Treating individual services as profit-and-loss units promises to transform financial management and clinical engagement. With plans imminent for foundation trusts, Monitor chair Bill Moyes puts the case for a fresh approach

In 2002, Derek Wanless' report for the Treasury stated that to maintain a publicly funded NHS, providing healthcare free at the point of delivery, three inputs were needed: greater funding, greater efficiency and less demand through improved public health.

The NHS is receiving greater funding but, with the rapid increases set to level off after 2008, improvements in public health remain a major challenge. With the Department of Health claiming only last month that the NHS could save£2.2bn if it was more efficient, the focus on improving financial productivity has never been greater.

The current system is not fully geared up to drive improved quality and productivity. There is very limited use of activity-based costing models. Hospitals' accounting and performance systems do not detail with any accuracy which services are profitable and which fail to break even.

While progress has been made towards a trust-level transparent financial framework, there remains a key gap at most trusts in service-level performance measurement.

Service-level economics measure the earnings and profit margins for each service in a trust. So in 'trust A', for example, orthopaedics, cardiology, and gynaecology would all have their own individual budget and profit margin target. This enables the trust to monitor performance, plan their business and identify problem areas much more accurately.

Monitor believes improving efficiency and profitability should be a main focus for the next year for foundation trusts, both to deliver the best quality of care and to generate sufficient surpluses to improve their asset base.

Last year foundations delivered a productivity gain of 2.2 per cent cost improvement against 1.7 per cent payment by results efficiency assumption. In their annual plans for this year, they predict an increase in the delivery of cost improvement plans against tariff, achieving 3 per cent cost improvement against the 2.5 per cent payment by results efficiency assumption.

This is a step in the right direction. But as the competition between NHS providers grows, with patient choice and stronger commissioning playing a greater role in dictating activity levels, every provider will need increasing profit margins.

Understanding how the profitability of each service contributes to target earnings means that foundation trusts can understand the margins required to run their businesses effectively and structure their service portfolios to hit targets.

If foundation trusts measured performance at service level, it would encourage four things: more informed negotiations with commissioners and tariff-setters, identification of key areas for operational improvement, detailed analysis of service portfolios, and the identification of growth priorities.

Improved diagnosis
Service-level performance data would also enable foundation trusts to monitor their profit margins at specialty level and encourage robust understanding of service strategy. By identifying profitability issues in particular services, operational intervention would be quick and accurately targeted. Where Monitor gets involved, diagnosis of the problem would be faster and more accurate, and solutions better targeted.

For the health system as a whole, this could mean better tariff-setting based on accurate reference costs, more effective decisions on care settings and pathway management and better visibility of financial risk and sustainability of key services.

By generating more accurate information, foundation trusts will also let primary care trusts think more strategically about the long-term implications of reconfiguration.

For strategic health authorities which want to drive progress on the foundation trust pipeline, more informed negotiations with commissioners and the tariff-setter will help identify areas for investment or subsidy. Understanding the relationship between cost and income is key in the drive towards self-sustaining hospitals.

The benefits of better visibility of financial information of this type are borne out by international best practice. Studies at hospitals in Scandinavia, Germany, the US and Australia indicate that accurate service-level data can drive productivity and focus cost improvements.

Global perspectives
Monitor has researched best practice in service-level economics from around the world and there are many examples of this data giving boards and clinicians the information they need to drive productivity.

A good example is the New York Presbyterian University Hospital in the US, which needed to determine whether it had sufficient cash to support its capital plan for the next eight years. The service-level data allowed it to model capital flows for that period and make a sustainable investment in a new hospital build, based on detailed service-level growth plans.

In Norway, the Rikshospitalet University Hospital needed to assess which areas to target for productivity improvements. By using sub-specialty data, it was able to target high-impact improvements in cardiology.

Monitor is running pilots of service-level reporting at three foundation trusts - University College London (see below), Chelsea and Westminster and Frimley Park. Findings from these pilots suggest that economic forecasts will generate useful insights into the state of a trust and highlight improvement priorities.

The response from executives and clinical staff has been very positive. Both clinical and non-clinical staff saw considerable value in linking activity and costs. For example, finance directors feel that detailed income and expenditure data enables them to understand why a directorate is losing money under payment by results and, most importantly, do something about it.

The pilots have shown that service-level economics can be produced using a combination of reference cost index information and activity-based cost and income drivers in the first two months. However, the re-allocation of non-tariff income and costs (eg research and development, income from private patients) to individual services may take a little longer.

Feedback from the pilots has also shown that service-level economics is a valuable decision-making tool. We've found an appetite for it among senior management, but gaining buy-in from the clinicians is crucial to success.

As the NHS system moves to plural provision, with block contracts replaced by activity-based contracts and organisations no longer able to rely on end-of-year brokerage, it will be vital for clinicians to be provided with the information they need to engage actively in decision making.

In the cases where Monitor has already overseen successful turnaround of foundation trusts, engaging clinicians and ensuring they have the information to make the right strategic decisions has been integral to their success.

If clinicians and trust finance directors are to make properly informed decisions about which specialties to emphasise or de-emphasise, which primary care trust negotiations to prioritise and how to maximise the return from their assets, they need information on service-level profitability.

Requiring trusts to report financial information can be achieved without an excessive increase in the regulatory burden. And while improving financial transparency, service-level financial information will help ensure greater accountability for service and consultant-level performance and capture vital information on the cost (or quality) of treatment options.

Extracting this information shouldn't be seen as burdensome, but a natural progression for effective boards. Any additional requirements and costs required to deliver service-level economic forecasting will be greatly offset by corresponding gains in profitability and service quality.

Monitor will be consulting with foundation trusts on the introduction of service-level economics into the compliance and assessment framework in a forthcoming consultation, which will be sent to trusts shortly.

Bill Moyes is executive chair of foundation trust regulator Monitor.

' It puts more responsibility into the hands of clinicians'
The new econoimNo-one would attempt to run Tesco using a single budget because it would be virtually impossible to spot savings without sacrificing quality. So why should foundation trusts?

University College London Hospitals foundation trust, for example, has costs of£500m a year and£500m income.

'It's very hard to make it relevant to frontline staff,' says Professor David Fish, medical director of the clinical board for specialist hospitals.

The trust is looking at service-level economics, which involves breaking down costs by directorate, department and so on.

'The further down the journey you can go, the more useful it is in making the best use of resources,' explains Professor Fish.

The trust worked with management consultants McKinsey to pilot the concept. They identified that, under the tariff, seven-day inpatient neurology was particularly inefficient.

Rather than taking a simple approach of, say, cutting staffing by 10 per cent, they looked at how length of stay could be managed more efficiently and which conditions could be cared for on an ambulatory basis.

Such decisions require the expertise of clinicians, who like the idea because it helps them understand where costs lie in order to improve efficiency. Departments can look at their own income and expenditure, just as each branch of Tesco would.

?It is more likely to work if there is clinical leadership,? says Professor Fish. ?The closer you get to the frontline teams, the more useful it will be.?

Professor Fish predicts that it will be impossible to meet the significant financial challenges facing the health service over the coming years through the old method of reducing costs.

There will need to be a much greater focus on how to change the pattern of services to give patients what they want, at the same time as minimising costs,' he says.

Service-line accounting will enable trusts to understand their costs and income in order to deliver a more efficient service that customers will want.

An important aspect, says Professor Fish, is involving clinicians. 'Ultimately it puts much more responsibility and accountability into the hands of frontline clinicians for the use of resources, and for the other side of the equation of patient experience, quality and throughput. Then trying to bring those together in a way that hasn't happened before.'

Jennifer Taylor

The consultant?s view
In the current climate, all trusts are faced with choices on how they can be more efficient. In this context the creation of income and expenditure accounts by directorate, specialty ? and possibly sub-specialty ? becomes essential.

Tariff reflects the 'fully absorbed' cost of 'outputs', which can only be easily allocated to frontline services. The basic analysis of the full cost of a specialty can be difficult to communicate as it presumes a level of control over indirect and overhead costs that they do not have.

Discussions between accountants and clinicians on the comparison of fully absorbed cost vs tariff usually begin with why such a large proportion of the costs of pathology, theatres etc is being borne by the specialty.

Recent discussions have therefore centred on the practice more widely used in manufacturing 'contribution to overhead', or the margin of profit that arises when direct costs such as medical and nursing staff and consumables have been accounted for.

This avoids the debate on how the organisation is structured, whether a clinician could access a laboratory test for half the cost and what corporate functions do to warrant such a large budget.

But this is less than half the discussion. Once direct costs can be compared to income and contribution calculated, the issue of how to measure cost effectiveness of indirect and overhead departments remains.

KPMG advocates a gradual move to the allocation of indirect costs such as pathology, radiology and theatres based on agreed activity measures.

Departments then become more aware of the resources they use outside their own sphere.

This encourages frontline departments to be more discerning in use of 'support' services.

The indirect departments in turn become more aware of how costs relate to activity and develop smarter practices.

The costs of indirect departments gradually become 'direct costs' for which the specialty ultimately becomes responsible.

'Profit centres' can then be established and it will become easier to pinpoint the least cost-effective areas. Frontline departments will be more aware of the resources they consume in the wider organisation and potentially produce quicker, slicker services.

The question of overheads remains. Corporate overheads have traditionally been apportioned across departments on the basis of rudimentary measures -- headcount, floor area, bed days. These measures are adequate to achieve fully absorbed costs, but can rarely be equitably attributed to the direct functions that have little or no say over the buildings they occupy, the board structure of their organisations or the requirement to have a patient advice and liaison services, internal and external audit etc.

Despite the crude measures used for apportioning, we encourage more advanced organisations to show the cost of overheads against each specialty.

We encourage direct services (or profit centres) to take responsibility for the resources used by the patient. This encourages a focus on the patient pathway, promotes internal challenge and provides invaluable information to inform strategic decisions.

A clear understanding of the costs and income of specialties can lead to improved understanding on the whole.

However, a trust wishing to drive through cost and efficiency improvements must also understand their departmental costs and develop robust and comparable indicators to demonstrate improved economy and efficiency -- for example, the cost per theatre hour, bed day etc.

Income and expenditure accounts do not replace such analysis, but sit alongside it for a full and real picture of the organisation's position.

Kate Barber is a consultant with KPMG.

Click herefor a Monitor presentation on service-line economics