Chapter 11 Maximizing Profits Copyright 2015 Health Administration Press

After mastering this material, students will be able to  define measures of profitability,  describe how to increase profits,  explain how to maximize profits, and  discuss how for-profit (FP) and not-for- profit (NFP) providers differ. 2Copyright 2015 Health Administration Press

DEFINING PROFITABILITY 3Copyright 2015 Health Administration Press

Defining Profitability  Profit = Revenue − Cost  Both revenue and cost – are accounting constructs, and – need not correspond to cash flow. 4Copyright 2015 Health Administration Press

Profit is an accounting construct.  A profitable organization – might have cash flow problems, and/or – might not be earning an adequate ROI.  But unprofitable organizations are more likely to have these problems. 5Copyright 2015 Health Administration Press

A Profitable Investment with Potential Cash Flow Problems RevenueExpenseCash Flow Year 0$0$1,000,000 Year 1$500,000$100,000$400,000 Year 2$500,000$100,000$400,000 Year 3$500,000$100,000$400,000 Year 4$500,000$100,000$400,000 6Copyright 2015 Health Administration Press

A Seemingly Profitable Investment  Revenue = $1,000,000  Cost = $800,000 – Labor = $400,000 – Supplies = $300,000 – Facility = $100,000  What’s the profit? 7Copyright 2015 Health Administration Press

A Seemingly Profitable Investment  Profit = $1,000,000 − $800,000 – Labor = $400,000 – Supplies = $300,000 – Facility = $100,000  Facility is worth $400,000 in another use. – Accounting cost ≠ opportunity cost. – This does not generate economic profits. 8Copyright 2015 Health Administration Press

Profit Measures  Gross Profit Ratio = (R − C) / R – R = revenue – C = cost of products sold  ROE = return on equity  ROI = return on investment 9Copyright 2015 Health Administration Press

Profit Measures  Gross Profit Ratio = (R − C) / R  ROE = return on equity – Profit/equity – Equity = value of owners’ investment  ROI = return on investment – Profit/investment – Specific to a project or investment 10Copyright 2015 Health Administration Press

Importance of Profitability  For FP and NFP firms alike – Sister Irene Kraus of the Daughters of Charity: “No margin, no mission” – Unprofitable firms slowly going out of business  For all managers 11Copyright 2015 Health Administration Press

Profit maximization is important.  It’s important for understanding – what your FP or NFP firm should do, and – what other FP or NFP firms will do.  Firms that do not maximize profits risk – failing, – wasting resources, and – not producing what consumers want. 12Copyright 2015 Health Administration Press

HOW TO MAXIMIZE PROFITS 13Copyright 2015 Health Administration Press

How do we maximize profits?  What should we start doing?  What should we stop doing? 14Copyright 2015 Health Administration Press

How to Maximize Profits  Increase efficiency  Shed unprofitable contracts  Add profitable contracts  Close unprofitable business lines  Open profitable business lines  Price to increase profits 15Copyright 2015 Health Administration Press

Increasing Efficiency  An essential part of profit maximization – High-cost producers struggle. – Cost reductions can be very profitable.  Neither easy nor fun – It often involves firing workers. – The ones fired may have done nothing wrong. 16Copyright 2015 Health Administration Press

But inefficient firms often fail.  Workers lose jobs.  Customers lose a supplier.  Stakeholders lose their investments. 17Copyright 2015 Health Administration Press

Cost cuts can increase profits. Status Quo4% Cut7% Cut Revenue$3,000 Cost$3,100$2,976$2,883 Profit($100)$24$117 Margin-3.3%0.8%3.9% 18Copyright 2015 Health Administration Press

All firms: To maximize profit  expand only if marginal revenue > marginal cost, and  stay in a line of business only if profits are adequate.  What’s an adequate profit? 19Copyright 2015 Health Administration Press

Defining Terms  Marginal revenue (MR) – Change in revenue/change in output – Can be positive or negative  Marginal cost (MC) – Change in cost/change in output – Is always positive 20Copyright 2015 Health Administration Press

Marginal revenue: change in revenue divided by change in volume PriceQuantityRevenueMR $2000$0 $160800$128,000$160 $1201,600$192,000$80 $80 = ($192,000 - $128,000)/(1,600 – 800) 21Copyright 2015 Health Administration Press

Marginal revenue can be negative. PriceQuantityRevenueMR $2000$0 $160800$128,000$160 $1201,600$192,000$80 2,400$192,000$0 $403,200$128,000$80 $04,000$0$160 22Copyright 2015 Health Administration Press

FOR-PROFIT SUPPLY 23Copyright 2015 Health Administration Press

For-Profit Supply  Expand as long as MR > MC  Be sure that P > ATC 24Copyright 2015 Health Administration Press

Increase volume (cut price) if price > AC and MR > MC Price$10.00$9.00$8.00 Quantity Revenue$1,000$2,700$3,200 MR?? Cost$600$1,800$2,400 MC?? Profit?? 25 Copyright 2015 Health Administration Press

Is price > AC? Price$10.00$9.00$8.00 Quantity Revenue$1,000$2,700$3,200 MR?? Cost$600$1,800$2,400 MC?? Profit?? 26 Copyright 2015 Health Administration Press

Is MR > MC when price is $9? When price is $8? Price$10.00$9.00$8.00 Quantity Revenue$1,000$2,700$3,200 MR?? Cost$600$1,800$2,400 MC?? Profit?? 27 Copyright 2015 Health Administration Press

Maximum profits may be negative.  What should you do then? 28Copyright 2015 Health Administration Press

FOR-PROFIT AND NOT-FOR-PROFIT FIRMS 29Copyright 2015 Health Administration Press

Do any healthcare firms try to maximize profits?  Owner-managed firms  Firms owned by share holders  Many NFP firms 30Copyright 2015 Health Administration Press

NFP supply may differ from FP supply for three reasons.  Different goals  Lower costs due to NFP status  A more severe agency problem, such as – multiple goals, – ownership impossible for managers, and – all firms having an agency problem. 31Copyright 2015 Health Administration Press

NFP Supply: MR + MB = MC  MB > 0, produce more than FP  MB = 0, produce as much as FP  MB < 0, produce less than FP 32Copyright 2015 Health Administration Press

MR + MB = MC has little or no predictive power.  MC may differ for NFPs.  We don’t observe MB.  MB may depend on other income. – Struggling NFP may act like FP. – Flush NFP may have large MB.  Why should NFP firms get tax breaks? 33Copyright 2015 Health Administration Press

CHOOSING CONTRACTS THAT MAXIMIZE PROFITS 34Copyright 2015 Health Administration Press

Knowing how to maximize profits is vital, even if that’s not a priority.  If MR is greater than MC – Increase output – Cut prices  If MR is less than MC – Cut output – Increase prices 35Copyright 2015 Health Administration Press

Should you sign this contract?  Contract 1 – Volume =2,000 – Revenue =$200,000 – Cost =$150,000 36Copyright 2015 Health Administration Press

Which do you prefer? Why? Contract 1  Volume = 2,000  Revenue = $200,000  Cost =$150,000 Contract 2  Volume = 3,000  Revenue = $300,000  Cost =$270,000 37Copyright 2015 Health Administration Press

Contract 2 has lower profits. 38 Contract 1  Volume = 2,000  Revenue = $200,000  Cost =$150,000 Contract 2  Volume = 3,000  Revenue = $300,000  Cost =$270,000  MC = $120  MR = $100 Copyright 2015 Health Administration Press

CONCLUSIONS 39Copyright 2015 Health Administration Press

Profit maximization is important.  Profits can be increased by – increasing efficiency, – using marginal cost pricing, – making deals only if revenue > cost, – expanding volume if MR > MC, and – reducing volume if MR < MC. 40Copyright 2015 Health Administration Press

The same rules apply to pricing and contracting.  Are profits adequate?  With MR > MC – Cut prices – Increase volume  With MR < MC – Increase prices – Reduce volume 41Copyright 2015 Health Administration Press

Not-for-Profit Organizations  Sometimes different from for-profits  But not always  They need to be profitable, too. 42Copyright 2015 Health Administration Press