HSMP 587 - Health Care Fin. Mngmt 2/27/17

HSMP 587 - Health Care Fin. Mngmt 2/27/17 Winter 2017 Dr. Neal Wallace

Problem Set # 5 Answers

1) Why is it important to estimate your profitability for each type of service you provide? Why might you want to also assess profitability using “non-sunk” costs only? Is it ever OK to maintain a product line that is not profitable?

Estimating the profitability of each of the specific products you produce is critical in considering pricing strategies and the overall financial viability of your current production choices (e.g. whether you should be producing all the things you do, or which you might need to produce more efficiently). You may often want to consider doing this analysis using only “non-sunk” costs as these more limited costs tend to be more stable over time. Sunk costs often reflect more highly variable capital costs so that one year’s estimates may not fully reflect future profitability. Since non-sunk costs are also minimum operating costs, we may want to know if a service line is at least covering the basic costs of producing it. There is nothing wrong with holding on to “non-profitable” services if they fit the organizations mission and/or they provide some form of “quality” that substantially enhances demand for your other product lines.

2) What is a break-even analysis and why would you want to do it?

A break even analysis identifies the minimum number of visits you need to produce to “breakeven” or generate just enough revenue to meet you essential or minimum operating costs. Your minimum operating costs are your “non-sunk” costs. In our case these are our costs excluding depreciation and principal payments on our debt, as these are “optional” expenses to pay back for sunk capital costs. Dividing our minimum operating costs by our average revenue per visit gives us our overall breakeven number of visits. Note that since we have a cost allocation, we could determine our minimum operating costs for each final product and come up with a breakeven visit rate for each product line.

3) Suppose we decide to keep our clinic open in the evening. Would our cost per visit (overall or by type) likely be the same/higher/lower than before? Why?

Our cost per visit would likely be lower due to economies of scale. We will have more variable costs, such as lab supplies and higher labor costs, but we don’t need to rent more space and probably don’t need to have more administration. Thus the incremental costs for opening in the evening will only reflect our additional variable costs, while our fixed costs will be spread over more visits produced, lowering our overall cost per visit. HSMP 587 - Health Care Fin. Mngmt 2/27/17 Winter 2017 Dr. Neal Wallace

Problem Set # 5 Answers

4) What is a transfer price, what is it used for, and how do you determine what it is?

A transfer price is the internal cost of producing an intermediate product (e.g. our lab services). It is used as a benchmark for contracting out as we would not want to contract for lab services at a price higher than our own transfer price. Transfer prices come from step-down cost allocation. In the case of lab services, it would be the fully allocated cost of lab divided by the number of lab visits produced.

5) How does quality relate to your decision to contract out for services, and how might you estimate its importance?

Price and quality are critical variables in any economic transaction. In the decision to contact out (the “make or buy” decision), you want to make sure that a contractor can provide you with a service with a combination of price and quality that is better than what you could do yourself. In our lab example, timeliness and accuracy of lab tests is critical. Cheaper externally produced lab visits are no good if they can’t provide the timeliness and accuracy we need. We can use various parts of our financial model to estimate the cost of quality. In the lab example we know that lab visits only go to initial and high/low risk visits (from stats or cost-allocation set- up). Using our revenue stats we can estimate the average revenue from these types of visits and recognize that a “bad” lab test can result in a “lost” visit that goes unreimbursed at the average revenue rate for those visits. This is the basis for any “cost of lab quality” analysis.