FMW5HW

Please complete problems 7-29 through 7-33 listed below for convenience. Compile your answers in a word document.

Answer the following problems:  

7-29. Millbridge Hospital buys its supplies in bulk and has recently switched vendors. The first purchase Millbridge made was for 500 boxes of gauze at $3.46 a box. The purchase had payment terms of 2/15 N/30. Millbridge earns four percent on its idle cash. Should it take the discount or not? Justify your answer by showing calculations. (Refer to Appendix 7-B to solve this problem.) ATTACHED

7-30. Meals for the Homeless usually experiences seasonality in its cash balances. In December, contributions from donors increase its cash balances, and then these balances are used throughout the following year. By the fall, Meals for the Homeless has a tight cash flow. It has a line of credit with its bank, which allows it to draw up to $500,000 at seven percent interest per year. During 2013, Meals for the Homeless draws down $135,000 on October 1 and repays it at the start of business on January 3, 2014—exactly 94 days later. How much should it pay back on January 3, and how much of that is interest? 

7-31. Meals for the Homeless has many sources of income, but they pay Meals very differently. Specifically, Meals has contracts with the city, county, and state to provide food services. In addition, Meals has contracted with a private foundation to augment its foods with more healthful options. The city owes Meals $400,000, half of which is current, one-quarter is more than 30 days but less than 61 days old, 15% is between 61 and 90 days old, and the remainder is more than 91 days old. The county owes Meals $900,000, only one-third of which is current, another one-third is more than 30 days but less than 61 days old, and the remainder is more than 90 days old. The state owes Meals $1.5 million, 40% is current, 30% is between 30 and 60 days old, 20% is between 61 and 90 days old, and the remainder is more than 91 days old. The foundation owes Meals $150, 000, of which half is current and the other half is more than 30 days but less than 61 days old. Prepare an accounts-receivable aging schedule for Meals by total dollars and percent. 

7-32. Millbridge Hospital receives earned income from several sources: Medicare, Medicaid, private insurance, and self-pay customers. The federal government owes the hospital $7 million, 60% is current, 30% is between 31 and 61 days old, and the remaining 10% is between 61 and 90 days old. The state owes the hospital $5 million for Medicaid, 40% of which is current, 30% is between 31 and 60 days old, 20% is between 61 and 90 days old, and the remainder is more than 91 days old. Private insurance owes the hospital $4 million, half of which is current, 25% is between 31 and 60 days old, and the remaining percent is more than 91 days old. Self-pay customers owe $1 million, 30% is current, 40% is 31 to 60 days old, 10% is 61 to 90 days old, and the remainder is more than 91 days old. Prepare an accounts-receivable aging schedule by total dollars and by percent. 

7-33. Millbridge Hospital buys 10,000 boxes of latex gloves every year. Each box costs the hospital $7 dollars. The cost to place an order for the gloves—which covers the employee staff time, shipping costs, the hospital’s receiving center for inventorying, for example—is estimated at $50 dollars per order. Carrying costs (for storing the boxes, verifying the inventory periodically, etc.) are estimated at 50 cents per box per year. Millbridge uses a six percent interest-cost assumption in its calculations. How many boxes should be ordered at a time? How many orders per year should there be? What are the total ordering and carrying costs at the EOQ (economic order quantity)? Contrast these costs at the EOQ to the total cost if all boxes were simply ordered at the start of the year. (Refer to Appendix 7-A to solve this problem.) ATTACHED

References:

Financial Management for Public Health and Not-for-Profit Organizations (4th edition)

Assignment reading attached!

Chapter 7 • Managing Short-Term Resources and Obligations 257

APPENDIX 7-B

Credit Terms

An important trade credit issue involves whether an
organization should take discounts if offered. W hen
a credit discount is offered, it usually pays to take
the discount. A formula can be used to determine the
annual interest rate implicit in trade credit discounts:

Implicit
interest rate

Discount
Discounted price

X 365 day
s

X lO0O/o

days sooner

(7.B.1)

For example, suppose that HOS purchased $5,000
of pharmaceuticals with payment terms of 2/10 N/30.
A 2 percent discount on a $5,000 purchase would be
$100. This means that if the discount is taken, only
$4,900 would have to be paid. By taking the discount,
the hospital must make payment by the 10th day rather
than the 30th day. This means that payment is made 20
days sooner than would otherwise be the case:

Implicit
interest rate

$100 365 days
x 100% –X—

$4,900 20 days

= 37.2%

Although the stated discount rate of 2 percent
seems· to be rather small, gaining a 2 percent dis­
count off the net price, in exchange for paying just 20
days sooner, represents a high annual rate of return.
Suppose that the organization bas $4,900 of cash avail­
able to pay the bill on the 10th day. For it to make
sense not to pay the bill promptly and take the dis­
count, we would have to invest the money for the
next 20 days in an investment that would earn at least
$100 over that period. Any investment that could give
us that return would be earning profits or interest at a
rate of at least 37.2 percent per year.

That is, $4,900 X 37.2 percent per year X (20
days/365 days) = $100. That means if we sta1ted with
$4,900 and earned interest at 37.2 percent per year for
a period of 20 days, we would earn $100 in interest.
Together with the $4,900 we start with we would have
$5,000. If we have projects available to invest in for 20
days that would pay at an annual rate that is even more
than 37.2 percent, it would make sense to invest in the
projects rather than take the discount. We would earn
more than $100 interest for the 20 days and have more
than $5,000 at the end of 20 days. We could pay $5,000
and still have something left. But if we can only earn at

an annual rate of return less than 37.2 percent for those
20 days, then $4,900 plus interest would be less than
the $5,000 needed to pay the full amount due. So we
would be better off just taking the discount and paying
the $4,900. Since most organizations do not have avail­
able investments that are assured of earning such a high
rate, it pays to take the discount and pay promptly.

Suppose that we do not have the $4,900 in cash
to make the payment on the 10th day. However, a
bank is willing to lend us $4,900 at an annual inter­
est rate of 10 percent. Ten percent of $4,900 is $490
per year. Dividing this by 365 days in a year comes
to $1.34 per day. We only need to borrow the money
for 20 days. Twenty times $1.34 is $26.84. That is the
amount of interest we would have to pay the bank for
the 20-day loan of $4,900. To save $100, we would
have to pay the bank about $27. This is clearly a good
deal. So even if you have to borrow money to take the
discount, you should, as long as you can borrow at an
interest rate of less than 37.2 percent per year.

This assumes, of course, that the invoice will be
paid on time if the discount is not taken. Suppose,
however, that Meals for the Homeless often pays its
bills late. Sometimes it pays after two months, or even
three months. Would it make sense to take the dis­
count and pay in 10 days or to wait and pay the bill
after 90 days? Paying after 10 days is 80 days earlier
than the normal 90 days before making our payment:

Implicit
interest rate
Implicit
interest rate
Discount
Discounted price

x 365
days x lO0O/o

days sooner
(7.B.1)

$100 365 days
x 100% — x—

$4,900 80 days

= 9.3%

If Meals can earn more than 9.3 percent on its
investments, it should wait to pay the bill. If Meals
does not have enough money to pay the bill and a
bank would charge more than 9.3 percent, then it is
better off waiting, assuming its suppliers are willing to
wait to receive payment and do not charge interest for
late payments. Otbe1wise, Meals should pay promptly
and take the discount.

1

1. Describe key methodologies for the practical application of financial management in healthcare
organizations.

Reading Assignment

Chapter 7:
Managing Short-Term Resources and Obligations

Chapter 8:
Accountability and Control

Unit Lesson

Unit V considers techniques and approaches designed to maximize the benefit of short-term resources and
minimize the cost of short-term obligations. Both of these aspects are important for a successful healthcare
organization. Healthcare has definitely been “squeezed” financially by government and other payers over
recent years, making these topics more important today than ever before in the history of American medicine.

The process of controlling short-term resources and obligations is referred to as working capital management.
In performing working capital management, the manager must ensure that adequate cash is on hand to meet
the organization’s needs and also to minimize the cost of having that cash available. To do this, the manager
must carefully monitor and control cash inflows and outflows. Cash not immediately needed should be
invested, earning a return for the organization. The organization should use a cash budget and should employ
lock boxes and concentration banking when appropriate. You will learn more about lock boxes and
concentration banking as you read this unit.

The issue of working capital management has become more crucial today because of delays in payments
from managed care organizations and other payers. Twenty years ago it was common for insurance
companies to pay their bills to hospitals and doctors in about two weeks’ time. Under indemnity insurance at
that time, the payer had no right of approval or denial for services; they were simply paying a percentage of
the total bill (often 80%) and leaving the remainder for payment by the patient (typically 20%). Payment came
rather quickly under that scenario, but those days are gone. Today managed care organizations have
contractual rights to approve or deny services, and also to request additional information from patient,
hospital, or doctor. The process of reviewing, challenging, denying claims, and considering appeals seems to
drag on forever, and throughout the process, the provider is waiting for the money. Managed care
organizations often take 60-90 days to remit payment to healthcare organizations, posing new challenges in
managing cash flow for the medical facility.

When there is excess cash at the hospital or clinic, it should be invested. A variety of marketable securities
may be appropriate for an organization. Such securities can provide a higher yield for the organization while
still offering reasonable liquidity and safety of principal. Healthcare organizations today will invest in
certificates of deposit, mutual funds, bonds, and even individual stocks as a way of earning some return on
investment. Not all of these options are available to all healthcare facilities; for example a government-owned
hospital (city, county, or state) is typically prohibited by law from investing in stocks.

Strong efforts must be made to collect accounts receivable as soon as possible, an increasing challenge for
healthcare facilities today. This reduces the rate of bad debts and also allows the collect receivables to start
earning interest sooner. Experience in healthcare management tells us that if we do not collect for services

2

UNIT x STUDY GUIDE

Title
early, we may never collect at all. Collections past 90 days from the date of service typically go down
substantially and are much more difficult to collect.

Often problems with receivables management stem from inadequate data systems. Sound and current data
are required to allow invoices to be issued promptly, and then more data are required to track outstanding
receivable balances. As you read this unit, you will learn about the process of accounts receivable aging, and
that is crucial learning. We must be able to identify payer types and specific payers where we have delays or
difficulty in collecting, and then focus on those areas in order to reduce receivables. Typically, the measure of
receivables employed by hospitals and clinics is days in accounts receivable. Keeping that number low, and
constantly trying to reduce it, is a key aspect of healthcare financial management today!

We also need to consider inventory expense. Excess supplies should be not be kept by the organization. The
money spent now to pay for inventory that is not needed until later could be used by the organization for some
other purpose. At a minimum, the money could be invested in the organization’s savings account, earning
interest. The economic order quantity and just-in-time techniques can provide managers with assistance in
minimizing the cost of inventory. Meanwhile, the ongoing concern in healthcare organizations, different from
some other businesses, is that we dare not run out of certain supplies and medications because a patient
may need them urgently! Managing the inventory of patient care supplies is a challenging job, and the
profession of materials management has emerged in U.S. healthcare to address that.

Short-term obligations must also be managed carefully. The organization desires to have sufficient cash to
pay its obligations when they are due. However, if the organization pays it bills before they are due, it will lose
the interest it could have earned if it had left the cash in the savings account for a little longer rather than
paying the obligation. Managers should take advantage of opportunities to delay payments, if the delay does
not have any negative implications for the organization. A time-honored expression applies here, and it is
simply true: never part with money until you have to. The managed care organizations are in no hurry to pay
the hospital or clinic today, so we should pay our bills to vendors when they are due—not even one day
before they are due.

If an organization is to succeed, it must achieve their plans to the greatest extent possible. Management
control systems are used by organizations to motivate their employees to try to achieve those plans. Under
management control systems, departments and individual employees are held accountable for their actions
and results. These results show up on the variance reports that are prepared each month and reported at the
CEO, CFO, and board of director’s level of the organization.

We must also know how we intend to measure results. We can focus on just the revenues and expenses
budgeted and the actual revenues and expenses. Or, the organization can be more sophisticated and try to
assess things such as its efficiency and effectiveness in measuring its overall performance. Variances arise if
actual performance differs, or varies, from expectations. Developing an understanding of why variances have
occurred can help the organization avoid undesirable variances in the future.

Conclusion

To keep the organization functioning optimally, it must also focus on issues related to ethics and the
safeguarding of its resources. To achieve planned status, it is vital for personnel to be as ethical and error-
free as possible. The elements of a control system are designed to minimize the resource losses that the
organization suffers either by intent or by accident.

This is a crucial unit of learning in this course; how an organization manages its short-term resources and
short-term obligations can literally make or break the organization, so you must be very strong in this area.

254 Part III • Implementation and Controlling Results

APPENDIX 7-A

Economic Order Quantity

As noted in the chapter, in addition to having to pay
for inventory when, or shortly after, it is acquired,
there are other costs related to inventory. We must
have physical space to store it, we may need to pay to
insure it, and there are costs related to placing an order
and having it shipped. A method called the economic
order quantity (EOQ) considers all of these factors
in calculating the inventory level at which additional
inventory should be ordered.

The more inventory ordered at one time, the
sooner we pay for inventory and the greater the costs
for things such as inventory storage. These are called
canying or holding costs. However, if we keep rela­
tively little inventory on hand, to keep carrying costs
low, we will have to order inventory more often. That
drives ordering costs up. EOQ balances these two fac­
tors to find the optimal amount to order.

There are two categories of carrying costs: capital
costs and out-of-pocket costs. The capital cost is the cost
related to having paid for inventory, as opposed to using
those resources for alternative uses. At a minimum, this
is the forgone interest that could have been earned on
the money paid for inventory. Out-of-pocket costs are
other costs related to holding inventory, including rent
on space where inventory is kept, insurance and taxes
on the value of inventory, the cost of annual inventory
counts, the losses due to obsolescence and date-related
expirations, and the costs of damage, loss, and theft.

Ordering costs include the cost of having an
employee spend time placing orders, the shipping
and handling charges for the orders, and the cost of
correcting errors when orders are placed. The more
orders, the more errors.

There is an offsetting dynamic in inventory man­
agement. The more orders per year, the less inventory
that needs to be on hand at any given time, and there­
fore the lower the carrying cost. However, the more
orders per year, the greater the amount the organiza­
tion spends on placing orders, shipping and handling
costs, and error correction. The total costs of inventory
are the sum of the amount paid for inventory, plus the
carrying costs, plus the ordering costs:

Total Inventory Cost = Purchase Cost
+ Carrying Cost + Ordering Cost

The goal of inventory management is to minimize this
total without reducing the quality of services the orga­
nization provides.

We will use TC to stand for the total inventory
cost, P to stand for the purchase cost per unit, CC
for the total carrying cost, and OC for the total order­
ing cost. N will stand for the total number of units of
inventory ordered for the year. Therefore,

TC = (P X N) + CC + OC (7.A.1)

We will let C stand for the annual cost to carry one
unit of inventory. The annual total carrying cost, CC, is
then equal to the carrying cost per unit, C, multiplied
by the average number of units on hand. Assume that
Q is the number of units of inventory ordered each
time an order is placed. On average at any given time
we will have Q -;- 2 units on hand. If we start with
Q units and use them until there are O units left, ori
average we will have half of Q units on hand. Carrying
costs are determined using the average number of
units of inventory on hand. The carrying costs will
therefore be as follows:

CC= C X
Q
2

C

Q

2

(7.A.2)

That is, the carrying costs per year (CC) will be equal to
the carrying costs of one unit (C), multiplied by the aver­
age number of units on hand at any given time (Q/2).9

A formula can also be developed for ordering
costs. We will let O stand for the cost of making one
order. The total ordering cost, OC, is the cost of mak­
ing an order, 0, times the number of orders per year.
Recall that the total number of units needed for the
year is N and Q is the number of units in each order.
Then N/Q is the number of orders placed per year.
The ordering costs are as follows:

N
OC = 0 X –

Q

ON
Q

(7.A.3)

9This becomes somewhat more complex if a safety stock is kept on
hand at all times. In such a case the CC is equal to C multiplied by
the sum of Q + 2 plus the safety stock. However, this is not needed
for the EOQ calculation. Safety stocks will not affect the economic
order quantity, since they are projected to be constantly on hand
regardless of the frequency or size of orders.

•

Chapter 7 • Managing Short-Term Resources and Obligations 255

That is, the total cost of placing all orders for the year
(0C) is the cost of making one order (0) multiplied
by the number of orders per year (N/Q). For instance,
suppose that Meals for the Homeless buys 2,000 sacks
of rice each year (N = 2,000). If it orders 200 sacks at
a time (Q = 200), it would have to make 10 orders per
year (N/Q = 2,000/200 = 10).

We now can calculate the purchase cost of
the inventory, the carrying costs, and the order­
ing cost. Suppose that Meals pays $2 per sack for
rice. Each time it places an order, it takes a paid
clerk about $8.075 worth of time to process the order.
The delivery cost is $1 per order. This $9.075 is the
only ordering cost. Meals could earn 8 percent in­
terest on its money. Therefore, the capital part of
the carrying cost is $.16 per sack per year (8% X $2
price = $ .16). Other canying costs are determined to
be $2.84 per sack per year. Therefore, the total car­
rying costs are $3 per sack per year. W hat is the total
cost of inventory, assuming that there are 10 orders
per year?

TC = (P X N) + CC + OC (7.A.1)

The first part of the equation to be calculated is
the purchase cost of the inventory:

P X N = $2 X 2,000 = $4,000

Next, we need to find the carrying cost:

CC= C x Q _
CQ

2 – 2

CC =
$3 X

200

2
= $300

Finally, we need the ordering cost:

OC = 0 X
N ON

Q

$9.075 X 2,000
= $90.75oc =

200

So the total costs are as follows:

(7.A.2)
(7.A.3)

TC= (P X N) + CC + OC (7.A.1)
TC = $4,000 + $300 + $90 .75 = $4,390.75

However, it was arbitrarily decided that there
would be 10 orders of 200 sacks each. The EOQ
model is designed to determine the optimal number to

order at one time. The formula to determine the opti­
mal number to order at one time is as follows:

Q* = �2 �N
(7.A.4)

where Q* is the optimal amount to order each time.

Q* =
2 X $9.075 X 2,000

$3
= 110

This result differs from the 200 sacks per order that
we used earlier. If we use this result, how will it af­
fect total costs? The purchase cost will still be $4,000 .
However, the canying costs and ordering costs will
change:

CC= C x Q _
CQ

2 – -2-

cc =
$3 X 110

2
= $165

Finally, we need the ordering cost:

N ON
OC =OX-=­

Q Q

OC =
$9.075 X 2,000

= $l65
110

So, the total costs are as follows:

(7.A.2)
(7.A.3)

TC = (P X N) + CC + OC (7.A.1)
TC = $4,000 + $165 + $165 = $4,330

The new total cost of $4,330 represents a cost
decrease of $60 .75. Relative to the total cost, this may
not seem to be a great savings. However, if you put
aside the purchase cost of the invento1y, the carrying
and ordering costs have fallen from $390.75 to $330.
This is more than a 15 percent savings. Across all
inventory items for an organization, this could amount
to a substantial dollar amount of savings.

It is not coincidental that the ordering cost equals
the canying cost. The total cost is minimized at the
point where these two costs are exactly the same!

It is important that EOQ calculations only
include relevant costs. Carrying and ordering costs
that are relevant are those that vary as a result of
our EOQ decision. That is, if ordering more or
less frequently will affect a cost, it is relevant and
should be included in the calculation. For example,

256 Part Ill • Implementation and Controlling Results

ordering less frequently will likely increase capital
costs related to interest. It would also likely affect
shipping and handling, so these are relevant costs
that belong in the calculation. By contrast, the cost
of the purchasing department manager will probably
not change with the number of orders. Therefore,
none of that manager’s salary should be included in
the ordering costs.

The basic EOQ model, as presented here,
involves making a number of assumptions that are
often not true. For example, it involves assuming that
any number of units can be purchased. In some cases,
an item might only be sold in certain quantities, such
as hundreds or dozens. Another assumption is that the
price per unit does not change if we order differing
numbers of units with each order. It is possible that
we might get a quantity discount for large orders. Such
a discount could offset some of the higher carrying
cost related to large orders.

Another assumption is that we will use up our
last unit of an item just when the next shipment
arrives. A delay in processing, however, could cause
inventory to arrive late, and we might run out of cer­
tain items. To avoid negative consequences of such
stockouts, we might want to keep a safety stock on

hand. How large should that safety stock be? That will
depend on how long it takes to get more invento1y if
we statt to run out. It also depends on how serious the
consequences of running out are. Is it life or death, or
merely an inconvenience?

One of the greatest difficulties in employing
EOQ is determining the carrying and ordering costs. In
most cases, however, at least the major components of
such costs-for example, the amount of labor needed
to place an order–can be calculated. The purpose of
this discussion of EOQ is to familiarize the reader with
the basic concept of inventoty management. Many
more sophisticated issues, such as those noted here,
are addressed in more advanced books on managerial
accounting and on operations management. Some of
these are included in the list of readings at the end of
the chapter.

Inventory models are a part of any efficient man­
agement operation that invests dollars in inventory.
Public, health, and not-for-profit organizations have
often considered their inventories to be of nominal
value. However, the costs of ordering and carrying
invento1y are sometimes surprisingly high, and use of
a tool such as EOQ should at least be examined for
potential savings.

— — ———————————

Key Terms from This Appendix

carrying costs of inventory. Capital costs and
out-of pocket costs related to holding inventory.
Capital cost represents the lost interest because money
is tied up in inventory. Out-of-pocket costs include
such expenses as insurance on the value of inventory,
annual inspections, and obsolescence of inventory.

economic order quantity (EOQ). Approach to
determine the balance between ordering costs and

carrying costs; optimal number of units of invento1y
to be ordered each time an order is placed.

holding costs. See carrying costs of inventory.

ordering costs. Includes those costs associated
with an order of inventory such as clerk time for
preparation of a purchase order.

stockout costs. Costs incurred when an inventory
item is not available but is needed.