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EXHIBIT 5.9 Atlanta Clinic:

Breakeven Point with Discounted Revenue Revenues and Costs ($) 4,967,462 Total Costs Fixed Costs Old Total Revenues New Total Revenues 0 69,165 84,928 Volume (Number of Visits) Nothing much has changed in terms of core economic underpinnings because of the new discounted-charge environment. The clinic is worse off economically, but the clinic s cost structure, managerial incentives, and solutions to financial problems are essentially the same. To increase profit, more services must be provided or costs must be cut. In short, the movement from charges to discounted charges is not that radical with regard to its impact on profit analysis and managerial decision making. The major difference is that the clinic is now under greater financial pressure. However, as we discuss in the next major section, the clinic s entire incentive structure will change if it moves to a capitated environment.

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Evaluating the Alternative Strategies What should Atlanta s managers do? If Peachtree s discount proposal is accepted, the clinic is expected to lose $580,962 rather than make a profit of $419,038.

The difference is a swing of $1 million in profit in the wrong direction, hardly an enticing prospect. What happened to the missing $1 million? It is now in the hands of Peachtree HMO, which is paying $1 million less to one of its providers (25,000 visits . $40 savings = $1,000,000). This will be reflected as a cost savings on Peachtree s income statement and, if the savings is not passed on to the ultimate payers (typically employers), will result in a $1 million profit increase.

If market forces in Atlanta Clinic s service area suggest that making a counteroffer to Peachtree is not feasible perhaps because the clinic is being pitted against another provider the comparison of a loss of $580,792 to a profit of $419,038 is irrelevant. The only relevant issue at hand for the short term is the comparison of the $580,792 loss if the clinic accepts the proposal to the $1,376,462 loss if the proposal is rejected and Peachtree s patients are lost to the clinic. Although neither outcome is appealing, the acceptance of the discount appears to be the lesser of two evils. In fact, the acceptance of the discount is better by $1,376,462 . $580,792 = $795,670. Accepting the discount proposal appears to be Atlanta s best short-term strategy because Peachtree s patients still produce a positive contribution margin of $60 . $28.18 = $31.82 per visit, which would be forgone if the clinic were to rebuff Peachtree s offer.

That $31.82 per visit contribution margin, when multiplied by the expected 25,000 visits on the contract, puts $795,500 on the total contribution margin table that otherwise would be lost.

However, Atlanta s managers cannot ignore the long-term implications associated with accepting the proposal. These are not addressed in detail here, but clearly the clinic cannot survive either scenario in the long run because the clinic s revenues are not covering the full costs of providing services. In the meantime, bleeding $580,962 of losses in 2016 may be better than bleeding $1,376,462 until the clinic can adjust to market forces in its service area. This adjustment may be as simple as merely absorbing the losses while the clinic s competitors, perhaps in poorer financial condition, exit the market as they face the same difficult economic choices. Should this happen, a new equilibrium would be established in the marketplace that would allow the clinic to raise its prices. If the long-term solution is not that simple, Atlanta Clinic must reduce its cost structure or perish.

Another problem associated with accepting the discount offer is that the clinic s other payers will undoubtedly learn about the reduced payments and want to renegotiate their contracts with the same, or an even greater, discount. Such a reaction would clearly place the clinic under even more financial pressure, and a draconian change in either volume or operating costs would be required for survival.

Marginal Analysis The Atlanta/Peachtree illustration points out one way in which the contribution margin can be used in managerial decision making. To help reinforce the concept, the analysis can be viewed from a different perspective. Suppose the clinic is forecasting a base case volume of only 50,000 visits for 2016 and Peachtree HMO offers to provide the clinic 25,000 additional visits at $60 revenue per visit. These 25,000 visits are called marginal, or incremental, visits, because they add to the existing base of visits. Should Atlanta s managers accept this offer? (For purposes of this marginal analysis illustration, assume the relevant range begins at 50,000 visits.) Although each marginal visit from the contract brings in only $60 compared to $100 on the clinic s other contracts, the marginal cost, or Marginal cost The cost of one additional unit of volume (for example, one more inpatient day or patient visit).

incremental cost, which is the cost associated with each additional visit, is the variable cost rate of $28.18. If we assume that the relevant range extends to 75,000 patient visits, the clinic s $4,967,462 in fixed costs will be incurred whether the volume is 50,000 or 75,000 visits. Because fixed costs are assumed to be unaffected by the offer, these costs are not relevant to the analysis. In finance parlance, the clinic s fixed costs are said to be nonincremental to the decision. With each new visit having a contribution margin (the marginal contribution margin) of $60.00 . $28.18 = $31.82, each visit contributes positively to Atlanta s recovery of fixed costs and potentially to profits, so the offer must be seriously considered.

Note, however, that the analysis would change if 75,000 visits is beyond the relevant range. In that case, new fixed costs would have to be incurred, which would be incremental to the decision. In this situation, the marginal cost would consist of the variable cost rate plus the incremental fixed cost per additional visit. If this pushes the marginal cost per visit above $60, the offer loses its financial attractiveness. Of course, the clinic still faces the long-run problem of other payers requesting discounts discussed at the end of the previous section.

SELF-TEST QUESTIONS 1. What is the impact of a discount contract on fixed costs, total variable costs, and the breakeven point?

2. What is meant by marginal analysis?

3. What is meant by the statement, Marginal analysis is made more complicated by long-run considerations ?

4. Do marginal costs always consist only of variable costs?

Profit Analysis in a Capitated Environment The analysis changes when a provider operates in a capitated environment.

Although the extent of third-party payer use of capitation has varied over time, many people believe that capitation will be used more in the future as healthcare reform forces payers to grapple with the problem of increasing quality while constraining costs. For example, one payment strategy for accountable care organizations (ACOs) is to couple capitation payments to providers with meaningful incentives to ensure quality. Our discussion of a capitated payment profit analysis both provides an excellent review of the concepts presented in previous sections and highlights the basic differences between capitation and fee-for-service reimbursement methodologies.

To begin, assume that the purchaser of services from Atlanta Clinic is the Alliance, a local business coalition. As in previous illustrations, assume the Alliance is paying the clinic $7,500,000 to provide services for an expected 75,000 visits, but now the amount is capitated. Although projected total revenues remain the same as the previous base case (see Exhibit 5.5), the nature of the capitated revenues is different. The $7,500,000 that the Alliance is paying is not explicitly related to the amount of services (number of visits) provided by the clinic but to the size of the covered employee group.

In essence, Atlanta Clinic is no longer merely selling healthcare services as it had in the fee-for-service or discounted fee-for-service environment. Now the clinic is taking on the insurance function in the sense that it is responsible for the health status (utilization) of the covered population and must bear the attendant risks. If the total costs of services delivered by the clinic exceed the premium revenue (paid monthly on a per member basis), the clinic will suffer the financial consequences. However, if the clinic can efficiently manage the healthcare of the served population, it will be the economic beneficiary.

How might Atlanta s managers evaluate whether the $7,500,000 revenue attached to the contract is adequate? To do the analysis, they need two critical pieces of information: cost information and actuarial (utilization) information.

The clinic already has the cost accounting information the full cost per visit is expected to be $94.41 (at a volume of 75,000 visits), with an underlying cost structure of $28.18 per visit in variable costs and $4,967,462 in fixed costs.

For its actuarial information, Atlanta s managers estimate that the Alliance will have a covered population of 18,750 members with an expected utilization rate of four visits per member per year. Thus, the total number of visits expected is 18,750 . 4 = 75,000. Although this appears to be the same 75,000 visits as in the fee-for-service environment, the implications of the Alliance volume differ significantly. Because there is no direct link between the volume of services provided and revenues, utilization above expected levels will bring increased costs with no corresponding increase in revenues.

The revenues expected from this contract $7,500,000 exceed the expected costs of serving this population, which are 75,000 visits multiplied by $94.41 per visit, or $7,080,750. Thus, this contract is expected to generate a profit of $419,250, which, not surprisingly, is the same as the original base case fee-for-service result (except for a rounding difference) (see Exhibit 5.5).

A Graphical View in Terms of Utilization Exhibit 5.10 contains a graphical profit (CVP) analysis for the capitation contract that is constructed similar to the fee-for-service graphs shown previously for Atlanta Clinic in that the horizontal axis shows volume (number of visits) while the vertical axis shows revenues and costs. Also shown is the same underlying cost structure of $4,967,462 in fixed costs coupled with a variable cost rate of $28.18. One significant difference, however, is that instead of being upward sloping, the total revenues line is horizontal, which shows that total revenue is $7,500,000 regardless of volume as measured by the number of visits.

EXHIBIT 5.10 Atlanta Clinic:

Breakeven Point Under Capitation Using Number of Visits as the Volume Measure Revenues and Costs ($) Loss Profit Total Costs Fixed Costs 0 89,870 Volume (Number of Visits) 7,500,000 Total Revenues 4,967,462 Several subtle messages are inherent in this flat revenue line. First, it tells managers that revenue is being driven by something other than the volume of services provided. Under capitation, revenue is being driven by the insurance contract (i.e., by the premium payment and the number of covered lives, or enrollees). This change in the revenue source is the core of the logic switch from fee-for-service to capitation; the clinic is being rewarded to manage the healthcare of the population served rather than merely to provide services.

However, the clinic s costs are still driven by the amount of services provided (the number of visits).

A second critical point about Exhibit 5.10 is the difference between the flat revenue and the flat fixed-cost base. Atlanta has a spread of $7,500,000 . $4,967,462 = $2,532,538 to work with in managing the healthcare of this population for the period of the contract. If total variable costs equal $2,532,538, the clinic breaks even; if total variable costs exceed $2,532,538, the clinic loses. Thus, to make a profit, the number of visits must be less than $2,532,538 $28.18 = 89,870. If everyone in the organization, especially the managers and clinicians, does not understand the inherent utilization risk under capitation, the clinic could find itself in serious financial trouble. On the other hand, if Atlanta s managers and clinicians at all levels understand and manage this utilization risk, a handsome reward may be gained. (Note that the breakeven volume of 89,870 visits exceeds the relevant range maximum of 85,000 visits for the cost structure used. Thus, it is likely that costs would be greater than predicted and hence the breakeven volume is even less than 89,870 visits.) A key feature of capitation is the reversal of the profit and loss portions of the graph. To see this, compare Exhibit 5.10 with Exhibit 5.4. The idea that profits occur at lower volumes under capitation is contrary to the fee-for-service environment. It is obvious, however, when one recognizes that the contribution margin, on a per visit basis, is $0 . $28.18 = .$28.18. Thus, each additional visit increases costs by $28.18 without bringing in additional revenue.

The optimal short-term response to capitation from a purely financial perspective is to take the money and provide as few services as legally possible.

Of course, the clinic would not have the contract renewed in subsequent years, but it would have maximized short-term profit. Obviously, this course of action is neither appropriate nor feasible. Still, its implications are at the heart of concerns expressed by critics of capitation about the incentive created to withhold patient care. The solution to this problem is to monitor and reward (with bonus payments) providers that maintain or improve quality and, at the same time, reduce costs.

A Graphical View in Terms of Membership Looking at Exhibit 5.10 is like being Alice peering through the looking glass and finding that everything is reversed. The key to this problem is that the horizontal axis does not measure the volume to which revenues are related; that is, Exhibit 5.10 has number of visits on the horizontal axis, just as if Atlanta Clinic were selling healthcare services. It is not; it is now selling healthcare assurance to a defined population and is being paid on the basis of population size, so the appropriate horizontal axis value is the number of members (enrollees).

Exhibit 5.11 recognizes that membership, rather than the amount of services provided, drives revenues. With the number of members on the horizontal axis, the total revenues line is no longer flat; revenues only look flat when they are considered relative to the number of visits. The revenue earned by the clinic is actually $7,500,000 18,750 = $400 per member, which could be broken down to a monthly premium of $400 12 = $33.33.

Thus, the expected $7,500,000 revenue shown in Exhibit 5.5 results from an expected enrollee population of 18,750 members.

The cost structure can easily be expressed on a membership basis as well. Fixed costs are no problem within the relevant range; they are inherently volume insensitive whether volume is measured by number of visits or number of members. Thus, Exhibit 5.11 shows fixed costs as the same flat, dashed line as before. However, the variable cost rate based on number of enrollees is not the same as the variable cost rate based on number of visits.

EXHIBIT 5.11 Atlanta Clinic:

Breakeven Point Under Capitation Using Number of Members as the Volume Measure Revenues and Costs ($) 4,967,462 Loss Profit Total Costs Fixed Costs 17,2910 Volume (Number of Members) Total Revenues ($400 per Member) Per member variable cost must be estimated from two other factors: the variable cost rate of $28.18 per visit and the expected utilization rate of four visits per year. The combination of the two is 4 . $28.18 = $112.72, which is the clinic s expected variable cost per member. Expressed on a per member basis, the contribution margin is now $400 . $112.72 = $287.28, as opposed to the .$28.18 when volume is based on number of visits.

The analysis based on number of members reveals that two elements are critical to controlling total variable costs under capitation: the underlying variable cost of the service ($28.18 per visit) and the number of visits per member (four). The two-variable nature of the variable cost rate makes cost control more difficult under capitation. In a fee-for-service environment, cost control entails only minimizing per visit expenses; utilization is not an issue. If anything, utilization is good because per visit revenue almost always exceeds the variable cost rate. (In other words, there is a positive contribution margin.) Capitation requires a change in managerial thinking because utilization is now a component of the variable cost rate and hence total variable costs.

Of course, control of fixed costs is always financially prudent, regardless of the type of reimbursement.

Conversely, there is one positive feature of the variable cost structure under capitation. With two elements to control, the clinic has more opportunity to lower the variable cost rate under capitation than under fee-for-service reimbursement. The key is the ability of Atlanta s managers to control utilization.

If both utilization and per visit costs can be reduced, the clinic can reap greater benefits (profits) than are possible under fee-for-service reimbursement.

Projected P&L Statement Analysis Exhibit 5.12 contains three projected P&L statements in this capitated environment, each for a different volume level. Let s start with the middle col- umn the one that contains the expected 75,000 patient visits. The bottom line $419,038 is the same as in the fee-for-service analysis, which reinforces the point that, at least superficially, the capitated contract is not inherently better or worse than the fee-for-service contract.

What would happen if the clinic experienced more visits than predicted?

If the number of visits increases by 10 percent, or by 7,500, to 82,500, the right column in Exhibit 5.12 shows that profit would decrease by $419,038 . $207,688 = $211,350. This occurs because total revenues stay constant while costs increase at a rate of $28.18 for each additional visit. With 7,500 additional visits, the clinic s costs increase by 7,500 . $28.18 = $211,350.

Obviously, this is quite in contrast to the significant increase in profit at this volume level that would occur in a fee-for-service environment.

Under capitation, a decrease in visits will improve the profitability of the clinic. When the number of visits decreases to 69,165, which is the break- even point in a fee-for-service environment, profit in a capitated environment increases by $164,430 to $583,468. This increase is explained by the decrease in visits (5,835) multiplied by the contribution margin (.$28.18), which results in a $164,430 decrease in costs while revenues remain constant.

The Importance of Utilization Exhibit 5.12 provides information on the impact of utilization changes on profitability. The center column, the base case, is once again our starting point. With an assumed utilization of four visits for each of Peachtree s 18,750 members, 75,000 visits result in a projected profit of $419,038.

EXHIBIT 5.12 Number of Visits Atlanta Clinic:

69,165 75,000 82,500 2016 Projected P&L Statements Total revenues $7,500,000 $7,500,000 $7,500,000 Under Total variable costs ($28.18 . Volume) Total contribution margin Fixed costs Profit 1,949,070 $5,550,930 4,967,462 $ 583,468 2,113,500 $5,386,500 4,967,462 $ 419,038 2,324,850 $ 5,175,150 4,967,462 $ 207,688 Capitation (based on 69,165, 75,000, and 82,500 patient visits) However, if Atlanta s managers are not able to limit utilization to the level forecasted (or less), the clinic s profit will fall. Assume that realized utilization is actually 4.4 visits per member, rather than the 4.0 forecasted.

This higher utilization would result in 4.4 . 18,750 = 82,500 visits, which produces the profit of $207,688 shown in the rightmost column in Exhibit 5.12. Because revenues are fixed and total costs are tied to volume, higher utilization leads to higher costs and lower profit. With the same 82,500 visits but with total variable costs of $2,324,850 at the higher utilization rate, the variable cost per member increases to $2,324,850 18,750 = $123.99, which could also be found by multiplying 4.4 visits per member by the variable cost rate of $28.18.

The left-hand column of Exhibit 5.12 shows that the clinic s profitability would increase to $583,468 if utilization were reduced to 3.69 visits per member, producing about 69,165 total visits. With lower utilization, total variable costs are reduced and profit increases. The point is that the ability of a provider to control utilization is the primary key to profitability in a capitated environment. Less utilization means lower total costs, and lower total costs mean greater profit.

The Importance of the Number of Members Exhibit 5.13 contains the projected P&L statements under capitation, recast to focus on the number of members. Assuming a per member utilization of four visits per year, a 10 percent membership increase to 20,625 members increases the projected profit by about 128 percent. However, if membership declines to 17,291, the clinic just breaks even.

We can use the breakeven equation to verify the breakeven point:

Total revenues . Total variable costs . Fixed costs = Profit ($400 . Members) . ($112.72 . Members) . $4,967,462 = $0 $287.28 . Members = $4,967,462 Members = 17,291.

EXHIBIT 5.13 Atlanta Clinic: Number of Members 2016 Projected P&L Statements 17,291 18,750 20,625 Under Capitation Total revenues ($400 . Number $ 6,916,400 $7,500,000 $8,250,000 (based on of members) 17,291, 18,750, Total variable costs ($112.72 . Members) 1,949,042 2,113,500 2,324,850 and 20,625 Total contribution margin $4,967,358 $5,386,500 $ 5,925,150 members) Fixed costs 4,967,462 4,967,462 4,967,462 Profit ($ 104) $ 419,038 $ 957,688 Breakeven analysis reaffirms that the clinic needs 17,291 members in its contract with the Alliance to break even, given the assumed cost structure, which in turn assumes utilization of four visits per member and a variable cost rate of $28.18 per visit.

Assuming constant per member utilization, more members increases profitability because additional members create additional revenues that presumably exceed their incremental (variable) costs. Indeed, the degree of operating leverage (DOL) concept (discussed in the Chapter 5 Supplement) can be applied here. As shown in Exhibit 5.13, a 10 percent increase to 20,625 members from a base case membership of 18,750 results in a (roughly) 128.5 percent increase in profit (from $419,038 to $957,688, or by $538,650).

Thus, each 1 percent increase in membership increases profitability by 12.85 percent. Similarly, if membership decreases to the breakeven point of 17,291, a decrease of 7.8 percent, profitability falls by 7.8% . 12.85 = 100%, which leads to a profit of zero.

SELF-TEST 1. Under capitation, what is the difference between a CVP graph QUESTIONS with the number of visits on the x-axis and one with the number of members on the x-axis?

2. What is unique about the contribution margin under capitation?

3. Why is utilization management so important in a capitated environment?

4. Why is the number of members so important in a capitated environment?

The Impact of Cost Structure on Financial Risk The financial risk of a healthcare provider, at least in theory, is minimized by having a cost structure that matches its revenue structure. To illustrate, consider a clinic with all payers using fee-for-service reimbursement and hence generating revenues directly related to volume. If the clinic s cost structure consisted of all variable costs (no fixed costs), then each visit would incur costs but at the same time create revenues. Assuming that the per visit revenue amount exceeds the variable cost rate (per visit costs), the clinic would lock in a profit on each visit. The total profitability of the clinic would be uncertain, as it is tied to volume, but the ability of the clinic to generate a profit would be guaranteed.

At the other extreme, consider a clinic that is totally capitated. In this situation, assuming a fixed number of covered lives, the clinic s revenue stream is fixed regardless of the volume of services provided. Now, to match the revenue and cost structures, the clinic must have all fixed (no variable) For Your Consideration Matching Cost and Revenue Structures Healthcare providers can lower their financial risk by matching the cost structure to the revenue structure. For example, providers that are primarily reimbursed on a fee-for-service basis can lower risk by converting fixed costs to variable costs. Conversely, providers that are primarily reimbursed on a capitated basis can lower risk by converting variable costs to fixed costs.

Assume that you are the business manager of a large cardiology group practice. Virtually all of the practice s revenues are on a fee-for-service basis. However, the practice s two largest cost categories, labor and diagnostic equipment, are fixed. You are concerned about the potential for volumes to fall in the future and want to take some actions to reduce the financial risk of the practice.

What cost structure is optimal for the practice?

What can be done to labor costs to improve the cost structure? To equipment costs? Suppose the change in cost structure will increase overall practice costs at next year s expected volume.

How does that influence your actions?

SELF-TEST QUESTIONS costs. Assuming that annual fixed revenue exceeds annual fixed costs, the clinic has a guaranteed profit at the end of the year.

Note that in both illustrations, the key to minimizing risk (ensuring a profit) is to create a cost structure that matches the revenue structure: variable costs for fee-for-service revenues and fixed costs for capitated revenues. Of course, real world problems occur when a provider tries to implement a cost structure that matches its revenue structure. First, few providers are reimbursed solely on a fee-for-service or a capitated basis. Most providers encounter a mix of reimbursement methods. Still, they are either predominantly fee-for-service or predominantly capitated.

Second, providers do not have complete control over their cost structures. It is impossible for providers to create cost structures with all variable or all fixed costs.

Nevertheless, managers can take actions to change their existing cost structure to one that is more compatible with the revenue structure (has less risk). For example, assume a medical group practice is reimbursed almost exclusively on a per procedure basis. To minimize financial risk, the practice can take actions such as paying physicians on a per procedure basis and using per procedure leases for diagnostic equipment. The greater the proportion of variable costs in the practice s cost structure, the lower its financial risk.

1. Explain this statement: To minimize financial risk, match the cost structure to the revenue structure. 2. What cost structure would minimize risk if a provider had all fee- for-service reimbursement?

3. What cost structure would minimize risk if a provider were entirely capitated?

4. What are the real-world constraints on creating matching cost structures?

Key Concepts Managers rely on managerial accounting information to plan for and control a business s operations. A critical part of managerial accounting information is the measurement of costs and the use of this information in profit analysis. The key concepts of this chapter are as follows:

Costs can be classified by their relationship to the amount of services provided.

Variable costs are those costs that are expected to increase and decrease with volume (patient days, number of visits, and so on), while fixed costs are the costs that are expected to remain constant regardless of volume within some relevant range.

The relationship between cost and activity (volume) is called underlying cost structure.

Profit analysis, often called cost-volume-profit (CVP) analysis, is an analytical technique that typically is used to analyze the effects of volume changes on revenues, costs, and profit.

A projected profit and loss (P&L) statement is a profit projection that, in a profit analysis context, uses assumed values for volume, price, and costs.

Breakeven analysis is used to estimate the volume needed (or the value of another variable, such as price) for the organization to break even in profitability.

Accounting breakeven occurs when revenues equal accounting costs (zero profit), while economic breakeven occurs when revenues equal accounting costs plus some profit target.

Contribution margin is the difference between unit price and the variable cost rate. Hence, contribution margin is the per unit dollar amount available to first cover an organization s fixed costs and then to contribute to profits.

In marginal analysis, the focus is on the incremental (marginal) profitability associated with increasing or decreasing volume.

A capitated environment dramatically differs from a fee-forservice environment. In essence, a capitated provider takes on the insurance function.

The keys to success in a capitated environment are to manage (reduce) utilization and increase the number of members covered.

To minimize financial risk, a provider should strive to attain a cost structure that matches its revenue structure.

In Chapter 6, the discussion of managerial accounting continues with an examination of costing at the department level.

Questions 5.1 Explain the differences between fixed costs and variable costs.

5.2 Total costs are made up of what components?

5.3 a. What is cost-volume-profit (CVP) analysis?

b. Why is it so useful to health services managers?

5.4 a. Define contribution margin.

b. What is its economic meaning?

5.5 a. Write out and explain the equation for volume breakeven.

b. What role does contribution margin play in this equation?

5.6 What elements of profit analysis change when a provider moves from a fee-for-service to a discounted fee-for-service environment?

5.7 What are the critical differences in profit analysis when it is conducted in a capitated environment versus a fee-for-service environment?

5.8 How do provider incentives differ when the provider moves from a fee-for-service to a capitated environment?

5.9 a. What cost structure is best when a provider is primarily capitated?

Explain.

b. What cost structure is best when a provider is reimbursed primarily by fee-for-service? Explain.

Problems 5.1 Consider the CVP graphs below for two providers operating in a fee- for-service environment:

a. Assuming the graphs are drawn to the same scale, which provider has the greater fixed costs? The greater variable cost rate? The greater per unit revenue?

b. Which provider has the greater contribution margin?

c. Which provider needs the higher volume to break even?

d. How would the graphs below change if the providers were operating in a discounted fee-for-service environment? In a capitated environment?

Provider A Provider B 5.2 Consider the data in the table below for three independent health services organizations:

Total Fixed Total Revenues Variable Costs Costs Costs Profit a. $2,000 $1,400 ? $2,000 ?

b. ? 1,000 ? 1,600 $2,400 c. 4,000 ? $600 ? 400 Fill in the missing data indicated by question marks.

5.3 Assume that a radiologist group practice has the following cost structure:

Fixed costs $500,000 Variable cost per procedure 25 Charge (revenue) per procedure 100 Furthermore, assume that the group expects to perform 7,500 procedures in the coming year.

a. Construct the group s base case projected P&L statement.

b. What is the group s contribution margin? What is its breakeven point?

c. What volume is required to provide a pretax profit of $100,000? A pretax profit of $200,000?

d. Sketch out a CVP analysis graph depicting the base case situation.

e. Now assume that the practice contracts with one HMO, and the plan proposes a 20 percent discount from charges. Redo questions a, b, c, and d under these conditions.

5.4 General Hospital, a not-for-profit acute care facility, has the following cost structure for its inpatient services:

Fixed costs $10,000,000 Variable cost per inpatient day 200 Charge (revenue) per inpatient day 1,000 The hospital expects to have a patient load of 15,000 inpatient days next year.

a. Construct the hospital s base case projected P&L statement.

b. What is the hospital s breakeven point?

c. What volume is required to provide a profit of $1,000,000? A profit of $500,000?

d. Now assume that 20 percent of the hospital s inpatient days come from a managed care plan that wants a 25 percent discount from charges. Should the hospital agree to the discount proposal?

5.5 You are considering starting a walk-in clinic. Your financial projections for the first year of operations are as follows:

Revenues (10,000 visits) $400,000 Wages and benefits 220,000 Rent 5,000 Depreciation 30,000 Utilities 2,500 Medical supplies 50,000 Administrative supplies 10,000 Assume that all costs are fixed, except supply costs, which are variable.

Furthermore, assume that the clinic must pay taxes at a 30 percent rate.

a. Construct the clinic s projected P&L statement.

b. What number of visits is required to break even?

c. What number of visits is required to provide you with an after-tax profit of $100,000?

5.6 (Hint: The concept of operating leverage, reviewed in this problem, is covered in the Chapter 5 Supplement.) Review the walk-in clinic data presented in Problem 5.5. Construct projected P&L statements at volume levels of 8,000, 9,000, 10,000, 11,000, and 12,000 visits.

a. Assume that the base case forecast is 10,000 visits. What is the clinic s degree of operating leverage (DOL) at this volume level?

Confirm the net incomes at the other volume levels using the DOL combined with the percent changes in volume.

b. Now assume that the base case volume is 9,000 visits. What is the DOL at this volume?

5.7 Grandview Clinic has fixed costs of $2 million and an average variable cost rate of $15 per visit. Its sole payer, an HMO, has proposed an annual capitation payment of $150 for each of its 20,000 members.

Past experience indicates the population served will average two visits per year.

a. Construct the base case projected P&L statement on the contract.

b. Sketch two CVP analysis graphs for the clinic one with number of visits on the x-axis and one with number of members on the x-axis. Compare and contrast these graphs with the one in Problem 5.3.d.

c. What is the clinic s contribution margin on the contract? How does this value compare with the value in Problem 5.3.b?

d. What profit gain can be realized if the clinic can lower per member utilization to 1.8 visits?

5.8 Triangle Pediatrics currently provides 1,000 visits per year at a price of $50 per visit. The variable cost per visit (variable cost rate) is $30, and total fixed costs are $15,000. The business manager suggests that Triangle Pediatrics can increase the number of visits to 1,200 per year by cutting the price per visit by $5 and increasing the fixed advertising budget by $5,000.

a. Construct the base case projected P&L statement and the projected P&L statement incorporating the proposed changes.

Should Triangle Pediatrics make the suggested changes?

b. How much would visit volume need to increase in order for Triangle Pediatrics to break even with the proposed changes?

5.9 Charity Hospital, a not-for-profit, has a maximum capacity of 15,000 discharges per year. Variable patient service costs are $495 per discharge. Variable general and administrative costs are $5 per discharge. Fixed hospital overhead costs are $4,000,000 per year. The current reimbursement rate is $1,000 per discharge.

a. What is Charity s breakeven volume in number of discharges?

b. Now assume Charity s total discharges for 2014 totaled 10,000. In late 2014, a specialty cardiac hospital opened near Charity, so that discharges in 2015 will reach only 8,500. Management is planning to cut fixed costs so that the total for 2015 will be $1,000,000 less than in 2014. Management is also considering reducing variable staffing costs in order to earn a target profit that will be the same dollar amount as the profit earned in 2014. Charity has already had 4,000 discharges in 2015 at a reimbursement rate of $1,000 per discharge with variable costs unchanged. What contribution margin per unit is needed on the remaining 4,500 discharges in order to reach the target profit?

Resources For a more in-depth treatment of cost measurement in health services organizations, see Finkler, S. A., D. M. Ward, and T. D. Calabrese. 2011. Accounting Fundamentals for Health Care Management. Sudbury, MA: Jones & Bartlett.

Young, D. W. 2014. Management Accounting in Health Care Organizations. New York: Jossey-Bass.

In addition, see Al-Hajeri, M., M. Hartmann, S. Jabr, P. C. Smith, and M. Z. Younis. 2011. Cost- Volume-Profit Analysis and Expected Benefit of Health Services: A Study of Cardiac Catheterization Services. Journal of Health Care Finance (Spring):

87 100.

Angert, S., and H. Seabrook. 2011. Next-Generation Cost Management. Healthcare Financial Management (March): 47 52.

Arredondo, R. 2014. Why Revisit Your Cost-Accounting Strategy. Healthcare Financial Management (July): 68 73.

Cleverley, W. O., and J. O. Cleverley. 2011. A Better Way to Measure Volume and Benchmark Costs. Healthcare Financial Management (March): 78 86.

. 2010. Cost Reduction: Identifying the Opportunities. Healthcare Financial Management (March): 53 59.

Daly, R. 2014. Innovations in Cost Management. Healthcare Financial Management (March): 51 56.

Koutsakos, G. 2011. Measuring Cost When Inpatient Service Acuity Varies. Healthcare Financial Management (November): 52 56.

Liu, L. L., D. A. Forgione, and M. Z. Younis. 2012. A Comparative Analysis of the CVP Structure of Nonprofit Teaching and For-Profit Non-teaching Hospitals. Journal of Health Care Finance (Fall): 12 38.

Rauh, S. S., E. Wadsworth, and W. B. Weeks. 2010. The Fixed-Cost Dilemma:

What Counts When Counting Cost-Reduction Efforts? Healthcare Financial Management (March): 60 63.

Selivanoff, P. 2011. The Impact of Healthcare Reform on Hospital Costing Systems. Healthcare Financial Management (May): 110 16.

Spence, J. 2013. 5 Ways to Make Cost Accounting a Strategic Function in Hospitals. Healthcare Financial Management (March): 40.

SEMI-FIXED COSTS AND OPERATING 5 LEVERAGE Semi-fixed Costs Fixed and variable costs represent two ends of the volume classification spectrum.

Here, within the relevant range, the costs are either independent of volume (fixed) or directly related to volume (variable). A third classification, semi-fixed costs, falls in between the two extremes. A semi-fixed cost is one that is fixed over some range of volume, but this range is smaller than the relevant range used in the analysis. Note that another volume classification is semi-variable costs. Such costs have both a fixed and a variable component.

An example might be a business s telephone costs, which could have a fixed (base) charge component plus additional charges that depend on the number of minutes of usage.

To illustrate semi-fixed costs, assume that the actual relevant range of volume for the clinical laboratory discussed in the chapter is 10,000 to 20,000 tests. However, the laboratory s current workforce can only handle up to 15,000 tests per year, so an additional technician, at an annual cost of $35,000, would be required if volume were to exceed that level. Now, labor costs are fixed from 10,000 to 15,000 tests, and then again fixed at a higher level from 15,000 to 20,000 tests, but they are not fixed at the same level throughout the entire relevant range of 10,000 to 20,000 tests. Semi-fixed costs are fixed within ranges of volume, but there are multiple ranges of semi- fixed costs within the relevant range. Because a plot of semi-fixed costs versus volume looks like a step function, such costs sometimes are called step-fixed or step-variable costs.

Exhibits S5.1 and S5.2 illustrate the cost structure of the laboratory within the new relevant range and with the addition of semi-fixed costs. As shown in Exhibit S5.1, the inclusion of semi-fixed costs prevents average fixed cost and average cost per test from continuously declining throughout the relevant range. At volumes above 15,000 tests, the laboratory must add a technician at a cost of $35,000. This causes a jump in total fixed costs (consisting of fixed and semi-fixed costs), average fixed cost, total costs, and average cost per test. However, once this jump (or step) occurs, average fixed cost and average cost per test again begin to decline as volume increases.

EXHIBIT S5.1 Cost Structure Variable Costs per Test Fixed Costs per Year Semi-fixed Costs Chapter 5 Supplement Illustration:

Fixed, Semi-fixed, Laboratory supplies $10 Labor $100,000 Other fixed costs 50,000$150,000 Increase in labor costs above 15,000 tests $35,000 and Variable Costs Total Total Average Fixed Semi-fixed Fixed Variable Total Cost Volume Costs Costs Costs Costs Costs per Test 10,000 $150,000 $ 0 $150,000 $100,000 $250,000 $25.00 14,000 150,000 0 150,000 140,000 290,000 20.71 15,000 150,000 0 150,000 150,000 300,000 20.00 16,000 150,000 35,000 185,000 160,000 345,000 21.56 20,000 150,000 35,000 185,000 200,000 385,000 19.25 SELF-TEST QUESTIONS The jump in total costs is easily identified on the total costs line shown in Exhibit S5.2. Because of the negative impact of this sudden increase in total costs, the laboratory department head would probably try to avoid hiring an additional technician when volume exceeds 15,000 tests, especially if volume is expected to be only slightly above the jump point or is expected to be temporary. Perhaps new incentives could be put into place to encourage the current technicians to be more productive. Such an action could lower costs in general and create a situation in which the average cost per test would decline continuously throughout the relevant range.

Although semi-fixed costs are common within health services organizations, they add a level of complexity to profit (CVP) analysis without adding a great deal of additional insight. Thus, the examples presented in the main text of Chapter 5 assume that an organization s cost structure consists only of fixed and variable costs.

1. What is a semi-fixed cost?

2. How does the addition of semi-fixed costs change a cost structure graph?

3. What is the impact of semi-fixed costs on per unit average cost?

Operating Leverage As we demonstrate in the chapter, profit (CVP) analysis is used to examine how changes in volume affect profits and to estimate breakeven points. Assume Costs ($) 250,000 150,000 100,000 35,000 0 EXHIBIT S5.2 Cost Structure Graph Total Costs TotalVariable Costs Fixed Costs Semi-Fixed Costs 15,000 20,00010,000 Volume (Number of Tests) Chapter 5 Supplement now that Atlanta Clinic s managers believe that changes in the local market for healthcare services will occur that increase their volume estimate for 2016 to 82,500 visits an increase of 7,500 visits over the original 75,000 visit base case estimate. (The relevant range for Atlanta s cost structure is 65,000 to 85,000 visits.) Exhibit S5.3 contains the clinic s projected P&L statements at 69,165 (accounting breakeven), 75,000 (base case), and 82,500 visits. The first two columns were previously constructed in Chapter 5, while the third column, which represents the 82,500 visit estimate, is new.

Now that P&L statements have been created at three different volume levels, the consequences of volume changes can be better understood. As the clinic s forecasted volume moves from 75,000 visits to 82,500 visits, its profit increases by $957,688 . $419,038 = $538,650. This increase is equal to the additional 7,500 visits multiplied by the $71.82 contribution margin. When the volume is beyond the accounting breakeven point, any additional visits are gravy that is, the clinic s fixed costs are now covered, so all contribution margin additions flow directly to profit. Similarly, the outcome is known if the clinic s projected volume dropped from 75,000 to 69,165 visits. In this case, the decrease of 5,835 visits . $71.82 contribution margin = $419,070, which is the loss of profit (except for a rounding difference) that results from the volume decrease.

EXHIBIT S5.3 Atlanta Clinic:

2016 Projected P&L Statements (based on 69,165, 75,000, and 82,500 patient visits) Number of Visits 69,165 75,000 82,500 Total revenues ($100 . Volume) Total variable costs ($28.18 . Volume) Total contribution margin ($71.82 . Volume) Fixed costs Profit $6,916,500 1,949,070 $4,967,430 4,967,462 ($ 32) $7,500,000 2,113,500 $8,250,000 2,324,850$5,386,500 4,967,462 $ 419,038 $ 5,925,150 4,967,462 $ 957,688 Chapter 5 Supplement The movement from 75,000 to 82,500 visits resulted in a (82,500 .

75,000) 75,000 = 7,500 75,000 = 0.10 = 10% increase in volume and thus total revenues. While the top line of the P&L statement total revenues increased by 10 percent, the bottom line of the statement profit increased by 128.5 percent ($538,650 $419,038 = 1.285 = 128.5%). This incredible increase in profit occurs because the clinic is reaping the benefit of its cost structure, which includes fixed costs that do not increase with volume.

If a high proportion of a business s total costs are fixed, the business is said to have high operating leverage. In physics, leverage implies the use of a lever to raise a heavy object with a small amount of force. In politics, individuals who have leverage can accomplish much with the smallest word or action. In finance, high operating leverage means that a relatively small change in volume results in a large change in profit.

Operating leverage is measured by the degree of operating leverage (DOL), which in this illustration is calculated at any given volume by dividing the total contribution margin by profit. At a volume of 75,000 visits, Atlanta Clinic s degree of operating leverage is Total contribution margin Profit = $5,386,500 $419,038 = 12.85. The DOL indicates how much profit will change for each 1 percent change in volume. Thus, at a volume of 75,000 visits, each 1 percent change in volume produces a 12.85 percent change in profit, so a 10 percent increase in volume results in a 10% . 12.85 = 128.5% increase in profit. Note, however, that the DOL changes with volume, so the 12.85 DOL calculated here is applicable only to a starting volume of 75,000 visits.

Cost structures differ widely among industries and among organizations within a given industry. The DOL is greatest in health services organizations with a large proportion of fixed costs and, consequently, a low proportion of variable costs. The end result is a high contribution margin, which contributes to a high DOL. In economics terminology, high-DOL businesses are said to have economies of scale because higher volumes lead to lower per unit total costs. In such businesses, a small increase in revenue produces a relatively large increase in profit. However, high-DOL businesses have relatively high breakeven points, which increase the risk of losses. Also, operating leverage is a double-edged sword: High-DOL businesses suffer large profit declines, and potentially large losses, if volume falls.

To illustrate the negative effect of a high DOL, consider this question:

What would happen to Atlanta Clinic s profit if volume fell by 7.8 percent from the base case level of 75,000 visits? To answer this question, recognize that profit would decline by 7.8% . 12.85 = 100%, so the clinic s profit would fall to zero. The data in Exhibit S5.3 confirm this answer. At a projected volume of 69,165 visits (a decrease of 7.8 percent from 75,000 visits), the clinic s profit is zero (except for a rounding difference). Of course, this volume was previously identified in the chapter as the breakeven point.

To what extent can managers influence a business s operating leverage?

In many respects, operating leverage is determined by the inherent nature of the business. In general, hospitals and other institutional providers must make large investments in fixed assets (land, buildings, and equipment), and hence they have a high proportion of fixed costs and high operating leverage. Conversely, home health care businesses and other noninstitutional providers need few fixed assets, so they tend to have relatively low operating leverage. Still, managers can somewhat influence operating leverage. For example, organizations can make use of temporary, rather than permanent, employees to handle peak patient loads. Also, assets can be leased on a per use (per procedure) basis, rather than purchased or leased on a fixed rental basis. Actions such as these tend to reduce the proportion of fixed costs in an organization s cost structure and hence reduce operating leverage.

1. What is operating leverage, and how is it measured?

2. Why is the operating leverage concept important to managers?

3. Can managers influence their firms operating leverage?

4. How does an organization s cost structure affect its exposure to economies of scale?

SELF-TEST QUESTIONS Chapter 5 Supplement DEPARTMENTAL COSTING AND COST 6 ALLOCATION Learning Objectives After studying this chapter, readers will be able to Differentiate between direct and indirect (overhead) costs.

Explain why proper cost allocation is important to health services organizations.

Define a cost driver and explain the characteristics of a good driver as opposed to a poor one.

Describe the three primary methods used to allocate overhead costs among revenue-producing departments.

Apply cost allocation principles across a wide range of situations within health services organizations.

Introduction In Chapter 5 we discussed organizational costing, which requires the classification of costs according to their relationship to volume. In this chapter we introduce departmental costing, which requires an additional classification of costs the relationship between costs and the department being analyzed. In essence, we will see that some costs are unique to the department, while other costs stem from resources that belong to the organization as a whole. Once it is recognized that some costs are organizational in nature rather than department specific, it becomes necessary to create a system that allocates organizational costs to individual departments. For now, we will focus on costing at the department level.

In the next chapter, we will discuss costing (and pricing) of individual service lines. Although some of this chapter s material is conceptual in nature, much of it involves the application of various allocation techniques. Thus, a considerable portion of the chapter is devoted to examples of cost allocation in different settings.

Direct Versus Indirect (Overhead) Costs Some costs about 50 percent of a health services organization s cost structure are unique to the reporting subunit and hence usually can be identified Direct cost A cost that is tied exclusively to a subunit, such as the salaries of laboratory department employees.

When a subunit is eliminated, its direct costs disappear.

Indirect (overhead) cost A cost that is tied to shared resources rather than to an individual subunit of an organization; for example, facilities costs.

SELF-TEST QUESTIONS Cost allocation The process by which overhead costs are assigned (allocated) to individual departments.

with relative certainty. To illustrate, consider a hospital s clinical laboratory department. Certain costs are unique to the department: for example, the salaries and benefits for the managers and technicians who work there and the costs of the equipment and supplies used to conduct the tests. These costs, which would not occur if the laboratory were closed, are classified as the direct costs of the department.

Unfortunately, direct costs constitute only a portion of the department s entire cost structure. The remaining resources used by the laboratory are not unique to the laboratory; the department uses many shared resources of the hospital as a whole. For example, the laboratory shares the organization s physical space (facilities) as well as its infrastructure, which includes information systems, utilities, housekeeping, maintenance, medical records, and general administration. The costs that are not borne exclusively by the laboratory department are called indirect costs, or overhead costs.

Indirect costs, in contrast to direct costs, are much more difficult to measure at the department level for the precise reason that they arise from shared resources that is, if the laboratory department were closed, the indirect costs would not disappear. Perhaps some indirect costs could be reduced, but the hospital would still require a basic infrastructure to operate its remaining departments. The direct/indirect classification has relevance only at the subunit level; if the unit of analysis is the entire organization, all costs are direct by definition. Thus, in our Chapter 5 discussion of organizational costing, we did not have to introduce the concept of direct versus indirect costs.

Note that the two cost classifications (fixed/variable and direct/indirect) overlay one another. That is, fixed costs typically include both direct and indirect costs, while variable costs, in most cases, contain only direct costs (although they can include both direct and indirect costs). Conversely, direct costs usually include fixed and variable costs, while indirect costs typically include only fixed costs.

1. What is the difference between direct and indirect costs?

2. Give some examples of each type of cost for a hospital s emergency services department.

Introduction to Cost Allocation A critical part of cost measurement at the department level is the assignment, or allocation, of indirect costs. Cost allocation is essentially a pricing process within the organization whereby managers allocate the costs of one department to other departments. Because this pricing process does not occur in a market setting, no objective standard exists that establishes the price for the transferred services. Thus, cost allocation within a business must, to the extent possible, establish prices that proxy those that would be set under market conditions.

What costs within a health services organization must be allocated?

Typically, the overhead costs of the business, such as those incurred by administrators, facilities management personnel, financial staffs, and housekeeping and maintenance personnel, must be allocated to those departments that generate revenues for the organization (generally patient services departments).

The allocation of overhead costs to patient services departments is necessary because there would be no need for such costs in the first place if there were no patient services departments. Thus, decisions regarding pricing and service offerings by the patient services departments must be based on the full costs associated with each service, including both direct and overhead (indirect) costs. Clearly, the proper allocation of overhead costs is essential to good decision making within health services organizations.

The goal of cost allocation is to assign all of the costs of an organization to the activities that cause them to be incurred. With complete cost data accessible in the organization s managerial accounting system, managers can make better decisions regarding cost control, what services should be offered, and how these services should be priced. Of course, the more complex the managerial accounting system, the higher the costs of developing, implementing, and operating the system. As in all situations, the benefits associated with more accurate cost data must be weighed against the costs required to develop such data.

Interestingly, much of the motivation for more accurate cost allocation systems comes from the recipients of overhead services. Managers at all levels within health services organizations are under pressure to optimize financial performance, which translates to reducing costs. Indeed, many department heads are evaluated, and hence compensated and promoted, primarily on the basis of profitability, assuming that performance along other dimensions is satisfactory. For such a performance evaluation system to work, all parties must perceive the cost allocation process to be accurate and fair because managers are held accountable for both the direct and the indirect costs of their departments. In other words, department heads are held accountable for the full costs associated with services performed by their departments.

SELF-TEST QUESTIONS 1. What is meant by the term cost allocation? By the term full costs?

2. What is the goal of cost allocation?

3. Why is cost allocation important to health services managers?

Cost pool A group of overhead costs to be allocated; for example, facilities costs or marketing costs.

Cost driver The basis on which a cost pool is allocated; for example, square footage for facilities costs.

Allocation rate The numerical value used to allocate overhead costs; for example, $10 per square foot of occupied space for facilities costs.

Cost Allocation Basics To assign costs from one activity to another, two important elements must be identified: a cost pool and a cost driver. A cost pool is a grouping of similar costs to be allocated, while a cost driver is the basis upon which the allocation is made. To illustrate, the costs of a hospital s housekeeping department might be allocated to the other departments on the basis of the size of each department s physical space. The logic here is that the amount of housekeeping resources expended in each department is directly related to the physical size of that department. In this situation, total housekeeping costs would be the cost pool, and the number of square feet of occupied space would be the cost driver.

When the cost pool amount is divided by the total amount of the cost driver, the result is the overhead allocation rate. Thus, in the housekeeping illustration, the allocation rate is the total housekeeping costs of the organization divided by the total space (square footage) occupied by the departments receiving the allocation. This procedure results in an allocation rate measured in dollar cost per square foot of space used. In the patient services departments, full (total) costs would include the direct costs of each department and an allocation for housekeeping services, made on the basis of the amount of occupied space.

Cost Pools Typically, a cost pool consists of all of the direct costs of one support department.

However, if a single support department offers several substantially different services, and the patient services departments use those services in different relative amounts, it may be beneficial to separate the costs of that support department into multiple pools.

For example, suppose a hospital s financial services department provides two significantly different services: patient billing/collections and budgeting.

Furthermore, assume that the routine care department uses proportionally more patient billing/collections services than does the laboratory department, but the laboratory department uses proportionally more budgeting services than does the routine care department. In this situation, it would be best to create two cost pools for one support department. To do this, the total costs of financial services would be divided into a billing pool and a budgeting pool.

Then, cost drivers would be chosen for each pool and the costs allocated to the patient services departments as described in the following sections.

Cost Drivers Perhaps the most important step in the cost allocation process is the identification of proper cost drivers. Traditionally, overhead costs were aggregated across all support departments and then divided by a rough measure of organizational volume, resulting in an allocation rate of some dollar amount of generic overhead per unit of volume.

For example, the total inpatient overhead costs of a hospital might be divided by total inpatient days, giving an allocation rate of so many dollars per patient day, which is called the per diem overhead rate. If a hospital had 72,000 patient days in 2015 and its total inpatient overhead costs were $36 million, the overhead allocation rate would be $36,000,000 72,000 = $500 per patient day (per diem). Regardless of the type of patients treated within an inpatient services department (adult versus child, trauma versus illness, acute versus critical care, and so on), the $500 per diem allocation rate would be applied to determine the total indirect cost allocation for that department.

However, it is clear that not all overhead costs are tied to the number of patient days. For example, overhead costs associated with admission, discharge, and billing are typically not related to the number of patient days but to the number of admissions. Thus, tying all overhead costs to a single cost driver improperly allocates such costs, which distorts reported costs for patient services and hence raises concerns about the effectiveness of decisions based on such costs. In state-of-the-art cost management systems, the various types of overhead costs are separated into different cost pools, and the most appropriate cost driver for each pool is identified.

The theoretical basis for identifying cost drivers is the extent to which costs from a pool actually vary as the value of the driver changes. For example, does a patient services department with 10,000 square feet of space use twice the amount of housekeeping services as a department with only 5,000 square feet of space? The better the relationship (correlation) between actual resource expenditures at each subunit and the cost driver, the better the cost driver and the better the resulting cost allocations.

Effective cost drivers possess two important characteristics. First, and perhaps the less important of the two, is fairness that is, does the cost driver chosen result in an allocation that is fair to the patient services departments?

The second, and perhaps more important, characteristic is cost control that is, does the cost driver chosen create incentives for departments to use less of that overhead service?

For example, there is little that a patient services department manager can do to influence overhead cost allocations if the cost driver is patient days.

In fact, the action needed to reduce patient days might lead to negative financial consequences for the organization. An effective cost driver will encourage patient services department managers to take overhead cost reduction actions that do not have negative implications for the organization. The remainder of this chapter emphasizes the importance of effective cost drivers, including several illustrations that distinguish good drivers from poor ones.

Industry Practice Hospitals and Housekeeping Cost Drivers Most hospitals use square footage to allocate housekeeping costs. The rationale, of course, is that a patient services department that is twice as big as another will require twice the expenditure of housekeeping resources. The advantage of this cost driver is that it is easy to measure and does not change very often.

The disadvantage of using square footage as the cost driver is that some patient services departments require more housekeeping support because of the nature of the service, even when similar-sized spaces are occupied. For example, emergency departments require more intense housekeeping services than do neonatal care units.

Is there a better cost driver available for allocating housekeeping costs? If so, what is it?

Describe how the new and improved cost driver would work.

EXHIBIT 6.1 Prairie View Clinic:

Allocation of Housekeeping Overhead to the Physical Therapy Department The Allocation Process The steps involved in allocating overhead costs are summarized in Exhibit 6.1, which illustrates how Prairie View Clinic allocated its housekeeping costs for 2016. Cost allocation takes place both for historical purposes, in which realized costs over the past year are allocated, and for planning purposes, in which estimated future costs are allocated to aid in pricing and other decisions. The examples in this chapter generally assume that the purpose of the allocation is for financial planning and budgeting, so the data presented are estimated for the coming year 2016.

The first step in the allocation process is to establish the cost pool. In this case, the clinic is allocating housekeeping costs, so the cost pool is the projected total costs of the housekeeping department $100,000.

Next, the most effective cost driver must be identified. After considerable investigation, Prairie View s managers concluded that the best cost driver for housekeeping costs is labor hours that is, the number of hours of housekeeping services required by the clinic s departments is the variable most closely related to the actual cost of providing these services. The intent here, of course, is to pick the cost driver that provides the most accurate cause-and-effect relationship between the use of housekeeping services and the costs of the housekeeping Step One: Determine the Cost Pool The departmental costs to be allocated are for the housekeeping department, which has total budgeted costs for 2016 of $100,000.

Step Two: Determine the Cost Driver The best cost driver was judged to be the number of hours of housekeeping services provided. An expected total of 10,000 hours of such services will be provided in 2016 to those departments that will receive the allocation.

Step Three: Calculate the Allocation Rate $100,000 10,000 hours = $10 per hour of housekeeping services provided.

Step Four: Determine the Allocation Amount The physical therapy department uses 3,000 hours of housekeeping services, so its allocation of housekeeping department overhead is $10.3,000 = $30,000.

department. For 2016, Prairie View s managers estimate that the housekeeping department will provide 10,000 hours of service to the departments that will receive the allocation.

Now that the cost pool and cost driver have been defined and measured, the allocation rate is established by dividing the expected total overhead cost (the cost pool) by the expected total volume of the cost driver: $100,000 10,000 hours = $10 per hour of services provided.

Key Equation: Allocation Rate The allocation rate is the rate used to calculate each user department s allocation of an overhead cost pool. To illustrate, assume the financial services department has $1,000,000 in total costs (the cost pool) and the patient services departments in total generate 500,000 bills (the cost driver). Then, the allocation rate is $2 per bill:

Allocation rate = Cost pool amount Cost driver volume = $1,000,000 500,000 bills = $2 per bill.

The final step in the process is to make the allocation to each department.

To illustrate the allocation, consider the physical therapy (PT) department one of Prairie View s patient services departments. For 2016, PT is expected to use 3,000 hours of housekeeping services, so the dollar amount of housekeeping overhead allocated to PT is $10 . 3,000 = $30,000. Other departments within the clinic will also use housekeeping services, and their allocations would be made in a similar manner the $10 allocation rate per hour of services used is multiplied by the amount of each department s hourly utilization of housekeeping services. When all departments are considered, the 10,000 hours of housekeeping services is fully distributed among the using departments. For any one department, the amount allocated depends on both the allocation rate and the amount of housekeeping services used.

SELF-TEST QUESTIONS 1. What are the definitions of a cost pool, a cost driver, and an allocation rate?

2. Under what conditions should a single overhead department be divided into multiple cost pools?

3. On what theoretical basis are cost drivers chosen?

4. What two characteristics make an effective cost driver?

5. What are the four steps in the cost allocation process?

Cost Allocation Methods Mathematically, cost allocation can be accomplished in a variety of ways, and the method used is somewhat discretionary. No matter what method is chosen, all support department costs eventually must be allocated to the departments (generally patient services departments) that create the need for those costs.

The key differences among the methods are how support services provided by one department are allocated to other support departments. The direct method totally ignores services provided by one support department to another. Two other allocation methods address intrasupport department allocations.

The reciprocal method recognizes all of the intrasupport department services, and the step-down method represents a compromise that recognizes some, but not all, of the intrasupport department services. Regardless of the method, all of the support costs within an organization ultimately are allocated from support departments to the departments that generate revenues for the organization.

Exhibit 6.2 summarizes the three allocation methods. Prairie View Clinic, which is used in the illustration, has three support departments (human EXHIBIT 6.2 Prairie View Support Departments Patient Services Departments Clinic: Direct Method Alternative Human Resources Cost Allocation Methods Housekeeping Physical Therapy Internal Medicine Administration Reciprocal Method Human Resources Housekeeping Physical Therapy Administration Internal Medicine Step-Down Method Human Resources Housekeeping Physical Therapy Administration Internal Medicine resources, housekeeping, and administration) and two patient services departments (physical therapy and internal medicine).

Under the direct method, shown in the top section of Exhibit 6.2, each support department s costs are allocated directly to the patient services departments that use the services. Thus, none of the support services costs are allocated to other support departments. In the illustration, both physical therapy and internal medicine use the services of all three support departments, so the costs of each support department are allocated to both patient services departments. The key feature of the direct method and the feature that makes it relatively simple to apply is that no intrasupport department allocations are recognized. Thus, under the direct method, only the direct costs of the support departments are allocated to the patient services departments because no indirect costs have been created by intrasupport department allocations.

As shown in the center section of Exhibit 6.2, the reciprocal method recognizes the support department interdependencies among human resources, housekeeping, and administration, and hence it generally is considered to be more accurate and objective than the direct method. The reciprocal method derives its name from the fact that it recognizes all of the services that departments provide to and receive from other departments. The good news is that this method captures all of the intrasupport department relationships, so no information is ignored and no biases are introduced into the cost allocation process. The bad news is that the reciprocal method relies on the simultaneous solution of a series of equations representing the utilization of intrasupport department services. Thus, it is relatively complex, which makes it difficult to explain to department heads and typically more costly to implement.

The step-down method, which is shown in the lower section of Exhibit 6.2, represents a compromise between the simplicity of the direct method and the complexity of the reciprocal method. It recognizes some of the intrasupport department effects that the direct method ignores, but it does not recognize the full range of interdependencies as does the reciprocal method. The step- down method derives its name from the sequential, stair-step pattern of the allocation process, which requires that the allocation take place in a specific sequence. As shown in the exhibit, all the direct costs of human resources first are allocated to both the patient services departments and the other two support departments. Human resources is then closed out because all of its costs have been allocated. Next, housekeeping costs, which now consist of both direct and indirect costs (the allocation from human resources), are allocated to the patient services departments and the remaining support department administration. Finally, the direct and indirect costs of administration are allocated to the patient services departments. The final allocation from administration includes human resources and housekeeping costs because a portion of these support costs has been allocated or stepped down to administration.

Direct method A cost allocation method in which all overhead costs are allocated directly from the overhead departments to the patient services departments with no recognition that overhead services are provided to other support departments.

Reciprocal method A cost allocation method that recognizes all of the overhead services provided by one support department to another.

Step-down method A cost allocation method that recognizes some of the overhead services provided by one support department to another.

SELF-TEST QUESTIONS Profit center A business unit (in our examples, typically a department) that generates revenues as well as costs, and hence its profitability can be measured.

Cost center A business unit that does not generate revenues, and hence only its costs can be measured.

The critical difference between the step-down and reciprocal methods is that after each allocation is made in the step-down method, a support department is removed from the process. Even though housekeeping and administration provide support services back to human resources, these indirect costs are not recognized because human resources is removed from the allocation process after the initial allocation. Such costs are recognized in the reciprocal method.

1. What are the three primary methods of cost allocation?

2. Explain how they differ.

3. Which one do you think is best? Which is the worst?

Direct Method Illustration The best way to gain a more in-depth understanding of cost allocation is to work through several allocation illustrations. We begin with the direct method.

As shown in Exhibit 6.3, Kensington Hospital has three revenue-producing patient services departments: routine care, laboratory, and radiology. Accountants often call the patient services departments profit centers, because they not only incur costs but also create revenues. Conversely, overhead departments are called cost centers in that they incur costs but create no revenues.

Hospital costs are divided into those costs attributable to the profit centers (direct costs) and those costs attributable to the support departments (overhead costs). Of course, the overhead costs are direct costs to the support departments, but when they are allocated to the patient services departments, these direct costs become indirect (overhead) costs.

The data show that the revenues for each of the patient services departments are much greater than their direct costs. Furthermore, Kensington s projected total revenues of $27,000,000 exceed the hospital s projected total costs of $25,450,000. However, the aggregate revenue and cost amounts provide no information to Kensington s managers concerning the true profitability of each patient services department. To determine true profitability by profit center, the full costs of providing patient services, including both direct and indirect costs, must be measured. Only then can the hospital s managers develop rational pricing and cost control strategies.

As previously discussed, three decisions are required when allocating costs: how to define the cost pools, what the cost drivers are, and which method of allocation to use. We begin by illustrating the direct method of cost allocation. The step-down method is discussed in the Chapter 6 Supplement.

The cost pools (total costs) for the support departments are given in the lower section of Exhibit 6.3. Financial services costs are $1,500,000; Projected Revenues by Patient Services Department Routine Care Laboratory Radiology Total revenues Projected Costs for All Departments Patient Services Departments (Direct Costs):

Routine Care Laboratory Radiology Total costs Support Services Departments (Overhead Costs):

Financial Services Facilities Housekeeping General Administration Human Resources Total overhead costs Total costs of both patient and support services Projected profit $16,000,000 5,000,000 6,000,000 $27,000,000 $ 5,500,000 3,300,000 2,800,000 $ 11,600,000 $ 1,500,000 3,800,000 1,600,000 4,400,000 2,550,000 $ 13,850,000 $25,450,000 $ 1,550,000 EXHIBIT 6.3 Kensington Hospital: 2016 Revenue and Cost Projections facilities costs equal $3,800,000; housekeeping costs are $1,600,000; general administration costs total $4,400,000; and human resources costs equal $2,550,000. Thus, overhead costs at the hospital total $13,850,000, which ultimately must be allocated to the hospital s three patient services departments.

Kensington s managers believe that little is to be gained by dividing any of the support departments into multiple cost pools, so each support department constitutes one cost pool.

The next step in the allocation process is to identify the best cost drivers for each cost pool. Exhibit 6.4 provides a summary of the support departments and their assigned cost drivers. Unfortunately, the selection of cost drivers is not an easy process, and to a large extent the usefulness of the entire cost allocation process depends on choosing the most effective drivers.

As discussed later, Kensington s selection of cost drivers, like many selections made in real-world situations, is somewhat of a compromise between effectiveness and simplicity.

EXHIBIT 6.4 Kensington Hospital:

Assigned Cost Drivers Support Services Department Cost Driver Financial Services Patient services revenue Facilities Space utilization (square footage) Housekeeping Labor hours General Administration Salary dollars Human Resources Salary dollars The cost driver chosen for financial services is patient services revenue.

Financial services provides a full range of financial support to the hospital.

The bulk of its efforts are devoted to patient billing and collections, but it is also involved in financial and managerial accounting, budgeting and report preparation, and a host of other financial tasks. Tying the allocation of this support department to the amount of patient services revenues assumes a strong positive relationship between the amount of financial services provided to each patient services department and revenues generated by that department.

Clearly, patient services revenue is a relatively inaccurate cost driver, and hence the resulting cost allocation has limitations. In the next section, we discuss the benefits of moving from a poor cost driver to a better one.

The amount of space used (square footage) is the basis for allocating the costs of facilities. This cost driver is often used by health services organizations to allocate the initial costs of land, buildings, and equipment as well as the costs of maintenance and other facilities services. The logic applied here is that the patient services departments with the most space require the most facilities and hence the most facilities support. Of course, this assumption does not always hold. For example, in any year, facilities may be required to support a special large project for one of the patient services departments, resulting in costs that far exceed that department s proportional space utilization.

Nevertheless, over the long run at Kensington Hospital, the relative costs of facilities utilization by the patient services departments track closely with the space occupied by those departments.

Two of the remaining support departments, general administration and human resources, also use a relatively poor cost driver, salary dollars. If radiology has payroll costs that are five times larger than those of laboratory, radiology will be charged (allocated) five times as much of the costs incurred by administration and personnel. This cost driver is often used, but in reality it is not very good. Thus, the allocated costs from general administration and human resources probably do not truly represent the relative amounts of utilization of these overhead services.

Housekeeping has chosen perhaps the best cost driver namely, the number of labor hours of housekeeping services consumed. In many organizations, housekeeping costs are allocated on the basis of square footage, using the logic that the amount of space occupied by a department accurately reflects housekeeping efforts and hence costs. This assumption may or may not be valid, however. In effect, large-space departments may be subsidizing small- space departments, such as emergency services, where space may be limited but the intensity of work requires a significant amount of housekeeping services.

To account for such situations at Kensington Hospital, housekeeping is using a better cost driver one that more closely aligns to the actual resources expended in providing support to the patient services departments.

The development and use of the best cost driver is a cost benefit issue.

Housekeeping must devote resources to tracking where their workers spend their time, an effort that would not be required if the cost driver were square footage. The benefit, of course, is a cost driver that makes it easier for Kensington s senior managers to hold department heads responsible for both direct and indirect costs. If the head of the radiology department does not like the amount of housekeeping costs that are being charged to the department, she can do something about it: use fewer housekeeping services. With an inferior cost driver, such as square footage, there is little that patient services department heads can do if they do not like the housekeeping allocation. In most cases, reduction of square footage is not a practical way to deal with excessive housekeeping costs.

With labor hours consumed as the cost driver, the cost control solution for patient services department heads is to reduce the amount of housekeeping services used. If all patient services department heads are made to think this way by having the right incentive system in place, ultimately the hospital will discover it is as efficient as possible in using housekeeping services. In the long run, the direct costs of the housekeeping department currently $1,600,000 will fall as these services are more efficiently used. In reality, the secondary benefit of choosing a more effective cost driver is a more equitable allocation. The primary benefit is that a good cost driver creates an incentive to use less of the support service, which ultimately leads to lower overhead costs for the organization.

Exhibit 6.5 contains the initial data necessary for the allocation. The first column of the exhibit lists the patient services departments. The amounts of the chosen cost drivers consumed by each patient services department are listed after that: patient services revenue used for allocating financial services costs, square footage used for facilities allocations, housekeeping labor hours used for housekeeping allocations, and departmental salary dollars used for both general administration and human resources allocations.

If Kensington were using the step-down or reciprocal allocation methods, the information shown in Exhibit 6.5 would have to include the support departments because the data would be needed for intrasupport department EXHIBIT 6.5 Kensington Patient Hospital: Services Square Housekeeping Salary Patient Services Department Revenues Feet Labor Hours Dollars Departmental Summary Data Routine Care $16,000,000 199,800 76,000 $ 5,709,000 Laboratory 5,000,000 39,600 6,000 2,035,000 Radiology 6,000,000 61,200 9,000 2,439,000 Total $27,000,000 300,600 91,000 $10,183,000 allocations. By using the direct method, the hospital ignores intrasupport department dependencies, so the totals indicated at the bottom of each column reflect only the use of support services by the patient services departments, to which are allocated all of the support costs.

Exhibit 6.6 divides the dollar amount of each cost pool by the total amount of each cost driver to derive the allocation rates. For example, the cost pool (direct costs) for financial services totals $1,500,000, which will be allocated as indirect (overhead) costs to the patient services departments that have a total of $27,000,000 in patient services revenues. The allocation rate for financial services, therefore, is $1,500,000 $27,000,000 = $0.05556 per dollar of patient services revenue.

As previously mentioned, the allocation of indirect costs can be viewed as an internal pricing mechanism. Thus, the heads of the revenue-producing departments can look at Exhibit 6.6 and see the rate that they are being charged for support services, which amounts to the following:

$0.05556 for each dollar of patient services revenue generated for financial services support.

$12.64 per square foot of space used for facilities support.

EXHIBIT 6.6 Kensington Hospital:

Department Cost Pool (total costs) Cost Driver Total Utilization Allocation Ratea Overhead Allocation Rates Financial Services FacilitiesHousekeeping$1,500,000 3,800,000 1,600,000 Patient revenue Square feetLabor hours$27,000,000 300,600 91,000$0.05556 12.64 17.58 GeneralAdministration 4,400,000 Salary dollars $10,183,000 0.432 Human Resources 2,550,000 Salary dollars $10,183,000 0.250 a $ per unit of the cost driver $17.58 per labor hour consumed for housekeeping support.

$0.432 per salary dollar paid to department employees for general administrative overhead.

$0.250 per salary dollar for human resources support.

If radiology pays a technician $10 an hour in direct labor costs for each hour the technician works, the department will also be charged 0.432 . $10.00 = $4.32 for general administrative overhead and 0.250 . $10.00 = $2.50 for human resources overhead, plus additional allocations for financial services, facilities, and housekeeping support. Having two cost pools, in this case the general administration and human resources departments, that use the same cost driver (salary dollars) is not unusual. However, the allocation rate is different for the two support departments because they have different cost pool amounts.

The final step in the allocation process is to calculate the actual dollar allocation to each of the patient services departments, which is shown in Exhibit 6.7. The support departments are listed in the first column, along with the applicable allocation rate, while the patient services departments are listed across the top. To illustrate the calculations, consider the routine care department. It produces $16,000,000 in patient services revenue, and the overhead allocation rate for financial services is $0.05556 per dollar of patient services revenue, so the allocation for such support is 0.05556 . $16,000,000 = $888,960. Furthermore, routine care has 199,800 square feet of space; with a facilities rate of $12.64 per square foot, its allocation for facilities support is $12.64 . 199,800 = $2,525,472.

The allocations to the routine care department for housekeeping, general administration, and human resources support shown in Exhibit 6.7 were calculated similarly. The end result is that $8,644,050 out of a total of $13,850,000 of the indirect (overhead) costs of Kensington Hospital are allocated to routine care. Routine care also has direct costs of $5,500,000, so the full (total) costs of the department, including both direct and indirect, are $8,644,050 + $5,500,000 = $14,144,050. The cost allocations and total cost calculations for the laboratory and radiology departments shown in Exhibit 6.7 were done in a similar manner.

For general management purposes, understanding the mechanics of the allocation is less important than recognizing the value of choosing effective cost drivers. The cost driver for housekeeping services (i.e., the number of service hours provided) is good in the sense that it reflects the true level of effort expended by this department in support of the patient services departments.

The patient services department heads are being fairly charged for these services, and more important, patient services department heads can take actions to lower the allocated amounts by reducing the amount of housekeeping services used.

EXHIBIT 6.7 Kensington Hospital: Final Allocations Patient Services Department Support Department (allocation rate) Routine Care Laboratory Radiology Financial Services ($0.05556) . $16,000,000 = $ 888,960 . $5,000,000 = $ 277,800 . $6,000,000 = $ 333,360 Facilities ($12.64) . 199,800 = 2,525,472 . 39,600 = 500,544 . 61,200 = 773,568 Housekeeping ($17.58) . 76,000 = 1,336,080 . 6,000 = 105,480 . 9,000 = 158,220 Administration ($0.432) . 5,709,000 = 2,466,288 . 2,035,000 = 879,120 . 2,439,000 = 1,053,648 Personnel ($0.250) . 5,709,000 = 1,427,250 . 2,035,000 = 508,750 . 2,439,000 = 609,750 Total indirect costs $ 8,644,050 $ 2,271,694 $ 2,928,546 Direct costs $ 5,500,000 $ 3,300,000 $ 2,800,000 Total costs $ 14,144,050 $ 5,571,694 $ 5,728,546 Total indirect costs = $8,644,050 + $2,271,694 + $2,928,546 = $13,844,290.

Total costs = $14,144,050 + $5,571,694 + $5,728,546 = $25,444,290.

Note: Because of rounding in the allocation process, the totals here differ slightly from the values contained in Exhibit 6.3.

In closing this illustration, note how Exhibit 6.7, after the allocation process, reconciles with Exhibit 6.3, before the allocation process. First, as shown in Exhibit 6.3, total support services (overhead) costs are $13,850,000.

This is the same amount (except for a rounding difference) shown in Exhibit 6.7 as the total overhead allocated to the patient services departments:

$8,644,050 (to routine care) + $2,271,694 (to laboratory) + $2,928,546 (to radiology) = $13,844,290. The total after-allocation costs of $25,444,290 shown in Exhibit 6.7 also equal the original forecast for total costs in Exhibit 6.3 of $25,450,000 (again, except for a rounding difference).

SELF-TEST 1. Briefly outline the allocation procedures used by Kensington QUESTIONS Hospital.

2. What underlying characteristic creates a good cost driver?

3. What are the two properties of an effective cost driver?

4. What is the most important organizational benefit derived from the selection of an effective cost driver?

Cost Allocation and Departmental Profitability At this point, you must be thinking that Kensington Hospital spent a lot of time and effort in the cost allocation process. Was it all worth it? What did Kensington s managers gain from the effort? Well, the answer is this: They now know the profitability of the patient services departments when all costs, including indirect costs, are considered.

Exhibit 6.8 summarizes the profitability of Kensington s patient services departments when viewed from both direct cost and total (full) cost perspectives.

In effect, Exhibit 6.8 contains projected profit-and-loss statements for the patient services departments for 2016. Sections 1 and 2 list projected revenues and projected direct costs, respectively, of the three patient services departments. Then, Section 3 lists the profitability of each department when only direct costs are considered. As you see, all three patient services departments are profitable in this situation, which may make everyone happy, at least temporarily.

Note that the values in parentheses in Section 3 are profit margins, defined as Profit Revenues. For example, the profit margin listed for the routine care department is $10,500,000 $16,000,000 = 0.656 = 65.6%, which can be interpreted as each dollar of revenues leading to 65.6 cents in profits when only direct costs are considered. The higher the margin, the better (more profitable) the department. Profit margins make it easier for healthcare managers to compare the relative profitability of departments. Based on the margin values in Section 3, we see that the aggregate profit of all patient services departments is 57.0 percent, so routine care is doing better than average, EXHIBIT 6.8 Kensington Hospital: 2016 Patient Services Department Revenue, Cost, and Profitability Projections (margins listed in parentheses) 1. Projected Revenues Routine Care Laboratory Radiology Total revenues 2. Projected Direct Costs Routine Care Laboratory Radiology Total direct costs 3. Projected Profit on Direct Costs Routine Care Laboratory Radiology Aggregate profit on direct costs 4. Projected Indirect Costs Routine Care Laboratory Radiology Total indirect costs 5. Projected Profit on Total Costs Routine Care Laboratory Radiology Aggregate profit on total costs $ 16,000,000 5,000,000 6,000,000 $27,000,000 $ 5,500,000 3,300,000 2,800,000 $ 11,600,000 $ 10,500,000 (65.6%) 1,700,000 (34.0) 3,200,000 (53.3) $15,400,000 (57.0%) $ 8,644,050 2,271,694 2,928,546 $13,844,290 $ 1,855,950 (11.6%) .571,694 (.11.4) 271,454 (4.5) $ 1,555,710 (5.8%) Note: Because of rounding in the allocation process, some of the values here differ slightly from the values contained in Exhibit 6.3.

radiology is slightly worse than average, and laboratory is doing much worse than average. Still, all departments are profitable.

Section 4 of Exhibit 6.8 lists the indirect costs allocated to each patient services department, which were taken from Exhibit 6.7, and Section 5 lists patient services department profitability when total (full) costs, including direct and indirect, are considered. Now, based on Section 5 data, we see that one of the three patient services departments, laboratory, is expected to experience an 11.4 percent profit margin loss in 2016. In addition, the true profitability of the patient services departments is not nearly as high as shown in Section 3 when only direct costs were considered. Now, the aggregate (average) margin is only 5.8 percent as compared to 57.0 percent when only direct costs are considered.

The real moral of this story is that looking at departmental profitability solely on the basis of direct costs, although valuable for some purposes, does not give a complete picture of each department s financial status. To obtain the best measure of departmental profitability, it is necessary to include both direct and indirect costs in the analysis.

Changing to a More Effective Cost Driver The Kensington Hospital example illustrated the direct method of cost allocation. In this section, we illustrate the benefits of moving from a poor cost driver to a better one.

Kensington historically has allocated the $1,500,000 in financial services costs on the basis of the dollar volume of patient services provided. However, it was widely recognized that this driver was not highly correlated with the actual amount of overhead services provided by the financial services department to each patient services department, and hence it was not perceived by the patient services department heads as being fair. More important, it did not create an incentive for overhead cost reduction because patient services department heads would not reduce the amount of services provided (and hence reduce revenues) just to lower their overhead allocations.

A thorough analysis of the work done by the financial services department indicated that its primary task in support of the patient services departments is generating third-party payer billings and collecting the payments on those bills. Thus, Kensington s managers concluded that the cost of providing financial services is more highly correlated with the number of bills generated than with patient services revenues, so number of bills was chosen as the new cost driver.

Exhibit 6.9 contains the new cost allocations for financial services as well as a comparison with the allocations under the old (patient services revenue) driver. Note that the allocations have changed substantially. Because For Your Consideration Profitability and Bonuses As shown in Exhibit 6.8, the profitability of Kensington Hospital s three patient services departments is forecasted for 2016 on the basis of direct costs and full (total) costs, which include indirect costs. When only direct costs are considered, the ranking of departmental profitability (from high to low) is routine care, radiology, and laboratory.

Furthermore, all departments are profitable. However, when indirect costs are added to the mix, the order stays the same but one of the departments (laboratory) becomes unprofitable.

Now assume that Kensington compensates its department heads using a base salary plus bonus system, with the bonus tied to department profitability as measured by profit margin. If the department is unprofitable, there is no bonus, and the higher the profitability, the greater the bonus. Kensington s chief financial officer argues that bonuses should be based on total costs.

After all, she says, that s what really counts. On the other hand, the laboratory department head had this to say: We patient services department bosses have no control whatsoever of overhead costs, so why should we be held responsible for them? What do you think? Should bonuses be based on profitability measured using only direct costs, or should they be based on total costs?

Should bonuses be tied to profitability at all, or should they be tied to patient outcomes or some other metric?

EXHIBIT 6.9 Kensington Hospital:

New Financial Services Department Allocations the average amount of a routine care department bill is much higher than the average amounts of laboratory and radiology department bills, the routine care department has significantly fewer bills than the other patient services departments in spite of its significantly higher revenues. Thus, the new financial services allocation is much lower than the amount under the old driver for the routine care department, but it is much higher for the laboratory and radiology departments.

The move to a different cost driver represents more than just change for the sake of change. It represents an attempt by Kensington s managers to base the allocation of financial services costs on the actual amount of support provided by the financial services department to each patient services department.

By doing so, the overhead allocation will have economic meaning and hence will be perceived by patient services department heads as being fair.

Furthermore, the new cost driver could encourage patient services department heads to reduce their utilization of financial services support and lower Kensington s overhead costs, such as by consolidating bills in a way that would result in fewer bills.

In spite of the improvement that results from the change, the new cost driver is not perfect. Other changes could be made to improve the allocation even more. For example, the financial services department performs tasks other than billing, such as generating numerous reports for the organization, including financial statements and budget reports. Indeed, the department Utilization of Financial Services Patient Services Department Routine Care Laboratory Radiology Total Allocation Rate Number of Bills Required 3,200 60,300 36,500 100,000 $1,500,000 100,000 = $15.00 per bill.

Allocations New Old Difference Routine Care $15.00 . 3,200 = $ 48,000 $ 888,960 $ 840,960 Laboratory 15.00 . 60,300 = 904,500 277,800 +626,700 Radiology 15.00 . 36,500 = 547,500 333,360 +214,140 Total $1,500,000 $1,500,000 $ 0 has one analyst whose full-time job is creating and interpreting budget reports (budgeting is discussed in detail in Chapter 8). A better allocation of financial services department costs, therefore, may require that financial services costs be separated into two (or more) pools, each with its own cost driver. If this were done, some proportion of the department s total costs of $1,500,000 would be assigned to report preparation, and a separate cost driver would be identified to allocate these costs to the patient services departments.

Even though a better cost driver may be developed, the change that has taken place is still meaningful. Cost accounting studies generally have shown that the relationship between overhead cost consumption and volume, measured either by revenues or units of service, is not very strong. Indeed, use of volume as the cost driver often results in systematic, as opposed to random, errors in cost allocation. Volume-based allocation schemes create a bias against larger revenue-producing departments by overallocating their costs, while the overhead costs of smaller revenue-producing departments are underallocated. This bias occurs primarily because a volume-based cost driver fails to recognize the economies of scale inherent in larger departments in the utilization of overhead services. For example, it probably costs no more to bill a third-party payer for $5,000 than it does to bill for $500, as far as the resources required to produce and transmit the bill and to monitor and collect the payment. Yet a revenue-based allocation scheme would allocate more financial services costs to a patient services department with relatively high charges than to a department with relatively low charges that had exactly the same patient load and the same number of bills.

Although the cost driver (allocation) change made above appears to be a zero-sum game (i.e., one patient services department benefits while the other two lose), the decision to make the change was not really difficult for Kensington s senior managers. With a better cost driver, the hospital has moved to a more equitable allocation of financial services costs, even though it may not seem that way to the department heads who saw their allocated amounts increase. However, those departments with allocation increases for financial services (laboratory and radiology) are now being allocated their fair share of those overhead expenses. They were formerly being subsidized by the routine care department, whose allocation was too high.

In addition, the heads of revenue-producing departments can now reap the benefits of their efforts to make the billing process more efficient. If the laboratory department director does not like the new higher allocation, he or she can do something about it generate fewer bills. The task must be done without lowering the total billing amount, which may not be easy. In fact, the effort will probably have to be done jointly with the financial services department and perhaps with the cooperation of third-party payers.

The critical point is that patient services department heads are now motivated to participate in making the billing process more efficient. If the laboratory department can cut the number of bills in half, it can cut its allocation in half. If other patient services departments can do this, Kensington will eventually discover that it can get along with fewer resources devoted to financial services and can thus reduce total overhead costs. A reduction in overhead costs is the ultimate benefit of moving to a better cost driver. A well-chosen cost driver makes patient services department heads accountable for the use of support department resources, which is the starting point in gaining control of overhead costs within any organization.

SELF-TEST QUESTIONS 1. What are the advantages of changing from a poor cost driver to a better one?

2. What are the costs involved in the change?

3. Why is good cost allocation critical to good decision making?

Final Thoughts on Cost Allocation This chapter has been more mechanical than conceptual, but readers should not lose sight of the basic principles of cost allocation. First, cost allocation is Industry Practice Overhead Ratio A Shortcut to Overhead Cost Allocation In this chapter, we discussed the traditional method of overhead cost allocation. In essence, overhead costs were grouped into cost pools, appropriate drivers were chosen, allocation rates were calculated, and user department allocations were estimated based on the amount of the cost driver consumed.

A simpler method of cost allocation involves the use of a ratio called the overhead ratio, which is defined generically as Overhead costs Revenue.

The specific definition of this ratio depends on the setting in which it is used: for example, hospital versus medical practice versus long-term care facility.

The values of these ratios also vary by type of provider but usually fall in the range of 50 to 70 percent.

Here s how the shortcut works. Assume that an orthopedic practice has total revenues (continued) driven by the need to measure costs and, for revenue centers, profits at the department level. Thus, the primary goal of cost allocation is to allocate all support department costs to those departments that create the need for those costs, typically the patient services departments. In general, cost drivers should be chosen that have a high correlation with the amount of overhead services consumed the greater the consumption of services, the higher the allocation.

In addition, to be effective, cost drivers must meet two tests. First, they must create an allocation system that is perceived as being fair; managers must believe that the overhead allocations to their departments truly reflect the amount of overhead services consumed. Second, the allocation process should foster cost reduction within the organization.

To ensure fairness and cost control incentives, cost drivers must reflect those factors that truly influence the amount of overhead services consumed.

In any organization, the better the cost allocation system meets these two tests, the better the managerial decisions will be.

After all, costs play a major role in many provider decisions, such as what prices to charge, what services to offer, and how much clinical managers should be paid. If the cost allocation system is faulty, those decisions may be flawed and the financial condition of the business and employee morale will be degraded. Although the allocation process may seem rather mundane, the more confidence that all managers have in its validity, the better the organization will function.

1. What is the goal of cost allocation?

(continued from previous page) of $10,000,000 and total overhead costs of $5,000,000. Using the generic definition of the overhead ratio, the practice s overhead ratio is $5,000,000 $10,000,000 = 0.50, or 50%. Now assume that the clinical services core, one of the divisions of the practice, has revenues of $6,000,000. To estimate the overhead allocation for that division, simply multiply the division s revenues by the overhead ratio: $6,000,000.0.50 = $3,000,000. Thus, based on this down and dirty allocation, the clinical service core has $6,000,000.$3,000,000 = $3,000,000 available to cover the division s direct costs.

What do you think about this shortcut method of cost allocation? What are its advantages and disadvantages relative to the traditional method described in this chapter?

SELF-TEST QUESTIONS 2. What are the two primary tests that good cost allocation processes pass?

3. Why is the cost allocation process important to health services managers?

Key Concepts This chapter focuses on costing at the department level, which requires cost allocation. The key concepts are as follows:

Direct costs are the unique and exclusive costs of one unit of an organization, such as the labor costs of one department, and therefore are relatively easy to measure.

Indirect costs, in contrast, are inherently difficult to measure because they involve a shared resource of the organization as a whole, such as general administration costs.

The goal of cost allocation is to assign the overhead costs of an organization to the departments that cause them to be incurred (the patient services departments).

(continued) (continued from previous page) The motivation to improve cost allocation systems comes largely from the increasing pressure to optimize economic performance within health services organizations and the resultant managerial incentive systems that focus on financial performance.

A cost pool is a dollar amount of overhead services to be allocated.

In general, a cost pool consists of the total costs of one support department. However, under some circumstances, it may be better to divide the costs of a support department into multiple cost pools.

A cost driver is the basis for making allocations from a cost pool.

The identification of effective cost drivers is essential to a sound cost allocation system.

Cost drivers are chosen on the basis of their correlation with the amount of overhead services used. The greater the overhead service utilization, the greater the cost allocation.

An effective cost driver will be perceived by department heads as being fair and will promote cost reduction within the organization.

There are three primary methods for cost allocation: direct, reciprocal, and step-down.

The direct method recognizes no intrasupport department services.

Thus, support department costs are allocated exclusively to patient services departments.

The reciprocal method recognizes all intrasupport department services. Unfortunately, the reciprocal method is the most complex to implement and explain to department heads.

The step-down method represents a compromise that recognizes some of the intrasupport department services.

Regardless of the allocation method, all costs eventually end up in the patient services departments.

Although this chapter contains a great deal of detail, the most important point to remember is that a sound cost allocation system is required for making good pricing (and service) decisions, which is the topic of discussion in the next chapter.

Questions 6.1 What are the primary differences between direct and indirect costs?

6.2 What is the goal of cost allocation?

6.3 a. What are the three primary methods of cost allocation?

b. What are the differences among them?

6.4 a. What is a cost pool?

b. What is a cost driver?

c. How is the cost allocation rate determined?

6.5 Under what circumstances should an overhead department be divided into multiple cost pools?

6.6 Effective cost drivers, and hence the resulting allocation system, must have what two important attributes?

6.7 Briefly describe (illustrate) the cost allocation process. (To keep things simple, use the direct method for your illustration.) 6.8 Which is the better cost driver for the costs of a hospital s financial services department: patient services department revenues or number of bills generated? Explain your rationale.

Problems 6.1 The housekeeping services department of Ruger Clinic, a multispecialty practice in Toledo, Ohio, had $100,000 in direct costs during 2015. These costs must be allocated to Ruger s three revenue-producing patient services departments using the direct method. Two cost drivers are under consideration: patient services revenue and hours of housekeeping services used. The patient services departments generated $5 million in total revenues during 2015, and to support these clinical activities, they used 5,000 hours of housekeeping services.

a. What is the value of the cost pool?

b. What is the allocation rate if patient services revenue is used as the cost driver?

hours of housekeeping services is used as the cost driver?

6.2 Refer to Problem 6.1. Assume that the three patient services departments are adult services, pediatric services, and other services.

The patient services revenue and hours of housekeeping services for each department are as follows:

Department Revenue Housekeeping Hours Adult Services $3,000,000 1,500 Pediatric Services 1,500,000 3,000 Other Services 500,000 500 Total $5,000,000 5,000 a. What is the dollar allocation to each patient services department if patient services revenue is used as the cost driver?

b. What is the dollar allocation to each patient services department if hours of housekeeping support is used as the cost driver?

c. What is the difference in the allocation to each department between the two drivers?

d. Which of the two drivers is better? Why?

The following data pertain to problems 6.3 through 6.6:

St. Benedict s Hospital has three support departments and four patient services departments. The direct costs to each of the support departments are as follows:

General Administration $2,000,000 Facilities 5,000,000 Financial Services 3,000,000 Selected data for the three support and four patient services departments are shown below:

Patient Space Services (square Housekeeping Salary Department Revenue feet) Labor Hours Dollars Support:

General 10,000 2,000 $ 1,500,000 Administration Facilities 20,000 5,000 3,000,000 Financial Services 15,000 3,000 2,000,000 Total 45,000 10,000 $ 6,500,000 Patient Services:

Routine Care $30,000,000 400,000 150,000 $12,000,000 Intensive Care 4,000,000 40,000 30,000 5,000,000 Diagnostic Services 6,000,000 60,000 15,000 6,000,000 Other Services 10,000,000 100,000 25,000 7,000,000 Total $50,000,000 600,000 220,000 $30,000,000 Grand Total $50,000,000 645,000 230,000 $36,500,000 6.3 Assume that the hospital uses the direct method for cost allocation.

Furthermore, the cost driver for general administration and financial services is patient services revenue, while the cost driver for facilities is space utilization.

a. What are the appropriate allocation rates?

b. Use an allocation table similar to Exhibit 6.7 to allocate the hospital s overhead costs to the patient services departments.

6.4 Assume that the hospital uses salary dollars as the cost driver for general administration, housekeeping labor hours as the cost driver for facilities, and patient services revenue as the cost driver for financial services. (The majority of the costs of the facilities department stem from the provision of housekeeping services.) a. What are the appropriate allocation rates?

b. Use an allocation table similar to the one used for Problem 6.3 to allocate the hospital s overhead costs to the patient services departments.

c. Compare the dollar allocations with those obtained in Problem 6.3. Explain the differences.

d. Which of the two cost driver schemes is better? Explain your answer.

6.5 (Hint: The step-down method of cost allocation, reviewed in this problem, is covered in detail in the Chapter 6 Supplement.) Now assume that the hospital uses the step-down method for cost allocation, with salary dollars as the cost driver for general administration, housekeeping labor hours as the cost driver for facilities, and patient services revenue as the cost driver for financial services. Assume also that the general administration department provides the most services to other support departments, followed closely by the facilities department. The financial services department provides the least services to the other support departments.

a. Use an allocation table to allocate the hospital s overhead costs to the patient services departments.

b. Compare the dollar allocations with those obtained in Problem 6.4. Explain the differences.

c. Is the direct method or the step-down method better for cost allocation within St. Benedict s? Explain your answer.

6.6 Return to the direct method of cost allocation and use the same cost drivers as specified in Problem 6.4 for the general administration and facilities departments. However, assume that $2,000,000 of financial services costs is related to billing and managerial reporting and $1,000,000 is related to payroll and personnel management activities.

a. Devise and implement a cost allocation scheme that recognizes that the financial services department has two widely different functions.

b. Is there any additional information that would be useful in completing Part a of this problem?

c. What are the costs and benefits to St. Benedict s of creating two cost pools for the allocation of financial services costs?

The following data pertain to problems 6.7 and 6.8:

St. Luke s Hospital has three support departments and four patient services departments. The direct costs to each of the support departments are as follows:

General Administration $4,000,000 Maintenance 5,000,000 Employee Benefits 4,000,000 Selected data for the three support and four patient services departments are shown below:

Number of Patient Space Full-Time Services (square Equivalent Salary Department Revenue feet) Employees Dollars Support:

General 8,000 15 $ 2,500,000 Administration Maintenance 10,000 75 3,500,000 Employee Benefits 7,000 50 3,000,000 Total 25,000 140 $ 9,000,000 Patient Services:

Routine Care $40,000,000 500,000 700 $18,000,000 Intensive Care 7,000,000 45,000 200 6,000,000 Obstetrics Services 4,000,000 35,000 150 4,000,000 Other Services 12,000,000 200,000 400 8,000,000 Total $63,000,000 780,000 1,450 $36,000,000 Grand Total $63,000,000 805,000 1,590 $45,000,000 6.7 Assume that the hospital uses the direct method for cost allocation.

Furthermore, the cost driver for general administration is patient services revenue, the cost driver for maintenance is space utilization, and the cost driver for employee benefits is the number of full-time equivalent employees.

a. What are the appropriate allocation rates?

b. Use an allocation table similar to Exhibit 6.7 to allocate the hospital s overhead costs to the patient services departments.

6.8 Assume that the hospital uses salary dollars as the cost driver for general administration and employee benefits, and space utilization as the cost driver for maintenance.

a. What are the appropriate allocation rates?

b. Use an allocation table similar to Exhibit 6.7 to allocate the hospital s overhead costs to the patient services departments.

c. Compare the dollar allocations with those obtained in Problem 6.7. Explain the differences.

Resources For a more in-depth treatment of cost measurement in health services organizations, see Finkler, S. A., D. M. Ward, and T. D. Calabrese. 2011. Accounting Fundamentals for Health Care Management. Sudbury, MA: Jones & Bartlett.

Young, D. W. 2014. Management Accounting in Health Care Organizations. New York: Jossey-Bass.

In addition, see Cooper, R., and T. R. Kramer. 2008. The Problem with Revenue-Based Cost Assignment. MGMA Connexion (April): 44 47.

Meeting, D. T., and R. O. Harvey. 1998. Strategic Cost Accounting Helps Create a Competitive Edge. Healthcare Financial Management (December): 43 51.

Muise, M. L., and B. A. Amoia. 2006. Step Up to the Step-Down Method. Healthcare Financial Management (May): 72 77.

Young, D. W. 2008. Profit Centers in Clinical Care Departments: An Idea Whose Time Has Gone. Healthcare Financial Management (March): 66 71.

6 STEP-DOWN METHOD ILLUSTRATION In the chapter, we noted that there are several methods for allocating overhead costs to user departments. We discussed three methods (direct, step-down, and reciprocal) but only illustrated the direct method. (In fact, there is a fourth method, double apportionment, which is not covered in this book.) In this supplement, we use Fargo Medical Associates, which has two support departments (financial services and general administration) and two patient services departments (home care and diagnostic services), to illustrate the step-down method. In the illustration of the direct method presented in Chapter 6, support department costs were allocated solely to the patient services departments, with no recognition of the provision of intrasupport department services. Here we recognize, at least partially, that support departments provide services to one another.

The allocation is summarized in Exhibit S6.1. Under the step-down method, a new decision must be made: Which of Fargo s two support departments is the most primary? That is, which support department provides more services to the other? Fargo s managers, after some analysis, concluded that the general administration department provides more support to the financial services department than the financial services department does to general administration. Thus, in the step-down process, the first support department to be allocated is general administration.

In the direct method, the $312,425 in general administration direct costs would be allocated only to the two patient services departments. However, in the step-down method, the $312,425 will be allocated not only to the two patient services (revenue-producing) departments but also to financial services, the other support department. Thus, the initial allocation in the top section of Exhibit S6.1 shows that general administration costs are allocated to three departments: the financial services department in addition to the home care and diagnostic services departments.

The allocation of general administration costs is made using the payroll costs of the receiving departments as the cost driver. The total payroll for Fargo, less the general administration department, is $4,307,281, so the $312,425 in general administration costs are allocated at a rate of $312,425 $4,307,281 = $0.072534 per dollar of payroll. Based on this allocation rate, the allocation of general administration costs to the financial services department is 0.072534 . $505,321 = $36,653, while the allocation to the home care department is 0.072534 . $3,376,845 = $244,936. The key point here is that under the EXHIBIT S6.1 Initial Allocation of Administration Department Costs: Fargo Medical Administration costs = $312,425 Associates:

Allocation rate = $312,425 $4,307,281 = $0.072534 per dollar of payroll Step-Down Financial Diagnostic Allocation of Services Home Care Services Total Administration Payroll costs $505,321 $3,376,845 $425,115 $4,307,281 and Financial Percent of total 11.7% 78.4% 9.9% 100.0% Services Costs Allocation $ 36,653 $ 244,936 $ 30,835 $ 312,424 Subsequent Allocation of Financial Services Department Costs:

Financial Services costs = $665,031 + $36,653 = $701,684 Allocation rate = $701,684 14,456 = $48.539 per bill Number of bills 10,508 3,948 14,456 Percent of total 72.7% 27.3% 100% Allocation $ 0 $ 510,051 $191,632 $ 701,683 Chapter 6 Supplement step-down method, overhead costs are allocated both to other support departments and to patient services departments, while under the direct method, overhead costs are allocated only to patient services departments.

Now that general administration costs have been allocated across both support and patient services departments, the role of the general administration department in the allocation process is completed. The next step is to allocate financial services costs, which now include both direct costs and the indirect costs from the allocation of general administration overhead. The allocation of financial services department costs is shown in the bottom section of Exhibit S6.1. Although the financial services department has only $665,031 in direct costs, the total amount to be allocated is $701,684 because it includes $36,653 of allocated general administration overhead. Because some of the costs of general administration now flow through the financial services department, the allocation of financial services costs to the patient services departments is somewhat greater than it would be using the direct method. However, the allocation of general administration costs to the patient services departments is less under the step-down method than under the direct method because some costs that had been allocated directly to patient services departments are now allocated to the financial services department, another support department.

The step-down method of allocation is somewhat more complicated than the direct method. However, a good managerial accounting system can accomplish either allocation method quite easily. The real disadvantage of the step-down method is that it is more difficult for department heads to understand, especially in large, complex organizations. Still, for the reasons discussed SELF-TEST QUESTIONS in Chapter 6 (fairness and cost control), managers want the best possible allocation system. In addition, Medicare requires that providers use the step- down method when reporting Medicare costs. Thus, in practice, the use of the step-down method dominates the others.

1. What is the primary difference between the direct and step-down methods of cost allocation?

2. Why might organizations adopt a more complicated allocation system rather than use the direct method?

Chapter 6 Supplement 7 SERVICE LINE COSTING AND PRICING Learning Objectives After studying this chapter, readers will be able to Describe the following methods used to cost individual services:

cost-to-charge ratio (CCR), relative value unit (RVU), activity- based costing (ABC), and time-driven activity-based costing (TDABC).

Describe the difference between providers as price setters and providers as price takers, and how this difference affects pricing decisions.

Explain the difference between full cost pricing and marginal cost pricing.

Describe the concept of target costing and its importance to health services managers.

Explain how accounting and actuarial information are used to make pricing decisions.

Conduct basic analyses to set prices and determine service offerings under fee-for-service and capitation payment methodologies.

Introduction In our discussion of managerial accounting, we have examined costing at the organizational level (along with profit [CVP] analysis) and costing at the department level (and its major feature, cost allocation). Although these are important concepts, the holy grail of cost estimation is costing at the service or individual patient level. Thus, we begin this chapter with a discussion of some of the techniques used (and proposed) to estimate costs at the micro level.

Among the most important uses of managerial accounting data is establishing a price for a particular service or, given a price, estimating whether or not the service will be profitable. For example, in a charge-based environment, managers of healthcare providers must set prices on the services that their organizations offer. Managers also must determine whether or not to offer volume discounts to valued payer groups, such as managed care plans or business coalitions, and how large these discounts should be. Such decisions are called pricing decisions.

In many situations, insurers, especially governmental and managed care plans, dictate the reimbursement amount. Therefore, health services managers are not setting prices but must decide whether or not the payment is sufficient to assume the risks associated with providing services to the covered populations.

These decisions are called service decisions. Because service decision analyses are similar to pricing decision analyses, the two types of analyses are discussed jointly. In addition, service decisions are discussed in detail in the Chapter 7 Supplement. Of course, one of the key inputs into both pricing and service decisions is the cost of the services under consideration, and hence the chapter begins with costing at the service and patient level.

Pricing and service decisions affect a business s revenues and costs and hence its financial condition, which ultimately determines the business s longterm viability. The importance of such decisions is easy to understand. In essence, pricing and service decisions determine both the strategic direction of the business and the ability of the organization to survive, prosper, and meet the needs of the populations served.

Service Line Costing As discussed in chapters 1 and 2, one of the key elements of healthcare reform is cost reduction at the provider level. This focus is paramount at accountable care organizations (ACOs), in which the goal is to create capitated contracts that encourage providers to shift attention from optimizing reimbursement to increasing quality while containing costs. In order to contain costs, as well as make better decisions when negotiating capitated contracts, it is necessary to know (or at least have a reasonable idea of) costs at the individual service or even patient level.

Several methods are used to estimate costs at the service level. In this section, we discuss three of the methods: cost-to-charge ratio (CCR), relative value unit (RVU), and activity-based costing (ABC). In addition, we introduce time-driven activity-based costing (TDABC), a relatively new approach that focuses on costing multiple services provided to individual patients.

The Setting To illustrate costing at the service level, consider Tarheel Family Practice (TFP), a large physician group that provides multiple services to its patient population. TFP is organized into five departments, one of which is the routine services department.

For ease of discussion, we assume that the department provides only two services: X and Y. Data relevant to our illustrations are summarized in Exhibit 7.1.

The department has 10,000 visits annually, split evenly between the two services. The department s total annual costs come to $1,027,500, with EXHIBIT 7.1 Service X Service Y Total Tarheel Family Annual volume (visits) RVUs per visit Annual costs:

5,000 10 5,000 18 10,000 Practice:

Selected Routine Direct $242,500 $ 485,000 $ 727,500 Services Indirect (overhead) 300,000 Department Total costs $1,027,500 Data Annual charges $700,000 $1,400,000 $2,100,000 Annual revenues $400,000 $ 900,000 $1,300,000 (reimbursements) $300,000 of department overhead (including both TFP overhead allocated to the department and department overhead that supports both services), $242,500 in direct costs of Service X, and $485,000 in direct costs of Service Y. Finally, the department s charges (based on chargemaster prices) total $2,100,000, while actual revenues (reimbursements) total $1,300,000, split between the two services as shown in Exhibit 7.1. Before we begin discussing the individual costing methods, we want to emphasize that this example is highly simplified. Its purpose is merely to give you a flavor of the alternative methods available for costing individual services.

Cost-to-Charge Ratio Method The cost-to-charge ratio (CCR) method is the most basic of the three methods for costing individual services. The CCR method is based on two assumptions:

(1) The indirect costs allocated to the services constitute a single cost that is proportional across all services provided. In other words, each service consumes indirect costs in the same proportion as the department as a whole.

(2) Charges, or alternatively reimbursement rates, reflect the level of intensity of the service provided and, hence, the resource use, including both TFP and department overhead.

We begin by focusing on charges. With indirect (overhead) costs of $300,000 supporting total charges of $2,100,000, the cost-to-charge ratio is CCR = Indirect costs Total charges = $300,000 $2,100,000 = 0.143 = 14.3%.

Key Equation: Cost-to-Charge Ratio Suppose a nursing home has annual indirect (overhead) costs of $1,500,000 and $4,500,000 in charges. The cost-to-charge ratio (CCR) is calculated as follows:

(continued) Cost-to-charge ratio (CCR) A ratio used to estimate the overhead costs of individual services.

Defined as the ratio of indirect (overhead) costs to charges (or alternatively, to service revenues).

(continued from previous page) CCR = Indirect costs Total charges = $1,500,000 $4,500,000 = 0.333 = 33.3%.

Note that the cost-to-charge ratio can also be defined using total revenues (reimbursements) in place of charges.

Once the CCR has been calculated for the department, it is used to estimate the overhead costs for each individual service: Service overhead costs = CCR . Service charges. Thus, the overhead cost allocations for services X and Y are:

Service X: 0.143 . $700,000 = $100,100.

Service Y: 0.143 . $1,400,000 = $200,200.

The total amount of overhead allocated to the two services is $100,100 + $200,200 = $300,300, which, except for a rounding difference, equals the $300,000 in total indirect costs for the department.

To obtain the full costs of each service line, merely add the direct costs to the amounts allocated for overhead: Full (total) service costs = Direct cost + Indirect cost. The results are:

Service X: $242,500 + $100,100 = $342,600.

Service Y: $485,000 + $200,200 = $685,200.

As a check, the full costs of both services total $342,600 + $685,200 For Your Consideration Charges Versus Revenues in the CCR Method The illustration of the cost-to-charge ratio (CCR) method of costing at the service level presented two possible approaches: One uses charges as the basis of the allocation, and one uses revenues (reimbursements). Although the results between the two varied by only small percentages ( 2.25 percent and 1.12 percent), in other situations the variation could be much larger.

For healthcare providers using the CCR method, and many do, the choice must be made (continued) = $1,027,800, which again, except for a rounding difference, equals the total costs of the department.

Finally, to obtain the average cost per visit for each service, merely divide total costs by number of visits:

Service X: $342,600 5,000 = $68.52.

Service Y: $485,000 5,000 = $97.00.

Note that revenues can be used as an alternative to charges in the CCR method.

The procedure is the same as described above, but now revenues are used to calculate the CCR. Here is the calculation:

With indirect (overhead) costs of $300,000 supporting total revenues (reimbursements) of $1,300,000, the cost-to-charge ratio is CCR = $300,000 $1,300,000 = 0.231 = 23.1%. Using this new value for the CCR, and revenues in lieu of charges, the overhead cost allocations are:

Service X: 0.231 . $400,000 = $92,400.

Service Y: 0.231 . $900,000 = $207,900.

Finally, to obtain the full costs of each service line, the calculations are:

Service X: $242,500 + $92,400 = $334,900.

Service Y: $485,000 + $207,900 = $692,900.

As a check, the full costs of both services total $334,900 + $692,900 = $1,027,800, which again, except for a round (continued from previous page) as to which approach to use. (For some Medicare calculations, the use of charges is required; however, for internal use, providers may use either charges or revenues.) In theory, the choice should reflect the metric (charges or revenues) that best mimics the relationship to the amount of overhead resources consumed. But is that metric charges or revenues? Charges supposedly reflect the underlying costs of the service the higher the charges, the higher the costs. However, there is much anecdotal evidence (e.g., the $10 aspirin) indicating that charges are not a good reflection of costs. On the other hand, are revenues a better reflection of costs? Private insurers, Medicare, and Medicaid often have large differences in reimbursement amounts for the same service.

What do you think? Should the CCR method use charges or revenues as the metric? What justification is there to support your answer?

ing difference, equals the total costs of the department.

Exhibit 7.2 contains a comparison of the results. In this particular illustration, there is little difference between the allocation results using charges as the basis for the allocation and using revenues (reimbursements) as the basis.

Relative Value Unit Method In contrast to the CCR method, which ties overhead resource consumption Relative value unit to charges (or revenues), the relative value unit (RVU) method ties the use (RVU) method A method for of overhead resources to the complexity and time required for each service. In estimating the other words, this method uses the intensity of the service provided, as mea overhead costs of sured by relative value units (RVUs), as the basis for allocating overhead. As individual services we discussed in Chapter 2, its use in healthcare pricing and reimbursement is based on the intensity of the influenced primarily by the resource-based relative value scale (RBRVS), which service provided uses RVUs to set Medicare payments for physician services.

as measured by To begin our illustration of the RVU method, assume that a study by the RVUs.

medical director of Tarheel Family Practice identified the number of RVUs required to perform each service. The result was the assignment of 10 RVUs for Service X and 18 RVUs for Service Y. (RVU estimates for many healthcare services are available from several sources, including Medicare and professional associations.) The RVU analysis is summarized in Exhibit 7.3. First, the RVUs for each service were multiplied by the annual volume, and the products were summed to obtain the total RVUs for the department 140,000. Now with department overhead costs of $300,000 to support 140,000 RVUs, the overhead cost per EXHIBIT 7.2 CCR Method:

Comparison of Results Using Charges and Revenues Traditional costing The top-down approach to costing that first identifies costs at the department level and then (potentially) assigns these costs to individual services.

Service X Service Y Total Allocation Based on Charges:

Direct Indirect Total Allocation Based on Revenues:

Direct Indirect Total Difference $242,500 100,100 $342,600 $242,500 92,400 $334,900 .$ 7,700 2.25% $485,000 200,200 $685,200 $ 727,500 300,300 $1,027,800 $485,000 207,900 $692,900 $ 727,500 300,300 $1,027,800 $ 7,700 1.12% $ 0 0.00% Note: Some rounding differences occur between the data in Exhibit 7.1 and those in Exhibit 7.2.

RVU is $300,000 140,000 = $2.143. The final step in the overhead cost allocation is to multiply the cost per RVU by the total number of RVUs of each service to obtain the overhead allocation:

Service X total overhead cost = $2.143 . 50,000 = $107,150.

Service Y total overhead cost = $2.143 . 90,000 = $192,870.

Now, the total costs of each service are merely the direct costs of the service plus the overhead allocation:

Service X: $242,500 + $107,150 = $349,650.

Service Y: $485,000 + $192,870 = $677,870.

As a final check, note that the total costs of each service sum to $1,027,520, which, except for a small rounding difference, equals the total costs of the department, $1,027,500.

The goal of RVU costing is to reflect the cost of the overhead resources used to provide the service. Of course, the key to the fairness of RVU costing is how well the number of RVUs assigned to each service matches the cost of the overhead resources consumed. Because of the difficulties involved in initially assigning RVU values to services, this method is used most often when RVU values have already been estimated, such as for procedures performed by physicians.

Activity-Based Costing Method Our discussion thus far has focused on what might be called traditional costing methods. In essence, the traditional methods begin with aggregate EXHIBIT 7.3 Service RVUs Volume Total RVUs RVU Analysis for X 10 5,000 50,000 Y 18 5,000 90,000 140,000 Overhead cost per RVU = $300,000 140,000 = $2.143.

Service X total overhead cost = $2.143.50,000 = $107,150.

Service Y total overhead cost = $2.143.90,000 = $192,870.

Total overhead costs = $107,150 + $192,870 = $300,020.

Note: Some rounding differences occur between the data in Exhibit 7.1 and those in Exhibit 7.3.

costs, typically at the department level. Overhead costs are then allocated downstream, first to the patient services departments and then, using the CCR or RVU method, down to individual services. Thus, traditional methods can be thought of as top-down allocation. Although traditional costing works well for estimating costs at the department level, its usefulness for estimating the costs of activities within or across departments, such as individual tests, services, or diagnoses, or by individual patients is limited. Our next approach, activity-based costing (ABC), is generally acknowledged to be superior to the traditional methods.

ABC uses an upstream approach to cost allocation. Its premise is that all costs within an organization stem from activities, hence its name. In ABC, because activities, rather than departments, are the focus of the process, costs can be more easily assigned to individual patients, individual physicians, particular diagnoses, a reimbursement contract, a managed care population, and so on.

The key to cost allocation under ABC is to identify the activities that are performed to provide a particular service and then aggregate the costs of the activities. The steps required to implement ABC are as follows:

Identify the relevant activities.

Estimate the cost of each activity, including both direct and indirect.

Assign cost drivers for each activity.

Collect activity data for each service.

Calculate the total cost of the service by aggregating activity costs.

To illustrate the ABC concept, suppose that the seven activities performed by the routine services department of Tarheel Family Practice are (1) patient check-in, including insurance verification; (2) preliminary assessment; (3) diagnosis; (4) treatment; (5) prescription writing; (6) patient check-out; and (7) third-party payer billing. As in our previous examples, we must reiterate that this illustration is highly simplified. Its purpose is merely to give you a flavor of how ABC works.

Services X and Y Activity-based costing (ABC) The bottom-up approach to costing that identifies the activities required to provide a particular service, estimates the costs of those activities, and then aggregates those costs.

Exhibit 7.4 contains the initial data and allocation rate calculations. To illustrate, the annual costs of the patient check-in activity, consisting of clerical labor and supplies (direct costs) plus space and other overhead (indirect costs), are $50,000 to support 10,000 total visits, so the allocation rate is $50,000 10,000 = $5.00 per visit. For another illustration, the total (direct labor by one nurse and overhead) cost required to conduct the initial assessment is $75,000, spread over (5,000 visits . 5 minutes for Service X) + (5,000 visits . 10 minutes for Service Y) = 25,000 + 50,000 = 75,000 minutes annually, giving an allocation rate of $75,000 75,000 = $1 per minute.

As shown in Exhibit 7.5, the final step in the ABC process is to aggregate the activity costs for each service. Note that this is done on a per service basis. For example, for Service X, the cost of check-in is 1 visit . $5.00 = $5.00; the cost of assessment is 5 minutes . $1.00 = $5.00; and the cost of diagnosis is 10 minutes . $2.00 = $20.00. Other activity costs for Service X and Service Y were calculated in a similar manner.

The end result of summing the individual activity costs associated with each service is an average cost of $75.10 for Service X and $130.40 for Service Y. The ability of the routine services department to estimate the costs of its individual services allows the services to be priced properly (on the basis of costs). In addition, cost control is made easier because the activities, and hence resource expenditures, associated with each service have been clearly identified.

Note that the total annual costs of providing Service X are 5,000 visits . $75.10 = $375,500, while the total costs for Service Y are 5,000 visits .

$130.40 = $652,000. Because there are only two services in this simple example, the total costs of the routine services department are $375,500 + $652,000 = $1,027,500, which equals the total cost amount identified in Exhibit 7.1.

Clearly, ABC holds great promise for healthcare providers. The ability to assess the costs of individual services with more confidence than that inherent in traditional costing methods provides managers with better information regarding the true costs of providing services. However, the information and resource requirements to establish an ABC system far exceed those required for traditional cost allocation. For this reason, traditional cost allocation still dominates the scene, but ABC is becoming more prevalent as the need for better cost data becomes more important and as providers invest in newer and more powerful managerial accounting systems.

Time-Driven Activity-Based Costing (TDABC) Method The final method of costing that we discuss is a relatively new concept that, for now, is more of a theoretical approach than one that is widely used in practice.

Still, it offers the promise of expanding the concept of cost measurement beyond individual service costing in a way that has the potential of leading to better (including lower cost) treatment plans.

EXHIBIT 7.4 ABC Illustration: Initial Data and Allocation Rate Calculation Activity Data Allocation Activity Annual Costs Cost Driver Service X Service Y Total Rate Check-in $ 50,000 Visits 5,000 5,000 10,000 $ 5.00 Assessment 75,000 Minutes per service 5 10 75,000 1.00 Diagnosis 250,000 Minutes per service 10 15 125,000 2.00 Treatment 450,000 Minutes per service 10 20 150,000 3.00 Prescription 2,500 Number of drugs 0.5 2 12,500 0.20 Check-out 50,000 Visits 5,000 5,000 10,000 5.00 Billing 150,000 Number of bills per visit 1 2 15,000 10.00 Total costs $1,027,500 EXHIBIT 7.5 ABC Illustration: Final Aggregation of Activity Costs per Visit Service X Service Y Activity Cost Driver Rate Consumption Cost Consumption Cost Check-in Visits $ 5.00 1 $ 5.00 1 $ 5.00 Assessment Number of minutes 1.00 5 5.00 10 10.00 Diagnosis Number of minutes 2.00 10 20.00 15 30.00 Treatment Number of minutes 3.00 10 30.00 20 60.00 Prescription Number of drugs 0.20 0.5 0.10 2.0 0.40 Check-out Visits 5.00 1 5.00 1 5.00 Billing Number of bills 10.00 1.0 10.00 2.0 20.00 Cost per service $75.10 $130.40 The idea behind the time-driven activity-based costing (TDABC) method is that individual service costs are not the correct way to view the cost of providing services. Rather, the costing system should account for the total costs of all the resources used to treat a single diagnosis as a patient traverses the entire health system. To accomplish this feat, the sequence and duration of the clinical and administrative processes must be tracked for individual patients across time. The rationale for the TDABC method is that the value of healthcare services must be measured in terms of patient outcomes achieved per total dollar expended. Value is increased when outcomes are improved at similar costs or when costs are reduced while maintaining outcome quality.

(See the Resources section at the end of this chapter for more information on the TDABC method.) Here are the steps in the TDABC method:

Select the medical condition to be studied. For each condition, complications and comorbidities must be considered along with the beginning and end of the patient care cycle. For chronic conditions, the patient care cycle is defined by a period of time, often a year.

Define the care delivery chain. The second step is to define the principal activities that comprise the patient s care. This becomes the road map of the activities involved in a complete cycle of care.

Develop process maps of each activity. In this step, the resources required for each activity are identified. In essence, the labor, equipment, supplies, facilities, overhead, and other resources are listed.

Also, the time required for each activity must be recorded. (Note that time recording may be treated as a separate step.) Estimate the cost of supplying the patient care resources. Here, both the direct and indirect costs of each activity are estimated.

Generally, direct costs include such items as labor, equipment depreciation or lease costs, and supplies. Indirect costs cover such items as facilities space and furnishings along with billing and collections, general administration, and other typical support functions. (Note that this step can be broken down into several substeps.) Calculate the total cost of patient care. In the final step, the costs of all the activities are summed to estimate the total cost of a patient s complete cycle of care.

Although we do not present an illustration of TDABC here, it is clear that this costing method offers the best hope for creating a healthcare delivery system that truly delivers value. The key is better measurement of both the treatment costs across the continuum of services needed to treat patients and the outcomes that result.

Time-driven activity-based costing (TDABC) An approach to costing that focuses on the entire cost of a patient s cycle of care rather than on the cost of individual services.

SELF-TEST QUESTIONS Price taker A business that has no power to influence the prices set by the marketplace (or by government payers).

1. Briefly describe the following service costing methods:

a. Cost-to-charge ratio (CCR) b. Relative value unit (RVU) c. Activity-based costing (ABC) 2. Explain how time-driven activity-based costing (TDABC) differs from the other three methods.

Healthcare Providers and the Power to Set Prices Now that we have finished our discussion of costing at the service (and patient) level, it is time to move on to pricing. Two extremes exist regarding the power of healthcare providers to set prices. At one extreme, providers have no power whatsoever and must accept the reimbursement rates set by the marketplace.

At the other extreme, providers can set any prices (within reason) they desire, and payers must accept those prices. Clearly, few real-world markets for healthcare services support such extreme positions across all payers. Nevertheless, thinking in such terms can help health services managers better understand the pricing and service decisions they face.

Providers as Price Takers As discussed throughout the book, healthcare services are provided in an increasingly competitive marketplace. As providers respond to market competition, managers must assess the ability of their organizations to influence the prices paid for the services offered. If the organization is one of a large number of providers in a service area with a large number of commercial fee- for-service purchasers (payers), and if little distinguishes the services offered by different providers, economic theory suggests that prices will be set by local supply-and-demand conditions. Thus, the actions of a single participant, whether the participant is a provider or a payer, cannot influence the prices set in the marketplace. In such a perfectly competitive market, healthcare providers are said to be price takers because they are constrained by (or must take ) the prices set in the marketplace.

Although few markets for healthcare services are perfectly competitive, some payers notably government payers such as Medicare and insurers with significant market power can set reimbursement levels on a take-it-or-leaveit basis. In this situation, as in competitive markets, providers also are price takers in the sense that they have little influence over reimbursement rates.

Because many markets either are somewhat competitive or are dominated by large insurers, and because governmental payers cover a significant proportion of the population, most providers probably qualify as price takers for a large percentage of their revenue.

As a general rule, providers that are price takers must take price as a given and concentrate managerial efforts on cost structure and utilization to ensure that their services are profitable. From a purely financial perspective, a price-taking provider should offer all services with costs that are less than the given price, even if that price has fallen because of discounting or other market actions.

Although the pure financial approach to service decisions is obviously simplistic, it does raise an important managerial accounting issue: What costs are relevant to the decision at hand? To ensure long-term sustainability, prices must cover full costs. However, prices that do not cover full costs may be acceptable for short periods, and it might be in the provider s long-run best interests to do so. This matter is discussed in the next major section.

Providers as Price Setters In contrast to price takers, healthcare providers with market dominance enjoy large market shares and hence exercise some pricing power. Within limits, such providers can decide what prices to set on the services offered. Furthermore, if a provider s services can be differentiated from others on the basis of quality, convenience, or some other characteristic, the provider also has the ability, again within limits, to set prices on the differentiated services. Healthcare providers that have such pricing power are called price setters. Price setter A business that The situation would be much easier for managers if a provider s status has the power to as a price taker or price setter were fixed for all payers for all services for long set the market periods of time. Unfortunately, the market for healthcare services is ever chang-prices for its goods ing, and hence providers can quickly move from one status to the other. For or services.

example, the merger of two healthcare providers may create sufficient market power to change two price takers, as separate entities, into one price setter, as a combined entity. Furthermore, providers can be price takers for some services and price setters for others or price takers for some payers and price setters for others. To make matters even more complicated, a large provider that serves separate market areas may be a price taker for a particular service in one geographic market yet be a price setter for the same service in another geographic market.

SELF-TEST QUESTIONS 1. What is the difference between a price taker and a price setter?

2. Are healthcare providers generally either price takers or price setters exclusively? Explain your answer.

Full cost pricing The process of setting prices to cover all costs plus a profit component.

Price-Setting Strategies When providers are price setters, alternative strategies can be used to price healthcare services. Unfortunately, no single strategy is most appropriate in all situations. In this section, we discuss two of the price-setting strategies most frequently used by health services organizations.

Full Cost Pricing Full cost pricing recognizes that to remain viable in the long run, health services organizations must set prices that recover all costs associated with operating the business. Thus, the full cost of a service whether a patient day in a hospital, a visit to a clinic, a laboratory test, or the treatment of a particular diagnosis must include the following: (1) the direct variable costs of providing the service; (2) the direct fixed costs; (3) the appropriate share of the overhead expenses of the organization, to ensure future capability; and (4) a profit component.

Because of the difficulties inherent in estimating the costs of individual services with any confidence, such costs must be viewed with some skepticism.

Nevertheless, in the aggregate, revenues must cover both direct and overhead costs, and hence prices in total must create revenues that cover all costs of an organization. Furthermore, all businesses need profits to survive in the long run.

In not-for-profit businesses, prices must be set high enough to provide the profits needed to support asset replacement and to meet growth targets. In addition, for-profit providers must provide equity investors with an explicit financial return on their investment. The bottom line here is that to recover full costs, including economic costs, prices must be set to cover accounting costs plus a profit target.

Marginal Cost Pricing In economics, the marginal cost of an item is the cost of providing one additional unit of output, whether that output is a product or a service. For example, suppose that a hospital currently provides 40,000 patient days of care. Its marginal cost, based on inpatient days as the unit of output, is the cost of providing the 40,001st day of care. In this situation, it is likely that fixed costs, both direct and overhead, will not have to increase to support this volume increase, so the marginal cost that must be covered consists solely of the variable costs associated with an additional one-day stay.

In most situations, no additional labor costs would be involved; additional personnel would not be hired nor overtime required. The marginal cost, therefore, consists of variable costs such as laundry, food and expendable supplies, and any additional utility services consumed during that day.

Obviously, the marginal cost associated with one additional patient day is far less than the full cost, which must include all costs plus a profit component.

Many proponents of government programs such as Medicare and Medicaid argue that payments to providers should be made on the basis of marginal rather than full costs. The argument here is that some price above marginal cost is all that is required for the provider to make money on government- sponsored patients. By implication, nongovernmental payers would cover all other costs. However, what would happen if all payers for a particular provider set reimbursement rates based on marginal costs? If such a situation occurred, the organization would not recover its total costs and would ultimately fail.

Should any prices be set on the basis of marginal costs? In theory, the answer is no. For prices to be equitable, all payers should pay their fair share in covering providers total costs. Furthermore, if marginal cost pricing should be adopted, which payer(s) should receive its benefits by being charged lower prices? Should it be the government because it is taxpayer funded, or should it be the last payer to contract with the provider? There are no good answers to these questions, so the easy way out, at least conceptually, is to require all payers to pay full costs and equitably share the burden of the organization s total costs.

As a practical matter, it may make sense for healthcare providers to occasionally use marginal cost pricing to attract a new patient clientele or to retain an existing clientele (i.e., gain or retain market share). To survive in the long run, however, businesses must earn revenues that cover their full costs. Thus, either marginal cost pricing must be a temporary measure or the organization Marginal cost pricing The process of setting prices to cover only marginal costs.

Cross- subsidization (price shifting) The pricing approach wherein some payers are charged more than full costs to make up for other payers that are paying less than full costs.

must employ cross-subsidization (price shifting). In such situations, some payers are overcharged for services, as compared to full costs, while others are undercharged.

Historically, price shifting was used by providers to support services, such as emergency care, teaching and research, and indigent care, that were not self-supporting.

Without such price-shifting strategies, many providers would not have been able to offer a full range of services. More recently, price shifting has been used to subsidize governmental payers, primarily Medicaid, which critics contend is setting reimbursement rates that fall far short of full costs.

Payers that pay in excess of costs were traditionally willing to accept price shifting because of their concern for the greater good and the fact that the additional burden For Your Consideration Hospitals, Captive Health Plans, and Price Setting Assume that you are the CEO of Space Coast Healthcare, a large regional hospital serving a patient population of more than 300,000. The hospital has virtually no competition and hence dominates the local inpatient services market. However, the local health insurance market is dominated by two large companies: one national in scope and the other a major statewide player. You fear that the purchasing clout of the two third-party payers will put so much pressure on prices that it will be difficult for the hospital to maintain sufficient profitability to ensure financial soundness.

To counteract the market dominance of the payers, the hospital is starting its own managed care company, beginning with a single HMO-style (continued) (continued from previous page) managed care plan. Once the managed care plan begins operations, it will be sending patients to the hospital. Thus, a decision must be made regarding the hospital s pricing policy for its inhouse managed care plan. Should it price high to maintain strong margins, or should it price low to help the fledgling managed care plan attract members?

What do you think? Does marginal cost pricing or full cost pricing make more sense? Is the optimal pricing strategy the same in the short run as in the long run?

was not excessive. Today, however, overall healthcare costs have risen to the point where the major purchasers of healthcare services are less and less willing to support the costs associated with providing services to others, and hence purchasers are demanding prices that cover only true costs, without cross-subsidies. Payers perhaps rightly believe that they do not have the moral responsibility to fund healthcare services for those outside of their covered populations.

SELF-TEST QUESTIONS 1. Describe two common pricing strategies used by price setters and their implications for financial survivability.

2. What is cross-subsidization (price shifting)?

3. Is cross-subsidization used by providers as frequently today as it was in the past? If not, why?

Target Costing Target costing Target costing is a management strategy that helps providers deal with situ- For price takers, ations in which they are price takers. Target costing assumes the price for a the process of service is a given by the marketplace and then subtracts the desired profit reducing costs (if necessary) to on that service to obtain the target cost level. If possible, management then the point where reduces the full cost of the service to the target level. Essentially, target costing a profit is earned backs into the cost at which a healthcare service must be provided to attain on the market- a given profitability target.

determined price.

Perhaps the greatest value of target costing lies in the fact that it forces managers to recognize that the market, rather than the provider, is setting prices. Thus, to ensure a sound financial condition, providers must attain cost structures compatible with the revenue stream. Providers that cannot lower costs to the level required to make a profit ultimately fail.

SELF-TEST QUESTIONS 1. What is target costing?

2. What is its greatest value?

Setting Fee-for-Service Prices on Individual Services The best way to understand the mechanics of pricing decisions is to work through some illustrations. The first example illustrates the conceptual approach to setting fee-for-service prices on individual services.

Assume that the managers of Windsor Clinic, a not-for-profit provider, plan to offer a new service. The clinic s financial manager has estimated the following cost data for the service:

Variable cost per visit $ 10 Annual direct fixed costs 100,000 Annual overhead allocation 25,000 Furthermore, the clinic s marketing consultant believes that demand for the new service will be 5,000 patient visits during its first year of operation.

To begin, Windsor s managers want to know what price must be set on each visit for the service to break even during the first year. To answer this question, we will apply the profit (CVP) analysis method discussed in Chapter 5, but now our focus is on price breakeven rather than volume breakeven. For accounting breakeven, the expected profit of the service must be zero, so revenues less costs must equal zero. One way to calculate the breakeven price is to express the relationship between revenues, costs, and profit in equation form:

Total revenues . Total costs = $0 Total revenues . Total variable costs . Direct fixed costs . Overhead = $0 (5,000 . Price) . (5,000 . $10) . $100,000 . $25,000 = $0 (5,000 . Price) . $175,000 = $0 5,000 . Price = $175,000 Price = $175,000 5,000 = $35.

Thus, under the utilization and cost assumptions developed by the clinic s managers, a price of $35 per visit must be set on the new service to break even in the accounting sense.

Of course, Windsor s managers want the service to earn a profit and hence to achieve economic breakeven. Suppose the goal is to make a profit of $100,000 on the new service. The calculations above show that costs at 5,000 visits are expected to total $175,000. Thus, to make a profit of $100,000, service revenues must total $175,000 + $100,000 = $275,000. With 5,000 visits, the price must be set at $275,000 5,000 = $55 per visit.

Up to this point, the analysis has focused on full cost pricing. Suppose Windsor s managers wanted to price the service aggressively to quickly build market share. What price would be set under marginal cost pricing? Now the service must only cover the variable (marginal) cost of $10 per visit, so a price of $10 is all that is required. This price, which is well below the accounting breakeven of $35 and the economic breakeven of $55, would result in a loss of $125,000 ($100,000 in direct fixed costs and $25,000 in overhead) during the first year the service is offered, assuming that the aggressive pricing does not affect the 5,000-visit utilization estimate.

Key Equation: Price Breakeven Suppose a clinical laboratory has fixed costs of $500,000, a variable cost rate of $20, and a volume of 20,000 tests. Price breakeven is obtained by solving the following equation for price:

Total revenues . Total variable costs . Fixed costs = Profit (20,000 . Price) . ($20 . 20,000) . $500,000 = Profit.

For accounting breakeven, profit is zero, so the equation becomes (20,000 . Price) . $400,000 . $500,000 = $0.

Thus, the breakeven price is $45 per test:

(20,000 . Price) = $900,000 Price = $900,000 20,000 = $45 per test.

For economic breakeven, insert the desired profit amount on the right side of the equation in place of $0.

What price should Windsor s managers actually set on the new service?

It should be obvious to readers that a great deal of judgment is required to make this decision. One important consideration is the relationship between price and volume, which the analysis has ignored by assuming that the service would produce 5,000 visits regardless of price. A more complete analysis would examine the effect of different prices and volumes on profits. Another consideration is how easy it would be to increase the price that is initially set. If price increases are expected to be met with a great deal of resistance, pricing low to gain market share today might not be a good long-run strategy.

SELF-TEST QUESTIONS 1. Briefly explain the conceptual process for pricing individual services.

2. What do you think the price should be on Windsor s new service?

Justify your answer.

Setting Prices Under Capitation The second illustration focuses on how one hospital priced a new capitated product. Exhibit 7.6 contains relevant 2016 forecasted revenue and cost data for Montana Medical Center (MMC), a 350-bed, not-for-profit hospital.

According to its managers best estimates, MMC is expecting to earn a profit of $1,662,312 in 2016. The data consist first of a worksheet that breaks down the cost data by payer. Here, the assumption is that all payers use fee-forservice reimbursement, including discounted fee-for-service. The Exhibit 7.6 cost data include the hospital s cost structure, broken down by variable costs; fixed costs, including both direct and overhead (the $71,746,561 given in the profit and loss [P&L] statement); and contribution margin.

To illustrate the nature of the data, consider MMC s Medicare patients.

Medicare is expected to provide the hospital with 4,268 admissions at an average revenue of $7,327 per admission, for total revenues of 4,268 . $7,327 = $31,271,636. Expected variable cost per admission for a Medicare patient is $2,529, which results in expected total variable costs of 4,268 . $2,529 = $10,793,772. The difference between expected total revenues and the expected total variable costs produces a forecasted total contribution margin of $31,271,636 . $10,793,772 = $20,477,864 for the Medicare patient group. This total contribution margin is combined with the total contribution margins of the other payer groups to produce an expected aggregate total contribution margin for the hospital of $73,408,873. As shown in the P&L EXHIBIT 7.6 Average Variable Total Montana Number of Revenue per Revenue Cost per Variable Contribution Payer Admissions Admission by Payer Admission Costs Margin Medical Center:

Projected Payer Payer Worksheet: Worksheet and Medicare 4,268 $7,327 $ 31,271,636 $2,529 $ 10,793,772 $20,477,864 P&L Statement Medicaid 5,895 5,448 32,115,960 1,575 9,284,625 22,831,335 for 2016 Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544 Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140 Commercial 1,408 11,770 16,572,160 2,969 4,180,352 12,391,808 Self-Pay 1,289 2,053 2,646,317 1,489 1,919,321 726,996 Other 1,149 11,539 13,258,311 3,085 3,544,665 9,713,646 Total 17,054 $108,583,746 $35,174,873 $73,408,873 Weighted average $6,367 $2,063 P&L Statement:

Total revenues $ 108,583,746 Variable costs 35,174,873 Contribution margin $ 73,408,873 Fixed costs 71,746,561 Profit $ 1,662,312 EXHIBIT 7.7 Montana Medical Center:

Initial Assumptions for a Capitated Plan statement portion of Exhibit 7.6, the total contribution margin both covers MMC s forecasted fixed costs of $71,746,561 and produces an expected profit of $1,662,312.

MMC s managers are considering taking a bold strategic action offer a capitated plan for inpatient services. One of the first tasks that must be performed is setting the price for the new plan. Exhibit 7.7 contains the key assumptions inherent in the pricing decision. The hospital s managers believe that about 13 percent of the current patient base would be converted to the capitated plan. To be conservative, the assumption was made that no additional patients would be generated. Thus, at least initially, patients in the capitated plan would come from MMC s current patient base. In effect, MMC would have to cannibalize from its own business with the expectation of protecting current market share and using the capitated plan as a marketing tool to expand market share in the future.

Assumptions also have been made regarding where the cannibalization would occur and the number of admissions under the capitated plan. These data are provided in points 2 and 3 of Exhibit 7.7. The patient mix assumptions will be important when costs are estimated for the new plan.

MMC s managers believe, at least initially, that hospital utilization will be unaffected by the conversion of some patients from fee-for-service contracts to capitation. Another expectation is that variable costs for the new plan would be the same as experienced in the past with each payer group. These are two important assumptions. MMC s managers are assuming that the utilization and delivery of healthcare services for the capitated population will be exactly 1. The capitated plan will initially enroll the following percentages of the hospital s current patients:

a. Medicaid: 20 percent b. Commercial: 40 percent c. Self-pay: 40 percent 2. Assuming that utilization rates are not affected by the change to a capitated plan, admissions from the capitated group are expected to total (0.20.5,895) + (0.40.1,408) + (0.40.1,289) = 2,258.

3. Based on current coverage information, the patient population under capitation (number of enrollees) would be 25,000.

4. Variable costs for capitated patients will remain the same as currently estimated for each payer group.

5. Total fixed costs will remain the same.

6. All other assumptions inherent in the Exhibit 7.1 forecast hold for the capitated plan.

7. The goal for the price set for capitated enrollees will be to generate, at a minimum, the profit forecasted in Exhibit 7.1 under fee-for-service reimbursement.

the same as for the fee-for-service population. This is probably a reasonable starting assumption given that the capitated population will represent only a small portion of MMC s overall business. However, if changes in payer reimbursement methodologies lead to a greater proportion of capitated patients, both utilization patterns and the underlying cost structure are likely to change as the hospital responds to the incentives created.

Finally, and perhaps most important in terms of pricing strategy, the capitated price that MMC plans to offer to the market must result in the same profit ($1,662,312) expected if the hospital were to remain totally fee-forservice.

The underlying logic here is that MMC s managers want to experiment with capitation, but they are unwilling to do so at the expense of the bottom line. This pricing goal, and the expected cost structure of serving the capitated population, therefore, will drive the monthly premium established for the capitated product. If the goal of preserving the bottom line while adding the new product proves to be unattainable, MMC s managers will have to reevaluate their initial pricing strategy.

Exhibit 7.8 contains an analysis similar to the one shown in Exhibit 7.6, except that Exhibit 7.8 includes the proposed capitated plan. Changes from the Exhibit 7.6 values are shown in boldface. For example, the entire first line of the worksheet, labeled Capitated, is in boldface because this is MMC s new service line, which does not appear in Exhibit 7.6. Also in boldface are selected values on the Medicaid, commercial, and self-pay lines; these values will change because of the shift of some of these payer groups patients to the capitated plan.

Note that the Exhibit 7.8 volume levels reflect the expected patient shifts from fee-for-service to capitation. For example, the Medicaid group reflects the 20 percent decrease resulting from patients shifting to the capitated plan:

0.80 . 5,895 = 4,716. The commercial and self-pay payer groups also reflect their 40 percent losses in admissions to the new plan. In total, the capitated plan is expected to siphon off 0.20 . 5,895 = 1,179 Medicaid admissions, 0.40 . 1,408 = 563 commercial admissions, and 0.40 . 1,289 = 516 self-pay admissions, for a total of 2,258 admissions.

For now, pass by the revenue columns in Exhibit 7.8 and focus on the variable cost columns for the capitated patients. Because each capitated patient is expected to have the same variable cost as under the previous plans, variable costs for the capitated plan are expected to total (1,179 . $1,575) + (563 . $2,969) + (516 . $1,489) = $4,296,796. With an expected number of admissions of 2,258, the average variable cost per capitated admission is $4,296,794 2,258 = $1,903. (Note that the values in exhibits 7.6 and 7.8 were obtained from a spreadsheet analysis, which does not round to the nearest dollar. Thus, there are some minor rounding differences when the calculations are made by hand.) EXHIBIT 7.8 AveragAverage Variable Total Montana Number of Revenue per Revenue Cost per Variable Contribution Payer Admissions Admission by Payer Admission Costs Margin Medical Center:

Projected Analysis Assuming 25,000 Enrollees and Constant Profit Payer Worksheet:

Capitated Medicare Medicaid Montana Care Managed Care Blue Cross Commercial Self-Pay Other Total 2,258 4,268 4,716 828 1,885 332 845 773 1,149 17,054 $ 6,250 7,327 5,448 4,305 3,842 5,761 11,770 2,053 11,539 $ 14,110,583 31,271,636 25,692,768 3,564,540 7,242,170 1,912,652 9,943,296 1,587,790 13,258,331 $108,583,746 $1,903 2,529 1,575 1,907 1,638 2,366 2,969 1,489 3,085 $ 4,296,794 10,793,772 7,427,700 1,578,996 3,087,630 785,512 2,508,211 1,151,593 3,544,665 $35,174,873 $ 9,813,789 20,477,864 18,265,068 1,985,544 4,154,540 1,127,140 7,435,085 436,198 9,713,646 $73,408,873 Weighted average $ 6,367 $2,063 Annual capitated revenue requirements = $14,110,583 25,000 = $564.42 per member.

Monthly capitated revenue requirements = $564.42 12 = $47.04 per member per month (PMPM).

P&L Statement:

Total revenues Variable costs Contribution margin Fixed costs Profit $ 108,583,746 35,174,873 $ 73,408,873 71,746,561 $ 1,662,312 Now consider the revenue columns. To keep the projected profit the same as in Exhibit 7.6, revenues must total $108,583,746. Furthermore, expected total revenues from all payer groups except the new plan amount to $94,473,163. Thus, the capitated plan must bring in revenue of $108,583,746 . $94,473,163 = $14,110,583 to achieve MMC s target profit. This calculation can be thought of as working backward on (or up) the projected P&L statement shown at the bottom of Exhibit 7.8.

With expected admissions of 2,258, the average revenue per admission can be calculated as $14,110,583 2,258 = $6,250. However, this implied average revenue per admission has no real meaning in a capitated plan because MMC will not be charging these patients on a per admission basis. The calculated per admission revenue value of $6,250 is a fee-for-service equivalent revenue, and every worker at MMC must recognize that the hospital will not actually receive $6,250 per admission under the new plan. As MMC s patients move from fee-for-service to capitation, revenue will be based on enrollment rather than admissions.

With all this information at hand, MMC s managers now can price the new plan. Total revenues of $14,110,583 are required from 25,000 enrollees, so the annual revenue per enrollee is $14,110,583 25,000 = $564.42. Because premiums are normally expressed on a per member per month (PMPM) basis, the annual revenue requirement must be divided by 12 to obtain $47.04 PMPM. This PMPM charge is what MMC s managers would set as the initial price when marketing the new plan.

The illustration presented here describes how MMC s managers could establish a price for a new capitated plan. However, a good pricing analysis goes well beyond the base case analysis, which uses the most likely estimates for all input variables number of enrollees, variable costs, and so on. The second part of a complete pricing analysis involves scenario analysis, whereby Scenario analysis A project risk MMC s managers assess the impact of changing assumptions in key variable analysis technique values. The idea here is to create alternative scenarios in addition to the most that examines likely (base case) scenario. In this way, MMC s managers can obtain a feel for alternative the uncertainty involved in creating the new capitated product. outcomes, generally three, as In order to keep this chapter manageable, we will not illustrate scenario opposed to only analysis here. However, the value and structure of scenario analysis will be the most likely discussed in detail in Chapter 15 with our coverage of capital budgeting outcome.

(project) risk analysis.

SELF-TEST QUESTIONS 1. Briefly explain why the base case analysis required the calculation to move up the P&L statement rather than down (the normal direction).

2. How are capitated revenue requirements typically expressed?

3. What is scenario analysis, and why is it so critical to good pricing decisions?

4. What is the most uncertain variable in MMC s capitated plan pricing analysis?

Key Concepts Managers rely on managerial accounting and actuarial information to help make pricing and service decisions. Pricing decisions involve setting prices on services for which the provider is a price setter, while service decisions involve whether or not to offer a service when the price is set by the payer (the provider is a price taker). Service decisions are illustrated in the supplement to this chapter. The key concepts of this chapter are as follows:

The primary methods for costing individual services are the (1) cost-to-charge ratio (CCR), (2) relative value unit (RVU), and (3) activity-based costing (ABC).

(continued) (continued from previous page) In addition, time-driven activity-based costing (TDABC) is a relatively new method to estimate the costs of treating individual patient diagnoses over time.

Pricing decisions are based on an organization s need for revenues to (1) cover the full cost of doing business and (2) provide the profits necessary to acquire new technologies and offer new services.

Price takers are healthcare providers that have to accept, more or less, the prices set in the marketplace for their services, including the prices set by governmental insurers.

Price setters are healthcare providers that have market power or whose services can be differentiated from others, such as by quality or convenience, and hence have the ability to set the prices on some or all of their services.

Full cost pricing permits businesses to recover all costs, including direct fixed, direct variable, and overhead, while marginal cost pricing recovers only marginal (typically direct variable) costs.

Purchasers of healthcare services exercise considerable market power, thereby restricting the ability of providers to cross-subsidize (price shift).

Target costing takes the prices paid for healthcare services as a given and then determines the cost structure necessary for financial survival given the prices set.

Pricing decisions are supported by a variety of analyses that use both actuarial and managerial accounting data. Typically, such analyses include a base case, which uses the most likely estimates for all input values, plus a scenario analysis, which considers the effects of alternative assumptions.

In the next chapter, our coverage of managerial accounting continues with a discussion of planning and budgeting.

Questions 7.1 Describe the following methods used to estimate the cost of individual services:

a. Cost-to-charge ratio (CCR) method b. Relative value unit (RVU) method c. Activity-based costing (ABC) method 7.2 What is the time-driven activity-based costing method (TDABC), and how does it differ from the methods listed in Question 7.1?

7.3 a. Using a medical group practice to illustrate your answer, explain the difference between a price setter and a price taker.

b. Can most providers be classified strictly as either a price setter or a price taker?

7.4 Explain the essential differences between full cost pricing and marginal cost pricing strategies.

7.5 What would happen financially to a health services organization over time if its prices were set at a. Full costs?

b. Marginal costs?

7.6 a. What is cross-subsidization (price shifting)?

b. Is it as prevalent today as it has been in the past?

7.7 a. What is target costing?

b. Suppose a hospital was offered a capitation rate for a covered population of $40 per member per month (PMPM). Briefly explain how target costing would be applied in this situation.

7.8 What is the role of accounting information in pricing decisions?

7.9 a. What is scenario analysis as applied to pricing decisions?

b. Why is it such an important part of the process?

Problems 7.1 Assume that the managers of Fort Winston Hospital are setting the price on a new outpatient service. Here are relevant data estimates:

Variable cost per visit $ 5.00 Annual direct fixed costs $500,000 Annual overhead allocation $ 50,000 Expected annual utilization (visits) 10,000 a. What per visit price must be set for the service to break even? To earn an annual profit of $100,000?

b. Repeat Part a, but assume that the variable cost per visit is $10.

c. Return to the data given in the problem. Again repeat Part a, but assume that direct fixed costs are $1,000,000.

d. Repeat Part a assuming both $10 in variable cost and $1,000,000 in direct fixed costs.

7.2 The audiology department at Randall Clinic offers many services to the clinic s patients. The three most common, along with cost and utilization data, are as follows:

Variable Cost Annual Direct Annual Number Service per Service Fixed Costs of Visits Basic examination $ 5 $50,000 3,000 Advanced examination 7 30,000 1,500 Therapy session 10 40,000 500 a. What is the fee schedule for these services, assuming that the goal is to cover only variable and direct fixed costs?

b. Assume that the audiology department is allocated $100,000 in total overhead by the clinic, and the department director has allocated $50,000 of this amount to the three services listed above. What is the fee schedule assuming that these overhead costs must be covered?

(To answer this question, assume that the allocation of overhead costs to each service is made on the basis of number of visits.) c. Assume that these services must make a combined profit of $25,000. Now what is the fee schedule? (To answer this question, assume that the profit requirement is allocated in the same way as overhead costs.) 7.3 Allied Laboratories is combining some of its most common tests into one-price packages. One such package will contain three tests that have the following variable costs:

Test A Test B Test C Disposable syringe $3.00 $3.00 $3.00 Blood vial 0.50 0.50 0.50 Forms 0.15 0.15 0.15 Reagents 0.80 0.60 1.20 Sterile bandage 0.10 0.10 0.10 Breakage/losses 0.05 0.05 0.05 When the tests are combined, only one syringe, form, and sterile bandage will be used. Furthermore, only one charge for breakage/losses will apply. Two blood vials are required, and reagent costs will remain the same (reagents from all three tests are required).

a. As a starting point, what is the price of the combined test assuming marginal cost pricing?

b. Assume that Allied wants a contribution margin of $10 per test.

What price must be set to achieve this goal?

c. Allied estimates that 2,000 of the combined tests will be conducted during the first year. The annual allocation of direct fixed and overhead costs totals $40,000. What price must be set to cover full costs? What price must be set to produce a profit of $20,000 on the combined test?

7.4 Assume that Valley Forge Hospital has only the following three payer groups:

Number of Average Revenue Variable Cost Admissions per Admission per Admission Commercial 1,000 $5,000 $3,000 PennCare 4,000 4,500 4,000 Medicare 8,000 7,000 2,500 The hospital s fixed costs are $38 million.

a. What is the hospital s net income?

b. Assume that half of the 100,000 covered lives in the commercial payer group will be moved into a capitated plan. All utilization and cost data remain the same. What PMPM rate will the hospital have to charge to retain its Part a net income?

c. What overall net income would be produced if the admission rate of the capitated group were reduced from the commercial level by 10 percent?

d. Assuming that the utilization reduction also occurs, what overall net income would be produced if the variable cost per admission for the capitated group were lowered to $2,200?

7.5 Bay Pines Medical Center estimates that a capitated population of 50,000 would have the following base case utilization and total cost characteristics:

Inpatient Days per Average Cost Service Category 1,000 Enrollees per Day General 150 $1,500 Surgical 125 1,800 Psychiatric 70 700 Alcohol/drug abuse 38 500 Maternity 42 1,500 Total 425 $1,367 In addition to medical costs, Bay Pines allocates 10 percent of the total premium for administration/reserves.

a. What is the PMPM rate that Bay Pines must set to cover medical costs plus administrative expenses?

b. What would be the rate if a utilization management program were to reduce utilization within each patient service category by 10 percent? By 20 percent?

c. Return to the initial base case utilization assumption. What rate would be set if the average cost on each service were reduced by 10 percent?

d. Assume that both utilization and cost reductions were made. What would the premium be?

7.6 Assume that a primary care physician practice performs only physical examinations. However, there are three levels of examination I, II, and III that vary in depth and complexity. An RVU analysis indicates that a Level I examination requires 10 RVUs, a Level II exam 20 RVUs, and a Level III exam 30 RVUs. The total costs to run the practice, including a diagnostic laboratory, amount to $500,000 annually, and the numbers of examinations administered annually are 2,400 Level I, 800 Level II, and 400 Level III.

a. Using RVU methodology, what is the estimated cost per type of examination?

b. If the goal of the practice is to earn a 20 percent profit margin on each examination, how should the examinations be priced?

7.7 Consider the following data for a clinical laboratory:

Activity Data Annual Activity Costs Cost Driver Test A Test B Test C Test D Receive specimen $ 10,000 Number of tests 2,000 1,500 1,000 500 Set up equipment 25,000 Number of minutes per test 5 5 10 10 Run test 100,000 Number of minutes per test 1 5 10 20 Record results 10,000 Number of minutes per test 2 2 2 4 Transmit results 5,000 Number of minutes per test 3 3 3 3 Total costs $150,000 a. Using ABC techniques, determine the allocation rate for each activity.

b. Now, using this allocation rate, estimate the total cost of performing each test.

c. Verify that the total annual costs aggregated from individual test costs equal the total annual costs of the laboratory given in the table above.

7.8 A hospital pharmacy fills three types of prescriptions. Prescription A requires refrigeration to maintain the drug s activity. Prescription B has potentially fatal interactions with other drugs and therefore requires careful review by a pharmacist. Prescription C is a basic, common drug that presents little risk to the patient. Prescription A is a brand-name drug still on patent, and therefore the charge for the drug is high relative to its cost. Consider the following data for the hospital pharmacy:

Annual Prescription Volume, Total Direct Costs, and Total Charges Prescription (Rx) A Prescription (Rx) B Prescription (Rx) C Annual volume Total direct costs Total charges 50 $ 7,668 $35,000 200 $48,840 $70,000 1,000 $31,300 $50,000 Budgeted Overhead Costs and Activity Data Annual Activity Costs Cost Driver Cost Driver Consumption per One Rx Rx A Rx B Rx C Refrigeration $ 8,000 Number of units requiring 1 0 0 refrigeration Materials 24,000 Number of feet to drug 50 20 10 handling storage area Prescription 90,000 Number of pharmacist 15 60 3 review minutes Total costs $122,000 a. Using the cost-to-charges ratio (CCR) method, determine the overhead that would be allocated to each type of prescription, A, B, and C.

b. Determine the total cost (Direct cost + Indirect cost) of filling one of each type of prescription if overhead is allocated using CCR.

c. Using ABC techniques, determine the allocation rate for each overhead activity and determine the overhead that would be allocated to each type of prescription, A, B, and C.

d. Determine the total cost (Direct cost + Indirect cost) of filling one of each type of prescription if overhead is allocated using ABC techniques.

e. Explain the reasons for the difference in the full cost of each prescription in parts b and d.

7.9 Consider the following data for a primary care practice that provides two types of services, A and B:

Activity Data Activity Annual Costs Cost Driver Service A Service B Check-in $ 100,000 Visit volume 7,000 15,000 Assessment 250,000 Minutes per service 15 8 Diagnosis 600,000 Minutes per service 20 10 Treatment 1,200,000 Minutes per service 5 5 Check-out 125,000 Visit volume 7,000 15,000 Billing 250,000 Number of bills 3 1 Total $2,525,000 a. Using ABC techniques, determine the allocation rate for each activity.

b. Determine the costs per visit for each type of service.

c. Verify that the total annual costs aggregated from individual visit costs equal the total annual costs of the practice given in the table above.

Resources For a more in-depth treatment of the TDABC method of costing, see Kaplan, R. S. 2014. Improving Value with Time-Driven Activity-Based Costing (TDABC). Healthcare Financial Management (June): 77 83.

Kaplan, R. S., and M. E. Porter. 2011. The Big Idea: How to Solve the Cost Crisis in Health Care. Harvard Business Review (September): 47 64.

Kaplan, R. S., M. Witkowski, M. Abbott, A. B. Guzman, L. D. Higgins, J. G. Meara, E. Padden, A. S. Shah, P. Waters, M. Weidemeier, S. Wertheimer, and T. W.

Feeley. 2014. Using Time-Driven Activity-Based Costing to Identify Value Improvement Opportunities in Healthcare. Journal of Healthcare Management (November/December): 399 413.

In addition, see Barton, S., D. Lancaster, and M. Bieker. 2008. Chargemaster Maintenance: Think Spring Cleaning All Year Round. Healthcare Financial Management (November):

42 46.

Bilsky, S. D., and J. M. Aber. 2007. Lining Up Your Service Lines. Healthcare Financial Management (July): 68 73.

Buchler, R. 2014. Achieving Strategic Cost Reduction in the OR. Healthcare Financial Management (October): 42 46.

Cleverley, W. O., and J. O. Cleverley. 2008. 10 Myths of Strategic Pricing. Healthcare Financial Management (May): 82 87.

. 2007. Setting Defensible and Appropriate Prices in Healthcare. Healthcare Executive (January/February): 9 12.

Greenspun, H., and W. Bercik. 2013. Cost-Outcomes Focus is Essential for ACO Success. Healthcare Financial Management (February): 96 102.

Griebl, O., and C. Skalka. 2007. The Growing Imperative of Effective Pricing Strategies and Tools for Not-for-Profit Hospitals. Healthcare Financial Management (October): 76 80.

Houck, S., and J. O. Cleverley. 2014. How Hospitals Approach Price Transparency. Healthcare Financial Management (September): 57 62.

Mulaik, M. W., P. Kassing, and K. M. Nichols. 2014. Medicare s New CT and MRI Cost Centers Demand Accurate Cost Reporting. Healthcare Financial Management (October): 28 30.

Pandey, S. 2012. Applying the ABCs in Provider Organizations. Healthcare Financial Management (November): 112 20.

Pederson, C. D. 2005. Cost-Based Pricing and the Underperforming Physician Group. Healthcare Financial Management (October): 62 68.

Richmond, R. 2013. A Better Approach to Cost Estimation. Healthcare Financial Management (March): 87 90.

Stodolak, F. 2008. Hospital Zero-Base Pricing Can Make a Difference. Healthcare Financial Management (September): 102 8.

Sturm, A., and F. Tiedemann. 2013. Developing a Consumer Pricing Strategy. Healthcare Financial Management (May): 104 8.

Wichmann, R., and R. Clark. 2006. Developing a Defensible Pricing Strategy. Healthcare Financial Management (October): 72 80.

Winterhalter, S. J. 2011. Economic Factors Converge: Force Hospitals to Review Pricing Strategies. Journal of Health Care Finance (Summer): 15 35.

7 MAKING SERVICE DECISIONS The primary focus of the illustrations in Chapter 7 is price setting. In this supplement, we present an illustration of a related decision the service decision.

Now, our focus is on evaluating the attractiveness of contract proposals with given prices.

County Health Plan (CHP), an HMO with 40,000 members, has proposed a new contract that would capitate Baptist Memorial Hospital for all inpatient services provided to CHP s commercial enrollees whose primary care physicians are affiliated with the hospital. The proposal calls for a capitation payment of $35 per member per month (PMPM) for the first year of the contract.

Baptist s managers must decide whether or not to accept the proposal.

To begin the analysis, Baptist s managed care analysts developed the inpatient actuarial data contained in Exhibit S7.1. The data are presented under two levels of utilization management. The data in the top section are based on a loosely managed population in Baptist s service area. These data represent a bare minimum of utilization management effort and hence reflect relatively poor utilization management practices. The bottom section contains data that represent the best-observed utilization management practices based on hospitals located in service areas that have extremely high managed care penetration. The differences between the two data sets illustrate the potential for improved financial performance that comes with more sophisticated utilization management systems. Both sets of data reflect populations with characteristics similar to CHP s commercial enrollees.

To illustrate the calculations, consider the top line in the top section (General). Under loosely managed utilization, the covered population is expected to use 157 days of general medical services for each 1,000 enrollees.

Furthermore, the costs associated with one day of such services total $1,500.

Thus, the general services costs for each 1,000 enrollees are expected to be 157 . $1,500 = $235,500 or $19.62 PMPM. Calculations for other inpatient services were performed similarly and added to obtain total medical costs of $50.39 PMPM.

There are two additional categories of costs besides medical costs. Each section of the exhibit has lines for administrative costs and risk (profit) margin.

Administrative costs include costs incurred in managing the contract, such as costs associated with patient verification, utilization management, quality assurance, and member services.

EXHIBIT S7.1 Loosely Managed (Suboptimal) Utilization:

CHP/Baptist Average Cost Memorial Inpatient Days Average Cost per Member Hospital:

Service Category per 1,000 Enrollees per Day per Month* Contract General 157 $1,500 $19.62 Analysis Under Surgical 132 1,800 19.80 Two Utilization Psychiatric 71 700 4.14 Management Alcohol/Drug abuse 38 500 1.58 Scenarios Maternity 42 1,500 5.25 Total medical costs 440 $1,374 $50.39 Administrative costs 2.80 Risk (profit) margin 2.80 Total PMPM $55.99 Tightly Managed (Optimal) Utilization:

Average Cost Inpatient Days Average Cost per Member Service Category per 1,000 Enrollees per Day per Month* Chapter 7 Supplement General 79 $1,600 $10.53 Surgical 58 1,900 9.18 Psychiatric 13 800 0.87 Alcohol/Drug abuse 4 600 0.20 Maternity 26 1,600 3.47 Total medical costs 180 $1,617 $24.25 Administrative costs 1.35 Risk (profit) margin 1.35 Total PMPM $26.95 Note: Some rounding differences occur in the table.

*Based on 40,000 members (enrollees).

The second category of nonmedical costs is the risk (profit) margin.

Because Baptist would be bearing inpatient utilization risk for the covered population, it builds in a margin both to provide a profit on the contract commensurate with the risk assumed and to create a reserve that could be tapped if utilization, and hence costs, exceeds the amount estimated. It is Baptist s practice to allow 10 percent of the total premium for these two nonmedical costs, so medical costs represent 90 percent of the total premium. For example, in the upper section of Exhibit S7.1, 0.9 . Total premium = $50.39, so Total premium = $50.39 0.9 = $55.99. Furthermore, it is Baptist s policy to split Chapter 7 Supplement Chapter 7 Supplement the $55.99 . $50.39 = $5.60 in nonmedical costs evenly between the two categories, so administrative costs and risk (profit) margin are allocated $2.80 each. Baptist s managers use the same 10 percent nonmedical cost allocation for both the loosely managed and tightly managed utilization scenarios. (One could argue that the greater the utilization management effort, the higher the administrative costs. Thus, it might be better to allocate a greater percentage for administrative costs in the tightly managed scenario than in the loosely managed scenario. In fact, administrative costs could require a higher dollar allocation under tightly managed utilization, even though the overall premium amount is lower.) Exhibit S7.1 sends a strong message to Baptist s managers regarding the acceptability of CHP s $35 PMPM contract offer. If Baptist were to accept the offer and then loosely manage the enrollee population, it would lose $55.99 . $35 = $20.99 PMPM on the contract. The costs in Exhibit S7.1 represent full costs as opposed to only variable (marginal) costs. Therefore, Baptist may be able to carry the contract in the short run, but it would not be able to sustain the contract over time. On the other hand, if Baptist could manage the enrollee population in accordance with best-observed practices, it would make a profit of $35 . $26.95 = $8.05 PMPM on the contract.

The contract also can be analyzed in accounting, rather than actuarial, terms. This format, along with required supporting calculations, is shown in Exhibit S7.2. Again, focus on the loosely managed section. In Exhibit S7.2, instead of showing inpatient days per 1,000 enrollees as in Exhibit S7.1, inpatient days are expressed in terms of the total number of enrollees, which is expected to be 40,000 for this contract. Thus, using utilization data from Exhibit S7.1, the total number of patient days of general medical services is 157 . 40 = 6,280. With an estimated cost of $1,500 per day, total costs for general medical services amount to 6,280 . $1,500 = $9,420,000. The costs for all service categories were calculated in the same way and total $24,192,000. Each nonmedical service cost was calculated as 40,000 . $2.80 . 12 = $1,344,000, resulting in total costs under loosely managed utilization of $26,880,000.

Regardless of the level of utilization management, revenues from the contract are expected to total 40,000 . $35 . 12 = $16,800,000. Thus, the projected P&L statements in simplified form consist of this revenue amount minus total costs under each utilization scenario. The end result is an expected net loss of $10,080,000 under loosely managed utilization and a profit of $3,864,000 under tightly managed utilization.

What should Baptist s managers do regarding the contract? For now, the decision appears simple: Accept the contract if the hospital can tightly manage utilization, or reject the contract if it cannot. Unfortunately, the base case contract analysis, like many financial analyses, raises more questions than it answers. This demonstrates that analyses conducted to help with pricing and PROJECTED COSTS:

Loosely Managed (Suboptimal) Utilization:

Inpatient Days Average Cost Total Service Category per 40,000 Enrollees per Day Annual Costs General Surgical Psychiatric Alcohol/Drug abuse Maternity Total medical costs 6,280 5,280 2,840 1,520 1,680 17,600 Administrative costs Risk (profit) margin Total annual costs Tightly Managed (Optimal) Utilization:

Inpatient Days Service Category per 40,000 Enrollees $1,500 1,800 700 500 1,500 $1,374 Average Cost per Day $ 9,420,000 9,504,000 1,988,000 760,000 2,520,000 $ 24,192,000 1,344,000 1,344,000 $26,880,000 Total Annual Costs EXHIBIT S7.2 CHP/Baptist Memorial Hospital:

Projected Costs and P&L Statements Chapter 7 Supplement General Surgical Psychiatric Alcohol/Drug abuse Maternity Total medical costs 3,160 2,320 520 160 1,040 7,200 $1,600 1,900 800 600 1,600 $1,617 $ 5,056,000 4,408,000 416,000 96,000 1,664,000 $ 11,640,000 Administrative costs Risk (profit) margin 648,000 648,000 Total annual costs $ 12,936,000 P&L STATEMENTS:

Loosely Managed (Suboptimal) Utilization:

Total revenues $16,800,000 Total costs 26,880,000 Profit (Loss) ($10,080,000) Tightly Managed (Optimal) Utilization:

Total revenues $16,800,000 Total costs 12,936,000 Profit (Loss) $ 3,864,000 Note: Some rounding differences occur in the table.

service decisions tend more often to raise managers awareness of potential consequences than offer simple solutions.

What else would Baptist s managers want to know prior to making the decision? One key element of information is the cost structure (fixed versus Chapter 7 Supplement Chapter 7 Supplement SELF-TEST QUESTIONS variable) associated with the contract. Even though the analyses indicate that the contract is unprofitable under loosely managed utilization, the analysis has been on a full cost basis. If the costs associated with the contract consist of 50 percent fixed costs and 50 percent variable costs, the variable cost PMPM in the worst case (loosely managed utilization) would be 0.50 . $55.99 = $28.00. At a premium of $35, the marginal PMPM contribution margin is $35 . $28 = $7. Thus, even under loose management, the premium would at least cover the contract s variable (marginal) costs. If Baptist cannot afford to lose the market share associated with CHP s members, its managers may deem the contract acceptable in the short run. Assuming that the hospital can improve its utilization management over time, eventually it will be able to cover the total costs associated with the contract.

Cost structure is not the only variable that can change over time. Perhaps Baptist can demonstrate superior quality and negotiate a higher premium over time. On the down side, perhaps CHP will gain additional market power over time and attempt to push the premium even lower. These are just a few of the imponderables that Baptist s managers must consider when making the service decision.

1. Why does utilization management play such an important role in pricing and service decisions under capitation?

2. Why are nonmedical costs included in the analysis?

3. What would you do regarding the contract if you were the CEO of Baptist Memorial Hospital?

4. What other factors should Baptist s managers consider when making the capitation contract decision?

FINANCIAL PLANNING AND BUDGETING 8 Learning Objectives After studying this chapter, readers will be able to Describe the overall planning process and the key components of the financial plan.

Discuss briefly the format and use of several types of budgets.

Explain the difference between a static budget and a flexible budget.

Create a simple operating budget.

Use variance analysis to assess financial performance and identify operational areas of concern.

Introduction Financial planning and budgeting play a critical role in the finance function of all health services organizations. In fact, one could argue (and usually win) that planning and budgeting are the most important of all finance-related tasks.

Planning encompasses the overall process of preparing for the future.

Because of its importance to organizational success, most health services managers, especially at large organizations, spend a great deal of time on activities related to planning. Budgeting is an offshoot of the planning process. A set of budgets is the basic managerial accounting tool used to tie together planning and control functions. In general, organizational plans focus on the long-term big picture, whereas budgets address the details of planning for the immediate future and, through the control mechanism, ensuring that current performance is consistent with organizational plans and goals.

This chapter introduces the planning process and discusses how financial plans and budgets are used within health services organizations. In particular, the chapter focuses on how managers can use flexible budgets and variance analysis to help exercise control over current operations. Unfortunately, in an introductory book, only the surface of these important topics can be scratched.

Strategic plan A document that defines the business s longterm direction along with the resources needed to get there.

Strategic Planning Financial plans and budgets are developed within the framework of the business s strategic plan. Strategic plans focus an organization s vision and priorities in response to a changing environment. Their primary purpose is to ensure that everyone within the organization is working toward the same goals. Most strategic plans consider a range of future outcomes, trends, and unknowns to arrive at a set of strategies that best use organizational resources. Many times, the strategic planning process taps into knowledge from diverse stakeholder groups who can help navigate an uncertain future. This broad perspective is helpful for better understanding the external environment and in developing strategies.

Simply put, strategic planning is a continuous process that guides organizational action and behavior. Here are some of the components of the strategic plan.

Values Statement The guiding light for the strategic plan is the organization s values statement, because values represent the core priorities that define the organization s culture.

In general, the values statement contains a list of four to six basic beliefs that underlie the organization. To illustrate, consider the following values statement of Bayside Memorial Hospital, a not-for-profit acute care hospital:

To treat everyone with respect and dignity To trust in all relationships To be compassionate in comfort and care To do the right thing at the right time for the right reason To be patient and tolerant To achieve excellence and ensure quality Mission Statement The mission statement, which must conform to the values statement, defines the organization s overall purpose and reason for existence. The mission may be defined either specifically or in more general terms, but, at a minimum, it must describe what the organization does and for whom. For example, an investor- owned medical equipment manufacturer might state that its mission is to provide our customers with state-of-the-art diagnostic systems at the lowest attainable cost, which will also maximize benefits to our employees and stockholders. Mission statements for not-for-profit businesses normally are stated in different terms. For example, here is Bayside s mission statement:

To provide comprehensive, state-of-the-art patient services To emphasize caring and other human values in the treatment of patients and in relations among employees, medical staff, and community To provide employees and medical staff with maximum opportunities to achieve their personal and professional goals Note, however, that regardless of the nature of the mission statement, the reality of competition in the health services industry forces all businesses, regardless of ownership, to operate in a manner consistent with financial viability.

Vision Statement The vision statement usually is developed concurrently with the mission statement.

The most effective vision statements are brief, single-sentence statements that describe the desired position of the organization at a future point in time say, ten years from now. The intent is to provide a single goal that motivates managers, employees, and the medical staff to work together to achieve it. Bayside s vision statement is to be the regional leader in providing state-of-the-art, compassionate care in a humanistic environment. In addition to providing limited guidance regarding management and employee behavior at Bayside, the values, mission, and vision statements provide managers with a framework for establishing the specific goals and objectives outlined in the operating plan, which we describe in the next section.

1. Briefly describe the nature and use of the following corporate planning tools:

a. Strategic plan b. Values statement c. Mission statement d. Vision statement 2. Why do financial planners need to be familiar with the business s strategic plan?

Operational Planning Whereas strategic planning provides general guidance for the long term, operational planning provides a road map for executing an organization s strategic plan. The key document in operational planning is the operating plan, which contains near-term operational objectives and the detailed guidance necessary to meet those objectives. In other words, the operating plan provides the how to or perhaps how we expect to portion of an organization s overall plan for the future. Operating plans can be developed for any time horizon, but most organizations use a five-year horizon, and thus the term five-year plan has become common. Note, however, that the plans are most detailed for the first year, with each succeeding year s plan becoming less specific.

SELF-TEST QUESTIONS Operating plan An organizational road map for the future, often for five years but with most detail for the first year.

Operating plans must be based on and consistent with the guidance provided in the organization s strategic plan.

EXHIBIT 8.1 Bayside Memorial Hospital:

Operating Plan Outline Exhibit 8.1 outlines the key elements of Bayside Memorial Hospital s operating plan, with an expanded section for the financial plan. A full outline would require several pages, but Exhibit 8.1 provides some insights into the format and contents of an operating plan. Note that the first chapter of the operating plan is drawn from the organization s strategic plan.

Organizational Goals The strategic plan discussed in the previous section contains the general philosophy and approach of the organization, as well as its long-term aspiration, but it does not provide managers with specific operational goals and objectives.

These are contained in Chapter 2 of the operating plan. Organizational goals are specific aims that management strives to attain. Organizational goals generally are qualitative in nature, such as keeping the firm s research and development efforts at the cutting edge of the industry. Multiple goals are Chapter 1 Organizational values, mission, and vision Chapter 2 Organizational goals and objectives Chapter 3 Projected business environment Chapter 4 Organizational strategies Chapter 5 Summary of projected business results Chapter 6 Service line plans Chapter 7 Functional area plans A. Marketing B. Operations C. Finance 1. Financial condition, capital investments, and financing a. Financial condition analysis b. Capital budget c. Forecasted financial statements d. External financing requirements 2. Current accounts and revenue cycle management a. Overall policy b. Cash budget c. Cash and marketable securities management d. Inventory management e. Revenue cycle management f. Short-term financing 3. Budgeting and control a. Statistics budget b. Revenue budget c. Expense budget d. Operating budget e. Control procedures D. Administration and human resources E. Facilities established, and they should be changed over time as conditions change.

A provider s organizational goals should be challenging yet realistically attainable.

Bayside Memorial Hospital divides its organizational goals into the following five major areas:

1. Quality and Patient Satisfaction To make quality performance the goal of each employee To be recognized by our patients as the provider of choice in our market area To identify and resolve areas of patient dissatisfaction as rapidly as possible 2. Medical Staff Relations To identify and develop timely channels of communication among all members of the medical staff, management, and board of directors To respond in a timely manner to all medical staff concerns brought to the attention of management To make Bayside Memorial Hospital a more desirable location to practice medicine To develop strategies to enhance the mutual commitment of the medical staff, administration, and board of directors for the benefit of the hospital s stakeholders To provide the highest-quality, most cost-effective medical care through a collaborative effort of the medical staff, administration, and board of directors 3. Human Resources Management To be recognized as the customer service leader in our market area To develop and manage human resources to make Bayside Memorial Hospital the most attractive location to work in our market area 4. Financial Performance To maintain a financial condition that permits us to be highly competitive in our market area To develop the systems necessary to identify inpatient and outpatient costs by unit of service 5. Health Systems Management To be a leader in applied technology based on patient needs To establish new services and programs in response to patient needs To be at the forefront of electronic medical records technology These goals occasionally conflict, and when they do, Bayside s senior managers have to make judgments regarding which one takes precedence.

Organizational Objectives Once an organization has defined its goals, it must develop objectives designed to help it achieve those goals. Although organizational goals are a starting point, their qualitative nature makes them unsuitable for use as specific measurable targets. Organizational objectives, on the other hand, are generally quantitative in nature, such as specifying a target market share or a target return on equity (ROE). Furthermore, the extent to which organizational objectives are met is commonly used as a basis for managers compensation.

To illustrate organizational objectives, consider Bayside s financial performance goal of maintaining a financial condition that permits the hospital to be highly competitive in its market area. The following objectives are tied to that goal:

To maintain or exceed the hospital s current 5.6 percent operating margin To maintain or exceed the hospital s current 7.3 percent total margin To increase the hospital s debt ratio to the range of 35 to 40 percent; however, this objective is not to be attained by initiating new programs or services that will lower the hospital s profit margin To maintain the hospital s liquidity as measured by the current ratio in the range of 2.0 to 2.5 To increase fixed asset utilization as measured by the fixed asset turnover ratio to 1.5 Organizational objectives give managers precise targets to shoot for.

But the objectives must support the business s goals and must be chosen carefully so that they are challenging yet attainable in a few years time. (Note that the financial measures listed above are discussed in detail in Chapter 17.) SELF-TEST QUESTIONS 1. What is the difference between strategic and operational planning?

2. How do organizational goals differ from organizational objectives?

3. What is the most common time horizon for operating plans?

Financial Planning Whereas strategic and operational planning focus on the overall organization, financial planning focuses on the finance function. The first part of the financial plan (Chapter 7.C of the operating plan in Exhibit 8.1) focuses on financial condition, capital investments, and financing at the organizational level.

Its first component is a review of the business s current financial condition, which provides the basis, or starting point, for the remainder of the financial plan. (Insights into how this is accomplished are presented in Chapter 17.) Next is the capital budget, which outlines future plans for capital investment (the purchase of land, buildings, and equipment). (Capital budgeting procedures are discussed in chapters 14 and 15.) This information feeds into the forecasted financial statements, which are projected for the next five years.

Finally, the organization s future financing requirements are listed, along with a plan for obtaining these funds. (Financing decisions are covered in chapters 11, 12, and 13.) As can be seen from its content, Section 1 of the financial plan provides an overview of the financial future of the organization.

Section 2 of the financial plan concerns current accounts management, which encompasses the management of current assets and current liabilities, including revenue cycle management. Here the plan provides overall guidance regarding day-to-day, short-term financial operations. (Current accounts and revenue cycle management are covered in Chapter 16.) In essence, Section 2 of the financial plan provides short-term operating benchmarks for all facets of current accounts management.

The budgeting and control portion (Section 3) of the financial plan provides financial goals at the micro level for example, by division, contract, or diagnosis and is used to control operations through frequent comparisons with actual results. In essence, this portion contains the budgets that provide the benchmarks managers should be striving to attain throughout the year.

Exhibit 8.2 contains the hospital s annual financial planning schedule.

This schedule illustrates that, as for most organizations, Bayside s financial planning process is essentially continuous. For Bayside, much of the financial planning function takes place at the department level, with technical assistance from the marketing, planning, and financial staffs. Larger organizations, with divisions, focus the planning process at the divisional level. Each division has its own mission and goals, as well as objectives and budgets designed to support its goals; these plans, when consolidated, constitute the overall operating plan.

If financial planning were compared to planning a cross-country road trip, Section 1 of the financial plan could be thought of as a road map of the United States, which provides the overview, while sections 2 and 3 could be thought of as the state and local maps, which provide the details.

1. Briefly describe the contents of a typical financial plan.

2. What are the primary differences between sections 1, 2, and 3 of the financial plan?

Financial plan The portion of the operating plan that focuses on the finance function.

SELF-TEST QUESTIONS EXHIBIT 8.2 Bayside Months Action Memorial Hospital:

Annual Financial Planning April May Marketing department analyzes national and local economic factors likely to influence Bayside s patient volume and reimbursement rates. At this time, a preliminary volume forecast is prepared for each service line.

Schedule June July Operating departments prepare new project (longterm asset) requirements as well as operating cost estimates based on the preliminary volume forecast.

August September Financial analysts evaluate proposed capital expenditures and department operating plans.

Preliminary forecasted financial statements are prepared with emphasis on Bayside s overall sources and uses of funds and forecasted financial condition.

October November All previous input is reviewed and the hospital s operating plan is drafted by the planning, financial, and departmental staffs. At this stage, the operating and cash budgets are finalized. Any changes that have occurred since the beginning of the planning process are incorporated into the plan.

December The operating plan, including all budgets for the coming year, is approved by the hospital s executive committee and submitted to the board of directors for final approval.

Budgeting The process of preparing and using a budget, which is a detailed plan (in dollar terms) that specifies how resources will be obtained and used during some future period.

Introduction to Budgeting Budgeting involves detailed plans, expressed in dollar terms, that specify how resources will be obtained and used during a specified future period of time.

In general, budgets rely heavily on revenue and cost estimates, so the budgeting process applies many of the managerial accounting concepts presented in chapters 5, 6, and 7.

To be of most use, budgets must be thought of not as accounting tools but as managerial tools. In reality, budgets are more important to line managers than to the financial staff because budgets provide the means to plan and communicate operational expectations within an organization. Every manager in that organization must be aware of the plans made by other managers and by the organization as a whole, and budgets provide the means of communication.

In addition, the budgeting process and the resultant final budget provide the means for senior executives to allocate financial resources among competing demands within an organization.

Although planning, communication, and allocation are important purposes of the budgeting process, perhaps the greatest value of budgeting is that it establishes financial benchmarks for control. When compared to actual results, budgets provide managers with feedback about the relative financial performance of the entity whether it is a department, a diagnosis, a contract, or the organization as a whole. Such comparisons help managers evaluate the performance of individuals, departments, product lines, reimbursement contracts, and so on.

Finally, budgets provide managers with information about what needs to be done to improve performance. When actual results fall short of those specified in the budget, managers use variance analysis to identify the areas that caused the subpar performance. In this way, managerial resources can be brought to bear on those areas of operations that offer the most promise for financial improvement. In addition, the information developed by comparing actual results with expected (planned) results (the control process) is useful in improving the overall accuracy of the planning process. Managers want to meet budget targets, and hence most managers will think long and hard when those targets are being developed.

SELF-TEST 1. What is budgeting? QUESTIONS 2. What are its primary purposes and benefits?

Initial Budgeting Decisions Managers must make many decisions regarding the budgeting process. This section covers decisions that focus on budget timing and the general approach to the budgeting process. The next major section discusses the types of budgets used within healthcare organizations.

Timing Virtually all health services organizations have annual budgets that set the standards for the coming year. However, it would take too long for managers to detect adverse trends if budget feedback were provided solely on an annual basis, so most organizations also have quarterly budgets, while some have monthly, weekly, or even daily budgets. Not all budget types or subunits within an organization use the same timing pattern. Additionally, many organizations prepare budgets for one or more out years, or years beyond the next budget year; these budgets are more closely aligned with financial planning Conventional than with operational control. budgeting An approach to budgeting that Conventional Versus Zero-Based Budgets uses the previous Traditionally, health services organizations have used the conventional bud- budget as the geting approach to their budget processes. In this approach, the previous starting point.

Zero-based budgeting An approach to budgeting that starts with a clean slate and requires complete justification of all budget items.

budget is used as the starting point for creating the new budget. Each line on the old budget is examined, and then adjustments are made to reflect changes in circumstances. In this approach, it is common for many budget changes to be applied more or less equally across departments and programs.

For example, labor costs might be assumed to increase at the same inflation rate for all departments and programs within an organization. In essence, the conventional approach to budgeting assumes that prior budgets are based on operational rationality, so the main issue is determining what changes (typically minor) must be made to the previous budget to account for changes in the operating environment. In other words, the assumption is made that the current budget accurately reflects the resource needs of the organization.

As its name implies, zero-based budgeting starts with a clean slate; that is, departments begin with a budget of zero. Department heads then must fully justify every line item in their budgets. In effect, departments and programs must justify their contribution (positive or negative) to the organization s financial condition each budget period. In some situations, department and program heads must create budgets that show the impact of alternative funding levels. Senior management then can use this information to make rational decisions about where cuts could be made in the event of financial constraints.

Conceptually, zero-based budgeting is superior to conventional budgeting.

Indeed, when zero-based budgeting was introduced in the 1970s, it was widely embraced. However, the managerial resources required for zero-based budgeting far exceed those required for conventional budgeting. Therefore, many organizations that initially adopted zero-based budgeting soon concluded that its benefits were not as great as its costs. There is evidence, however, that zero-based budgeting is making a comeback among health services organizations, primarily because market forces are requiring providers to implement cost control efforts on a more or less continuous basis.

As a compromise, some health services organizations use conventional budgeting annually but then use a zero-based budget on a less frequent basis say, every five years. An alternative is to use the conventional approach on 80 percent of the budget each year and the zero-based approach on 20 percent.

Then, over every five-year period, the entire budget will be subjected to zero- based budgeting. This approach takes advantage of the benefits of zero-based budgeting without creating a budgeting process in any year that is too time consuming for managers.

Top-Down Versus Bottom-Up Budgets The budget affects virtually everyone in the organization, and individuals reactions to the budgeting process can have considerable influence on an organization s overall effectiveness. Thus, one of the most important decisions regarding budget preparation is whether the budget should be created top-down or bottom-up.

In the bottom-up, or participatory, approach, budgets are developed first by department or program managers. Presumably, such individuals are most knowledgeable regarding their departments or programs financial needs. The department budgets are submitted to the finance department for review and compilation into the organizational budget, which then must be approved by senior management. Unfortunately, the aggregation of department or program budgets often results in an organizational budget that is not financially feasible.

In such cases, the component budgets must be sent back to the original preparers for revision, which starts a negotiation process aimed at creating a budget acceptable to all parties or at least to as many parties as possible.

A more authoritarian approach to budgeting is the top-down approach, in which little negotiation takes place between junior and senior managers. This approach has the advantages of being relatively expeditious and reflecting top management s perspective from the start. However, by limiting involvement and communication, the top-down approach often results in less commitment among junior managers and employees than does the bottom-up approach. Most people will perform better and make greater attempts to achieve budgetary goals if they have played a prominent role in setting those goals. The idea of participatory budgeting is to involve as many managers, and even employees, as possible in the budgetary process.

1. What time periods are used in budgeting?

2. What are the primary differences between conventional budgets and zero-based budgets?

3. What are the primary differences between top-down budgets and bottom-up budgets?

For Your Consideration Middle-Out Budgeting As you know, there are two primary approaches to the budgeting process. In the top-down approach, budgets are established by senior management, for example, the executive committee or board of directors (or trustees). In essence, senior management is dictating the financial resources to be allocated to the department level. In the bottom-up approach, department heads are responsible for creating their own budgets, which are then submitted up the chain for approval. Although the bottom-up approach has many virtues, in large organizations it often is impractical to have that many people involved in the budget process.

Some organizations are now experimenting with a hybrid budgeting approach called middle- out budgeting. Here, budgets are prepared at the divisional (services) level, for example, a hospital s inpatient, outpatient, clinical support, and administrative support divisions. Then the budgets are sent to both senior and junior (department) managers for review and ultimate approval.

In essence, middle managers who presumably are in the best position to understand both sides and can create a budget that is adequate yet not excessive act as go-betweens.

What do you think? Is there any merit to middle-out budgeting? Which approach do you think is best for a small organization, such as a three-doctor medical practice? What about a 600bed hospital?

SELF-TEST QUESTIONS Statistics budget A budget that contains the patient volume and resource need assumptions used in all other budgets.

Budget Types Although an organization s immediate financial expectations are expressed in a document called the budget (or master budget), in most organizations the budget is actually composed of several different budgets. Unlike an organization s financial statements, budget formats are not specified by external parties in the form of generally accepted accounting principles, or GAAP, so the contents and format of the budget are dictated by the organization s mission and structure and by managerial preferences. That said, several types of budgets are used either formally or informally at virtually all health services organizations.

Statistics Budget The statistics budget is the cornerstone of the budgeting process in that it specifies the patient volume and resource assumptions used in other budgets.

Because the statistics budget feeds into all other budgets, accuracy is particularly important. The statistics budget does not provide detailed information on required resources such as staffing or short-term operating asset requirements, but it provides general guidance.

Some organizations, especially smaller ones, may not have a separate statistics budget but instead may incorporate its data directly into the revenue and expense budgets or perhaps into a single operating budget. The advantage of having a separate statistics budget is that, within large organizations, it forces all other budgets to use the same set of volume and resource assumptions. Unfortunately, patient volume estimates, which are the heart of the statistics budget and which drive all other forecasts, are among the most difficult to make.

To illustrate the complexities of patient volume forecasting, consider the procedures followed by Bayside Memorial Hospital when it prepares its statistics budget. To begin, the demand for services is divided into four major groups: inpatient, outpatient, ancillary, and other services. Volume trends in each of these areas over the past five years are plotted, and a first approximation forecast is made, assuming a continuation of past trends. Next, the level of population growth and disease trends are forecasted. For example, what will be the growth in the over-65 population in the hospital s service area? These forecasts are used to develop volume by major diagnoses and to differentiate between normal services and critical care services.

Bayside s managers then analyze the competitive environment. Consideration is given to such factors as the hospital s inpatient and outpatient capacities, its competitors capacities, and new services or service improvements that either Bayside or its competitors might institute. Next, Bayside s managers consider the effect of the hospital s planned pricing actions on volume. For example, does the hospital have plans to raise outpatient charges to boost profit margins or to lower charges to gain market share and utilize excess capacity?

If such actions are expected to affect volume forecasts, these forecasts must be revised to reflect the expected impact. Marketing campaigns and changes in third-party payer contracts also affect volume, so probable developments in these areas also must be considered.

If the hospital s volume forecast is off the mark, the consequences can be serious. First, if the market for any particular service expands more than Bayside has expected and planned for, the hospital will not be able to meet its patients needs. Potential patients will end up going to competitors, and Bayside will lose market share and perhaps miss a major opportunity. However, if its projections are overly optimistic, Bayside could end up with too much capacity, which means higher-than-necessary costs because of excess facilities and staff.

Revenue Budget Detailed information from the statistics budget feeds into the revenue budget, which combines patient volume and reimbursement data to develop revenue forecasts. Bayside s planners consider the hospital s pricing strategy for managed care plans, conventional fee-for-service contracts, and private-pay patients as well as trends in inflation and third-party payer reimbursement, all of which affect operating revenues.

The result is a compilation of operating revenue forecasts by service, both in the aggregate for example, inpatient revenue and on an individual diagnosis basis. The individual diagnosis forecasts are summed and then compared with the aggregate service group forecasts. Differences are reconciled, and the result is an operating revenue forecast for the hospital as a whole but with breakdowns by service categories and by individual diagnoses.

In addition to operating revenues, other revenues, such as interest income on investments and lease payments on medical office buildings, must be forecasted. Note that in all revenue forecasts both the amount and the timing are important. Thus, the revenue budget must forecast not only the amount of revenue but also when the revenue is expected to occur, typically by month.

Expense Budget Like the revenue budget, the expense budget is derived from data in the statistics budget. The focus here is on the costs of providing services rather than the resulting revenues. The expense budget typically is divided into labor (salaries, wages, and fringe benefits, including travel and education) and nonlabor components. The nonlabor components include expenses associated with such items as depreciation, leases, utilities, and administrative and medical supplies. Expenses normally are broken down into fixed and variable components. (As discussed later in this chapter, cost structure information is required if an organization uses flexible budgeting techniques.) Revenue budget A budget that focuses on the revenues of an organization or its subunits.

Expense budget A budget that focuses on the costs of providing goods or services.

Operating budget A single budget that combines both the revenue and expense budgets.

SELF-TEST QUESTIONS Operating Budget For larger organizations, the operating budget flows from the revenue and expense budgets. For smaller businesses, data typically found in the statistic, revenue, and expense budgets are used to create the operating budget in a single step. Because the operating budget (and, by definition, the revenue and expense budgets) is prepared using accrual accounting methods, it can be roughly thought of as a forecasted income statement. However, unlike the income statement, which is typically prepared at the organizational level, operating budgets are prepared at the subunit level say, a department or product line. Because of its overall importance to the budgeting process, the operating budget is the main focus of this chapter.

1. What are some of the budget types used within health services organizations?

2. Briefly describe the purpose and use of each.

3. How are the statistics budget, revenue and expense budgets, and operating budget related?

Constructing a Simple Operating Budget Exhibit 8.3 contains the 2015 operating budget for Carroll Clinic, an inner- city, primary care facility. Most operating budgets are more complex than this illustration, which has been kept simple for ease of discussion.

As with most financial forecasts, the starting point for the operating budget, which was developed in October 2014, is patient volume. A volume projection gives managers a starting point for making revenue and cost estimates.

As shown in Part I of Exhibit 8.3, Carroll Clinic s expected patient volume for 2015 comes from two sources: a fee-for-service (FFS) population expected to total 36,000 visits and a capitated population expected to average 30,000 members. Historically, annual utilization by the capitated population has averaged 0.15 visits per member-month, so in 2015 this population, which is expected to total 30,000 . 12 = 360,000 member-months, will provide 360,000 . 0.15 = 54,000 visits. In total, therefore, Carroll s patient base is expected to produce 36,000 + 54,000 = 90,000 visits. Armed with this Part I volume projection, Carroll s managers can proceed with revenue and cost projections.

Part II contains revenue data. The clinic s net collection for each FFS visit averages $25. Some visits will generate greater revenues, and some will generate less. On average, though, expected revenue is $25 per visit. Thus, 36,000 visits would produce $25 . 36,000 = $900,000 in FFS revenues. In addition, the premium for the capitated population is $3 per member per month (PMPM), which would generate a revenue of $3 . 360,000 member-months I.

Volume Assumptions:

A. FFS 36,000 visits B. Capitated lives 30,000 members Number of member-months 360,000 Expected utilization per member-month 0.15 Number of visits 54,000 visits C. Total expected visits 90,000 visits II.

Revenue Assumptions:

A. FFS $ 25 per visit . 36,000 expected visits $ 900,000 B. Capitated lives $ 3 PMPM .360,000 actualmember-months $ 1,080,000 C. Total expected revenues $ 1,980,000 III.

Cost Assumptions:

A. Variable Costs:

Labor $ 1,200,000 (48,000 hours at $25/hour) Supplies 150,000 (100,000 units at $1.50/unit) Total variable costs $ 1,350,000 Variable cost per visit $ 15 ($1,350,000 90,000) B. Fixed Costs:

Overhead, plant, and equipment $ 500,000 C. Total expected costs $ 1,850,000 IV.

Pro Forma Profit and Loss (P&L) Statement:

Revenues:

FFS $ 900,000 Capitated 1,080,000 Total $ 1,980,000 Costs:

Variable:

FFS $ 540,000 Capitated 810,000 Total $ 1,350,000 Contribution margin $ 630,000 Fixed costs 500,000 Projected profit $ 130,000 EXHIBIT 8.3 Carroll Clinic:

2015 Operating Budget = $1,080,000. Considering both patient sources, total revenues for the clinic are forecasted to be $900,000 + $1,080,000 = $1,980,000 in 2015.

Because of the uncertainty inherent in the clinic s volume estimates, it is useful to recognize that total revenues will be $1,980,000 only if the volume forecast holds. In reality, Total revenues = ($25 . Number of FFS visits) + ($3 . Number of capitated member-months). If the actual number of FFS visits is more or less than 90,000 in 2015, or the number of capitated lives (and hence member-months) is something other than 30,000, the resulting revenues will be different from the $1,980,000 forecast.

Part III of Exhibit 8.3 focuses on expenses. To support the forecasted 90,000 visits, the clinic is expected to use 48,000 hours of medical labor at an average cost of $25 per hour, for a total labor expense of 48,000 . $25 = $1,200,000. Thus, labor costs are expected to average $1,200,000 90,000 = $13.33 per visit in 2015. In reality, all labor costs are not variable, but there are a sufficient number of workers who either work part time or are paid on the basis of productivity to closely tie labor hours to the number of visits.

Supplies expense, the bulk of which is inherently variable in nature, historically has averaged about $1.50 per bundle (unit) of supplies, with 100,000 units expected to be used to support 90,000 visits. (A unit of supplies is a more or less standard package that contains both administrative and clinical supplies.) Thus, supplies expense is expected to total $150,000, or $150,000 90,000 = $1.67 on a per visit basis. Taken together, Carroll s labor and supplies variable costs are forecasted to be $13.33 + $1.67 = $15 per visit in 2015. The same amount can be calculated by dividing total variable costs by the number of visits: $1,350,000 90,000 = $15.

Finally, the clinic is expected to incur $500,000 of fixed costs, primarily administrative overhead, some labor costs, depreciation, and lease expense.

Therefore, to serve the anticipated 90,000 visits, costs are expected to consist of $1,350,000 in variable costs plus $500,000 in fixed costs, for a total of $1,850,000. Again, it is important to recognize that some costs (in Carroll s case, a majority of costs) are tied to volume. Thus, total costs can be expressed as ($15 . Number of visits) + $500,000. If the actual number of visits in 2015 is more or less than 90,000, total costs will differ from the $1,850,000 budget estimate.

The final section (Part IV) of Exhibit 8.3 contains Carroll Clinic s budgeted 2015 profit and loss (P&L) statement, the heart of the operating budget. The difference between the projected revenues of $1,980,000 and the projected variable costs of $1,350,000 produces a total contribution margin of $630,000. Deducting the forecasted fixed costs of $500,000 results in a budgeted profit of $130,000.

The true purpose of the operating budget is to set financial goals for the clinic. In effect, the operating budget can be thought of as a contract between the organization and its managers. Thus, the $130,000 profit forecast becomes the overall profit benchmark for the clinic in 2015, and individual managers will be held accountable for the revenues and expenses needed to meet the budget.

1. What are some of the key assumptions required to prepare an operating budget?

2. Do the required assumptions depend on the type of organization and the nature of its reimbursement contracts?

3. Why is the budgeted profit and loss (P&L) statement so important?

Variance Analysis Variance analysis, which focuses on differences (variances) between realized values and forecasts, is an important technique for controlling financial performance.

This section includes a discussion of the basics of variance analysis, including flexible budgeting, as well as an illustration of the process.

Variance Analysis Basics In accounting, a variance is the difference between an actual (realized) value and the budgeted value, often called a standard. Note that the accounting definition of variance is different from the statistical definition, although both meanings connote a difference from some base value. In effect, variance analysis is an examination and interpretation of differences between what has actually happened and what was planned. If the budget is based on realistic expectations, variance analysis can provide managers with useful information.

Variance analysis does not provide all the answers, but it does help managers ask the right questions.

Variance analysis is essential to the managerial control process. Actions taken in response to variance analysis often have the potential to dramatically improve the operations and financial performance of the organization. For example, many variances are controllable (can be corrected by managerial actions), so managers can take actions to avoid unfavorable variances in the future.

The primary focus of variance analysis should not be to assign blame for unfavorable results. Rather, the goal of variance analysis is to uncover the cause of operational problems so that these problems can be corrected as quickly as possible and avoided, or at least minimized, in the future. Unfortunately, not all variances are controllable by management. Nevertheless, knowledge of such variances is essential to the overall management and well-being of the organization. It may be necessary to revise plans, for example, to tighten controllable costs in an attempt to offset unfavorable cost variances in areas that are beyond managerial control.

SELF-TEST QUESTIONS Variance analysis A technique used in budgeting in which realized values are compared with budgeted values to help control operations.

Variance The difference between what actually happened and what was expected to happen.

Static Versus Flexible Budgets To be of maximum use to managers, variance analysis must be approached Static budget systematically. The starting point for such analyses is the static budget, which A budget that is is the original approved budget unadjusted for differences between planned and prepared at the actual (realized) patient volumes. However, at the end of a budget period, it beginning of a planning period. is unlikely that realized volume will equal budgeted volume, and it would be useful to know which variances are due to volume forecast errors and which variances are caused by other factors.

To illustrate this concept, consider Carroll Clinic s 2015 operating budget contained in Exhibit 8.3. The profit projection, $130,000, is predicated on specific volume assumptions: 36,000 visits for the FFS population and 360,000 member-months, resulting in 54,000 visits, for the capitated population. At the end of the year, the clinic s managers will compare actual profits with budgeted profits. The problem, of course, is that it is highly unlikely that actual profits will result from 36,000 fee-for-service visits and 360,000 member-months (with 54,000 visits) for the capitated population.

The number of fee-for-service visits might be higher or lower than forecasted, and the capitated population might be greater or less than forecasted and use services at a different rate than assumed in the static budget. Thus, if Carroll s managers were to merely compare the realized profit with the $130,000 profit in the static budget, they would not know whether any profit difference is Flexible budget caused by forecasted and realized patient volume differences or by underlying A budget based on operational differences.

the static budget To provide an explanation of what is driving the profit variance, Carroll s but adjusted to reflect realized managers must create a flexible budget. A flexible budget is one in which the volume. static budget has been adjusted to reflect the actual volume achieved in the budget period. Essentially, flexible budgets are an after-the-fact device to tell managers what the results would have been under the volume level actually attained, assuming all other budgeting assumptions are held constant. The flex- For Your Consideration ible budget permits a more detailed analysis than is possible using only actual results Rolling Budgets compared to the static budget. However, a A rolling budget, also called a continuous bud- flexible budget requires the identification of get, is constantly updated. In essence, a rolling budget is kept current by adding a period to the variable and fixed costs and hence places a budget each time a period ends. For example, greater burden on the organization s manaassume an annual budget is created for Janu-gerial accounting system.

ary December 2015. When January 2015 ends, the budget is revised for the period February Variance Analysis Illustration 2015 January 2016. Thus, the budget remains To illustrate variance analysis, consider Car- annual, but the year is rolled forward by adding roll s static budget for 2015 (Exhibit 8.3), (continued) which projects a profit of $130,000. Data used for variance analysis are tracked in various parts of Carroll s managerial accounting information system throughout the year, and variance analyses are performed monthly. This allows managers to take necessary actions during the year to positively influence annual results. For purposes of this illustration, however, the monthly feedback is not shown. Rather, the focus is on the year-end results, which are contained in Exhibit 8.4.

Creating the Flexible Budget Exhibit 8.5 contains three sets of data for 2015. The static budget, which is taken from Exhibit 8.3, is the forecast made at the beginning of 2015; the actual results, taken from Exhibit 8.4, reflect what hap (continued from previous page) a month as each month passes by. Alternatively, the annual budget could be rolled forward by quarter, in which case it would be extended every three months.

A rolling budget allows managers to incorporate new information into the organizational budget in a timely manner and get a feel for how that information affects annual (but not necessarily fiscal year) results. Thus, forecasts can be revised and the results of managerial actions can be incorporated monthly, with results still forecasted on an annual basis.

What do you think? Are rolling budgets a valuable addition to the planning process? What information do rolling budgets provide that is not available in traditional quarterly and annual budgets?

pened. The flexible budget in the center column of Exhibit 8.5 reflects projected revenues and costs at the realized (actual) volume, as opposed to the projected volume, but incorporates all other assumptions that were used in the static (original) budget. By analyzing differences in these three data sets, Carroll s managers can gain insights into why the clinic ended the year with a loss.

Note that the flexible budget maintains the original budget assumptions of Revenues = ($25 . Number of FFS visits) + ($3 . Number of capitated member-months) and Expenses = ($15 . Number of FFS visits) + ($15 .

Number of capitated visits) + $500,000. However, the flexible budget flexes (adjusts) revenues and costs to reflect actual volume levels. Thus, in the flexible budget column, Revenues = ($25 . 40,000) + ($3 . 360,000) = $1,000,000 + $1,080,000 = $2,080,000, and Expenses = ($15 . 40,000) + ($15 . 72,000) + $500,000 = $600,000 + $1,080,000 + $500,000 = $1,680,000 + $500,000 = $2,180,000. The flexible budget uses the original estimates for revenue and expense rates but couples these rates with realized volumes. In the static budget, these same rates were used in conjunction with forecasted volumes.

The flexible budget can be described as follows. The $2,080,000 in total revenues is what the clinic would have expected at the start of the year if the volume estimates had been 40,000 FFS visits and a capitated membership of 30,000. In addition, the total variable costs of $1,680,000 in the flexible budget are the costs that Carroll would have expected for 40,000 FFS visits and 72,000 capitated visits (based on a membership of 30,000). By definition, the fixed costs should be the same, within a reasonable range, no matter EXHIBIT 8.4 Carroll Clinic: I.

Volume:

A. FFS 40,000 visits 2015 Results B. Capitated lives 30,000 members Number of member-months 360,000 Actual utilization per member-month 0.20 Number of visits 72,000 visits C. Total actual visits 112,000 visits II.

Revenues:

A. FFS $ 24 per visit . 40,000 actual visits $ 960,000 B. Capitated lives $ 3 PMPM .360,000 actual member-months $ 1,080,000 C. Total actual revenues $ 2,040,000 III.

Costs:

A. Variable Costs:

Labor $ 1,557,400 (59,900 hours at $26/hour) Supplies 234,600 (124,800 units at $1.88/unit) Total variable costs $ 1,792,000 Variable cost per visit $ 16 ($1,792,000 112,000) B. Fixed Costs:

Overhead, plant, and equipment $ 500,000 C. Total actual costs $ 2,292,000 IV.

Profit and Loss Statement:

Revenues:

FFS $ 960,000 Capitated 1,080,000 Total $ 2,040,000 Costs:

Variable:

FFS $ 640,000 Capitated 1,152,000 Total $ 1,792,000 Contribution margin $ 248,000 Fixed costs 500,000 Actual profit ($ 252,000) what the volume level is. On net, the $100,000 loss shown on the flexible budget represents the profit expected given the initial assumed revenue, cost, and volume relationships, coupled with a forecasted volume that equals the realized volume.

EXHIBIT 8.5 Static Flexible Actual Carroll Clinic:

Budget Budget Results Static and Assumptions:

FFS visits Capitated visits Total 36,000 54,000 90,000 Revenues:

FFS Capitated Total $ 900,000 1,080,000 $1,980,000 Costs:

Variable:

FFS Capitated Total $ 540,000 810,000 $1,350,000 Contribution margin Fixed costs $ 630,000 500,000 Profit $ 130,000 40,000 72,000 112,000 $1,000,000 1,080,000 $2,080,000 $ 600,000 1,080,000 $1,680,000 $ 400,000 500,000 ($ 100,000) 40,000 72,000 112,000 $ 960,000 1,080,000 $2,040,000 $ 640,000 1,152,000 $ 1,792,000 $ 248,000 500,000 ($ 252,000) Flexible Budgets and Actual Results for 2015 Conducting the Variance Analysis As explained earlier, variance analysis involves comparing two amounts, with the variance being the difference between the values. For example, if at the beginning of the year, a hospital expected to make a profit of $2 million but actual results were a profit of $3 million, the variance would be $1 million.

The expected, or standard value, in this case $2 million of profits, is the profit goal of the hospital as expressed in the budget. As you will see from the following paragraphs, most variances are calculated in more or less the same way.

To begin Carroll Clinic s variance analysis, consider the data contained in Exhibit 8.5. The total, or profit, variance is the difference between the realized profit and the static profit. Thus, Profit variance = Actual profit . Static profit, or (.$252,000) . $130,000 = .$382,000. In words, Carroll s 2015 profitability was $382,000 below standard, or $382,000 less than expected.

Although this large negative variance should generate considerable concern among Carroll s managers, a more detailed analysis is required to determine the underlying causes.

Perhaps the first question that Carroll s management would want answered is this: Is the large loss (as compared to expectations) due to a revenue shortfall, cost overruns, or both? Exhibit 8.6 shows the .$382,000 profit variance at the top and breaks it down into its revenue and cost components.

EXHIBIT 8.6 Profit Variance and Revenue and Cost Components Profit Variance $382,000 Revenue Cost Variance Variance $60,000 $442,000 Profit variance = Actual profit Static profit Revenue variance = Actual revenues Static revenues Cost variance = Static costs Actual costs Note that in calculating all variances, we are using definitions (given in the bottom of each variance exhibit) that show bad results as a negative number. Variances can be defined so the resulting value is either a positive or a negative number. For example, when cost variances are calculated, they can be defined so that a negative variance means costs less than standard, which is good, or costs greater than standard, which is bad, depending on which value is subtracted from the other. In this example, all variances have been defined so that a negative number indicates an undesirable variance and not necessarily that the realized value is less than the standard. For example, a higher-thanstandard wage rate would be a negative variance, indicating that the variance is harmful to the clinic, even though realized wages were higher than expected.

The revenue variance shown in Exhibit 8.6 is Actual revenues . Static revenues = $2,040,000 . $1,980,000 = $60,000, which, because it is a positive variance, tells Carroll s managers that realized revenues were actually $60,000 higher than expected. However, the cost variance of Static costs . Actual costs = $1,350,000 . $1,792,000 = .$442,000 indicates that realized costs were much greater than expected. (Remember that our convention is that positive variances are good and negative variances are bad. ) The net effect of the revenue and cost variances is the $60,000 + (.$442,000) = .$382,000 profit variance. By breaking down the profit variance into revenue and cost components, it is readily apparent that the major cause of Carroll s poor profit performance in 2015 was that costs were too high. However, the analysis thus far does not discriminate between cost overruns caused by volume forecast errors and those caused by other factors.

Regarding the revenue variance, it would be nice to know if the greaterthan- expected revenues were due to greater-than-expected volume or greaterthan- expected prices (reimbursement). Exhibit 8.7 examines the revenue variance in more detail. Here, the $60,000 positive revenue variance is decomposed into volume and price variances. The volume variance is Flexible revenues . Static revenues = $2,080,000 . $1,980,000 = $100,000, and the price variance is Actual revenues . Flexible revenues = $2,040,000 . $2,080,000 = .$40,000.

These variances tell Carroll s managers that a higher-than-expected volume should have resulted in revenues being $100,000 greater than expected in 2015. However, this potential revenue increase was partially offset by the fact that realized prices (reimbursement) were less than expected. The end result of higher volume at lower prices is realized revenue that was $60,000 higher than forecasted. To keep this illustration manageable, the number of covered lives (enrollment) was held constant throughout the year. If this had not been the case, two flexible budgets would be required and the volume variance would have two components. (Refer to the note at the bottom of Exhibit 8.7.) Now let s change our focus to the cost side of the variance analysis.

Exhibit 8.8 breaks down the .$442,000 cost variance into volume and management components. The volume variance of Static costs . Flexible costs = $1,350,000 . $1,680,000 = .$330,000 indicates that a large portion of the $442,000 cost overrun was caused by the incorrect volume forecast: Higherthan- expected volume resulted in higher-than-expected costs. This higherthan- expected volume would not be a financial problem if it were additional fee-for-service patients, in which case higher costs as a result of higher volume would likely be more than offset by higher revenues. However, the fact that a majority of the higher volume (18,000 of 22,000 visits) came from capitated patients means that there was no matching revenue increase.

Revenue Variance $60,000 Volume Price Variance Variance $100,000 $40,000 Revenue variance = Actual revenues Static revenues Volume variance = Flexible revenues Static revenues Price variance = Actual revenues Flexible revenues EXHIBIT 8.7 Revenue Variance and Volume and Cost Components Note: In our example, there are no enrollment differences. However, if some patients are capitated, and there are enrollment differences between the static budget and realized results, the situation becomes more complex. Then, it is necessary to create two flexible budgets: (1) one flexed for both enrollment and utilization and (2) one flexed only for enrollment. With two flexible budgets, volume variances can be calculated for both changes in the number of covered lives and changes in utilization.

Volume variance = Flexible (enrollment and utilization) revenues Static revenues Enrollment variance = Flexible (enrollment) revenues Static revenues Utilization variance = Flexible (enrollment and utilization) revenues Flexible (enrollment) revenues EXHIBIT 8.8 Cost Variance and Volume and Management Components Cost Variance $442,000 Volume Management Variance Variance $330,000 $112,000 Cost variance = Static costs Actual costs Volume variance = Static costs Flexible costs Management variance = Flexible costs Actual costs In addition to the problem of higher-than-expected volume, $112,000 of the $442,000 cost overrun was caused by other factors. This amount is the so- called management variance, which is calculated as Flexible costs . Actual costs = $1,680,000 . $1,792,000 = .$112,000. The management variance gets its name from the assumption that any cost variances not caused by volume forecast inaccuracies are a result of either good or bad management performance. The theory here is that most clinical managers have limited (if any) control over the volume of services supplied, but they do have control over factors such as the amount of labor used, wage rates, supplies utilization and costs, and so forth. Thus, the $112,000 cost overrun classified as management variance can be influenced by managerial actions. If all standards in the static budget except the volume estimate were met, the cost overrun would have been only $330,000, and not the $442,000 realized.

To attempt to eliminate the management variance in future years, Carroll s managers must determine precisely where the cost overruns lie. The primary resources involved in operating costs are labor and supplies, so it would be valuable to learn which of the two areas contributed most to the management variance. Perhaps a more probing investigation can be made within labor and supplies: Is too much of each resource being used, or is too much money being paid for what is being used?

Exhibit 8.9 examines the components of the management variance.

We see that $64,075 of the management variance of $112,000 is a result of labor costs, so with no fixed cost variance, the remainder is the result of supplies costs. Furthermore, the $64,075 labor variance can be decomposed into that portion caused by productivity (the efficiency variance) problems and that portion caused by wage rate (the rate variance) overages. The numbers indicate that only a very small portion of the labor cost overrun was caused by productivity problems; the vast majority of the overrun was caused by higherthan- expected wage rates. This suggests that Carroll s managers have to take a close look to ensure that they are not paying higher wage rates than the local Management Variance $112,000 Labor Fixed Cost Supplies Variance Variance Variance $64,075 $0 $47,925 Rate Efficiency Price Usage Variance Variance Variance Variance $59,900 $4,175 $47,400 $525 Management variance = Flexible costs Actual costs Fixed cost variance = Flexible fixed costs Actual fixed costs Labor variance = Flexible labor costs Actual labor costs Rate variance = (Static rate Actual rate).Actual labor hours Efficiency variance = (Flexible hours Actual hours).Static rate Supplies variance = Flexible supplies costs Actual supplies costs Price variance = (Static price Actual price). Actual units Usage variance = (Flexible units Actual units).Static price EXHIBIT 8.9 Management Variance and Fixed Costs, Labor, and Supplies Components Note: The calculations of the component variances are not complex but lengthy. They are omitted for ease of illustration.

labor market dictates. Of course, Carroll wants to have quality employees, but at the same time, management needs to be concerned about labor costs.

How did Carroll do in 2015 regarding supplies costs? If $64,075 of the management variance of $112,000 is caused by labor costs, the remainder, $47,925, must be caused by supplies costs. Within the $47,925 supplies variance, the amount caused by excess usage (the usage variance) and the amount caused by price differentials (the price variance) can be determined. To begin, $525 of the supplies variance of $47,925 is caused by usage differences; the remainder ($47,400) is caused by price differences. Thus, the supplies cost overrun resulted almost exclusively from price increases the price paid was higher than that assumed in the static budget. Supplies usage was almost on target when volume differences are accounted for. Thus, it would be prudent for management to investigate the clinic s purchasing policy to see if prices can be lowered through such actions as changing vendors, making larger purchases at a single time, joining a purchasing alliance, or just negotiating better.

Final Comments on Variance Analysis It is important to recognize that the Carroll Clinic example presented here was meant to illustrate variance analysis techniques rather than illustrate a complete analysis. A complete analysis would encompass many more variances.

Furthermore, at most organizations, variance analysis would be conducted at the department level as well as at other sublevels, such as service or contract lines, in addition to the organization as a whole. Nevertheless, the Carroll Clinic example is sufficient to give readers a good feel for how variance analysis is conducted as well as its benefits to the organization.

Variance analysis helps managers identify the factors that cause realized profits to be different from those expected. If profits are higher than expected, managers can see why and then try to further exploit those factors in the future. If profits are lower than expected, managers can identify the causes and then embark on a plan to correct the deficiencies. Larger health services organizations have made significant improvements in their use of variance analysis. The benefit of expanding the level of information detail is that it is easier for managers to isolate and presumably rectify problem areas. Fortunately, the marginal cost of obtaining such detailed information is lower now than ever before because large amounts of managerial accounting information are being generated at many health services organizations to support cost control efforts and to aid in pricing and service decisions.

SELF-TEST QUESTIONS 1. What is variance analysis, and what is its value to healthcare providers?

2. What is the difference between a static budget and a flexible budget?

3. What are the components of profit variance? Of revenue variance?

Of cost variance?

Key Concepts Planning and budgeting are important managerial activities. In particular, budgets allow health services managers to plan for and set expectations for the future, assess financial performance on a timely basis, and ensure that operations are carried out in a manner consistent with expectations.

The key concepts of this chapter are as follows:

Planning encompasses the overall process of preparing for the future, while budgeting is the accounting process that ties together planning and control functions.

The strategic plan, which provides broad guidance for the long-term future, is the foundation of any organization s planning process.

The values statement contains the core beliefs of an organization.

The mission statement defines the organization s overall purpose (its reason for existence).

The vision statement describes the desired position of the organization at some point in the future, say, in ten years.

The operating plan, often called the five-year plan, provides more detailed guidance for the short term than is contained in the strategic plan.

Organizational goals are subjective (nonmeasurable) goals that the organization strives to attain, while organizational objectives are quantitative goals that provide managers with a specific measurable target.

The financial plan, which is the financial portion of the operating plan, contains three sections: (1) financial condition, capital investments, and financing; (2) current accounts and revenue cycle; and (3) budgeting and control.

Budgeting provides a means for communication and coordination of organizational expectations as well as allocation of financial resources. In addition, budgeting establishes benchmarks for control.

The conventional approach to budgeting uses the previous budget as the basis for constructing the new budget. Zero-based budgeting begins each budget as a clean slate, and all entries have to be justified each budget period.

Bottom-up budgeting, which begins at the unit level, encourages maximum involvement by junior managers. Conversely, top-down budgeting, which is less participatory in nature, is a more efficient way to communicate senior management s views.

There are several types of budgets, including the statistics budget, the revenue budget, the expense budget, and the operating budget.

The operating budget is the basic budget of an organization in that it sets the profit target for the budget period.

When the original budget, or static budget, is recast to reflect the actual volume of patients treated, leaving all other assumptions unchanged, the result is called a flexible budget.

A variance is the difference between a budgeted (planned) value, or standard, and the actual (realized) value. Variance analysis examines differences between budgeted and realized amounts with the goal of finding out why things went either badly or well.

To be most useful, variance analysis examines differences between actual results and the static and flexible budgets.

This chapter concludes the discussion of managerial accounting. Chapter 9 begins the examination of basic financial management concepts.

Questions 8.1 Why are planning and budgeting so important to an organization s success?

8.2 Briefly describe the planning process. Be sure to include summaries of the strategic, operating, and financial plans.

8.3 Describe the components of a financial plan.

8.4 How are the statistics, revenue, expense, and operating budgets related?

8.5 a. What are the advantages and disadvantages of conventional budgeting versus zero-based budgeting?

b. What organizational characteristics create likely candidates for zero-based budgeting?

8.6 If you were the CEO of Bayside Memorial Hospital, would you advocate a top-down or a bottom-up approach to budgeting? Explain your rationale.

8.7 What is variance analysis?

8.8 a. Explain the relationships among the static budget, flexible budget, and actual results.

b. Assume that a group practice has both capitated and fee-for-service (FFS) patients. Furthermore, the number of capitated enrollees has changed over the budget period. In order to calculate the volume variance and break it down into enrollment and utilization components, how many flexible budgets must be constructed?

Problems 8.1 Consider the following 2015 data for Newark General Hospital (in millions of dollars):

Static Flexible Actual Budget Budget Results Revenues $4.7 $4.8 $4.5 Costs 4.1 4.1 4.2 Profits 0.6 0.7 0.3 a. Calculate and interpret the profit variance.

b. Calculate and interpret the revenue variance.

c. Calculate and interpret the cost variance.

d. Calculate and interpret the volume and price variances on the revenue side.

e. Calculate and interpret the volume and management variances on the cost side.

f. How are the variances calculated above related?

8.2 Here are the 2015 revenues for the Wendover Group Practice Association for four different budgets (in thousands of dollars):

Static Flexible (Enrollment/ Flexible (Enrollment) Actual Budget Utilization) Budget Budget Results $425 $200 $180 $300 a. What do the budget data tell you about the nature of Wendover s patients: Are they capitated or fee-for-service? (Hint: See the note to Exhibit 8.7.) b. Calculate and interpret the following variances:

Revenue variance Volume variance Price variance Enrollment variance Utilization variance 8.3 Here are the budgets of Brandon Surgery Center for the most recent historical quarter (in thousands of dollars):

Static Flexible Actual Number of Surgeries 1,200 1,300 1,300 Patient Revenue $2,400 $2,600 $2,535 Salary Expense 1,200 1,300 1,365 Nonsalary Expense 600 650 585 Profit $ 600 $ 650 $ 585 The center assumes that all revenues and costs are variable and hence tied directly to patient volume.

a. Explain how each amount in the flexible budget was calculated.

(Hint: Examine the static budget to determine the relationship of each budget line to volume.) b. Determine the variances for each line of the profit and loss statement, both in dollar terms and in percentage terms. (Hint:

Each line has a total variance, a volume variance, and a price variance [for revenues] and management variance [for expenses].) c. What do the Part b results tell Brandon s managers about the surgery center s operations for the quarter?

8.4 Refer to Carroll Clinic s 2015 operating budget contained in Exhibit 8.3. Instead of the actual results reported in Exhibit 8.4, assume the results reported below:

Carroll Clinic: New 2015 Results I. Volume:

A. FFS 34,000 visits B. Capitated lives 30,000 members Number of member-months 360,000 Actual utilization per member-month 0.12 Number of visits 43,200 visits C. Total actual visits 77,200 visits II. Revenues:

A. FFS $ 28 per visit . 34,000 actual visits $ 952,000 B. Capitated lives $2.75 PMPM . 360,000 actual member-months $ 990,000 C. Total actual revenues $1,942,000 III. Costs:

A. Variable Costs:

Labor $1,242,000 (46,000 hours at $27/hour) Supplies 126,000 (90,000 units at $1.40/unit) Total variable costs $1,368,000 Variable cost per visit $ 17.72 ($1,368,000 77,200) B. Fixed Costs:

Overhead, plant, and $ 525,000 equipment C. Total actual costs $1,893,000 IV. Profit and Loss Statement:

Revenues:

FFS $ 952,000 Capitated 990,000 Total $1,975,000 Costs:

Variable:

FFS $ 602,487 Capitated 765,513 Total $1,368,000 Contribution margin $ 574,000 Fixed costs 525,000 Actual profit $ 49,000 a. Construct Carroll s flexible budget for 2015.

b. What are the profit variance, revenue variance, and cost variance?

c. Consider the revenue variance. What is the component volume variance? The price variance?

d. Break down the cost variance into volume and management components.

e. Break down the management variance into labor, supplies, and fixed costs variances.

f. Interpret your results. In particular, focus on the differences between the variance analysis here and the Carroll Clinic illustration presented in the chapter.

8.5 Instead of the results in Problem 8.4, consider the results reported below:

Carroll Clinic: New 2015 Results I. Volume:

A. FFS 34,000 visits B. Capitated lives 31,000 members Number of member-months 372,000 Actual utilization per member-month 0.11613 Number of visits 43,200 visits C. Total actual visits 77,200 visits II. Revenues:

A. FFS $ 28 per visit . 34,000 actual visits $ 952,000 B. Capitated lives $ 2.75 PMPM .372,000 actual member-months $1,023,000 C. Total actual revenues $1,975,000 (continued) III. Costs: (continued from previous page) A. Variable Costs:

Labor $1,242,000 (46,000 hours at $27/hour) Supplies 126,000 (90,000 units at $1.40/unit) Total variable costs $1,368,000 Variable cost per visit $17.72 ($1,368,000 77,200) B. Fixed Costs:

Overhead, plant, and equipment $ 525,000 C. Total actual costs $1,893,000 IV. Profit and Loss Statement:

Revenues:

FFS $ 952,000 Capitated 1,023,000 Total $1,975,000 Costs:

Variable:

FFS $ 602,487 Capitated 765,513 Total $1,368,000 Contribution margin $ 607,000 Fixed costs 525,000 Actual profit $ 82,000 Refer to Problem 8.4. Assume the results reported in that problem hold, except that a difference existed among budgeted (static) enrollment and realized enrollment. The corrected results are presented above.

a. Construct Carroll s flexible budgets for 2015. (Hint: Because of a change in enrollment, creating three flexible budgets is necessary.

See the note to Exhibit 8.7.) b. What are the profit variance, revenue variance, and cost variance?

c. Focus on the revenue side. What is the volume variance? The price variance? Break the volume variance into enrollment and utilization components. How does your answer here differ from your corresponding answer to Problem 8.4?

d. Now consider the cost side. What are the volume and management variances? Break down the management variance into labor, supplies, and fixed costs variances.

e. Interpret your results. In particular, focus on the differences between the variance analysis here and the one in Problem 8.4.

8.6 Chelsea Clinic projected the following budget information for 2015:

Total FFS Visit Volume 90,000 visits Payer Mix:

Blue Cross 40% Highmark 60% Reimbursement Rates:

Blue Cross $25 per visit Highmark $20 per visit Variable Costs Resource Inputs:

Labor 48,000 total hours Supplies 100,000 total units Resource Input Prices:

Labor $25.00 per hour Supplies $1.50 per unit Fixed Costs (overhead, $500,000 plant, and equipment) a. Construct Chelsea Clinic s operating budget for 2015.

b. Discuss how each key budget assumption might result in a budget variance, and name the variance that would be used to examine results associated with each assumption.

8.7 Refer to Problem 8.6. Chelsea Clinic s actual results for 2015 are shown in the table below.

Total FFS Visit Volume 100,000 visits Payer Mix:

Blue Cross 40% Highmark 60% Reimbursement Rates:

Blue Cross $28 per visit Highmark $18 per visit Variable Costs Resource Inputs:

Labor 50,000 total hours Supplies 150,000 total units (continued) (continued from previous page) Resource Input Prices:

Labor $28.00 per hour Supplies $1.50 per unit Fixed Costs (overhead, $500,000 plant, and equipment) a. Construct Chelsea Clinic s flexible budget and actual operating results for 2015.

b. What are the profit variance, revenue variance, and cost variance?

c. Focus on the revenue side. What is the volume variance? The price variance?

d. Now consider the cost side. What are the volume and management variances? Break down the management variance into labor, supplies, and fixed costs variances.

e. Interpret your results.

Resources Barr, P. 2005. Flexing Your Budget. Modern Healthcare (September 12): 24 26.

Bradley, L. S. 2008. Budgeting or Refusing to Budget: How Budget Workshops Can Reduce the Pain. Healthcare Financial Management (March): 56 59.

Cardamone, M. A., M. Shaver, and R. Worthman. 2004. Business Planning: Reasons, Definitions, and Elements. Healthcare Financial Management (April): 40 46.

Clark, J. J. 2005. Improving Hospital Budgeting and Accountability: A Best Practice Approach. Healthcare Financial Management (July): 78 83.

Dommert, H. J., and T. E. Getzen. 2005. On the Money: Making Forecasts What They Should Be. Healthcare Financial Management (November): 106 12.

Fuller, J., and M. Anderson. 2009. Common Ground: Productivity Benchmarking for CFOs and CNOs. Healthcare Financial Management (June): 100 108.

May, E. L. 2014. Financial Planning in a Value-Based World. Healthcare Executive (May/June): 11 18.

Miller, D., M. Allen, S. Schnittger, and T. Hackman. 2013. How Rolling Forecasting Facilitates Dynamic, Agile Planning. Healthcare Financial Management (November): 80 84.

Nugent, M. E. 2011. Budget Planning Under Payment Reform. Healthcare Finan cial Management (July): 38 42.

Person, M. M., III. 1997. The Zero-Base Hospital. Chicago: Health Administration Press.

Sorensen, D., and D. Sullivan. 2005. Managing Trade-Offs Makes Budgeting Processes Pay Off. Healthcare Financial Management (November): 54 60.

Swayne, L. M., W. J. Duncan, and P. M. Ginter. 2007. Strategic Management of Health Care Organizations. Malden, MA: Blackwell.

IV BASIC FINANCIAL MANAGEMENT CONCEPTS Parts II and III were devoted to financial and managerial accounting. Now, we turn our attention to financial management, which provides managers with the tools to make better financial decisions. But before we discuss the application of healthcare financial management theory and concepts to healthcare organizations, it is essential that readers gain a fundamental knowledge of two important foundation topics.

The first topic is time value analysis. Most financial management decisions involve future dollar amounts. For example, when a medical group practice uses debt financing, it is obligated to make a series of future principal and interest payments to the lender. Or when a hospital builds an outpatient surgery center, it expects the investment to provide a series of future cash inflows when the center is up and running. To estimate the financial impact of these transactions, future dollar amounts must be valued. The process of valuing cash flows that occur at different points in time is called time value analysis, and the first chapter of Part IV provides the concepts necessary to perform this analysis.

The second foundation topic is financial risk and required return. Virtually all financial decisions involve risk. To illustrate, there is the risk that the medical group practice that obtained debt financing will not be able to make the required loan payments. Or there is the risk that the cash flows expected from the hospital s new outpatient surgery center will be less than those forecasted when the center was built. Situations like these involve financial risk, and to make good financial decisions, managers must be able to define and measure such risk. Furthermore, risk must be incorporated into the decision-making process by setting a required rate of return that is appropriate for the riskiness of the transaction. The second chapter in this part provides the tools required both to understand financial risk and to translate risk into required return.

TIME VALUE ANALYSIS 9 Learning Objectives After studying this chapter, readers will be able to Explain why time value analysis is so important to healthcare financial management.

Find the present and future values for lump sums, annuities, and uneven cash flow streams.

Explain and apply the opportunity cost principle.

Measure the financial return on an investment in both dollar and percentage terms.

Describe and apply stated, periodic, and effective annual interest rates.

Introduction The financial (monetary) value of any asset, whether a financial asset, such as a stock or a bond, or a real asset, such as a piece of diagnostic equipment or an ambulatory surgery center, is based on future cash flows. However, a dollar to be received in the future is worth less than a current dollar because a dollar in hand today can be invested in an interest-bearing account and hence can be worth more than one dollar in the future. Because current dollars are worth more than future dollars, financial management decisions must account for cash flow timing differences. (Even if no investment opportunities existed, a dollar in hand would still be worth more than a dollar to be received in the future because a dollar today can be used for immediate consumption, whereas a dollar expected in the future cannot.) The process of assigning appropriate values to cash flows that occur at different points in time is called time value analysis. It is an important part of healthcare financial management because most financial investment analyses involve the valuation of future cash flows. In fact, of all the financial analysis techniques that are discussed in this book, none is more important than time value analysis. The concepts presented here are the cornerstones of most financial investment analyses, so a thorough understanding of time value concepts is essential to good decision making. In addition to the material in Time value analysis The use of time value of money techniques to value future cash flows. Sometimes called discounted cash flow analysis.

Time line A graphical representation of time and cash flows. May be an actual line or cells on a spreadsheet.

the chapter, the Chapter 9 Supplement contains two topics of less importance to healthcare finance: solving for interest rate and time, and amortization.

Time Lines The creation of a time line is the first step in time value analysis, especially when first learning time value concepts. Time lines make it easier to visualize when the cash flows in a particular analysis occur. To illustrate the time line concept, consider the following five-period time line:

0 1 234 5 Time 0 is any starting point (typically the time of the first cash flow in the analysis); Time 1 is one period from the starting point, or the end of Period 1; Time 2 is two periods from the starting point, or the end of Period 2; and so on. Thus, the numbers above the tick marks represent end-of-period values. Often, the periods are years, but other time intervals such as quarters, months, or days are also used when needed to fit the timing of the cash flows being evaluated. If the time periods are years, the interval from 0 to 1 would be Year 1, and the tick mark labeled 1 would represent both the end of Year 1 and the beginning of Year 2.

Cash flows are shown on a time line directly below the tick marks that match the point in time they are expected to occur. The interest rate that is relevant to the analysis is sometimes shown directly above the time line in the first period. Additionally, unknown cash flows the ones to be determined in the analysis are sometimes indicated by question marks. To illustrate, consider the following time line:

0 1 23 5% $100 ?

In this situation, the interest rate for each of the three periods is 5 percent, an investment of $100 is made at Time 0, and the Time 3 value is the unknown. The $100 is an outflow because it is shown as a negative cash flow. (Outflows are sometimes designated by parentheses rather than by minus signs.) In more complicated analyses, it is essential to use the proper signs to designate whether a cash flow is an inflow or an outflow. Furthermore, many financial calculators and some spreadsheet functions require that signs be attached to cash flows in time value analyses, even simple ones, before the calculation can be completed. Thus, to ensure that readers are familiar with the sign convention used in time value analyses, we use them on most illustrations in this book.

Time lines are a major key to learning time value concepts, but even experienced analysts use time lines when dealing with complex problems. The time line may be an actual line, as illustrated above, or it may be a series of columns (or rows) on a spreadsheet. Time lines are used extensively in the remainder of this book, so get into the habit of creating time lines when conducting analyses that involve future cash flows.

1. Draw a three-year time line that illustrates the following situation:

an investment of $10,000 at Time 0; inflows of $5,000 at the end of years 1, 2, and 3; and an interest rate of 10 percent during the entire three years.

2. Why is sign convention important in time value analyses?

Future Value of a Lump Sum: Compounding The process of going from today s values, or present values (PV), to future values is called compounding. Although compounding is not used extensively in healthcare financial management, it is the best starting point for learning time value analysis. To illustrate lump sum compounding, which deals with a single starting amount, suppose that the office manager of Meridian Clinic deposits $100 in a bank account that pays 5 percent annual interest (interest is credited to the account at the end of each year). How much would be in the account at the end of one year? To begin, here are the terms used in this time value analysis:

PV = $100 = present value, or beginning amount, of the account.

I = 5% = interest rate the bank pays on the account per year. The interest amount, which is paid at the end of the year, is based on the balance at the beginning of each year. Note that in time value calculations done by hand, I must be expressed as a decimal, so I = 0.05.

INT = dollars of interest earned during each year, which equals the beginning amount multiplied by the interest rate. Thus, INT = PV . I.

FVN = future value, or ending amount, of the account at the end of N years. Whereas PV is the value now, or present value, FVN is the value N years into the future after the interest earned has been added to the account.

N = number of years involved in the analysis.

SELF-TEST QUESTIONS Present value (PV) The beginning amount (current worth) of an investment of a lump sum, an annuity, or a series of unequal cash flows.

Compounding The process of finding the future value of a lump sum, an annuity, or a series of unequal cash flows.

In this example, N = 1, so FVN can be calculated as follows:

FVN = FV1 = PV + INT = PV + (PV . I) = PV . (1 + I).

The future value at the end of one year FV1 equals the present value multiplied by (1.0 plus the interest rate). This future value relationship can be used to find how much $100 will be worth at the end of one year if it is invested in an account that pays 5 percent interest:

FV1 = PV . (1 + I) = $100 . (1 + 0.05) = $100 . 1.05 = $105.

What would be the value of the $100 if Meridian Clinic left the money in the account for five years? Here is a time line that shows the amount at the end of each year:

01 2345 5% Beginning amount $100 Interest earned $ 5 $ 5.25 $ 5.51 $ 5.79 $ 6.08 End-of-year amount 105 110.25 115.76 121.55 127.63 Note the following points:

The account is opened with a deposit of $100. This is shown as an outflow at Year 0.

Meridian earns $100 . 0.05 = $5 of interest during the first year, so the amount in the account at the end of Year 1 is $100 + $5 = $105.

At the start of the second year, the account balance is $105. Interest of $105 . 0.05 = $5.25 is earned on the now larger amount, so the account balance at the end of the second year is $105 + $5.25 = $110.25. The Year 2 interest $5.25 is higher than the first year s interest $5 because $5 . 0.05 = $0.25 in interest was earned on the first year s interest.

This process continues, and because the beginning balance is higher in each succeeding year, the interest earned increases in each year.

The total interest earned $27.63 is reflected in the final balance $127.63 at the end of Year 5.

To better understand the mathematics of compounding, note that the Year 2 value $110.25 is equal to FV2 = FV1 . (1 + I) = PV . (1 + I) . (1 + I) = PV . (1 + I)2 = $100 . (1.05)2 = $110.25.

Furthermore, the balance at the end of Year 3 is FV3 = FV2 . (1 + I) = PV . (1 + I)3 = $100 . (1.05)3 = $115.76.

Continuing the calculation to the end of Year 5 gives FV5 = $100 . (1.05)5 = $127.63.

These calculations show that a pattern clearly exists in future value calculations.

In general, the future value of a lump sum at the end of N years can be found by applying this equation:

FVN = PV . (1 + I)N.

Future values, as well as most other time value problems, can be solved three ways: by regular calculator, financial calculator, or spreadsheet.

Key Equation: Future Value of a Lump Sum The future value of a lump sum (single value) can be found using a simple equation. For example, suppose $1,000 was invested for three years in an account paying 10 percent interest. The future value would be $1,331:

FVN = PV . (1 + I)N .

FV3 = $1,000 . (1.10)3 = $1,000 . 1.10 . 1.10 . 1.10 = $1,331.00.

Here, FVN is the future value at the end of Year N, PV is present value, and I is the interest rate. This equation can be solved with a regular calculator, a financial calculator, or a spreadsheet.

Regular Calculator Solution To use a regular calculator, multiply the PV by (1 + I) for N times or use the exponential function to raise (1 + I) to the Nth power and then multiply the 310 Heal thcare Finance result by the PV. Perhaps the easiest way to find the future value of $100 after five years when compounded at 5 percent is to enter $100, then multiply this amount by 1.05 for five times. If the calculator is set to display two decimal places, the answer would be $127.63:

0 1 2 3 4 5 $100.1.05 .1.05 .1.05 .1.05 .1.05 = $127.63 As denoted by the arrows, compounding involves moving to the right along the time line. In fact, the term compounding is used for finding future values because future values increase, or compound, over time.

Financial Calculator Solution Financial calculators have been programmed to solve many types of time value analyses, including future value of a lump sum. In effect, the future value equation is programmed directly into the calculator. With a financial calculator, the future value is found using three of the following five time value input keys:

On some financial calculators, the keys are buttons on the face of the calculator; on others, the time value variables are shown on the display after accessing the time value menu. Also, some calculators use different symbols to represent the number of periods and interest rate.

Finally, financial calculators today are quite powerful in that they can easily solve relatively complex time value of money problems. Note that these keys correspond to the five time value variables that are commonly used:

N = number of periods I = interest rate per period PV = present value PMT = payment (This key is used only if the cash flows involve an annuity, which is a series of equal payments. Annuities are discussed in a later section.) FV = future value Also, note that this chapter deals with analyses that involve only four of the five time value variables at any one time. Three of the variables will Copying and distribution of this PDF is prohibited without written permission.

For permission, please contact Copyright Clearance Center at www.copyright.com Chapter 9: Time Value Analysis 311 be known, and the calculator will solve for the fourth, unknown variable. In Chapter 11, when bond valuation is discussed, all five variables are included in the analysis.

To find the future value of $100 after five years at 5 percent interest using a financial calculator, just enter PV = 100, I = 5, and N = 5, and then press the FV key. The answer 127.63 (rounded to two decimal places) will appear. As stated previously, many financial calculators require that cash flows be designated as either inflows or outflows (entered as either positive or negative values). Applying this logic to the illustration, Meridian deposits the initial amount, which is an outflow to the firm, and takes out or receives the ending amount, which is an inflow to the firm. If the calculator requires this sign convention, the PV would be entered as .100. (If the PV were entered as 100, a positive value, the calculator would display .127.63 as the answer.) The calculator solution can be shown pictorially as follows:

Inputs 100 Output = 127.63 5 5 Some calculators require the user to press a Compute key before pressing the FV key. Finally, financial calculators permit specifying the number of decimal places that are displayed, even though 12 (or more) significant digits are actually used in the calculations. Two places are generally used for answers in dollars or percentages, and four places for decimal answers. The final answer, however, should be rounded to reflect the accuracy of the input values; it makes no sense to say that the return on a particular investment is 14.63827 percent when the cash flows are highly uncertain. The nature of the analysis dictates how many decimal places should be displayed.

Spreadsheet Solution A B C D 1 2 5 Nper Number of periods 3 $ 100.00 Pv Present value 4 5.0% Rate Interest rate 5 6 $ 127.63 =100*(1.05)^5 (entered into Cell A6) 7 8 $ 127.63 =A3*(1+A4)^A2 (entered into Cell A8) 9 10 $ 127.63 =FV(A4,A2 A3) (entered into Cell A10) Copying and distribution of this PDF is prohibited without written permission.

For permission, please contact Copyright Clearance Center at www.copyright.com Spreadsheet programs, such as Excel, are ideally suited for time value analyses. For simple time value calculations, it is easy to enter the appropriate formula directly into the spreadsheet. For example, you could enter the spreadsheet version of the future value equation into Cell A6: =100*(1.05)^5.

Here, = tells the spreadsheet that a formula is being entered into the cell; * is the spreadsheet multiplication sign; and ^ is the spreadsheet exponential, or power, sign. When this formula is entered into Cell A6, the value $127.63 appears in the cell (when formatted with a dollar sign to two decimal places).

Note that different spreadsheet programs use slightly different syntax in their time value analyses. The examples presented in this text use Excel syntax. Also note that some syntax changes over time as spreadsheet software is updated. If in doubt, use the help feature to ensure that you are using the correct formula.

In most situations, it is more useful to enter a formula that can accommodate changing input values than to embed these values directly in the formula, so it would be better to solve this future value problem with this formula: =A3*(1+A4)^A2, as done in Cell A8. Here, the present value ($100) is contained in Cell A3, the interest rate (0.05, which is displayed as 5%) in Cell A4, and the number of periods (5) in Cell A2. With this formula, future values can be easily calculated with different starting amounts, interest rates, or number of years by changing the values in the input cells.

In addition to entering the appropriate time value formulas, most time value solutions are preprogrammed in the spreadsheet software. The preprogrammed time value formulas are called functions. Like any formula, a time value function consists of a number of arithmetic calculations combined into one statement. By using functions, spreadsheet users can save the time and tedium of building formulas from scratch.

Each function begins with a unique name that identifies the calculation to be performed, along with one or more arguments (the input values for the calculation) enclosed in parentheses. The best way to access the time value functions is to use the spreadsheet s insert function (also called the function wizard), which is designated on the Excel toolbar by fx. For this future value problem, first move the cursor to Cell A10 (the cell where you want the answer to appear). Then click on the function wizard, select Financial for the function category and FV (future value) for Food for Thought the function name, and click OK. On the The Power of Compounding next menu, enter A4 for Rate, A2 for Nper The power of compounding is a phrase that (number of periods), and .A3 for Pv. (Note emphasizes the fact that a relatively small start-that the Pmt and Type entries are left blank ing value can grow to a large amount when for this problem. Also, note that the cell invested over a long period, even when the rate address entered for Pv has a minus sign. This (continued) is necessary for the answer to be displayed as a positive number.) Finally, click OK and (continued from previous page) the result $127.63 appears in Cell A10.

of growth (interest rate) is modest. For example, Note that most of the spreadsheet assume that a new parent places $1,000 in solutions shown in this book follow a similar a mutual fund to help pay the child s college expenses, which are expected to begin in 18 format. The input values and the output are years. If the mutual fund say, a common stock contained in Column A. If a spreadsheet fund holding a large number of securities earns function is used in the solution, the input a return of 10 percent per year, after 18 years value (argument) names are shown in Col- the value of the account would be $5,560, which umn B to the right of the input values. In is not an inconsequential sum. (Historically, 10 addition, the formula or function used to percent was considered a reasonable estimate for annual returns on a well-diversified portfolio calculate the output is shown in Column B of stocks. However, some market watchers now to the right of the output value. Finally, Col- believe that future returns will be less, say, 8 or 9 umn C contains the descriptive input names.

percent.) The most efficient way to solve most Now, assume that the money was meant problems that involve time value is to use to help fund the child s retirement, which is a financial calculator or spreadsheet. How-assumed to occur 65 years into the future. The value of the mutual fund account at that time ever, the basic mathematics behind the cal- would be $490,371, or nearly a half million dol culations must be understood to set up lars. Imagine that: $1,000 grows to nearly half a complex problems before solving them. In million all because of the power of compounding.

addition, the underlying logic must be The moral of this story is clear: When saving for understood to comprehend stock and bond retirement, or for any other purpose, start early.

valuation, lease analysis, capital budgeting analysis, and other important healthcare financial management topics.

SELF-TEST QUESTIONS 1. What is a lump sum?

2. What is compounding? What is interest on interest?

3. What are three solution techniques for solving lump sum compounding problems?

4. How does the future value of a lump sum change as the time is extended and as the interest rate increases?

Present Value of a Lump Sum: Discounting Suppose that GroupWest Health Plans, which has premium income reserves to invest, has been offered the chance to purchase a low-risk security from a local broker that will pay $127.63 at the end of five years. A local bank is currently offering 5 percent interest on a five-year certificate of deposit (CD), and GroupWest s managers regard the security offered by the broker as having the same risk as the bank CD. The 5 percent interest rate available on the Discounting The process of finding the current (present) value of a lump sum, an annuity, or a series of unequal cash flows.

bank CD is GroupWest s opportunity cost rate. (Opportunity costs are discussed in detail in the next section.) How much would GroupWest be willing to pay for the security that promises to pay $127.63 in five years?

Key Equation: Present Value of a Lump Sum The present value of a lump sum (single value) can be found using a simple equation. For example, suppose $1,000 was expected to be received in three years and the appropriate interest (discount) rate was 10 percent.

The present value would be $751.31:

PVN = FV (1 + I)N.

PV3 = $1,000 (1.10)3 = $1,000 1.10 1.10 1.10 = $751.31.

Here, PVN is the present value of a lump sum to be received N years in the future, FV is future value, and I is the discount rate. This equation can be solved with a regular calculator, a financial calculator, or a spreadsheet.

The future value example presented in the previous section showed that an initial amount of $100 invested at 5 percent per year would be worth $127.63 at the end of five years. Thus, GroupWest should be indifferent to the choice between $100 today and $127.63 at the end of five years. Today s $100 is defined as the present value, or PV, of $127.63 due in five years when the opportunity cost rate is 5 percent. If the price of the security being offered is exactly $100, GroupWest could buy it or turn it down because that is the security s fair value. If the price is less than $100, GroupWest should buy it, while if the price is greater than $100, GroupWest should decline the offer.

Conceptually, the present value of a cash flow due N years in the future is the amount that, if it were on hand today, would grow to equal the future amount when compounded at the opportunity cost rate. Because $100 would grow to $127.63 in five years at a 5 percent interest rate, $100 is the present value of $127.63 due five years in the future when the opportunity cost rate is 5 percent. In effect, the present value tells us what amount would have to be invested to earn the opportunity cost rate. If the investment can be obtained for a lesser amount, a higher rate will be earned. If the investment costs more than the present value, the rate earned will be less than the opportunity cost rate.

Finding present values is called discounting, and it is simply the reverse of compounding: If the PV is known, compound to find the FV; if the FV is known, discount to find the PV. Here are the solution techniques used to solve this discounting problem:

Chapter 9: Time Value Analysis 315 0 1 5% ? $127.63 2 3 4 5 To develop the discounting equation, solve the compounding equation for PV:

) ) ( ( = . + = + FV PV I PV FV I Compounding: 1 .

Discounting:

1 .

N N N N The equations show us that compounding problems are solved by multiplication, while discounting problems are solved by division.

Regular Calculator Solution Enter $127.63 and divide it five times by 1.05:

0 5% 1 $100 = 1.05 1.05 1.05 1.05 1.05 $127.63 2 3 4 5 As shown by the arrows, discounting is moving left along a time line.

As with compounding, the term discounting is descriptive. As we move left along a time line, values get smaller, or discount, over time.

Financial Calculator Solution Inputs 127.63 Output = 100 5 5 Spreadsheet Solution A B C D 1 2 5 Nper Number of periods 3 $ 127.63 Fv Future value 4 5.0% Rate Interest rate 5 6 $ 100.00 =A3/(1+A4)^A2 (entered into Cell A6) 7 8 $ 100.00 =PV(A4,A2 A3) (entered into Cell A8) 9 10 Copying and distribution of this PDF is prohibited without written permission.

For permission, please contact Copyright Clearance Center at www.copyright.com One solution would be to enter the applicable formula, as shown to the right of Cell A6: =A3/(1+A4)^A2. Here, the future value ($127.63) is contained in Cell A3, the interest rate (0.05, which is displayed as 5%) in Cell A4, and the number of periods (5) in Cell A2. With this formula, present values easily can be calculated with different starting future amounts, interest rates, or number of years.

The function approach is illustrated in Cell A8. First, move the cursor to that cell (the cell where you want the answer to appear). Then click on the function wizard, select Financial for the function category and PV (present value) for the function name, and click OK. On the next menu, enter A4 for Rate, A2 for Nper (number of periods), and .A3 for Fv. (Note that the Pmt and Type entries are left blank for this problem. Also, note that the cell address entered for Fv has a minus sign. This is necessary for the answer to be displayed as a positive number.) Finally, press OK and the result $100.00 appears in Cell A8.

SELF-TEST QUESTIONS 1. What is discounting? How is it related to compounding?

2. What are the three techniques for solving lump sum discounting problems?

3. How does the present value of a lump sum to be received in the future change as the time is extended and as the interest rate increases?

Opportunity Costs More Food for Thought In the last section, the opportunity cost Discounting at Work concept was used to set the discount rate At relatively high interest rates, funds due in on the time value analysis of GroupWest s the future are worth little today, and even at moderate discount rates, the present value of a investment opportunity. The opportunity sum due in the distant future is quite small. To cost concept plays a critical role in time value illustrate discounting at work, consider 100-year analysis. To illustrate, suppose an individual bonds. A bond is a type of debt security in which found the winning ticket for the Florida an investor loans some amount of principal say, lottery and now has $1 million to invest.

$1,000 to a company (borrower), which in turn Should the individual assign a cost to these promises to pay interest over the life of the bond and to return the principal amount at maturity. funds? At first blush it might appear that this Typically, the longest maturities for bonds are 30 money has zero cost because its acquisition to 40 years, but since the early 1990s, many com- was purely a matter of luck. However, as panies, including Columbia/HCA Healthcare (now soon as the lucky individual thinks about HCA), have issued 100-year bonds.

what to do with the $1 million, he or she has (continued) to think in terms of the opportunity costs involved. By using the funds to invest in one alternative for example, in the stock of Quest Diagnostics the individual forgoes the opportunity to make some other investment for example, buying US Treasury bonds. Thus, there is an opportunity cost associated with any investment planned for the $1 million, even though the investment capital (the lottery winnings) was free. The concept of opportunity costs applies to any investment, whether in financial assets or real assets and regardless of the source of the investment funds.

Because one investment decision automatically negates all other possible investments with the same funds, the cash flows expected to be earned from any investment must be discounted at a rate that reflects the return that could be earned on forgone investment opportunities. The problem is that the number of forgone investment opportunities is virtually infinite, so which one should be chosen to establish the opportunity cost rate? The opportunity cost rate to be applied in time value analysis (continued from previous page) At first blush, it might appear that anyone who would buy a 100-year bond must be irrational because there is little assurance that the borrower will even be around in 100 years to repay the amount borrowed. However, consider the present value of $1,000 (the face value of the bond and the amount to be returned to bondholders) to be received in 100 years. If the discount rate is 7.5 percent, which is roughly the interest rate that was set on the bond, the present value is a mere $0.72. Thus, the time value of money eroded the value of the bond s $1,000 principal repayment to the point that it was worth less than $1 at the time the bond was issued. This tells us that the value of the bond when it was sold was based primarily on the interest stream received in the early years of ownership and that the payments expected during the later years contributed little to the bond s initial $1,000 value. Thus, the risk of not recovering the initial $1,000 principal amount did not have a large impact on investors willingness to buy the bond.

More generically, the example illustrates that money to be received well into the future is worth relatively little today.

is the rate that could be earned on alternative investments of similar risk. It would not be logical to assign a low Opportunity cost opportunity cost rate to a series of risky cash flows, or vice versa. This concept The cost associated with is one of the cornerstones of investment analysis, so it is worth repeating. The alternative uses of opportunity cost (discount) rate applied to investment cash flows is the the same funds.

rate that could be earned on alternative investments of similar risk. For example, if It is important to recognize that the discounting process itself accounts money is used for one investment, for the opportunity cost of capital (i.e., the loss of use of the funds for other it is no longer purposes). In effect, discounting a potential investment at, say, 10 percent available for produces a present value that provides a 10 percent return. Thus, if the invest-other uses, so an opportunity cost ment can be obtained for less than its present value, it will earn more than arises.

its opportunity cost rate and hence is a good investment. Alternatively, if the cost of the investment is greater than its present value, it will earn less than the opportunity cost rate and hence, from a financial perspective, is a bad investment.

It is also important to note that the opportunity cost rate does not depend on the source of the funds to be invested. Rather, the primary determinant of this rate is the riskiness of the cash flows being discounted.

Thus, the same 10 percent opportunity cost rate would be applied to this potential investment regardless of whether the funds to be used for the investment were won in a lottery, taken out of petty cash, or obtained by selling some securities.

Generally, opportunity cost rates are obtained by looking at rates that could be earned or more precisely, rates that are expected to be earned on securities such as stocks or bonds. Securities are usually chosen to set opportunity cost rates because their expected returns are more easily estimated than rates of return on real assets such as hospital beds, MRI machines, outpatient surgery centers, and the like. Furthermore, as discussed in Chapter 12, securities traded in efficient markets generally provide the minimum return appropriate for the amount of risk assumed, so securities returns provide a good benchmark for other investments.

To illustrate the opportunity cost concept, assume that Oakdale Community Hospital is considering building a nursing home. The first step in the financial analysis is to forecast the cash flows that the nursing home is expected to produce, including the cost of building and operating the home as well as the expected patient service revenues. These cash flows, then, must be discounted at some opportunity cost rate to determine their present value.

Would the hospital s opportunity cost rate be (1) the expected rate of return on a bank CD; (2) the expected rate of return on the stock of Genesis HealthCare, which operates a large number of nursing homes and assisted living centers; or (3) the expected rate of return on pork belly futures? (Futures are investments that involve commodity contracts for delivery at some future time.) The answer is the expected rate of return on Genesis HealthCare stock because that is the rate of return available to the hospital on alternative investments of similar risk. Bank CDs are low-risk investments, so they would understate the opportunity cost rate in owning a nursing home. Conversely, pork belly futures are high-risk investments, so that rate of return is probably too high to apply to Oakdale s nursing home investment. The idea here is that Oakdale Community Hospital could presumably earn a fair return on a nursing home investment by buying Genesis HealthCare stock, so it would want to earn at least that much on its own nursing home, which is assumed to have the same risk as the stock investment.

Note that owning a single nursing home is riskier than owning the stock of a company that has a large number of nursing homes with geographic diversification. Also, an owner of Genesis HealthCare stock can easily sell the stock if things go sour, whereas it would be much more difficult for Oakdale to sell its nursing home. These differences in risk and liquidity suggest that the true opportunity cost rate is probably higher than the return that is expected from owning Genesis HealthCare stock. However, direct ownership of a nursing home implies control, while ownership of the stock of a large firm usually does not. Such control rights would tend to reduce the opportunity cost rate. The main point here is that in practice it may not be possible to obtain a perfect opportunity cost rate. Nevertheless, an imprecise one is better than none at all.

Note that the source of the funds used for the nursing home investment is not relevant to the analysis. Oakdale may obtain the needed funds by borrowing, by soliciting contributions, or by using excess cash accumulated from profit retention. (If Oakdale were investor owned, the funds could be obtained by selling more stock.) The discount rate applied to the nursing home cash flows depends only on the riskiness of those cash flows and the returns available on alternative investments of similar risk, not on the source of the investment funds.

At this point, you may question the ability of real-world analysts to assess the riskiness of a cash flow stream or to choose an opportunity cost rate with any confidence.

Fortunately, the process is not as difficult as it may appear here because businesses have benchmarks that can be used as starting points. (Chapter 13 contains a discussion of how benchmark opportunity cost rates are established for capital investments, while Chapter 15 presents a detailed discussion on how the riskiness of a cash flow stream can be assessed.) For Your Consideration Bastiat s Parable The parable of the broken window was written by French political economist Frederic Bastiat in 1850. The parable, also known as the glazier s fallacy, goes something like this:

Suppose the careless child of a shopkeeper happens to break a pane of glass in the shop s front window. A bystander to the accident offers the unfortunate shopkeeper this consolation:

Everybody must live what would become of glaziers (window repairers) if panes of glass were never broken? The glazier comes, replaces the pane, receives $100 (as valued today) for his work, and, in his heart, blesses the careless child.

This observation prompts the bystander to come to the conclusion that it is a good thing to break windows. After all, it causes money to circulate to the benefit of the entire economy.

At this point, Bastiat raises a red flag. The bystander s observation is flawed, he says, because the theory is confined to that which is seen; it takes no account of that which is not seen. Because the shopkeeper has spent $100 on the window, it is lost to him forever. If he had not had a window to replace, he might have bought new shoes or added another book to his library. In short, he would have employed his $100 in some other way, which this accident has prevented. What do you think of Bastiat s logic? Is he correct, or is breaking windows good for society?

Should the $100 expenditure be dictated by the child or by the father? How does this parable relate to the opportunity cost concept?

SELF-TEST QUESTIONS 1. Why does an investment have an opportunity cost rate even when the funds employed have no explicit cost?

2. How are opportunity cost rates established?

3. Does the opportunity cost rate depend on the source of the investment funds?

320 Heal thcare Finance Annuities Whereas lump sums are single values, an annuity is a series of equal payments at fixed intervals for a specified number of periods. Annuity payments, which are given the symbol PMT or Pmt, can occur at the beginning or end of each period. If the payments occur at the end of each period, as they typically do, the annuity is an ordinary (regular) annuity. If payments are made at the beginning of each period, the annuity is an annuity due. Because ordinary annuities are far more common in time value problems, when the term annuity is used in this book (or in general), payments are assumed to occur at the end of each period. Furthermore, we begin our discussion of annuities by focusing on ordinary annuities.

Ordinary Annuities If Meridian Clinic were to deposit $100 at the end of each year for three years in an account that paid 5 percent interest per year, how much would Meridian accumulate at the end of three years? The answer to this question is the future value of the annuity.

Regular Calculator Solution One approach to the problem is to compound each individual cash flow to Year 3, and then sum the resultant future values.

100 105 110.25 315.25 $ $ $100 $100 0 5% 1 2 3 The future value of any annuity is defined to occur at the end of the final period. Thus, for regular annuities, the future value coincides with the last payment.

Financial Calculator Solution Inputs 100 Output = 315.25 3 5 In annuity problems, the PMT key is used in conjunction with either the PV or FV key.

Annuity A series of payments of a fixed amount for a specified number of equal periods.

Payment (PMT) In time value analysis, the dollar amount of an annuity cash flow.

Ordinary (regular) annuity An annuity with payments occurring at the end of each period.

Annuity due An annuity with payments occurring at the beginning of each period.

Copying and distribution of this PDF is prohibited without written permission.

For permission, please contact Copyright Clearance Center at www.copyright.com Chapter 9: Time Value Analysis 321 Spreadsheet Solution A B C D 1 2 3 Nper Number of periods 3 $ (100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 7 8 $ 315.25 =FV(A4,A2,A3) (entered into Cell A8) 9 10 Here, we again use the future value function, but now we use the payment (Pmt) entry in the function wizard to recognize that the problem involves annuities. Place the cursor in Cell A8. Then, click on the function wizard, select Financial for the function category and FV (future value) for the function name, and press OK. On the next menu, enter A4 for Rate, A2 for Nper (number of periods), and A3 for Pmt. (Note that the Pv and Type entries are left blank for this problem.) Finally, press OK and the result $315.25 appears in Cell A8.

Suppose that Meridian was offered the following alternatives: a three-year annuity with payments of $100 at the end of each year or a lump sum payment today. Meridian has no need for the money during the next three years. If it accepts the annuity, it would deposit the payments in an account that pays 5 percent interest per year. Similarly, the lump sum payment would be deposited into the same account. How large must the lump sum payment be today to make it equivalent to the annuity? The answer to this question is the present value of the annuity, which for ordinary annuities occurs one period prior to the first payment.

Regular Calculator Solution 95.24 90.70 86.38 272.32 $100 $ $ $100 $100 0 5% 1 2 3 Financial Calculator Solution Inputs 3 5 100 Output = 272.32 Copying and distribution of this PDF is prohibited without written permission.

For permission, please contact Copyright Clearance Center at www.copyright.com Spreadsheet Solution A B C D 1 2 3 Nper Number of periods 3 $ (100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 7 8 $ 272.32 =PV(A4,A2,A3) (entered into Cell A8) 9 10 Here we use the present value function, but again with a payment entry to recognize that the problem involves annuities. Place the cursor in Cell A8.

Then click on the function wizard, select Financial for the function category and PV for the function name, and press OK. On the next menu, enter A4 for Rate, A2 for Nper (number of periods), and A3 for Pmt. (Note that the Fv and Type entries are left blank for this problem.) Finally, press OK and For Your Consideration If You Win the Lottery, Should You Take the Annuity or the Cash?

Suppose you had won the largest prize of the Powerball Lottery to date, $590,500,000. With odds reported at 1 in 175,223,510, you would have been very lucky indeed. Winners of Power- ball have two choices for how they can receive their winnings. They can receive 30 annual payments (in your case, 30.$19,683,333) or receive one lump sum (in your case, $370,896,781.) Which option should you choose?

The first step is to determine the discount rate that makes the present value of the annuity due equal to the lump sum; in other words, what is the rate of return that makes the present value of 30 annual payments of $19,683,333 equal to the lump sum of $370,896,781? It turns out that a discount rate of 3.59 percent makes the present value of the annuity due equal to the lump sum.

Now what? If you believe that, through careful investing, you can achieve an average annual rate of return greater than 3.59 percent, you should choose the lump sum and invest it accordingly.

However, if you believe that it is unlikely you can achieve an average annual rate of return (continued) the result $272.32 appears in Cell A8.

One especially important application of the annuity concept relates to loans with constant payments, such as mortgages, auto loans, and many bank loans to businesses.

Such loans are examined in more depth in the Chapter 9 Supplement.

Annuities Due If the three $100 payments in the previous example had been made at the beginning of each year, the annuity would have been an annuity due. Here are the solution techniques for the future value of an annuity due.

Regular Calculator Solution 0123 5% $100 $100 $100 105110.25115.76$ $ 331.01 The future value of an annuity due occurs one period after the final payment, while the future value of a regular annuity coincides with the final payment. Thus, as compared with an ordinary annuity, all the cash flows of an annuity due are compounded for one additional period, and hence the future value of an annuity due is greater than the future value of a similar ordinary annuity by (1 + I).

This logic leads to the following alternative approach for obtaining the future value of an annuity due:

of 3.59 percent, you should choose the annuity.

Of course, there are many other financial factors to consider, such as taxes, liquidity, and other assets and liabilities. There are nonfinancial fac- tors as well, such as your family circumstances and age. An 80-year-old Powerball winner likely has a different attitude toward a 30-year annuity than a 20-year-old winner does.

What do you think? What would you do if you had been the winner?

(continued from previous page) FV(Annuity due) = FV of an ordinary annuity . (1 + I) = $315.25 . 1.05 = $331.01.

Financial Calculator Solution Most financial calculators have a switch or key marked DUE or BEGIN that permits the switching of the mode from end-of-period payments (ordinary annuity) to beginning-of-period payments (annuity due). When the beginningof- period mode is activated, the calculator will normally indicate the changed mode by displaying the word BEGIN or some other symbol. To deal with annuities due, change the mode to the beginning of period and proceed as before. Because most problems will deal with end-of-period cash flows, do not forget to switch the calculator back to the END mode.

Spreadsheet Solution A B C D 1 2 3 Nper Number of periods 3 $ (100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 $ 331.01 =FV(A4,A2,A3 1) (entered into Cell A6) 7 8 $ 331.01 =FV(A4,A2,A3)*(1+A4) (entered into Cell A8) 9 10 One approach (as shown in Cell A6) is to use the spreadsheet future value (FV) function but with a 1 entered for Type (as opposed to a blank). Now the spreadsheet treats the entries as an annuity due, and $331.01 is displayed as the answer.

As an alternative, note that the solution is the same as for an ordinary annuity, except the result must be multiplied by (1 + Rate), which is (1 + A4) in this example. This solution approach is given in Cell A8. The result $331.01 is the future value of the annuity due. Here are the solution techniques for the present value of an annuity due.

Regular Calculator Solution 0123 95.2490.70$100$100$1005% $285.94 Because the payments are shifted to the left, each one is discounted for one less year. Thus, the present value of an annuity due is larger than that of a similar regular annuity.

Note that the present value of an annuity due can be thought of as the present value of an ordinary annuity that is compounded for one additional period, so it also can be found as follows:

PV (Annuity due) = PV of an ordinary annuity . (1 + I) = $272.32 . 1.05 = $285.94.

Financial Calculator Solution Activate the beginning-of-period mode (i.e., the BEGIN mode), and proceed as before. Again, because most problems will deal with end-of-period cash flows, do not forget to switch the calculator back to the END mode.

Spreadsheet Solution A B C D 1 2 3 Nper Number of periods 3 $ (100.00) Pmt Payment 4 5.0% Rate Interest rate 5 6 $ 285.94 =PV(A4,A2,A3 1) (entered into Cell A6) 7 8 $ 285.94 =PV(A4,A2,A3)*(1+A4) (entered into Cell A8) 9 10 As with future value, one approach (as shown in Cell A6) is to use the spreadsheet present value (PV) function but with a 1 entered for Type (as opposed to a blank). Now the spreadsheet treats the entries as an annuity due, and $285.94 is displayed as the answer.

Note that the alternative solution is the same as for an ordinary annuity, except the function in Cell A8 is multiplied by (1 + A4). The result $285.94 is the present value of the annuity due.

1. What is an annuity?

2. What is the difference between an ordinary annuity and an annuity due?

3. Which annuity has the greater future value: an ordinary annuity or an annuity due? Why?

4. Which annuity has the greater present value: an ordinary annuity or an annuity due? Why?

Perpetuities Most annuities call for payments to be made over some finite period of time for example, $100 per year for three years. However, some annuities go on indefinitely, or perpetually, and hence are called perpetuities. The present value of a perpetuity is found as follows:

Payment PMT PV (Perpetuity) == .

Interest rate I Perpetuities can be illustrated by some securities issued by the Canadian Healthcare Board. Each security promises to pay $100 annually in perpetuity (forever). What would each security be worth if the opportunity cost rate, or discount rate, is 10 percent? The answer is $1,000:

$100 PV (Perpetuity) == $1,000.

0.10 SELF-TEST QUESTIONS Perpetuity An annuity that lasts forever (has no maturity date).

A B C D 1 2 3 $ 100.00 Pmt Payment 4 10.0% Rate Interest rate 5 6 7 8 $ 1,000.00 =A3/A4 (entered into Cell A8) 9 10 Or, using a spreadsheet, merely enter the perpetuity formula into a cell, as shown here in Cell A8.

Suppose interest rates, and hence the opportunity cost rate, rose to 15 percent. What would happen to the security s value? The interest rate increase would decrease its value to $666.67:

$100 PV (Perpetuity) == $666.67.

0.15 Key Equation: Present Value of a Perpetuity The present value of a perpetuity (never-ending annuity) can be found using a simple equation. For example, suppose a $1,000 annual ordinary annuity had payments that lasted forever and that the appropriate interest (discount) rate was 8 percent. The present value of the perpetuity would be $12,500:

PV = Payment Interest rate = $1,000 0.08 = $12,500.

Because the payments last forever, the future value of a perpetuity is undefined.

Assume that interest rates fell to 5 percent. The rate decrease would increase the perpetuity s value to $2,000:

$100 PV (Perpetuity) == $2,000.

0.05 As illustrated above, the value of a perpetuity changes dramatically when interest rates (opportunity costs) change. All securities values are affected when such changes occur, but some types, such as perpetuities and long-term government bonds, are more sensitive to interest rate changes than others.

Conversely, securities such as short-term government bonds (T-bills) and one- year CDs are affected much less when interest rates change. The risks associated with interest rate changes are discussed in more detail in Chapter 11.

SELF-TEST QUESTIONS 1. What is a perpetuity?

2. What happens to the value of a perpetuity when interest rates increase or decrease?

Uneven Cash Flow Streams The definition of an annuity (or perpetuity) includes the words constant amount, so annuities involve payments that are the same in every period.

Although some financial decisions, such as bond valuation, do involve constant payments, most important healthcare financial analyses involve uneven, or nonconstant, cash flows. For example, the financial evaluation of a proposed outpatient clinic or MRI facility rarely involves constant cash flows.

In general, the term lump sum is used with a single dollar amount, the term payment (PMT) is reserved for annuities in which there are multiple constant dollar amounts, and the term cash flow (CF) is used when there is a series of uneven lump sum amounts. Financial calculators are set up to follow this convention. When dealing with uneven cash flows, the CF function, rather than the PMT key, is used.

Present Value The present value of an uneven cash flow stream is found as the sum of the present values of the individual cash flows in the stream. For example, suppose that Wilson Radiology Group is considering the purchase of a new X-ray machine. The group s managers forecast that the operation of the new machine would produce the following stream of cash inflows (in thousands of dollars):

012345 $100 $120 $150 $180 $250 What is the present value of the new X-ray machine investment if the appropriate discount (opportunity cost) rate is 10 percent?

Regular Calculator Solution The PV of each lump sum cash flow can be found using a regular calculator, and then these values are summed to find the present value of the stream $580,950:

o 1 2 3 4 5 10% $100 $120 $150 $180 $250 155.23 122.94 112.70 99.17 $ 90.91 $580.95 Financial Calculator Solution The present value of an uneven cash flow stream can be solved with most financial calculators by using the following steps:

Input the individual cash flows, in chronological order, into the cash flow register, where they usually are designated as CF0 and CFj (CF1, CF, CF, and so on) or just CF (CF, CF, CF, CF, and so on).

23 j 0123 Enter the discount rate.

Push the NPV key.

For this problem, enter 0, 100, 120, 150, 180, and 250 in that order into the calculator s cash flow register; enter I = 10; then push NPV to obtain the answer, 580.95. Note that an implied cash flow of zero is entered for CF0.

Three points should be noted about the calculator solution. First, when dealing with the cash flow register, the term NPV, rather than PV, is used to represent present value. The letter N in NPV stands for the word net, so NPV is the abbreviation for net present value. Net present value means the sum or net of the present values of a cash flow stream. Often, the stream will consist of both inflows and outflows, but the stream here contains all inflows.

Second, annuity cash flows within any uneven cash flow stream can be entered into the cash flow register most efficiently on most calculators by using the Nj key. This key allows the user to specify the number of times a constant payment occurs within the stream. (Some calculators prompt the user to enter the number of times each cash flow occurs.) Finally, amounts entered into the cash flow register remain there until the register is cleared. Thus, if a problem had been previously worked with eight cash flows, and a problem is worked with only four cash flows, the calculator assumes that the final four cash flows from the first calculation belong to the second calculation. Be sure to clear the register before starting a new time value analysis.

Spreadsheet Solution A B C D 1 2 10.0% Rate Interest rate 3 4 $ 100 Value 1 Year 1 CF 5 $ 120 Value 1 Year 2 CF 6 $ 150 Value 1 Year 3 CF 7 $ 180 Value 1 Year 4 CF 8 $ 250 Value 1 Year 5 CF 9 10 $ 580.95 =NPV(A2,A4:A8) (entered into Cell A10) The NPV function calculates the present value of a stream, called a spreadsheet range, of cash flows. First, the cash flow values must be entered into consecutive cells in the spreadsheet, as shown above in cells A4 through A8.

Next, the discount (opportunity cost) rate must be placed into a cell (as in Cell A2 above). Then, place the cursor in Cell A10, use the function wizard to select Financial and NPV, and press OK. On the next menu, enter A2 as Rate and A4:A8 as Value 1. Press OK, and the value $580.95 is displayed in the cell. (Note that the Value 1 entry is the range of cash flows contained in Cells A4 through A8.) The NPV function assumes that cash flows occur at the end of each period, so NPV is calculated as of the beginning of the period of the first cash flow specified in the range, which is one period before that cash flow occurs. Because the cash flow specified as the first flow in the range is a Year 1 value, the calculated NPV occurs at the beginning of Year 1, or the end of Year 0, which is correct for this illustration. However, if a Year 0 cash flow is included in the range, the NPV would be calculated at the beginning of Year 0 (the end of Year .1), which typically is incorrect. This problem is addressed in the next major section.

Future Value The future value of an uneven cash flow stream is found by compounding each payment to the end of the stream and then summing the future values.

Regular Calculator Solution The future value of each lump sum cash flow can be found using a regular calculator. Then, these values are summed to find the future value of the stream $935,630:

012345 10% $100 $120 $150 $180 $250.00 $935.63 Financial Calculator Solution Some financial calculators have a net future value (NFV) key that, after the cash flows have been entered into the cash flow register, can be used to obtain the future value of an uneven cash flow stream. However, analysts generally are more concerned with the present value of a cash flow stream than with its future value. The reason, of course, is that the present value represents the value of the investment today, which then can be compared to the cost of the investment whether a stock, a bond, an X-ray machine, or a new clinic to make the investment decision.

146.41159.72181.50198.00 SELF-TEST QUESTIONS Spreadsheet Solution Most spreadsheet programs do not have a function that computes the future value of an uneven cash flow stream. However, future values can be found by building a formula in a cell that replicates the regular calculator solution.

1. Give two examples of financial decisions that typically involve uneven cash flows.

2. Describe how present values of uneven cash flow streams are calculated using a regular calculator, using a financial calculator, and using a spreadsheet.

3. What is meant by net present value?

Using Time Value Analysis to Measure Return on Investment In most investments, an individual or a business spends cash today with the expectation of receiving cash in the future. The financial attractiveness of such investments is measured by return on investment (ROI), or just return. There are two basic ways of expressing ROI: in dollar terms and in percentage terms.

To illustrate the concept, let s reexamine the cash flows expected to be received if Wilson Radiology Group buys its new X-ray machine (shown on the time line in thousands of dollars). In the last section, we determined that the present value of these flows, when discounted at a 10 percent rate, is $580,950:

0 12345 10% $100 $120 $150 $180 $250 $ 90.91 99.17 112.70 122.94 155.23 $580.95 Dollar Return The $580,950 calculated above represents the present value of the cash flows that the X-ray machine is expected to provide to the group, assuming a 10 percent discount (opportunity cost) rate. This result tells us that a 10 percent return on a $580,950 investment would produce a cash flow stream that is identical to one being discounted.

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