1. Medical Cost and Performance Management August 3-6, 2019

2. 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

3. 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

4. Definitions 4

5. 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

6. 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

7. 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

8. 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

9. 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 %
 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 %
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

10. Overhead (Indirect) Cost Allocation10

11. 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

12. 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

13. 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

14. 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

15. Direct Allocation Administration Facilities Inpatient Services
Outpatient Clinics 15

16. Abbreviated Hospital Cost Allocation Table Direct Allocation16

17. Step-Down (Indirect) Allocation1 2
Administration
Facilities
Inpatient Services
Outpatient Services 17

18. Abbreviated Hospital Cost Allocation Table Step-Down (Indirect) Allocation18

19. Carroll University Hospital Determining the True Cost of Medical Services19

20. Big Bend Medical Center Fairness Issues in Cost Allocation20

21. Breakeven and Contribution Margin Analysis21

22. 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

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

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

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

26. 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

27. Carlsbad Home Care Breakeven Analysis27

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

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

30. Operating And Financial Leverage30

31. 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

32. 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

33. Impact of Operating Leverage
Clinic #1 Number of Visits 2,000 1, % 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 =EBIT $ 50,000 $ 10, % Operating Leverage Fixed Costs $110,000 = 73% Total Costs $150,000 Breakeven Visits 1,375
Clinic #2
2, %
$100 40
$ 60
$ 200, $ 150,000
80, ,000
70, ,000
$ 50, $ 20, %
$ 70,000 = 47%
$150,000
1,167 33

34. Operating Leverage
Clinic #1 Number of Visits 2,000 2, % 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 =EBIT $ 50,000 $ 90, % Operating Leverage Fixed Costs $110,000 = 73% Total Costs $150,000 Breakeven Visits 1,375
Clinic #2
2, , %
$100 40
$ 60
$ 200, $ 250,000
80, ,000
70, ,000
$ 50, $ 80, %
$ 70,000 = 47%
$150,000
1,167 34

35. Breakeven Graph Clinic #1
1,375 35

36. Breakeven Graph Clinic #2
1,167 36

37. 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

38. 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 ,000
Per Visit
Collections $100
Variable Cost
VC Margin $ 80
Collections $ 200,000
- Variable Costs ,000
- Fixed Costs ,000
= EBIT $ 50,000 38

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

40. 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
Net income $ 50,000
ROA (EBIT/Total Assets) %
ROE (Net Income/Equity) %
50% Debt
$ 50,000
20,000
$ 30,000
12.5%
15.0% 40

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

42. 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

43. Lakeside Hospital Putting it all Together43

44. Organizational Planning, Budgeting and Control44

45. 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

46. 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

47. Bedford Clinic Variance Analysis48

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

49. Bedford Clinic Flexible Budget Report49

50. Hampton Hospital Flexible Budgeting50

51. 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

52. 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