Medical Cost and Performance Management August 3-6, 2019

Learning Objectives This class is an introduction to the management and control of healthcare organization costs. It addresses the tools and accounting information healthcare leaders need in order to plan, control and continuously evaluate their organization’s financial performance. Key learning objectives include an understanding of: How healthcare costs are classified, allocated and reported. How to determine the true cost of your clinical services. The role and importance of internal controls. How to use breakeven and contribution margin analysis to manage clinical profitability. How financial and operating leverage impact your organization’s net income. How to use flexible budgeting to provide clear, actionable explanations for budget variances 2

Topics 1. Types of Cost Behaviors cost objects and service lines expensed vs. capitalized costs types of expensed costs  2. Methods of Cost Allocation direct allocation step-down allocation 3. Internal Controls 4. Cost Management Tools breakeven analysis contribution margin analysis 5. Cost and Performance Management Under Value Based Payments 6. Operating and Financial Leverage determinates of operating and financial leverage impact of leverage on net income 7. Planning, Budgeting and Control planning and control toolkit fixed vs. flexible budgeting fixed vs. flexible variance analysis   3

Definitions 4

Cost Objects and Service Lines A cost object is any output or activity for which separate cost data is desired. Examples might include a patient visit, a bed day, a type of procedure, a diagnostic test, etc You must have relevant cost data if you want to: establish pricing or subsidy determine whether to continue or discontinue a service exercise effective cost control  A service line is an integrated set of outputs or activities designed to address a market need, e.g., women’s health, ElderCare, Heart & Vascular Services. A service line is typically constructed of numerous cost objects. 5

Types of Costs Expensed Costs are those incurred in carrying out an organization’s day-to-day operating activities. They are found on the Income Statement, and are generally associated with the organization’s normal operating cycle. Capitalized Costs are those incurred to purchase an asset with a useful life of more than one year. They represent a long term investment which is not immediately charged to operations. The purchase initially shows up on the Balance Sheet as an asset purchase. The value of the item is then depreciated (tangible assets) or amortized (intangible assets) over a number of years according to a pre-defined schedule. These are non-cash expenses which show up on the Income Statement. 6

Types of Expensed Costs All departmental expensed costs can be classified along two dimensions: Direct or Indirect Direct costs are those that are directly traceable to the activities or output of a particular department. These are costs over which the departmental manager has some degree of control. Indirect costs are those costs allocated to a department. They are costs over which the departmental manager has no control. Variable, Semi-Variable or Fixed Variable costs vary in direct proportion to output or services rendered. Semi-Variable costs vary with changes in output but, unlike a variable cost, do not vary in direct proportion. Fixed costs remain the same as output or service level changes. 7

Current State of Cost Accounting in U. S Current State of Cost Accounting in U.S. Hospitals: Chaos Behind a Veil of Secrecy A 2017 national hospital system survey found that 90% of those responsible for pricing and managing medical services don’t know their true cost. As a result, most hospital systems don’t trust their data. Only 12% of hospital leaders report having any confidence in the accuracy of their cost information. The ratio of cost to charges (RCC) methodology is an imperfect but frequently used method to analyze costs at the service department level, but it’s not able to determine the cost across the care continuum. In 2017 hospital operating margins averaged only 2.6%, and 33% of hospitals had a negative margin. With thin margins and the introduction of capitated and bundled payment programs, understanding and managing cost is a critical competency. Source: Survey by Becker Healthcare / Strata Decision Technology 8

Ratio of Cost to Charges The ratio of costs-to-charges (RCC) is the ratio between a hospital’s operating expenses and billed charges (not collections). It can be calculated at the hospital level as well as the service center level.  For example, to compute the RCC for orthopedic surgery, the accounting staff divides the sum of the center’s full costs operating for the year by its total billed charges for that year. The result is the department’s RCC, e.g. Total Orthopedic Surgery Center Costs $15,000,000 Total Charges $40,000,000 Orthopedic Surgery Cost-to-Charge Ratio 37.5%  The ratio is then multiplied by the billed charge for any given procedure, e.g., a knee replacement, to determine that procedure’s cost: Knee Replacement Charge $40,000 Departmental Cost-to-Charge Ratio 37.5% Estimated Cost of a Knee Replacement $15,000 The presumption is that the true cost of a knee replacement bears the same relationship to its billed charge as any other orthopedic procedure. 9

Overhead (Indirect) Cost Allocation 10

Types of Departments Revenue Centers are those departments that are directly responsible for generating revenues, i.e., delivering billable medical services. Examples include: Inpatient Services Outpatient Clinics Emergency Department Service Centers are those departments that perform activities that support the Revenue Centers, but are not responsible for directly generating revenues. Examples include: Facilities Management Human Resources Central Administration 11

Allocating Service Center Costs In profit & loss accounting, the full cost of each service center must be allocated to the revenue centers using the appropriate cost driver. Facilities Management Inpatient Services Human Resources Outpatient Clinics Central Admin. Emergency Dept. 12

Allocating Service Center Costs The appropriate cost driver, or basis of allocation, of any service center’s cost is always arbitrary, and can vary from one organization to another. For example: The cost of the Facilities Department might be allocated by the amount of space used by each revenue department. The cost of the Human Resources Department might be allocated by the number of employees in each revenue department. The cost of Central Administration might be allocated by the payroll of each revenue department. 13

Allocating Service Costs There are two common methods for allocating service department costs to revenue departments: Direct Method Ignores other service departments when making the allocation. It allocates each service department’s costs directly to the revenue revenue-producing departments. Step-Down Method Recognizes that some service departments support activities in other service departments. Costs are allocated on a “step-down method” through the service departments until they all wind up in the revenue departments. 14

Direct Allocation Administration Facilities Inpatient Services Outpatient Clinics 15

Abbreviated Hospital Cost Allocation Table Direct Allocation 16

Step-Down (Indirect) Allocation 1 2 Administration Facilities Inpatient Services Outpatient Services 17

Abbreviated Hospital Cost Allocation Table Step-Down (Indirect) Allocation 18

Carroll University Hospital Determining the True Cost of Medical Services 19

Big Bend Medical Center Fairness Issues in Cost Allocation 20

Breakeven and Contribution Margin Analysis 21

Breakeven Analysis Breakeven analysis is the study of the relationship between the volume of output and operating income. It assumes that: expenses can be divided into fixed, variable, and semi-variable categories; the behavior of revenues and expenses are (reasonably) linear over some relevant range, i.e., no expected changes in operating efficiency or productivity; and case mix remains (relatively) constant. The Breakeven Point is the level of output at which revenues equal expenses and operating income is zero 22

Breakeven Scenario Per Unit Percentage of Collections Collections per Visit $ 150 100% Variable Cost per Visit 50 33% Variable Cost Margin $ 100 67% Monthly Fixed Expenses rent $ 7,000 salaries 40,500 depreciation 2,500 Total Fixed Expenses $ 50,000 $50,000 Fixed Expenses $100 Variable Cost Margin = 500 Visits per Period (Breakeven) 23

Breakeven Graph Collections $150 Variable Exp. 50 Margin $ 100 Fixed Exp. $ 50,000 Collections Office Visits 24

Breakeven Graph Collections $150 Variable Exp. 50 Collections VC Margin $ 100 Fixed Exp. $ 50,000 Collections Office Visits 25

General Hospital Breakeven Analysis General Hospital is a not-for-profit acute care facility with the following cost structure for its inpatient services: Fixed Cost $12,000,000 Variable Cost per Inpatient Day $800 Revenue per Inpatient Day $1,200 The hospital expects to have a patient load of 35,000 inpatient days next year. What is the hospital’s expected net profit? What is its breakeven point? Assuming the hospital has upside flexibility on its charges, how much would it have to raise its daily rate to earn a profit of $3 million? Assuming it has no charge flexibility, how much more volume would be required to earn a profit of $3 million? Assume 20% of the hospital’s inpatient days come from a managed care plan that wants a 15% discount from current posted charges, else they will shift their covered lives to a competing hospital. Should the General Hospital consent to the proposal? 26

Carlsbad Home Care Breakeven Analysis 27

Fee for Service Breakeven Revenue $ Profit Total Costs Fixed Costs Breakeven Service Volume 28

Value-Based Payment Breakeven $ Total Costs Revenue Profit Fixed Costs Breakeven Service Volume 29

Operating And Financial Leverage 30

Leverage Leverage is a measure of the sensitivity of a firm’s net income to any given change in revenues. It is a measure of the variability (riskiness) of the organization’s net income. The degree of leverage is determined by the ratio of fixed costs to total costs. The higher the percentage of fixed costs, the higher the leverage and the greater the variability of net income. There are two separate but related types of leverage: Operating Leverage is determined by the ratio of fixed to total operating costs. Increasing the percentage of fixed costs increases operating leverage. Financial Leverage is determined by the ratio of debt to total capitalization (debt + equity). Increasing the percentage of debt increases financial leverage.   31

Impact of Operating Leverage Clinic #1 Number of Visits 2,000 Per Visit Collections $100 -Variable Cost 20 =VC Margin $ 80 Collections $ 200,000 -Variable Costs 40,000 -Fixed Costs 110,000 =EBIT $ 50,000 Operating Leverage Fixed Costs $110,000 = 73% Total Costs $150,000 Breakeven Visits 1,375 Clinic #2 2,000 $100 40 $ 60 $ 200,000 80,000 70,000 $ 50,000 $ 70,000 = 47% $150,000 1,167 32

Impact of Operating Leverage Clinic #1 Number of Visits 2,000 1,500 -25% Per Visit Collections $100 -Variable Cost 20 VC Margin $ 80 Collections $ 200,000 $ 150,000 -Variable Costs 40,000 30,000 -Fixed Costs 110,000 110,000 =EBIT $ 50,000 $ 10,000 -80% Operating Leverage Fixed Costs $110,000 = 73% Total Costs $150,000 Breakeven Visits 1,375 Clinic #2 2,000 1500 -25% $100 40 $ 60 $ 200,000 $ 150,000 80,000 60,000 70,000 70,000 $ 50,000 $ 20,000 -60% $ 70,000 = 47% $150,000 1,167 33

Operating Leverage Clinic #1 Number of Visits 2,000 2,500 +25% Per Visit Collections $100 -Variable Cost 20 VC Margin $ 80 Collections $ 200,000 $ 250,000 -Variable Costs 40,000 50,000 -Fixed Costs 110,000 110,000 =EBIT $ 50,000 $ 90,000 +80% Operating Leverage Fixed Costs $110,000 = 73% Total Costs $150,000 Breakeven Visits 1,375 Clinic #2 2,000 2,500 +25% $100 40 $ 60 $ 200,000 $ 250,000 80,000 100,000 70,000 70,000 $ 50,000 $ 80,000 +60% $ 70,000 = 47% $150,000 1,167 34

Breakeven Graph Clinic #1 1,375 35

Breakeven Graph Clinic #2 1,167 36

Operating Leverage Conclusions Higher operating leverage (higher fixed/total expenses) increases the sensitivity of operating income to changes in revenues and raises the breakeven point. Conversely, lower operating leverage reduces the sensitivity of operating income to changes in revenues and lowers the breakeven point. Conclusion: When revenues are expected to rise, higher operating leverage works in your favor. When revenues are in danger of falling, lower operating leverage is more advantageous. 37

Impact of Financial Leverage Assume Clinic #1 in our example is a new, non-profit walk-in clinic that needs $400,000 in assets to begin operations. It’s forecast to produce $50,000 in first year operating earnings (EBIT). Number of Visits 2,000 Per Visit Collections $100 Variable Cost 20 VC Margin $ 80 Collections $ 200,000 - Variable Costs 40,000 - Fixed Costs 110,000 = EBIT $ 50,000 38

Alternative Balance Sheets Assume our walk-in clinic has three alternative capital structures All Equity 50% Debt 75% Debt Total Assets $400,000 $400,000 $400,000 Debt (10% cost) $ 0 $200,000 $300,000 Equity 400,000 200,000 100,000 Total Capital $400,000 $400,000 $400,000 39

Projected Income Statements $400,000 in Total Capitalization 75% Debt $ 50,000 30,000 $ 20,000 12.5% 20.0% All Equity EBIT $ 50,000 Interest expense @10% 0 Net income $ 50,000 ROA (EBIT/Total Assets) 12.5% ROE (Net Income/Equity) 12.5% 50% Debt $ 50,000 20,000 $ 30,000 12.5% 15.0% 40

Projected Income Statements $400,000 in Total Capitalization 75% Debt $ 30,000 30,000 $ 0 7.5% 0.0% All Equity EBIT $ 30,000 Interest expense @10% 0 Net income $ 30,000 ROA (EBIT/Total Assets) 7.5% ROE (Net Income/Equity) 7.5% 50% Debt $ 30,000 20,000 $ 10,000 7.5% 5.0% 41

Financial Leverage Conclusions Higher financial leverage (higher debt/total capital) increases the sensitivity of net income to changes in operating earnings while lower financial leverage reduces it. Conclusion: When revenues and operating earnings are rising, higher financial leverage (debt/total capital) works in your favor. When revenues and earnings are falling, lower financial leverage is preferred. In the short-run, it’s generally easier to change operating leverage than financial leverage. 42

Lakeside Hospital Putting it all Together 43

Organizational Planning, Budgeting and Control 44

Planning and Control Toolkit Long Term Mission. The organization’s business purpose and focus; why it exists. What it provides, to whom, and how. Vision. What the organization is expected to achieve or become in the mid- to long-range future. Strategic Plan. The strategies and tactics by which the organization will achieve its vision. Intermediate Term Operating Plan. Detailed plan for meeting the organization’s operating objectives over the next 3-5 years. The first year of the operating plan is frequently the annual operating budget. Capital Budget. A projection of the organization’s capital investment needs and how those needs will be financed. Short Term Cash Budget. A forecast of cash receipts and disbursements over a 6-12 month period of time. Operating Budget. A detailed projection of estimated revenues, expenses and net income over a one year period. Variance Analysis. An examination and interpretation of the difference between actual and budgeted or targeted levels of performance. 45

The Operating Budget Focuses on projected profitability (P&L) Top down vs. bottom up Revenue Budget case mix and volume reimbursement non-patient revenues Expense Budget direct vs. indirect fixed vs. variable 46

Bedford Clinic Variance Analysis 48

Bedford Clinic What You Would Like to Know The clinic manager effectively has little or no control over volume, case mix or revenue per case. That being the case, what would have been the projected profit if those items had been accurately budgeted? If they had been, how much of the resulting profit variance would have been due to those variables over which the manager does have control: cost of supplies cost of labor office fixed expenses 49

Bedford Clinic Flexible Budget Report 49

Hampton Hospital Flexible Budgeting 50

Lessons Learned on the Front Line All costs—direct, indirect, fixed, variable, capitalized—eventually have to be paid, and always from revenue producing departments. Trust your CFO to allocate indirect costs. If cost allocation procedures have not changed in 4-5 years, however, then it’s time for an open discussion. Be careful about evaluating and structuring bonuses in revenue departments on the basis of profitability. Benchmark all departments, particularly non-revenue ones. Marginal cost pricing (pricing based on variable costs only) is a bad idea. Payers love it, and are always resistant when they’re asked to convert to full cost pricing. Don’t negotiate pricing (contracting, discounts, etc.) until you know your true total cost for delivering the service. 51

Lessons Learned on the Front Line Know your breakeven level of service. Know what volume is required to cover your direct costs, and what is required to cover both direct and indirect. Most organizational knowledge is on the front line, at the point of patient service, so expense budgeting is more effective if done “bottom-up.” Most budgeting errors are in overestimating revenues. Cost estimates are likely to be more accurate. Carefully review all revenue assumptions and require realistic action plans for achieving them. Strong internal controls are absolutely necessary to protect assets and prevent errors and irregularities, which will surely occur in their absence. 52