PHHE 453 Prescott College Service Decisions Discussion

7-1CHAPTER 7
Pricing and Service Decisions
e Foundation of the American College of Healthcare Executives
11/3/11 Version
Among the most important uses of managerial
accounting information are establishing the
price and discounts on a service and, given a
price, estimating whether or not the service
will be profitable. Because such decisions
have a direct effect on providers’ profitability,
and hence financial condition, they play a key
role in mission performance.
7-2
Price Setters Versus Takers
■ When a provider has market dominance,
and hence can set its own prices (within
reason), it is said to be a price setter.
■ In other situations, providers are price
takers:
● Perfectly competitive markets
● Payer dominance
● Government programs
■ However, in many situations providers
are neither pure price takers nor price
setters and room for negotiation exists.
7-3
Pricing Strategies
■ When a provider is a price setter (or
when negotiation is possible), there
are several theoretical bases upon
which prices can be set.
■ The two most common are:
● Full cost pricing
● Marginal cost pricing
7-4
Full Cost Pricing
■ Under full cost pricing, prices for a
service are set to cover all costs:
● Direct variable costs
● Direct fixed costs
● Overhead (indirect) costs
■ In addition, a profit component
typically is added.
● How easy is it to measure full costs?
7-5
Marginal Cost Pricing
■ Under marginal cost pricing, prices for a
service are set to cover incremental, or
marginal, costs. Generally, this means
recovering only direct variable costs.
● Can a provider survive if all services are
priced at marginal cost?
● What is cross-subsidization, or price
shifting?
● Should marginal cost pricing ever be
used?
7-6
Target Costing
■ Target costing is a management strategy
used by price takers.
■ Under target costing:
● Revenues are projected assuming prices as
given in the marketplace.
● Required profits are subtracted from
revenues.
● The remainder is the target cost level.
● What is the primary benefit of target
costing?
7-7
Setting Prices on Individual Services
■ Assume Windsor Clinic plans to offer a
new outpatient service.
■ Projected data:
● Variable cost per visit
● Annual direct fixed costs
● Annual overhead allocation
● Number of visits
$10
$100,000
$25,000
5,000
■ What price must be set to achieve
accounting breakeven (zero profit)? To
achieve economic breakeven?
7-8
Price Required for Accounting BE
Total revenues – Total costs
= $0
Total revenues – Total VC
– Direct fixed costs
– Overhead
= $0
(5,000 x P) – (5,000 x $10)
– $100,000 – $25,000
= $0
(5,000 x P) – $175,000
= $0
5,000 x P
= $175,000
P = $175,000 ÷ 5,000
= $35.
7-9
Price Required for $100,000 Profit
Total revenues – Total VC
– Direct fixed costs
– Overhead
= $100,000
(5,000 x P) – (5,000 x $10)
– $100,000 – $25,000
= $100,000
(5,000 x P) – $175,000
= $100,000
5,000 x P
= $275,000
P = $275,000 ÷ 5,000
= $55.
7 – 10
Discussion Items
■ What price would be set under
marginal cost pricing?
■ What are the primary problems
inherent in price setting analyses of
this type?
7 – 11
Setting Prices Under Capitation
■ Montana Medical Center (MMC) has
1,400 admissions from one chargebased (FFS) payer with 15,000 members.
■ Relevant financial data:
● Average rev/per admission = $ 10,000.
● Average VC/per admission = $
3,000.
● Direct FC and overhead
= $9,000,000.
■ The payer wants to move to capitation.
What rate must be set on these patients
to achieve the current profit?
7 – 12
Current P&L Statement
Total revenues ($10,000 x 1,400)
Total VC ($3,000 x 1,400)
$14,000,000
4,200,000
Total CM ($7,000 x 1,400)
$ 9,800,000
Direct FC and overhead
Profit
9,000,000
$
800,000
7 – 13
Setting Prices Under Capitation (Cont.)
■ All else the same, MMC needs to obtain
the same total revenues, $14,000,000.
■ This amount of annual revenues must
be obtained from 15,000 enrollees:
$14,000,000 ÷ 15,000 = $933.33 per member.
■ But, capitation rates are quoted on a per
member per month (PMPM) basis:
$933.33 ÷ 12 = $77.78 PMPM.
7 – 14
Projected P&L Statement
Total rev. ($77.78 x 15,000 x 12)
Total VC ($3,000 x 1,400)
$14,000,000
4,200,000
Total CM
$ 9,800,000
Direct FC and overhead
Profit
9,000,000
$
800,000
7 – 15
Scenario Analysis
■ Note that the admission rate was
assumed to remain unchanged at:
1,400 ÷ 15,000 = 0.0933 per member.
■ Before making a decision, MMC
should analyze alternative scenarios,
a technique called scenario analysis.
■ What profit would result if a utilization
management program reduced the
admission rate to 0.08 admissions per
enrollee?
7 – 16
Scenario Analysis (Cont.)
■ If utilization were reduced, the number of
admissions would fall from 1,400 to:
15,000 x 0.08 = 1,200.
■ Therefore, variable costs would fall by:
200 x $3,000 = $600,000.
■ At $77.78 PMPM, profit would increase to:
$800,000 + $600,000 = $1,400,000.
7 – 17
Projected P&L Statement
Total revenues ($77.78 x 15,000 x 12) $14,000,000
Total VC ($3,000 x 1,200)
Total CM
Direct FC and overhead
Profit
3,600,000
$10,400,000
9,000,000
$ 1,400,000
● Should the direct fixed costs and overhead
be adjusted for the utilization change?
● Assume the utilization management program
costs $100,000. Should it be undertaken?
7 – 18
Scenario Analysis (Cont.)
Assume now that MMC wants to share
some of the utilization management
program gains with the payer. What
PMPM maintains the contract profit at
$800,000?
Now, revenue could fall by $600,000 to $13,400,000:
$13,400,000 ÷ 15,000 = $893.33 per member.
On a PMPM basis:
$893.33 ÷ 12 = $74.44 PMPM.
7 – 19
Projected P&L Statement
Total revenues ($74.44 x 15,000 x 12) $13,400,000
Total VC ($3,000 x 1,200)
3,600,000
Total CM
$ 9,800,000
Direct FC and overhead
Profit
9,000,000
$
800,000
7 – 20
Setting Managed Care Plan Rates
■ Managed care plans must set the rates
they charge to employers on the basis
of their costs of providing healthcare
services.
■ In general, the rates for different
services are estimated and then
aggregated.
■ This is usually done on a PMPM basis
regardless of the actual reimbursement
methods used to pay providers.
7 – 21
Setting Managed Care Plan Rates
(Cont.)
■ There are three techniques used to set
the rates for individual providers:
● Fee-for-service (FFS) approach
● Cost approach
● Demographic approach
■ In addition to covering services
provided, managed care plans must
incorporate administrative costs and
profits (reserves) into the PMPM rate.
7 – 22
FFS Approach
■ To illustrate the FFS method, assume
that BetterCare HMO targets 350
inpatient days for each 1,000 members
of an employee group, or 350 ÷ 1,000 =
0.350 per member.
■ Furthermore, previous experience in the
service area indicates that a fair
hospital FFS (per diem) rate is $1,000
per day.
● What drives the utilization assumption?
7 – 23
FFS Approach (Cont.)
PM utilization rate x FFS rate
Inpatient cost =
12
0.350 x $1,000
=
12
= $29.17 PMPM.
7 – 24
Cost Approach
■ Assume each enrollee will make 3
visits per year to a primary care
physician (PCP).
■ Each PCP can handle 4,000 patient
visits per year.
■ PCPs are compensated at an annual
rate of $175,000.
7 – 25
Cost Approach (Cont.)
■ Each member will require 3 ÷ 4,000 =
0.00075 PCPs.
■ The annual per member PCP cost is
0.00075 x $175,000 = $131.25.
■ Thus, the PMPM for PCP professional
fees is $131.25 ÷ 12 = $10.94.
■ Note that in practice it is common to
conduct the pricing analysis on the
basis of 1,000 members.
7 – 26
Total Physician Costs
■ Total physician costs (shown on the
next slide) include:
● Physician compensation
● Support staff compensation
● Supplies
● Overhead
■ In addition, an amount for practice
profit is included.
■ Finally, an amount is added for
referrals outside the HMO panel.
7 – 27
Total Physician Costs (Cont.)
Primary care
Specialist care
Support staff
Supplies
Overhead
Subtotal
Profit (10%)
In-area total
Outside referrals
Total
$10.94 PMPM
14.20
6.67
3.50
6.00
$41.31 PMPM
4.13
$45.44 PMPM
3.40
$48.84 PMPM
7 – 28
Demographic Approach (PMPM)
Demographics Primary Care
Age Band Male Female Male Female
0-1
1.9% 1.9% $47.00 $47.00
2-4
2.8 2.8 20.25 20.25
5-19
12.4 12.4 11.04 11.04
20-29
11.4 15.4 10.53 15.92
30-39
9.6 10.0 13.04 17.56
40-49
5.3 5.7 16.40 19.56
50-59
3.6 3.6 20.74 22.74
60+
0.7 0.5 24.93 25.60
Male/female cost
$ 7.07 $ 9.10 Total service
cost
$16.17
7 – 29
Total Premium Calculation
Clinical Costs:
Hospital inpatient
$ 27.35 PMPM
Other institutional
9.12
Pharmacy and DME benefits
7.00
Physician care
48.84
Total medical care costs $ 92.31 PMPM
HMO Costs:
Administration
$ 13.85 PMPM
Profit/Reserves
2.05
Total HMO costs
$ 15.90 PMPM
Total premium
$108.21 PMPM
7 – 30
Using RVUs to Set Prices
■ Relative value units (RVUs) measure
the relative amount of resources
consumed to provide a particular
service.
■ They form the basis for Medicare’s
RBRVS (Resource Based Relative
Value System) for physician
reimbursement.
■ We will use a laboratory setting to
illustrate the use of RVUs to set prices.
7 – 31
Using RVUs to Set Prices (Cont.)
■ To begin, the value of one RVU must
be defined. For example, it might
include:
● 10 minutes of technician time
● $1 of supplies
● $20 of equipment usage
● And so on
■ Then, the number of RVUs for each
activity (test) are established.
■ Finally, total annual costs and RVUs
are estimated.
7 – 32
Laboratory Annual Estimates
Test
Number of Number of
RVUs
Tests Total RVUs
Urinalysis
5
5,000
25,000
Blood typing
10
4,000
40,000
Blood cell count 50
1,000
50,000
Tissue analysis 200
250
50,000
165,000
Total annual costs = $250,000.
7 – 33
Finding the Cost and Price per RVU
Total annual costs
Cost per RVU =
Total number of RVUs
$250,000
=
165,000
= $1.52 per RVU.
To add a 25% markup,
Price = $1.52 x 1.25 = $1.90 per RVU.
7 – 34
Setting Test Prices
Test
Number Price
of RVUs per RVU Test Price
Urinalysis
5 $1.90 $ 9.50
Blood typing
10 1.90 19.00
Blood cell count 50 1.90 95.00
Tissue analysis 200 1.90 380.00
7 – 35
Service Decisions
■ Service decisions are analyzed in a
similar manner. The difference is that
the revenue rate is given, and the
provider must determine whether or
not its cost structure will permit a profit
to be earned.
● Why is scenario analysis so important
in pricing and service decision
analyses?
Chapter 5 Excel Table – SOLVING FOR VOLUME
Breakeven Volume = Fixed Costs/Contribution Margin
Revenue Per Unit
100
Variable Cost Per Unit
28.18
Contribtion Margin
71.82
volume
75000
Breakeven Volume (With Profit) = (Fixed Costs+Profit)/Contribution Margin
Revenue Per Unit
100
Variable Cost Per Unit
28.18
Contribtion Margin
71.82
volume
75000
Profit 100000
Total Revenue
Total Variable Costs
Fixed Costs
Total Revenue
Total Variable Costs
Fixed Costs
Volume
7500000
2113500
4967462
69,165 visits
Volume
7500000
2113500
4967462
70,558 visits
Chapter 7 Excel Table – SOLVING FOR PRICE
Windsor Clinic new outpatient service
What price must be set to break even?
Projected Data:
Variable cost per visit
$
10
Annual direct fixed costs
$ 100,000
Annual overhead allocation $ 25,000
Number of visits
5,000
Profit
$
–
Price Required for Accounting Breakeven
Total Revenue – Total Costs = 0
Total Variable Cost
$ 50,000
Annual Direct and Overhead $ 125,000
TOTAL COSTS $ 175,000
volume
5000
Price = Volume/Total Costs $
35
Price Required for $100,000 Profit
Total Revenue – Total Costs – Profit = 0
Total Variable Cost
$
50,000
Annual Direct and Overhead $ 125,000
Profit
$ 100,000
TOTAL COSTS $ 275,000
volume
5000
Price = Volume/Total Costs $
55
Chapter 7 Excel Table – SOLVING FOR PRICE
Montana Medical Center has 1400 admissions from one charge-based FFS payer with 15,000 members
Relevant financial data:
average revenue per admission
average variable cost per admissions
direct fixed costs and overhead
number of admissions
$
$
$
10,000
3,000
9,000,000
1,400
MMC P&L
Total Revenue = 10,000 x 1400
Total Variable Costs = 3000 x 1400
Total Contribution Margin = 7,000 x 1400
Direct FC and Overhead
Profit
$ 14,000,000
$ 4,200,000
$ 9,800,000
$ 9,000,000
$
800,000
Shift to Capitation for these 15000 members
Revenue
Total per member annually
TOTAL PER MEMBER PER MONTH (PMPM)
15,000
$ 14,000,000
$
933.33
$
77.78
average revenue per admission
average variable cost per admissions
direct fixed costs and overhead
number of admissions
MMC P&L
Total Revenue = 77.78 x 15,000 x 12
Total Variable Costs = 3000 x 1200
Total Contribution Margin = 7,000 x 1400
Direct FC and Overhead
Profit
$
$
$
10,000
3,000
9,000,000
1,200
$ 14,000,000
$ 3,600,000
$ 10,400,000
$ 9,000,000
$ 1,400,000
Setting Managed Care Plan Rates
FFS Approach
inpatient days
members
ratio
FFS per diem
inpatient cost =
$
350
1000
0.35 per member
1,000
Per Member Util Rate x FFS rate/12
= .35 x 1000/12
$29 per member per month
Cost Approach
3 visits to physician per member annually
each PCP can handle 4,000 visits annually
PCPs earn $175,000 annually
PCP time =3/4,000 = .00075 PCPs
= .00075 * $175,000
=$ 131.25 / 12
=$ 10.94 per member per month
Demographic Approach
uses FFS scheme to calculate costs based on demographics
Problem 5 – Chapter 7
PROBLEM 7.1(ab) Assume that the managers of Fort Winston Hospital are setting the price on
a new outpatient service. Here are the relevant data estimates:
Variable cost per visit
Annual direct fixed costs
Annual overhead allocation
Expected annual utilization
7.1(a)
$
5
$ 500.000
$ 50.000
10.000
What per-visit price must be set for the service to break even? To earn an annual profit of $100,000?
Total Variable Cost
Annual Direct and Overhead
TOTAL COSTS
volume
$
10000
Price = Total Costs/Volume
7.1(b)
Total Variable Cost
Annual Direct and Overhead
Profit
TOTAL COSTS
volume
Price = Total Costs/Volume
Repeat Part a, above but assume that the variable cost per visit is $10.
Total Variable Cost
Annual Direct and Overhead
TOTAL COSTS
volume
Price = Total Costs/Volume
$
10000
Total Variable Cost
Annual Direct and Overhead
Profit
TOTAL COSTS
volume
Price = Total Costs/Volume
rofit of $100,000?
$
10000
$
10000
Problem 5 – Chapter 7
PROBLEM 7.2(a)
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 per
service
Department
basic examination $
advanced examination$
therapy session
$
7.2(a)
Annual
number of
visits
Annual direct
fixed costs
5 $
7 $
10 $
50.000
30.000
40.000
3000
1500
500
What is the fee schedule for these services, assuming that the goal is to cover only
variable and direct fixed costs?
Basic Exam
Total Variable Cost
Annual Direct and Overhead
TOTAL COSTS
Volume
Price = Total Costs/Volume
$
– $
Advanced
Exam
– $
Therapy
–