cost control focuses on careful forecasting, planning, budget

preparation, reporting, and monitoring (is an effective use of available
resources).

Stages of cost control

1. Planning (before the fact control): It focuses on the prevention of problems

rather than diagnosis or cure.

2. Monitoring (control during the expenditure process ongoing): It focuses on

the monitor all costs, aware of problems, and take corrective action.

3. Feedback (after the fact control): It focuses on use of variance report to quick
identify problems (Is vital to the improvement of the future plans and results).

Effects of cost containment measures on health care systems

1.Cost containment can affect the quality of care received by patients.

2.Cost containment (Financial risk) changes the fundamental ethical basis of the
health care system.

3.Cost containment potentially restricts access not only to types of services but to
underserved populations.

Cost containment and nursing personnel:

1. Nursing division must streamline their evaluation and control system.

2. Nursing management must be careful to maintain its managerial flexibility in

negotiating labor contracts (extra money for critical care).
3. Major saving in the nursing division result from improved staffing practices it
(often takes money to save money).

Cost containment and nursing materials:

1. One major sources of loss is the staff (nursing, medical, others). So nurse's
executive will want to investigate the system for managing supplies and
equipment.

2. Focus on developing a fail-safe system of managing these supplies.

3. Be sure that the costs of administering such a system are less than the loss
incurred by theft.

4. Nursing division can save money personnel and material by some careful
review of its system.

5. It may be useful to hire a system analyst if no one of the staff is involved at

system analysis.

6. Nurse Manager should relate cost saving carefully to budgeting.

7. She must examine budgetary system of the institution to see if the procedures
encourage or discourage cost saving.

8. Must use sense in selecting equipment and supplies.

9. Nursing division and purchasing department cooperate for both costs saving
and appropriate purchasing.

Costing out of nursing services

o Is the process of estimating the monetary values of providing nursing care to

patients it can be estimated/ hours, / patient, /day.

o Determining the actual costs of nursing care, independent from other costs,
provides valuable information for D-M.
 Reasons for measuring nursing cost

1. Highly technological developed equipment.

2. Highly degree of specialization.
3. Increased quality of health services.
4. Increased in patient acuity.
5. Increased attention to utilization of beds.
6. Increased wages for health care workers.
7. Increased administrative and health care delivery costs.
8. Complex reimbursement mechanism.

Advantages of costing out of nursing services

1. The patient pays for the care rendered.

2. Customers start to realize that direct care has a price value.

3. Hospitals can receive compensation for what they provide, to help maximize
profits.

4. Nursing can be viewed as a revenue-generating center rather than a cost.

5. Enhance the professionalism of nursing through the traditional pattern of

reimbursement for services.

6. Stimulates productivity by enhance the use of human resources, contain costs,

and maintain quality.

7. Using a cost accounting system to assess and change the nursing department
helps establish a reputation for innovation and leadership.

8. Quick responsiveness to changes.

Disadvantages of costing of nursing services

1. It is difficult to associate some costs with a particular program.

2. It is difficult to justify the nursing care costs.
3. Quantifiable measures of all patients' outcomes are not available.

Methods for costing of nursing services

1. Costing per diem/costing per day:

2. Costing per diagnosis (DRG):

 DRGs is a strategy for grouping patients into categories based on the average
number of day of hospitalization for specific medical diagnosis, considers
factors such as patient's age, complications, and other illnesses.

 Payment includes the expected cots for: diagnostic tests, various therapies,
surgeries, and length of stay.

 Effective DRGs can be used not only to efficiently determine appropriate

staffing but also to estimate direct nursing care cost.

Methods for DRGs cost reduction (how the reduction occurs)

1. Reduces the prices paid for resources.

2. Reduces the length of stay.
3. Reduces intensity of services provided.
4. Improve efficiency.

o Since nursing is a personnel intensive high budget department, nurse managers

have recognized the need to monitor costs and identify areas for charge in order
to decrease expenditures.
o Nursing diagnosis was considered a better predictor for nursing care
requirements than DRG based on medical diagnosis that might fail to accurately
explain variance and predicts nursing time needed.

o The cost for a day at patient classification under level 1 can be distinguished
from a day at under 2, 3.

o The nurse manager must consider the organization decision about grouping of
patients in a particular patient classification level.

III-Cost per relative intensity measures (RIMs):

RIM are cost and allocated to DRG case mix categories through 3 steps:-

1. Dividing the total nursing costs for hospital by the total minutes of care
estimated or nursing resource used to provide care to all patients.

2. The number of minutes used by the total hospital population.

3. The cost of care each patient is determined by multiplying the RIM by the
minute of care required by the patient.

VI- Patient classification system (PCS):

o In nursing, PCs is the grouping of patient according to some observable or

interfered characteristics is the core of PCS.

o The nursing care system defines measures and converted the intensity of nursing
activities to time standard. Time standard can be converted to staffing plan to
calculate the ultimate cost of providing that care.

V-Work –sampling technique:

It is an industrial engineering technique in which data an individual from outside

the primary work group observes the activities of a selected sample of
 employees on regular intervals, records their activities and generalize from the
observed sample to estimate the percentage of the employer total time that
workers spend in each task

Fiscal Planning

 It is critical that unit managers have expertise in managing costs. Of all forms of
planning, many managers often perceive fiscal planning as the most difficult.

 Although familiar with the basics of fiscal planning, unit managers may
encounter difficulty with forecasting costs based on current and projected needs.
Sometimes this occurs because the manager has had little formal education or
training on budget preparation.

 Fiscal planning, like all types of planning, is a learned skill and improves with
practice. It is essential that fiscal planning be included in nursing curricula and
in management preparation programs.

 Because nursing budgets generally account for the greatest share of the total
expenses in healthcare institutions, participation in fiscal planning has become a
fundamental and powerful tool for nursing.

 Fiscal planning must be proactive, flexible, and clearly stated in measurable

terms; include short- and long-term planning; and involve as many people as
feasible in the budgetary process. This type of planning also requires vision,
creativity, and a thorough knowledge of the political, social, and economic
forces that shape health care.

 An essential feature of fiscal planning is responsibility accounting, which means

that each of an organization’s revenues, expenses, assets, and liabilities is
someone’s responsibility. As a corollary, the person with the most direct control
or influence on any of these financial elements should be held accountable for
them. At the unit level, this accountability generally falls to the manager.
 Leadership Roles

1. Is visionary in identifying or forecasting short- and long-term unit needs, thus

inspiring proactive rather than reactive fiscal planning.

2. Is knowledgeable about political, social, and economic factors that shape fiscal
planning in health care today.

3. Demonstrates flexibility in fiscal goal setting in a rapidly changing system.

4. Anticipates, recognizes, and creatively problem solves budgetary constraints.

5. Influences and inspires group members to become active in short- and long-
range fiscal planning.

6. Recognizes when fiscal constraints have resulted in an inability to meet

organizational or unit goals and communicates this insight effectively, following
the chain of command.

7. Ensures that patient safety is not jeopardized by cost containment.

Management Functions

1. Identifies the importance of and develops short- and long-range fiscal plans that
reflect unit needs.

2. Articulates and documents unit needs effectively to higher administrative levels.

3. Assesses the internal and external environment of the organization in forecasting

to identify driving forces and barriers to fiscal planning.

4. Demonstrates knowledge of budgeting and uses appropriate techniques to

budget effectively.

5. Provides opportunities for subordinates to participate in relevant fiscal planning.

6. Coordinates unit-level fiscal planning to be congruent with organizational goals

and objectives.
7. Accurately assesses personnel needs using predetermined standards or an
established patient classification system.

8. Coordinates the monitoring aspects of budget control.

9. Ensures that documentation of patient’s need for services and services rendered
is clear and complete to facilitate organizational reimbursement.