Problem 3 – Chapter 5Assume that a radiologist group practice has the following cost structure:

Fixed costs

Variable cost per procedure

Charge (revenue) per procedure

$

$

$

420,000

285

650

Further assume the practice expects to perform 7,500 procedures in the coming year.

a. construct the practice’s base case projected Profit and Loss (P&I) Statement

Total Revenue

Total Variable Cost

Total Contribution Margin

#VALUE!

Total Fixed Costs

Profit (net income)

b. What is the practice’s Breakeven Point?

Breakeven Volume = Fixed Costs/Contribution Margin Per Unit

Revenue Per Unit

$

650

Variable Cost Per Unit

$

285

Contribution Margin Per Unit

volume

7,500

Fixed Costs

$

420,000

Breakeven Volume

visits

c.(1) What volume is required to provide a pretax profit of $100,000

Breakeven Volume (With Profit) = (Fixed Costs+Profit)/Contribution Margin Per Unit

Revenue Per Unit

$

650

Variable Cost Per Unit

$

285

Contribution Margin Per Unit

Profit

volume

7,500

Fixed Costs

$

420,000

Breakeven Volume

visits

c.(2) What volume is required to provide a pretax profit of $200,000

Breakeven Volume (With Profit) = (Fixed Costs+Profit)/Contribution Margin Per Unit

Revenue Per Unit

$

650

Variable Cost Per Unit

$

285

Contribution Margin Per Unit

Profit

volume

7,500

Fixed Costs

$

420,000

Breakeven Volume

visits

Problem 3 – Chapter 5

PROBLEM 5.4(abc) – General Hospital, a not-for-profit acute care facility, has the following

cost structure for its inpatient services

Fixed costs

Variable cost per procedure

Charge (revenue) per procedure

$

$

$

12,500,000

550

2,855

The Hospital expects to have a patient load of 15,000 inpatient days next year.

a. construct the practice’s base case projected Profit and Loss (P&I) Statement

Total Revenue

Total Variable Cost

Total Contribution Margin

#VALUE!

Total Fixed Costs

Profit (net income)

b. What is the practice’s Breakeven Point?

Breakeven Volume = Fixed Costs/Contribution Margin Per Unit

Revenue Per Unit

$

2,855

Variable Cost Per Unit

$

550

Contribution Margin Per Unit

volume

15,000

Fixed Costs

$

12,500,000

Breakeven Volume

visits

c.(1) What volume is required to provide a profit of $800,000

Breakeven Volume (With Profit) = (Fixed Costs+Profit)/Contribution Margin Per Unit

Revenue Per Unit

$

2,855

Variable Cost Per Unit

$

550

Contribution Margin Per Unit

Profit

volume

15,000

Fixed Costs

Breakeven Volume

visits

c.(2) What volume is required to provide a pretax profit of $500,000

Breakeven Volume (With Profit) = (Fixed Costs+Profit)/Contribution Margin Per Unit

Revenue Per Unit

$

2,855

Variable Cost Per Unit

$

550

Contribution Margin Per Unit

Profit

volume

15,000

Fixed Costs

Breakeven Volume

visits

Chpt 5 – Cost Structure

VOLUME

Variable cost rate

Total Variable Costs

Fixed Costs

Total Costs

Average cost per visit

$

$

$

$

$

5000

25

125,000

300,000

425,000

85

Chapter 5 Excel Table

Total Costs = Total Fixed Costs + Total Variable Costs

VOLUME

75,000

70,000

80,000

Total Fixed Costs

4,967,462 4,967,462 4,967,462

Total Variable Costs

2,113,500 1,972,600 2,254,400

Total Costs

7,080,962 6,940,062 7,221,862

Variable Cost Rate = Total Variable Costs/Volume

Total Variable Costs

2,113,500

Volume

75,000

Variable Costs Rate

28

Cost per Visit

Profit Analysis

Revenue

Total Costs

Profit

94

99

90

7,500,000

7,080,962

419,038

7,000,000

6,940,062

59,938

8,000,000

7,221,862

778,138

Chapter 5 Excel Table

Contribution Margin = Differece between Variable per unit costs and profit

Per Unit

Total Revenue

Total Variable Cost

TOTAL CONTRIBUTION MARGIN

Fixed Costs

Profit

100

28.18

71.82

Volume

75000 7,500,000

75000 2,113,500

75000 5,386,500

4,967,462

419,038

Chapter 5 Excel Table

Breakeven Volume = Fixed Costs/Contribution Margin Breakeven Volume (With Profit) = (Fixed Costs+Profit)/Contribution Margin

Revenue Per Unit

100

Revenue Per Unit

100

Variable Cost Per Unit

28.18

Variable Cost Per Unit

28.18

Contribtion Margin

71.82

Contribtion Margin

71.82

volume

75000

volume

75000

Profit 100000

Total Revenue

Total Variable Costs

Fixed Costs

Volume

#######

#######

#######

69,165 visits

Total Revenue

Total Variable Costs

Fixed Costs

Volume

#######

#######

#######

70,558 visits

5-1

CHAPTER 5

Cost Behavior, and Profit Analysis

Managers of healthcare businesses have many

responsibilities, including planning, budgeting,

and overseeing routine operations. All of these

activities require information—a great deal of

information—which is created by the business’s

managerial accounting system. This chapter

begins the coverage with a focus on costs and

profits.

Copyright © 2012 by the Foundation of the American College of Healthcare Executives

10/27/11 Version

5-2

Financial Vs. Managerial Accounting

■ Financial accounting:

● Uses organizational (aggregate) data

● Designed for use by external parties

● Primarily historical

● Must adhere to external standards (GAAP)

■ Managerial accounting:

● Uses organizational and sub-unit data.

● Designed for use by managers.

● Primarily forward looking.

● Does not adhere to external standards.

5-3

Cost Classifications

■ Cost measurement is a critical part of

managerial accounting.

● In fact, there is an entire field of

accounting called cost accounting.

● Unfortunately, there is no single definition

of the term cost. Different costs are used

for different purposes.

■ Costs are classified in two major ways.

In this chapter, we focus on the

relationship of costs to volume.

5-4

Cost Classifications (Cont.)

■ The relationship between costs and the

volume of services provided is called

cost behavior or underlying cost

structure.

■ If the underlying cost structure is

known, managers can forecast costs at

different levels of patient volume.

■ In this context, costs may be:

● Fixed, which are independent of volume

● Variable, which depend on volume

● Semi-fixed, which partially depend on

volume

5-5

Cost Classifications (Cont.)

■ In the long-run, all costs are variable,

and hence these cost classifications

hold only in the short-run, say, for

one year.

■ Also, no costs are fixed throughout

an infinite range of volumes. Thus,

the concept of cost classifications

according to volume must be applied

within some relevant range of patient

volume.

5-6

Cost Structure Example: Walk-In Clinic

Variable Costs Per Visit

Fixed Costs Per Year

Clinical supplies $20

Other supplies

5

Variable cost rate $25

Facilities $ 30,000

Salaries

190,000

Overhead

80,000

$300,000

Total

Fixed Variable

Total Average

Volume Costs

Costs

Costs

Cost

1 $300,000 $ 25 $300,025 $300,025

100 300,000

2,500 302,500

3,025

200 300,000

5,000 305,000

1,525

1,000 300,000

25,000 325,000

325

5,000 300,000 125,000 425,000

85

10,000 300,000 250,000 550,000

55

25,000 300,000 625,000 925,000

37

Note: The relevant range is this example is unrealistic.

5-7

Cost Structure Example (Cont.)

■ Consider a volume of 5,000:

●

●

●

●

●

Fixed costs = $300,000.

Variable cost rate = $25.

Total variable costs = $125,000.

Total costs = $425,000.

Average cost per visit = $85.

■ Now consider a volume of 10,000:

●

●

●

●

●

Fixed costs = $300,000.

Variable cost rate = $25.

Total variable costs = $250,000.

Total costs = $550,000.

Average cost per visit = $55.

5-8

Graphical Cost Structure

Costs

($)

Total

Costs

Fixed

Costs

Total

Variable

Costs

Volume

(Number of Visits)

5-9

Profit (CVP) Analysis

■ Profit analysis, also called costvolume-profit (CVP) analysis, is a

technique used to assess the effects

of alternative volume assumptions on

costs and profits.

● Why is such information valuable to

health services managers?

5 – 10

Profit Analysis Example

Atlanta Clinic has forecasted the

following cost data on the basis of

75,000 expected visits:

Fixed costs

Total variable costs

Total costs

$4,967,462

2,113,500

$7,080,962

5 – 11

Profit Analysis Example (Cont.)

What is the variable cost rate?

Variable cost rate = Total variable costs

Volume

=

$2,113,500

75,000

= $28.18 per visit.

5 – 12

Profit Analysis Example (Cont.)

What is Atlanta’s cost behavior model?

Total costs = Fixed costs + Total variable costs

= $4,967,462 + ($28.18 x Volume) .

For example, at 70,000 visits:

Total costs = $4,967,462 + ($28.18 x 70,000)

= $4,967,462 + $1,972,600

= $6,940,062.

5 – 13

Profit Analysis Example (Cont.)

Cost/Volume Summary:

Volume = 70,000

TC = $4,967,462 + $1,972,600 = $6,940,062.

Volume = 75,000 (Base Case)

TC = $4,967,462 + $2,113,500 = $7,080,962.

Volume = 80,000

TC = $4,967,462 + $2,254,400 = $7,221,862.

5 – 14

Profit Analysis Example (Cont.)

● What do Atlanta’s managers learn from

the data on the previous slide?

● Now, suppose that the average revenue

per visit is expected to be $100. What

does the clinic’s cost and revenue

structure look like graphically?

5 – 15

Graphical Profit Analysis

Revenues

and Costs Where are profits and losses?

Where is the breakeven volume?

($)

Total

Revenues

Where is 75,000 visits?

Total

Costs

Fixed

Costs

Volume

(Number of Visits)

5 – 16

Forecasted (Projected) Profit and Loss

(P&L) Statement

■ The projected P&L statement uses cost

structure information along with the

revenue forecast and projected volume

to forecast profitability.

■ Although it looks like an income

statement, it does not have to follow

GAAP.

■ Because it is a forecast, it can be

influenced by managerial actions.

5 – 17

Base Case P&L Statement

Total revenues ($100 x 75,000) $7,500,000

Total VC ($28.18 x 75,000)

Total CM ($71.82 x 75,000)

Fixed costs

Profit

VC = Variable costs.

CM = Contribution margin.

2,113,500

$5,386,500

4,967,462

$ 419,038

5 – 18

Base Case P&L Statement (Cont.)

■ Note that base case total costs equal

fixed costs plus total variable costs or

$4,967,462 + $2,113,500 = $7,080,962.

■ Thus, Atlanta’s average per visit cost

is $7,080,962 / 75,000 = $94.41.

● What happens to the average cost per

visit as volume increases.

● Why?

5 – 19

Contribution Margin

■ The contribution margin is defined as the

difference between per visit (unit) revenue

and the variable cost rate.

■ It is the amount of each visit’s revenue that

is available to:

● First cover fixed costs.

● Flow to profit when fixed costs are covered.

■ In this illustration, the contribution margin

is $100 – $28.18 = $71.82.

5 – 20

Breakeven Analysis

■ Breakeven analysis is performed in

many different finance contexts.

■ Here, it is used to determine the

breakeven volume, defined as that

volume needed for an organization (or

service or program) to be financially

self-sufficient.

■ There are two types of breakeven:

● Accounting breakeven (zero profit)

● Economic breakeven (with profit)

5 – 21

Breakeven Analysis (Cont.)

What is the accounting breakeven for

Atlanta Clinic? There are two

approaches to answer this question:

● Projected P&L approach

● Graphical approach

P&L Approach

Total revenues – Total VC FC

= Profit

($100 x V) – ($28.18 x V) – $4,967,462 = $0

$71.82 x V = $4,967,462

V = $4,967,462 / $71.82 = 69,165 visits.

5 – 22

Breakeven Analysis (Cont.)

Note that the P&L approach can be

recast in a contribution margin format.

P&L Approach (Contribution Margin Format)

CM x V = Fixed costs

$71.82 x V = $4,967,462

V = $4,967,462 / $71.82 = 69,165 visits.

5 – 23

Graphical Breakeven Analysis

Revenues

and Costs

($)

Total

Revenues

Total

Costs

Fixed

Costs

69,165

Volume

(Number of Visits)

5 – 24

Breakeven Analysis (Cont.)

What is the economic breakeven if the

desired profit level is $100,000?

CM x V = Fixed costs + Profit

$71.82 x V = $5,067,462

V = $5,067,462 / $71.82 = 70,558 visits.

Note that the accounting breakeven is 69,165 visits.

The additional number of visits needed is 1,393.

1,393 x CM = 1,393 x $71.82 = $100,000.

5 – 25

Profit Analysis Under Discounted FFS

■ Suppose Atlanta Clinic is confronted

with a situation in which a payer

contributing 5,000 visits wants a 40

percent discount.

■ Atlanta’s managers might want to drop

the contract because a $60 per visit

payment is less than the $94.41 average

per visit cost.

■ But, further analysis is required.

5 – 26

P&L Statement With 70,000 Visits

Total revenues ($100 x 70,000) $7,000,000

Total VC ($28.18 x 70,000)

Total CM ($71.82 x 70,000)

Fixed costs

Profit

1,973,600

$5,027,400

4,967,462

$

59,938

5 – 27

P&L Statement With Discount Visits

Undiscounted revenue ($100 x 70,000)

$7,000,000

Discounted revenue ($60 x 5,000)

300,000

Total revenues ($97.33 x 75,000)

$7,300,000

Total VC ($28.18 x 75,000)

Total CM ($69.15 x 75,000)

Fixed costs

Profit

2,113,500

$5,186,500

4,967,462

$ 219,038

5 – 28

Graphical Profit Analysis

Revenues

and Costs

($)

Old Total

Revenues

New Total

Revenues

Total

Costs

Fixed

Costs

69,165 71,836

Volume

(Number of Visits)

5 – 29

Marginal (Incremental) Analysis

■ Suppose Atlanta Clinic is approached

by a new insurer.

● This payer is expected to contribute 5,000

additional visits.

● However, it wants a 40 percent discount,

resulting in a revenue of $60 per visit.

■ At a volume of 80,000, the clinic’s

average cost per visit is $7,221,862 /

80,000 = $90.27, so again Atlanta’s

managers might be tempted to say

“no.”

5 – 30

Base Case P&L Statement (Review)

Total revenues ($100 x 75,000) $7,500,000

Total VC ($28.18 x 75,000)

Total CM ($71.82 x 75,000)

Fixed costs

Profit

VC = Variable costs.

CM = Contribution margin.

2,113,500

$5,386,500

4,967,462

$ 419,038

5 – 31

P&L Statement With Added Volume

Undiscounted revenue ($100 x 75,000)

$7,500,000

Discounted revenue ($60 x 5,000)

300,000

Total revenues ($97.50 x 80,000)

$7,800,000

Total VC ($28.18 x 80,000)

Total CM ($69.32 x 80,000)

Fixed costs

Profit

2,254,400

$5,545,600

4,967,462

$ 578,138

5 – 32

Graphical Profit Analysis

Revenues

and Costs

($)

Old Total

Revenues

New Total

Revenues

Total

Costs

Fixed

Costs

69,165 71,660

Volume

(Number of Visits)

5 – 33

Marginal (Incremental) Analysis (Cont.)

■ The marginal cost of each visit is the

variable cost rate of $28.18 per visit.

■ The marginal revenue on the new

contract is $60 per visit, so the

contribution margin is $60 – $28.18 =

$31.82.

■ Thus, 5,000 incremental visits would add

5,000 x $31.82 = $159,100 to the bottom

line: $419,038 + $159,100 = $578,138.

5 – 34

Discussion Item

At this point, the numerical analysis

indicates that the offer should be

accepted. Considering all the factors

relevant to the decision, what should

Atlanta Clinic’s managers do?

5 – 35

Profit Analysis Under Capitation

■ Capitation changes the way in which

profit analysis is conducted

■ Perhaps the best way to see the effects

of capitation is by graphical analysis.

■ We will examine two approaches to

graphical analysis:

● In terms of utilization (number of visits).

● In terms of membership (covered lives).

5 – 36

Analysis Based on Visits

Revenues

and Costs

($)

Total

Revenues

Total

Costs

Fixed

Costs

Volume

(Number of Visits)

5 – 37

Analysis Based on Visits (Cont.)

■ On this graph, the profit and loss areas

are reversed from the fee-for-service

graph.

■ This “perverse” result occurs because

the contribution margin on a per visit

basis is negative.

● $0 – $28.18 = -$28.18.

● Each additional visit increases costs with

no increase in revenues.

5 – 38

Graphical Analysis Based on Members

Revenues

and Costs

($)

Total

Revenues

Total

Costs

Fixed

Costs

Note: Average utilization is

assumed regardless of volume.

Volume

(Number of Members)

5 – 39

Analysis Based on Members (Cont.)

■ Now, the profit and loss areas are the

same as on the fee-for-service graph.

■ On a per member basis, the

contribution margin is positive.

● Each additional member contributes

positively to profits.

● If per member annual revenue is $400 and

the variable cost rate (based on 4 visits

per year) is 4 x $28.18 = $112.72 per year,

the contribution margin is $400 – $112.72

= $287.28.

5 – 40

Discussion Items

● What do the graphs tell managers

about the importance of utilization

management:

● Under FFS reimbursement?

● Under capitation?

● What do the graphs tell about the

importance of the number of members

under capitation?

5 – 41

The Impact of Cost Structure on Risk

■ If reimbursement is tied exclusively to

volume (FFS), then the provider’s

financial risk is minimized if all costs

are variable.

■ If reimbursement is exclusively

capitated, then the provider’s financial

risk is minimized if all costs are fixed.

5 – 42

Graphical Analysis under FFS

Revenues

and Costs

($)

Total

Revenues

Total

VCs

=

Total

Costs

Volume

(Number of Visits)

5 – 43

Graphical Analysis under Capitation

Revenues

and Costs

($)

Total

Revenues

Fixed

Costs

=

Total

Costs

Volume

(Number of Visits)

5 – 44

Discussion Item

What are the implications of the

previous two slides for managerial

decision making?