Differentiate full-cost pricing from marginal cost pricing.

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118THEME SET-UP: Profit analysisCHAPTER 5PRICING DECISIONS AND PROFIT ANALYSISAs you know from chapters 3 and 4, Jen Latimer is the new manager at Big Sky Dermatology Special-ists, a small group practice in Jackson, Wyoming. After reviewing the practice’s revenue sources and examining its cost structure, Jen was ready to combine Big Sky’s cost and revenue structures to get a feel for next year’s profit potential. (Jen was accounting for all costs, except for physician compensation, so the “profit” projection was, in reality, the compensation available for the two physicians.) Jen knew that the practice’s profitability could be analyzed using a technique called profit analysis. (Accountants call this technique cost-volume-profit analysis.) She already identified the practice’s cost structure. At an expected (base case) volume of 10,000 visits, total costs were forecasted to be $1,000,000: Total costs = Fixed costs + Total variable costs = Fixed costs + (Variable cost rate×Volume) = $850,000 + ($15×10,000 visits) = $850,000 + $150,000 = $1,000,000.00_Reiter_Song (2354) Book.indb 1183/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis119Now, Jen must fold in the revenue structure of the practice. This process will allow her to analyze the impact of different volume assumptions on the practice’s profitability. (In addition, she can analyze the impact of different revenue and cost assumptions.)By the end of this chapter, you will have a better grasp of profit analysis and its benefit to healthcare managers. In addition, you, like Jen, will be able to examine Big Sky’s profitability under varying assumptions of volume, costs, and revenues.After studying this chapter, you will be able to do the following: ➤Explain the difference between price setters and price takers. ➤Differentiate full-cost pricing from marginal cost pricing. ➤Describe how target costing is used. ➤Conduct profit analyses to learn the impact of volume changes on profitability and to determine breakeven points. ➤Discuss the primary differences in profit analyses between fee-for-service and capitation reimbursement. ➤Explain how revenue and cost structures affect a healthcare organization’s risk.LEARNING OBjECTIvES00_Reiter_Song (2354) Book.indb 1193/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance1205.1 INTRODUCTIONOne of the most important uses of managerial accounting data is to establish a price for a particular service or, given a price, to determine whether the service will be profitable. For example, in a charge-based environment, healthcare managers must set prices on the services their organizations offer. Managers also must determine whether to offer volume discounts to valued payer groups, such as managed care plans or business coalitions, and how large these discounts should be.After prices are set, managers can estimate revenues on the basis of volume estimates. Furthermore, the business’s revenue structure (volumes coupled with reimbursement rates) can be combined with its cost structure to forecast profits under a wide range of operating assumptions. Having some knowledge of future profitability requirements, and the prices (and hence revenues) for attaining profitability, is critical for good financial decision-making.This chapter discusses pricing strategies and profit analysis. Along the way, it covers other important healthcare finance principles.5.2 HEALTHCARE PROVIDERS AND THE POWER TO SET PRICESA healthcare provider’s power to set prices falls somewhere along a spectrum of two extremes. At one extreme, providers have no power whatsoever and must accept the prices (reim-bursement amounts) set by the marketplace. At the other extreme, providers can set any prices desired (within reason), and payers must accept those prices. Clearly, few real-world markets for healthcare services support such extreme positions. Nevertheless, thinking in such terms can help healthcare managers understand the pricing decisions they face.PROvIDERS AS PRICE TAKERSIf a healthcare organization is one of many providers in a service area that has numerous purchasers (typically third-party payers), and if little distinguishes the services offered by the various providers, then economic theory suggests that the prices are set by local supply-and-demand conditions. Furthermore, the actions of a single participant—whether a provider or payer—cannot influence the prices set in the marketplace. In such a perfectly competitive market, healthcare providers are said to be price takers because they are constrained by (or must accept) the prices set in the marketplace.Few markets for healthcare services are perfectly competitive. But some payers—notably government payers and managed care plans with market power—can set reim-bursement levels on a take-it-or-leave-it basis. In this situation, as in competitive markets, providers are price takers in the sense that they have very little influence over reimbursement rates. Because many markets either are somewhat competitive or are dominated by large payer groups, and because government payers cover a significant proportion of the popula-tion, most providers probably qualify as price takers for a large percentage of their revenue.Price takerA provider that has no power to influence the prices set by the marketplace.In general, providers that are price takers must take price as a given and concentrate managerial efforts on cost structure and utilization to ensure that their services are profit-able. Thus, price takers are just as concerned about costs as are price setters (discussed in the next section).From a purely financial perspective, a price-taking provider should offer all profitable services, even when the price is reduced by discounting or other market actions. Although this approach to service decisions is obviously simplistic, it does raise an important issue: What costs are relevant to the decision at hand? To ensure long-term sustainability, prices must cover full (all) costs. However, prices that do not cover full costs may be acceptable for short periods, and it might be in the provider’s best interests to accept such prices.PROvIDERS AS PRICE SETTERSHealthcare providers with market dominance enjoy large market shares and hence exercise some pricing power. Within limits, such providers can decide what prices to set on the services offered. Furthermore, if a provider’s services can be differentiated from others on the basis of quality, convenience, or another characteristic, the provider also has the ability, again within limits, to set prices on the differentiated services. Healthcare providers that have such pricing power are called price setters.Accounting for market conditions when making forecasts or decisions about service offerings would be much easier for healthcare managers if a provider’s status as a price taker or a price setter were fixed for all payers, for all services, for long periods. But the healthcare market is ever changing, and providers can quickly move from one status to the other. For example, the merger of two healthcare providers may create sufficient market power to change two price takers (as separate entities) into one price setter (as a combined entity). Furthermore, providers can be price takers for some services (or some third-party payers or some geographic markets) and price setters for others.5.3 PRICE-SETTING STRATEGIESWhen providers are price setters, alternative strategies can be used to price healthcare services. No single strategy is most appropriate in all situations. In this section, we discuss the two price-setting strategies most frequently used by healthcare organizations.Price setterA provider that has the power (within reason) to set market prices for its services.SELF-TEST QUESTIONS1. What is the difference between a price taker and a price setter?2. Are healthcare providers generally either price takers or price setters exclusively? Explain your answer.00_Reiter_Song (2354) Book.indb 1203/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis121In general, providers that are price takers must take price as a given and concentrate managerial efforts on cost structure and utilization to ensure that their services are profit-able. Thus, price takers are just as concerned about costs as are price setters (discussed in the next section).From a purely financial perspective, a price-taking provider should offer all profitable services, even when the price is reduced by discounting or other market actions. Although this approach to service decisions is obviously simplistic, it does raise an important issue: What costs are relevant to the decision at hand? To ensure long-term sustainability, prices must cover full (all) costs. However, prices that do not cover full costs may be acceptable for short periods, and it might be in the provider’s best interests to accept such prices.PROvIDERS AS PRICE SETTERSHealthcare providers with market dominance enjoy large market shares and hence exercise some pricing power. Within limits, such providers can decide what prices to set on the services offered. Furthermore, if a provider’s services can be differentiated from others on the basis of quality, convenience, or another characteristic, the provider also has the ability, again within limits, to set prices on the differentiated services. Healthcare providers that have such pricing power are called price setters.Accounting for market conditions when making forecasts or decisions about service offerings would be much easier for healthcare managers if a provider’s status as a price taker or a price setter were fixed for all payers, for all services, for long periods. But the healthcare market is ever changing, and providers can quickly move from one status to the other. For example, the merger of two healthcare providers may create sufficient market power to change two price takers (as separate entities) into one price setter (as a combined entity). Furthermore, providers can be price takers for some services (or some third-party payers or some geographic markets) and price setters for others.5.3 PRICE-SETTING STRATEGIESWhen providers are price setters, alternative strategies can be used to price healthcare services. No single strategy is most appropriate in all situations. In this section, we discuss the two price-setting strategies most frequently used by healthcare organizations.Price setterA provider that has the power (within reason) to set market prices for its services.SELF-TEST QUESTIONS1. What is the difference between a price taker and a price setter?2. Are healthcare providers generally either price takers or price setters exclusively? Explain your answer.00_Reiter_Song (2354) Book.indb 1213/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance122FULL-COST PRICINGFull-cost pricing recognizes that to remain viable in the long run, healthcare organizations must set prices that recover all costs associated with operat-ing the business (see “Critical Concept: Full-Cost Pricing”). Thus, the full cost of a service—whether a patient day in a hospital, a visit to a clinic, a laboratory test, or the treatment of a particular diagnosis—must include the following: (1) the direct variable costs of providing the service, (2) the direct fixed costs, and (3) the appropriate share of the overhead expenses of the organization.Because allocating overhead costs is com-plicated (see chapter 4), the full costs of an indi-vidual service are difficult to determine with pre-cision and hence have to be viewed as merely an estimate of the true costs. Nevertheless, in the aggregate, revenues must cover both direct and overhead costs, and hence prices in total must cover all costs of an organization.Furthermore, all businesses need profits to survive in the long run. In not-for-profit businesses, prices must be set high enough to provide the profits needed to support asset replacement and to acquire new assets as needed to support volume growth and provide new technologies. For-profit providers, in addition to these support expenditures, must provide equity investors (owners) with a financial return on their investment. The bottom line is that full-cost pricing must cover all accounting costs plus a profit target.MARGINAL COST PRICINGIn economics, the marginal cost of an item is the cost of providing one additional unit of output, whether that output is a product or service, beyond the current volume. For example, suppose that a 150-bed hospital currently provides 40,000 patient days of care. Its marginal cost, based on inpatient day as the unit of service, is the cost of providing the 40,001st day of care. When only one additional day is added to a current volume of 40,000 patient days, fixed costs likely will not increase, so the marginal cost consists solely of the variable costs associated with an additional one-day stay.In most situations, no additional labor costs would be involved. The marginal cost, therefore, consists of expenses such as laundry, food and expendable supplies, and any additional utility services consumed during that day. Obviously, the marginal cost associ-ated with one additional patient day is far less than the full cost of that patient day, which must include all direct fixed and overhead costs plus a profit component.Should any prices be set on the basis of marginal costs? In theory, the answer is no. If all payers for a particular provider set reimbursement rates on the basis of marginal Marginal costThe cost of one additional unit of output; in an outpatient setting, the cost (typically only for supplies) of one more patient visit on top of the existing volume.costs, the organization would not recover its full costs, including direct and overhead, and hence would ultimately fail. For prices to be equitable, all payers should pay their fair shares in covering providers’ total costs. Furthermore, if marginal cost pricing should be adopted, which payer(s) should receive its benefits by being charged lower prices (see “Critical Concept: Marginal Cost Pric-ing”)? Should it be the government because it is taxpayer funded, or should it be the last payer to contract with the provider? These questions do not have good answers. The easy solution, at least conceptually, is to require all payers to pay full costs and hence equitably share the burden of the organization’s total costs.However, as a practical matter, it may make sense for healthcare providers to occa-sionally use marginal cost pricing to attract a new patient group or to retain an existing group (gain or retain market share). To survive in the long run, though, businesses must earn revenues that cover their full costs (see “For Your Consideration: Hospitals, Cap-tive Health Plans, and Price Setting”). Thus, marginal cost pricing must be a temporary measure, or the organization must overcharge other payers for services (compared to full cost) to make up for the losses on patients who are undercharged, called price shifting (or cross-subsidization).Historically, price shifting was used to support services that were not self-supporting, such as emergency care, teaching and research, and indigent care. Without using price-shifting strategies, many providers would not have been able to offer a full range of services. Payers were willing to accept price shifting because the additional burden was not excessive. Today, however, overall healthcare costs have risen to the point where the major purchasers of healthcare services are less willing to support the costs associated with providing services to others, and hence purchasers are demanding prices that cover only the true costs of the covered populations. Payers believe that they do not have the moral responsibility to fund healthcare services for others.Price shiftingThe act of charging more than full costs to one set of patients to compensate for charging less to another set. Also called cross-subsidization.SELF-TEST QUESTIONS1. Describe two common pricing strategies and their implications for financial survivability.2. What is price shifting (cross-subsidization)?3. Is cross-subsidization used as frequently today as it was in the past? If not, why?CRITICAL CONCEPTFull-Cost PricingIn full-cost pricing, prices are set to cover all costs associated with providing a particular service. Thus, the price must cover both direct and overhead costs. In addition, to truly cover all costs of doing business, including economic costs, the price must include a profit component. All providers, even not-for-profit ones, must earn a profit to ensure the ability to replace assets as needed, invest in new technologies, and expand facilities to meet growing community needs.00_Reiter_Song (2354) Book.indb 1223/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis123costs, the organization would not recover its full costs, including direct and overhead, and hence would ultimately fail. For prices to be equitable, all payers should pay their fair shares in covering providers’ total costs. Furthermore, if marginal cost pricing should be adopted, which payer(s) should receive its benefits by being charged lower prices (see “Critical Concept: Marginal Cost Pric-ing”)? Should it be the government because it is taxpayer funded, or should it be the last payer to contract with the provider? These questions do not have good answers. The easy solution, at least conceptually, is to require all payers to pay full costs and hence equitably share the burden of the organization’s total costs.However, as a practical matter, it may make sense for healthcare providers to occa-sionally use marginal cost pricing to attract a new patient group or to retain an existing group (gain or retain market share). To survive in the long run, though, businesses must earn revenues that cover their full costs (see “For Your Consideration: Hospitals, Cap-tive Health Plans, and Price Setting”). Thus, marginal cost pricing must be a temporary measure, or the organization must overcharge other payers for services (compared to full cost) to make up for the losses on patients who are undercharged, called price shifting (or cross-subsidization).Historically, price shifting was used to support services that were not self-supporting, such as emergency care, teaching and research, and indigent care. Without using price-shifting strategies, many providers would not have been able to offer a full range of services. Payers were willing to accept price shifting because the additional burden was not excessive. Today, however, overall healthcare costs have risen to the point where the major purchasers of healthcare services are less willing to support the costs associated with providing services to others, and hence purchasers are demanding prices that cover only the true costs of the covered populations. Payers believe that they do not have the moral responsibility to fund healthcare services for others.Price shiftingThe act of charging more than full costs to one set of patients to compensate for charging less to another set. Also called cross-subsidization.SELF-TEST QUESTIONS1. Describe two common pricing strategies and their implications for financial survivability.2. What is price shifting (cross-subsidization)?3. Is cross-subsidization used as frequently today as it was in the past? If not, why?CRITICAL CONCEPTMarginal Cost PricingIn marginal cost pricing, prices are set to cover only the mar-ginal cost of providing the service. In general, this means set-ting a price equal to variable costs. Marginal cost pricing is usually a temporary strategy, because it does not cover the full cost of providing services. Thus, it can be sustained over the long run only if the provider recoups the losses by charging more than full costs on other services.00_Reiter_Song (2354) Book.indb 1233/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance1245.4 TARGET COSTINGTarget costing is a management strategy that helps providers offset the limitations imposed when they are price takers (see “Critical Concept: Target Costing”). Target costing assumes that the amount received for a service is fixed and subtracts the desired profit on that service to obtain the target cost level. If possible, management uses this strategy to reduce the full cost of the service to the target level, with a goal of continuous cost reduction, which even-tually pushes costs below the target. Essentially, target costing backs into the cost at which a healthcare service must be provided in the long run to attain a given profitability target.Perhaps the greatest value of target costing lies in the fact that it forces managers to take seriously the prices set by external forces; that is, it recognizes that the purchasers of healthcare services are not concerned about the underlying costs of the services provided. Thus, to ensure financial survival, providers must attain cost structures compatible with the revenue stream. Providers that cannot lower costs to the level required to make a profit ultimately fail.FOR YOUR CONSIDERATIONHospitals, Captive Health Plans, and Price SettingAssume that you are the CEO of Gold Coast Healthcare, a large regional hospital serving a patient population of more than 300,000. The hospital has virtually no competition and hence has a strong position in the local inpatient services market. However, the local health insurance market is dominated by two large companies: one national in scope and the other a major statewide player. You fear that the purchasing clout of the two third-party payers will put so much pressure on prices that the hospital will have difficulty maintaining sufficient profitability to ensure financial soundness.To counteract the market dominance of the payers, the hospital is starting its own managed care organization, beginning with a single managed care plan organized like a health maintenance organization (HMO). Once the managed care plan begins operations, it will send any of its covered patients who require hospitalization to Gold Coast. Thus, a decision must be made regarding the hospital’s pricing policy for its self-operated managed care plan. Should the hospital price high (full-cost pricing) to maintain strong margins, or should it price low (marginal cost pricing) to help the fledgling managed care plan attract members?What do you think? Which pricing approach makes more sense for Gold Coast? Is the optimal pricing strategy the same in the short run as in the long run?00_Reiter_Song (2354) Book.indb 1243/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis1255.5 PROFIT ANALYSISProfit analysis is a technique used to analyze the effects of volume changes on profit. (Accoun-tants often refer to this technique as cost-volume-profit [CVP] analysis.) In addition, profit analysis can be used to examine the effects of alternative assumptions regarding costs and prices. Such information is useful as managers evaluate future courses of action regarding pricing and the introduction of new services (see “Critical Concept: Profit Analysis”).CRITICAL CONCEPTTarget CostingTarget costing is a strategy used by price takers. In essence, the price (reimbursement rate) is assumed to be fixed, and the goal is to create a cost structure for that service that allows the provider to make a profit. Target costing forces managers to focus on costs, rather than prices, as the key to profitability. To achieve a profit using this strategy, managers examine factors that are within their control (costs) as opposed to factors that are, for the most part, uncontrollable (prices).CRITICAL CONCEPTProfit AnalysisProfit analysis combines data on costs, volume, and prices to estimate the profitability of organizations, departments, or services. Profit analysis is an important component in planning for the future because it allows managers to see how profitability is affected by changes in cost, volume, and price assumptions. In essence, profit analysis is used to con-duct “what if” analyses—What if volume is lower than expected? What if prices are higher than anticipated? What if costs are higher than forecasted? And so on. The answers to these and similar questions provide managers with insights into the organization’s financial future.SELF-TEST QUESTIONS1. What is target costing?2. What is its greatest value?00_Reiter_Song (2354) Book.indb 1253/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance126BASIC DATAExhibit 5.1 presents the estimated annual costs for Atlanta Clinic, a large primary care practice, for 2016. These costs are based on the clinic’s best (most likely) estimate of vol-ume: 75,000 visits. The most likely estimate often is called the base case, so the data in exhibit 5.1 represent the clinic’s base case cost forecast. Expected total costs for 2016 are $7,080,962. Because these costs support 75,000 visits, the forecasted base case average cost per visit is $7,080,962 ÷ 75,000 = $94.41.Focusing solely on total costs does not provide the clinic’s managers with much information regarding potential alternative financial outcomes for 2016. Total cost infor-mation is necessary and useful, but the detailed breakdown in exhibit 5.1 gives the clinic’s managers more insight into the possible financial outcomes than can be obtained using a total cost focus.Exhibit 5.1 categorizes the clinic’s total costs of $7,080,962 into two components: total variable costs of $2,113,500 and total fixed costs of $4,967,462. As you know, these cost amounts are fundamentally different. The total fixed costs of $4,967,462 must be borne by the clinic regardless of actual volume, as long as it stays in the relevant range of 70,000–80,000 visits. However, total variable costs of $2,113,500 apply only to a volume of 75,000 patient visits. If the actual number of visits realized in 2016 is less than or greater Base caseIn profit analysis, the scenario (outcome) that is expected (most likely) to occur.Relevant rangeThe range of output (volume) for which the organization’s cost structure holds.Variable CostsFixed CostsTotal CostsSalaries and benefits Management and supervision$ 0$ 928,687$ 928,687 Coordinators442,617598,0631,040,680 Specialists038,60038,600 Technicians681,383552,6701,234,053 Clerical/administrative71,18258,240129,422 Social Security taxes89,622163,188252,810 Group health insurance115,924211,081327,005 Professional fees325,489383,360708,849Supplies313,283231,184544,467Utilities74,00045,040119,040Allocated overhead costs 0 1,757,349 1,757,349Total$2,113,500$4,967,462$7,080,962ExHIBIT 5.1Atlanta Clinic: Forecasted Cost Data for 2016 (Based on 75,000 Patient Visits)00_Reiter_Song (2354) Book.indb 1263/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis127than 75,000, total variable costs will be less than or greater than $2,113,500. (Of course, this is the primary reason that costs are classified as fixed and variable in the first place.)To conduct a profit analysis, it is necessary to express variable costs on a per-unit (variable cost rate) basis. For Atlanta Clinic, the implied variable cost rate is $2,113,500 ÷ 75,000 visits = $28.18 per visit. Thus, the clinic’s total costs at any volume in the relevant range can be calculated as follows: Total costs = Fixed costs + Total variable costs = $4,967,462 + ($28.18 × Number of visits).This equation, the clinic’s underlying cost structure (first introduced in chapter 4), shows that total costs depend on volume. To illustrate use of this model, consider three potential volumes for 2016: 70,000, 75,000, and 80,000 patient visits:Volume = 70,000: Total costs = $4,967,462 + ($28.18 × 70,000) = $4,967,462 + $1,972,600 = $6,940,062.Volume = 75,000: Total costs = $4,967,462 + ($28.18 × 75,000) = $4,967,462 + $2,113,500 = $7,080,962.Volume = 80,000: Total costs = $4,967,462 + ($28.18 × 80,000) = $4,967,462 + $2,254,400 = $7,221,862.When an organization’s costs are expressed in this way, it is easy to see that higher volume leads to higher total costs.Atlanta Clinic’s cost structure is plotted in exhibit 5.2. (To simplify the graph, we assume that the relevant range extends to zero visits.) Fixed costs are shown as a horizontal dashed line, and total costs are shown as an upward-sloping solid line with a slope (rise over run) equal to the variable cost rate of $28.18 per visit. Total variable costs are represented by the vertical distance between the total costs line and the fixed costs line.Note that Atlanta Clinic’s financial manager does not literally write out a check for $28.18 for each visit, although examples of variable costs in which she does so may exist. Rather, the clinic’s cost structure indicates that the clinic uses certain resources that its managers have defined as inherently variable, and the best estimate of the value of such resources, on average, is $28.18 per visit.To complete the profit analysis graph, a revenue component must be added to the cost structure. For 2016, the clinic expects revenues, on average, to be $100 per patient Underlying cost structureThe relationship between volume and an organization’s total costs. Often called cost structure.00_Reiter_Song (2354) Book.indb 1273/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance128visit. Total revenues are plotted in exhibit 5.2 as an upward-sloping solid line starting at the origin and having a slope of $100 per visit. If no visits occurred, total revenues would be zero; at 1 visit, total revenues would be $100; at 10 visits, total revenues would be $1,000; at 75,000 visits, total revenues would be $7,500,000; and so on. Note that the vertical dashed line is drawn at the point where total revenues equal total costs and the vertical dotted line is drawn at the base case volume estimate, 75,000 visits. We examine the significance of these two vertical lines in later sections.THE PROjECTED PROFIT AND LOSS STATEMENTTo begin the profit analysis, Atlanta Clinic’s managers forecast profit given the base case assumptions on costs, volume, and prices. Such a forecast is called a profit and loss (P&L) statement. P&L statements, as with all managerial accounting data, are developed for spe-cific purposes and hence can be formatted to best fit the situation at hand (see “Critical Concept: Profit and Loss [P&L] Statement”).Atlanta Clinic’s base case projected P&L statement is shown in exhibit 5.3. The bottom line projects Atlanta’s 2016 profit using base case (most likely estimate) values for costs, volume, and prices. Note that the format of a P&L statement for CVP analysis ExHIBIT 5.2Atlanta Clinic: Profit Analysis Graph4,967,462LossRevenuesandCosts($)ProfitTotal CostsFixedCosts69,165075,000Volume(Number ofVisits)TotalRevenues00_Reiter_Song (2354) Book.indb 1283/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis129purposes distinguishes between variable and fixed costs, whereas that of a P&L statement for other purposes may not make this distinction. Also, note that the projected P&L state-ment contains a line labeled “total contribution margin.” This concept is discussed in the next section.The projected P&L statement used in profit analysis contains four variables; three of the variables are assumed and the fourth is calculated. In exhibit 5.3, the assumed variables are expected volume (75,000 visits), expected price ($100 per visit), and expected costs (as defined by the clinic’s cost structure). Profit, the fourth variable, is calculated on the basis of the three assumed variables.The base case projected P&L statement in exhibit 5.3 represents only one point on the graphical model in exhibit 5.2. This point is shown by the dotted vertical line at a volume of 75,000 patient visits. Moving up along this dotted line, the distance from the x-axis to the horizontal line represents the $4,967,462 in fixed costs. The distance from the fixed costs line to the total costs line represents the $2,113,500 in total variable costs. The distance between the total costs line and the total revenues line represents the $419,038 profit. Of CRITICAL CONCEPTProfit and Loss (P&L) StatementA P&L (pronounced “P and L”) statement is a listing of revenues, expenses, and profit (revenues minus expenses). P&L statements can be provided in numerous formats, de-pending on the specific purpose of the statement. For example, for use in profit analysis, costs must be broken out as fixed and variable. P&L statements can be constructed for the entire organization, a department, or a service. Also, they can contain historical data, which report what has happened in the past, or forecasted data, which express expectations about the future.Total revenues ($100×75,000)$7,500,000Total variable costs ($28.18×75,000) 2,113,500Total contribution margin ($71.82×75,000)$5,386,500Fixed costs 4,967,462Profit$ 419,038ExHIBIT 5.3Atlanta Clinic: 2016 Base Case Projected P&L Statement (Based on 75,000 Patient Visits)00_Reiter_Song (2354) Book.indb 1293/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance130course, the graph in exhibit 5.2 is not drawn to scale and hence cannot be used to develop numerical data. Rather, it provides the clinic’s managers with a pictorial representation of the clinic’s projected profitability.CONTRIBUTION MARGINThe base case projected P&L statement in exhibit 5.3 introduces the concept of contribution margin, which is defined as the difference between per-unit revenue and per-unit variable cost (variable cost rate). In this illustration, the contribution margin is $100.00 – $28.18 = $71.82. What is the inherent meaning of this contribution margin value of $71.82? The contribu-tion margin appears to be a type of “profit” because it is calculated as revenue minus costs.However, because no fixed costs of providing service have been included in the calculation, it is not profit. Rather, because only variable costs have been stripped out, the contribution margin is the dollar amount of per-visit revenue available to cover Atlanta Clinic’s fixed costs. Only after fixed costs are fully recovered does the contribution margin begin to contribute to profit.With a contribution margin of $71.82 on each of the clinic’s 75,000 visits, the pro-jected base case total contribution margin for 2016 is $71.82 × 75,000 = $5,386,500, which is sufficient to cover the clinic’s fixed costs of $4,967,462 and then provide a $5,386,500 − $4,967,462 = $419,038 profit (see “Critical Concept: Contribution Margin and Total Contribution Margin”). After fixed costs have been covered, any additional visits contribute to the clinic’s profit at a rate of $71.82 per visit. Because many fixed costs cannot be changed quickly, contribution margin is often the measure managers look to when making short-term service decisions. For example, even if a service does not generate sufficient revenue to cover its full costs (including allocated overhead), the organization may be better off keeping the service than dropping it. A positive contribution margin will contribute to covering the fixed costs, many of which would likely remain even if the service were eliminated.CRITICAL CONCEPTContribution Margin and Total Contribution MarginContribution margin is the amount of per-unit revenue that is available to first cover fixed costs and then contribute to profitability. It is calculated as the revenue per unit of service minus the variable cost per unit of service (variable cost rate). The idea is that if we strip the variable costs out of revenue, we will be left with the amount available per unit of output to cover fixed costs. Once fixed costs are covered, any additional contribution margin amounts flow directly to profit.00_Reiter_Song (2354) Book.indb 1303/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis1315.6 BREAKEVEN ANALYSISBreakeven analysis is a method used to determine the value of a given input variable (e.g., volume, costs, price) that is required to achieve some minimum desired profit, holding other variables constant (see “Critical Concept: Breakeven Analysis”). For example, a clinical laboratory might determine that, at a given volume of tests, it must charge $23 per test to break even on total costs (i.e., produce a profit of zero). This means that at a price of $23 per test, the reimbursement rate just equals the full cost of providing that test. Alternatively, the laboratory might determine that, given a reimbursement rate of $20 per test, it would need to perform at least 1,050 tests in order to break even on total costs. At that volume, given a price of $20, the laboratory’s total revenues from the test equal the total costs of the test.CRITICAL CONCEPTContribution Margin and Total Contribution Margin (continued)To illustrate, consider your custom pen business (which we set up in chapter 4). The pens cost you $1.75 each, but you had to pay $50 to design the logo. The contribution margin on each pen is Per-unit revenue – Variable cost rate. If you sell the pens for $3 each, the contribution margin is $3.00 – $1.75 = $1.25. Thus, each pen sold will contribute $1.25 to cover the $50 fixed costs. Once you sell 40 pens, you will have recouped the $50 fixed costs (40×$1.25 = $50), so all sales after the first 40 create profits for your custom pen enterprise at a rate of $1.25 per pen sold.Total contribution margin is the sum of the contribution margins of all units sold. Assume that you sell 50 pens. With a contribution margin of $1.25 per pen, the total contribution margin is 50×$1.25 = $62.50. The first $50 of the total contribution margin is needed to cover your fixed costs of $50, so the remaining $12.50 flows to profit. Thus, at a volume of 60 pens, your profit is $12.50.SELF-TEST QUESTIONS1. Construct a simple P&L statement such as that shown in exhibit 5.3, and discuss its elements.2. Sketch and explain a simple diagram to match your exhibit.3. Define and explain the use of contribution margin and total contribu-tion margin.00_Reiter_Song (2354) Book.indb 1313/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance132Although the breakeven analysis discussed here is actually part of profit analysis, the concept is important enough to deserve its own section. For now, we use breakeven analysis to estimate the volume at which a business, department, or service becomes financially self-sufficient.When considering breakeven volume, you should be familiar with both definitions of the term. Accounting breakeven is defined as the volume needed to produce zero profit. In other words, it is the volume that produces revenues equal to total accounting costs. Economic breakeven is defined as the volume needed to produce some target profit level. In other words, it is the volume that creates revenues equal to total accounting costs plus the desired profit amount.As mentioned in the previous section, the P&L statement format used for profit analysis is a four-variable model. When the focus is profit (the calculated variable), the three assumed variables are costs, volume, and price. When the focus is volume breakeven, the same four variables are used, but profit is now assumed to be known while volume is the unknown (calculated) value (see “Critical Equation: Volume Breakeven”).To illustrate volume breakeven, the projected P&L statement presented in exhibit 5.3 can be expressed in equation form as shown here: Total revenues – Total variable costs – Fixed costs = Profit($100 × Volume) – ($28.18 × Volume) – $4,967,462 = Profit.Accounting breakevenAccounting breakeven occurs when all accounting costs are covered (zero profitability).Economic breakevenEconomic breakeven occurs when all accounting costs plus a profit target are covered.CRITICAL CONCEPTBreakeven AnalysisBreakeven analysis has many applications in healthcare finance. In the context of profit analysis, breakeven analysis involves finding the value of an input variable that produces some desired profit, holding other variables constant. Breakeven can be defined in two ways: on the basis of accounting costs alone (where the target profit is zero) or on the basis of accounting costs plus a nonzero profit target. For example, given current reimbursement rates and the organization’s cost structure, a nursing home might break even in an accounting sense when it has 45 residents, but may require 53 residents to reach a profit target of $50,000. Breakeven analysis can also be applied to variables other than volume. For example, a home health agency might break even if its per-visit costs are $70 or less, given reimbursement rates and expected volume. Or a radiology group might break even if its reimbursement averages $25 per reading, given expected volume and current costs.00_Reiter_Song (2354) Book.indb 1323/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis133At accounting breakeven, the clinic’s profit equals zero, so the breakeven equation can be rewritten this way:($100 × Volume) – ($28.18 × Volume) – $4,967,462 = $0.Rearranging so that only the terms related to volume appear on the left side produces this equation:($100 × Volume) – ($28.18 × Volume) = $4,967,462.CRITICAL EQUATIONVolume BreakevenVolume breakeven can be estimated using a very simple equation:(Contribution margin×Volume) – Fixed costs = $0 (or some profit target).To illustrate, what is the accounting breakeven volume of your custom pen business? Remember that the pens cost $1.75 apiece, and you paid a $50 fee for the logo. Also, you plan to sell the pens for $3.00 each. Under these assumptions, the contribution margin is $3.00 – $1.75 = $1.25, and the breakeven point is 40 pens: ($1.25×Volume) – $50 = $0 $1.25×Volume = $50 Volume = $50÷$1.25 = 40.As an alternative, breakeven could be defined as meeting some profit target. For ex-ample, assume you wanted to make $100 on your pen business. The breakeven volume now is 120 pens: ($1.25×Volume) – $50 = $100 $1.25×Volume = $150 Volume = $150÷$1.25 = 120.00_Reiter_Song (2354) Book.indb 1333/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance134Using basic algebra, the two terms on the left side can be combined because volume appears in both. The result is ($100 – $28.18) × Volume = $4,967,462 $71.82 × Volume = $4,967,462.The left side of the breakeven equation now contains the contribution margin, $71.82, multiplied by volume. Thus, the clinic will break even when the total contribution margin equals fixed costs. Solving the equation for volume results in a breakeven point of $4,967,462 ÷ $71.82 = 69,165 visits. Any volume greater than 69,165 visits produces an accounting profit for the clinic, while any volume less than 69,165 results in a loss.The logic behind the breakeven point is this: Each patient visit brings in $100, of which $28.18 is the variable cost to treat the patient. Once the variable cost is deducted, a $71.82 contribution margin results from each visit. If the clinic sets the contribution margin aside for the first 69,165 visits in 2016, it accumulates $4,967,430, which is enough (except for a small rounding difference) to cover its fixed costs. Once the clinic exceeds breakeven volume, each visit’s contribution margin flows directly to profit. If the clinic achieves its base case volume estimate of 75,000 visits, the 5,835 visits above the breakeven point will result in a total profit of 5,835 × $71.82 = $419,070, which matches the profit (again except for a rounding difference) shown on the clinic’s projected income statement in exhibit 5.3.On a profit analysis graph such as exhibit 5.2, accounting breakeven occurs at the intersection of the total revenues line and total costs line. This point is indicated by a vertical dashed line drawn at a volume of 69,165 visits. Before even one patient walks in the door, the clinic has already committed to $4,967,462 in fixed costs. Because the total revenues line is steeper than the total variable costs line (and hence the total costs line), contribution margin is positive. Thus, as volume increases, total revenues eventually catch up to the clinic’s cost structure. Any volume to the right of the breakeven point, which is shown as a dark-shaded area, produces a profit; any volume to the left, which is shown as a light-shaded area, results in a loss.This breakeven analysis contains three important assumptions:1. The price, or set of prices, for different types of patients and different payers is independent of volume. In other words, volume increases are not attained by lowering prices, and price increases are not met with volume declines.2. Costs can be reasonably subdivided into fixed and variable components.3. The breakeven volume is contained within the relevant range.Breakeven analysis is often performed in an iterative manner. After the breakeven volume is calculated, managers must determine whether the resulting volume can realistically be achieved at the price assumed in the analysis. If the price appears to be unreasonable for the breakeven volume, a new price has to be estimated and the breakeven analysis repeated. Likewise, if the cost structure used for the calculation appears to be unrealistic at the breakeven volume, operational and cost assumptions should be changed and the analysis repeated.Instead of asking how many visits are needed for accounting breakeven, Atlanta Clinic’s managers may ask how many visits are needed to achieve a $100,000 profit (or any other profit level the clinic targets). By building a profit target into the breakeven analysis, the focus is now on economic breakeven. The clinic will have a $419,038 profit if it receives 75,000 visits, and it will have no profit if it receives 69,165 visits. Thus, the number of visits required to achieve a $100,000 profit target (economic breakeven) is somewhere between 69,165 and 75,000—in fact, the number is 70,558: (Contribution margin × Volume) – Fixed costs = Profit target ($71.82 × Volume) – $4,967,462 = $100,000 $71.82 × Volume = $5,067,462 Volume = $5,067,462 ÷ $71.82 Volume = 70,558.5.7 MARGINAL ANALYSISNow assume that a new payer, Peachtree Managed Care Company (PMCC), makes a proposal to Atlanta Clinic’s managers. PMCC would like the clinic to provide primary healthcare services to its 1,500 enrollees. The best estimate is that these individuals would add 5,000 visits to the clinic’s base case forecast of 75,000. However, PMCC wants a dis-count of 40 percent from current pricing. Thus, the net price (and revenue) for the clinic’s new patients would be, on average, $60 per visit instead of the undiscounted $100 that is received on current patients. If the clinic refuses, PMCC will take its business elsewhere.At first blush, PMCC’s proposal appears to be unacceptable. Most important, $60 is less than the full cost of providing service, which was determined previously to be $94.41 per visit at a volume of 75,000. Thus, Atlanta would lose roughly $94.41 – $60 = $34.41 SELF-TEST QUESTIONS1. What is the purpose of breakeven analysis?2. What is the equation for volume breakeven?3. Why is breakeven analysis often conducted in an iterative manner?4. What is the difference between accounting breakeven and economic breakeven?00_Reiter_Song (2354) Book.indb 1343/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis135be achieved at the price assumed in the analysis. If the price appears to be unreasonable for the breakeven volume, a new price has to be estimated and the breakeven analysis repeated. Likewise, if the cost structure used for the calculation appears to be unrealistic at the breakeven volume, operational and cost assumptions should be changed and the analysis repeated.Instead of asking how many visits are needed for accounting breakeven, Atlanta Clinic’s managers may ask how many visits are needed to achieve a $100,000 profit (or any other profit level the clinic targets). By building a profit target into the breakeven analysis, the focus is now on economic breakeven. The clinic will have a $419,038 profit if it receives 75,000 visits, and it will have no profit if it receives 69,165 visits. Thus, the number of visits required to achieve a $100,000 profit target (economic breakeven) is somewhere between 69,165 and 75,000—in fact, the number is 70,558: (Contribution margin × Volume) – Fixed costs = Profit target ($71.82 × Volume) – $4,967,462 = $100,000 $71.82 × Volume = $5,067,462 Volume = $5,067,462 ÷ $71.82 Volume = 70,558.5.7 MARGINAL ANALYSISNow assume that a new payer, Peachtree Managed Care Company (PMCC), makes a proposal to Atlanta Clinic’s managers. PMCC would like the clinic to provide primary healthcare services to its 1,500 enrollees. The best estimate is that these individuals would add 5,000 visits to the clinic’s base case forecast of 75,000. However, PMCC wants a dis-count of 40 percent from current pricing. Thus, the net price (and revenue) for the clinic’s new patients would be, on average, $60 per visit instead of the undiscounted $100 that is received on current patients. If the clinic refuses, PMCC will take its business elsewhere.At first blush, PMCC’s proposal appears to be unacceptable. Most important, $60 is less than the full cost of providing service, which was determined previously to be $94.41 per visit at a volume of 75,000. Thus, Atlanta would lose roughly $94.41 – $60 = $34.41 SELF-TEST QUESTIONS1. What is the purpose of breakeven analysis?2. What is the equation for volume breakeven?3. Why is breakeven analysis often conducted in an iterative manner?4. What is the difference between accounting breakeven and economic breakeven?00_Reiter_Song (2354) Book.indb 1353/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance136per visit on PMCC’s patients. (This estimate is rough, because the average cost per visit decreases as the number of patient visits increases.) However, before the clinic’s managers reject PMCC’s pro-posal, they must examine it in more detail using a technique called marginal analysis (see “Critical Concept: Marginal Analysis”).Although each new (marginal) visit from the contract brings in only $60, compared with $100 on the clinic’s other contracts, the marginal cost of each new visit is the variable cost rate of $28.18. (Remember that marginal cost is the cost of the next unit sold.) The clinic’s $4,967,462 in fixed costs will be incurred whether PMCC’s offer is accepted or rejected, so these costs are not relevant to the decision. Because the contribution margin on the new contract is $60 – $28.18 = $31.82 per visit (a positive amount), each visit will contribute to the clinic’s recovery of fixed costs and ultimately flow to profit. Thus, the offer must be seriously considered. Note that this conclusion is based on the assumption that the relevant range of volume is from 70,000 to 80,000 visits, and hence the current level of fixed costs can support the added volume of 5,000 visits. However, if the contract were expected to add 10,000 visits, the conclusion might be different because the new volume extends beyond the relevant range. In that case, it might be necessary to add fixed costs to accommodate the 5,000 “excess” visits. If so, the marginal cost of each visit would be the $28.18 variable cost rate plus an additional per-visit fixed cost, which would change the numbers used in the analysis.To verify the positive impact of the proposal, consider the P&L statement in exhibit 5.4. Here, we have combined the existing 75,000 patient visits with the additional 5,000 visits, for a total of 80,000. The revenues had to be split between the two patient groups because of the price difference. However, the cost structure is assumed to hold, so it is the same, except for the fact that 80,000 visits are now expected. The result is that the clinic’s profit is now expected to be $578,138 instead of the $419,038 shown in exhibit 5.3 for the base case (75,000 visits).Note that the additional profit expected from the new contract is $578,138 – $419,038 = $159,100. We could have arrived at this result more easily by merely noting that each of the 5,000 new visits has a contribution margin of $31.82, so the total contribution margin is expected to be 5,000 × $31.82 = $159,100. Because the existing 75,000 patient visits are more than sufficient to cover fixed costs, the entire amount of the additional contribution margin flows to profit.What should the clinic’s managers do? If PMCC’s proposal is accepted, the clinic is expected to make an additional $159,100 in profit, so it appears to be a no-brainer. However, acceptance may have unintended consequences.For example, the clinic’s other payers will undoubtedly learn about the new contract with reduced payments and will want to renegotiate their own contracts to achieve the same, or an even greater, discount. Such a reaction could result in discounts being offered to current payers, which could result in the clinic losing more money on current patients than it gains on new patients. If that outcome were anticipated, the clinic’s managers would be better off saying no to the offer.Perhaps Atlanta Clinic can negotiate with PMCC and reach a compromise on the size of the discount. The quantitative analysis required to make the decision is relatively easy, but the qualitative issues are more complex—such is the nature of most financial decision-making (see “Healthcare in Practice: Costs and Revenues of Medical Practices”).SELF-TEST QUESTIONS1. What is the impact of a discounted contract on revenues, fixed costs, total variable costs, and the breakeven point?2. Describe marginal analysis.3. Can qualitative issues come into play in marginal analysis? Give an example.CRITICAL CONCEPTMarginal AnalysisMarginal analysis is used to analyze the impact of adding vol-ume to an existing base. For example, assume you have sold 40 of your pens at $3.00 each, but now a classmate offers to buy 20 more at $2.00 apiece. The total cost of 60 pens, based on a $1.75 cost of each pen and a $50 up-front charge, is (60×$1.75) + $50 = $155. Thus, the average cost per pen is $155 ÷ 60 = $2.58, so you might be inclined to say no to the offer, which is only $2.00 per pen. On the other hand, the $50 charge has already been covered by past sales, so the marginal cost to you of each additional pen is only the variable cost rate of $1.75. Thus, the contribution margin on each of the additional 20 pens is $2.00 – $1.75 = $0.25, so each pen sold would contribute that amount to your bottom line. Unless other issues are at play and need to be considered, you should take your classmate’s offer.00_Reiter_Song (2354) Book.indb 1363/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis137each of the 5,000 new visits has a contribution margin of $31.82, so the total contribution margin is expected to be 5,000 × $31.82 = $159,100. Because the existing 75,000 patient visits are more than sufficient to cover fixed costs, the entire amount of the additional contribution margin flows to profit.What should the clinic’s managers do? If PMCC’s proposal is accepted, the clinic is expected to make an additional $159,100 in profit, so it appears to be a no-brainer. However, acceptance may have unintended consequences.For example, the clinic’s other payers will undoubtedly learn about the new contract with reduced payments and will want to renegotiate their own contracts to achieve the same, or an even greater, discount. Such a reaction could result in discounts being offered to current payers, which could result in the clinic losing more money on current patients than it gains on new patients. If that outcome were anticipated, the clinic’s managers would be better off saying no to the offer.Perhaps Atlanta Clinic can negotiate with PMCC and reach a compromise on the size of the discount. The quantitative analysis required to make the decision is relatively easy, but the qualitative issues are more complex—such is the nature of most financial decision-making (see “Healthcare in Practice: Costs and Revenues of Medical Practices”).SELF-TEST QUESTIONS1. What is the impact of a discounted contract on revenues, fixed costs, total variable costs, and the breakeven point?2. Describe marginal analysis.3. Can qualitative issues come into play in marginal analysis? Give an example.Undiscounted revenue ($100×75,000)$7,500,000Discounted revenue ($60×5,000) 300,000 Total revenues$7,800,000Total variable costs ($28.18×80,000) 2,254,400 Total contribution margin$5,545,600Fixed costs 4,967,462Profit$ 578,138ExHIBIT 5.4Atlanta Clinic: 2016 Projected P&L Statement (Based on 75,000 Visits at $100 and 5,000 Visits at $60)00_Reiter_Song (2354) Book.indb 1373/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance138HEALTHCARE IN PRACTICECosts and Revenues of Medical PracticesThe Healthcare in Practice box in chapter 4 discusses the cost structure of an average primary care practice. Because practice costs (and revenues) are a function of the num-ber of physicians in the practice, the data presented here are on a per-physician basis.On average, each physician handles about 2,300 patients, who make about 5,300 encounters (visits) during which the physician performs about 11,000 procedures. In ad-dition, each physician requires $325,000 in operating (support) costs. If we use patient visits as the unit of output (volume), the operating cost per visit averages out to be about $325,000÷5,300 = roughly $61 per visit.However, the data do not break out fixed versus variable costs. Variable costs, which consist mostly of administrative supplies (e.g., forms, letterhead) and medical supplies (e.g., rubber gloves, needles, vaccines, dressings) are relatively small, say, $10 per visit. Following this assumption, the underlying cost structure for an average primary care practice looks like this:Total costs = $272,000 + ($10×Number of visits).On average, primary care physicians generate roughly $603,000 of revenues per physi-cian. Thus, the per-physician P&L statement, assuming 5,300 visits, can be expressed as follows:Total revenues $603,000Total variable costs ($10×5,300) 53,000 Total contribution margin $550,000Fixed costs 272,000Profit $278,000Of course, the $278,000 “profit” here represents the amount available for reinvest-ment in the practice as well as the primary care physician’s compensation.To convert the average per-physician P&L statement to an equation format, note that the average revenue per visit is $603,000÷5,300 = $113.77. Thus, Total revenues – Total variable costs – Fixed costs = Profit ($113.77×Volume) – ($10×Volume) – $272,000 = Profit.00_Reiter_Song (2354) Book.indb 1383/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis1395.8 PROFIT ANALYSIS IN A CAPITATED ENVIRONMENTThus far, the discussion of profit analysis has assumed fee-for-service reimbursement. However, it is important to consider how the analysis changes when a provider operates in a capitated environment. A discussion of capitation provides an excellent review of profit analysis and highlights the basic differences between capitation and fee-for-service reimbursement methods.HEALTHCARE IN PRACTICECosts and Revenues of Medical Practices (continued)So, at 5,300 visits, the profit per physician is ($113.77×5,300) – ($10×5,300) – $272,000 = Profit $603,000 – $53,000 – $272,000 = $278,000.Of course, this profit amount is the same as that calculated in the P&L statement. The advantage of the equation format is that we can now estimate profit at different volume levels. For example, assume that the volume is only 5,000 visits per physician, instead of the 5,300 visits forecasted. With fewer visits, the profit (and hence physician compensation) falls to $246,850: ($113.77×5,000) – ($10×5,000) – $272,000 = Profit $568,850 – $50,000 – $272,000 = $246,850.But with more visits (say, 5,600), the profit rises to $309,112: ($113.77×5,600) – ($10×5,600) – $272,000 = Profit $637,112 – $56,000 – $272,000 = $309,112.This analysis confirms that fee-for-service reimbursement creates a powerful incentive for clinicians to see as many patients as possible.Note: This Healthcare in Practice is based on information provided by the Medical Group Management Association, 2011, Performance and Practices of Successful Medical Groups, Englewood, CO: MGMA.00_Reiter_Song (2354) Book.indb 1393/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance140To begin, assume that Atlanta Clinic’s current payer is the Alliance, a local business coalition. The Alliance is paying the clinic $7,500,000 to provide services for an expected 75,000 visits, but the amount is capitated. Although the clinic’s projected total revenues remain the same (see exhibit 5.3), the situation is actually quite different. The $7,500,000 that the Alliance is paying is not explicitly tied to the amount of services provided by the clinic. Rather, it is tied to the size of the employee group (covered population).Under capitation, the clinic is taking on the additional risk associated with the amount of services provided (utilization risk). If the total costs of services delivered by the clinic exceed the premium revenue (paid monthly on a per-member basis), the clinic will suffer the financial consequences. However, if the clinic can efficiently manage the healthcare of the population served, it will be the economic beneficiary.How might Atlanta Clinic’s managers evaluate whether the $7,500,000 revenue attached to the contract is adequate? To conduct the analysis, the managers need two critical pieces of information: cost and utilization. The clinic already has the cost informa-tion—the full cost per visit is expected to be $94.41 (at a volume of 75,000 visits), with an underlying cost structure of $28.18 per visit in variable costs and $4,967,462 in fixed costs. For its actuarial information, the managers estimate that the Alliance will have a covered population of 18,750 members, with an expected (average) utilization rate of four visits per member per year. Thus, the total number of visits expected is 18,750 × 4 = 75,000.The revenues expected from this contract—$7,500,000—exceed the expected costs of serving this population, which are 75,000 visits multiplied by $94.41 per visit, or $7,080,750. Thus, this contract is expected to generate a profit of $419,250, which, not surprisingly, is the same as the original base case fee-for-service result (except for a round-ing difference); see exhibit 5.3.GRAPHICAL vIEW BASED ON UTILIZATIONExhibit 5.5 contains a graphical profit analysis for the capitation contract that is constructed similarly to the fee-for-service graph shown in exhibit 5.2—that is, the horizontal axis shows volume as measured by number of visits, while the vertical axis shows revenues and costs. Also shown is the same underlying cost structure of $4,967,462 in fixed costs, coupled with a variable cost rate of $28.18. One significant difference exists, however. Instead of being upward sloping, the total revenues line is horizontal, which shows that total revenue is $7,500,000 regardless of volume as measured by the number of visits.The flat revenue line in exhibit 5.5 tells managers that revenue is being driven by a factor other than the volume of services provided. Under capitation, revenue is driven by the per-member premium payment and number of enrollees.Also, note the difference between the revenue and fixed cost lines. Atlanta Clinic has a constant spread of $7,500,000 − $4,967,462 = $2,532,538 to work with in providing for the healthcare of this population for the period of the contract. If total variable costs Actuarial informationData (including utilization data for the covered population) regarding the financial risks associated with insurance programs.EnrolleeA member of a managed care plan. Or, more generally, an individual who has (is enrolled in) a health insurance plan.00_Reiter_Song (2354) Book.indb 1403/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis141equal $2,532,538, the clinic breaks even; if total variable costs exceed $2,532,538, the clinic loses money. Thus, to make a profit, the number of visits must be less than $2,532,538 ÷ $28.18 = 89,870. If everyone at the clinic does not understand the inherent utilization risk under capitation, the clinic could find itself in serious financial trouble. On the other hand, if all of the clinic’s managers and clinicians understand and manage this utilization risk, a handsome reward may result.The key feature of capitation is the reversal of the profit and loss portions of the graph. To see this shift, compare exhibit 5.2 with exhibit 5.5. The fact that profits occur at lower volumes under capitation differs from what will happen under the fee-for-service environment. This fact can be verified by examining the per-visit contribution margin under capitation: Revenue per visit – Variable cost per visit = $0 – $28.18 = −$28.18. With a negative contribution margin, each additional visit increases costs by $28.18 without bringing in additional revenue.From a purely financial perspective, the obvious response to capitation is to pro-vide minimal services (reduce utilization) because doing so generates the greatest profit, at least in the short run. Of course, the clinic would have trouble renewing the contract in subsequent years, and patients may become more ill (and costly to the practice) if only minimal service is provided, so this course of action is neither appropriate nor feasible. Still, ExHIBIT 5.5Atlanta Clinic: Profit Analysis Based on Number of Visits4,967,4627,500,000ProfitRevenuesandCosts($)LossTotalCostsFixedCosts89,8700Volume(Number ofVisits)Total Revenues00_Reiter_Song (2354) Book.indb 1413/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance142its implications are at the heart of concerns expressed by critics of managed care about the incentives to withhold patient care inherent in a capitated environment.GRAPHICAL vIEW BASED ON MEMBERSHIPExhibit 5.5 is like Alice (of Alice in Wonderland ) peering through the looking glass and finding that everything is reversed. The key to this problem is that the horizontal axis does not measure the volume to which revenues are related; that is, the horizontal axis in exhibit 5.5 measures number of visits, just as if Atlanta Clinic were reimbursed on a fee-for-service basis. Because it is now selling both healthcare services and insurance, the appropriate horizontal axis measure is the number of members (enrollees).Exhibit 5.6 recognizes that membership, rather than the amount of services provided, drives revenues. With number of members on the horizontal axis, the total revenues line is no longer flat; revenues only look flat when they are considered relative to the number of visits. The revenue earned by the clinic is actually $7,500,000 ÷ 18,750 = $400 per member; as membership increases, so do revenues.The cost structure can easily be expressed on a membership basis as well. Fixed costs are no problem in the relevant range; they are inherently volume insensitive, whether vol-ume is measured by number of visits or by number of members. Thus, exhibit 5.6 shows fixed costs as the same flat, dashed line as before. However, the variable cost rate based on number of enrollees is not the same as the variable cost rate based on number of visits. Per-member variable cost must be estimated from two factors: the variable cost rate of $28.18 per visit and the expected utilization of four visits per year. The combination of the two is 4 × $28.18 = $112.72, which is the clinic’s expected variable cost per member.Expressed on a per-member basis, the contribution margin is now Revenue per member – Variable cost per member = $400 – $112.72 = $287.28, rather than the −$28.18 when volume is measured by the number of visits. With a positive contribution margin, additional members translate to additional profitability.Note that under capitation, utilization volume is a component of the variable cost rate and hence total variable costs. Thus, utilization management becomes an important cost-control tool. Furthermore, if both utilization and per-visit costs can be reduced, the clinic can reap greater benefits (profits) than is possible under fee-for-service reimburse-ment. Of course, control of fixed costs is always financially prudent, regardless of the type of reimbursement.Also note that capitated revenues are driven by the number of members rather than the amount of services provided. Thus, capitation contracts must bring in a large number of enrollees. A large number of enrollees both increases revenues to providers and reduces risk. Risk reduction occurs because only a few high-utilization enrollees can create costs that exceed total capitated revenues if the number of patients is small.5.9 THE IMPACT OF COST STRUCTURE ON FINANCIAL RISKThe financial risk of a healthcare provider, at least in theory, is minimized by having a cost structure that “matches” its revenue structure. To illustrate, consider a clinic with all payers SELF-TEST QUESTIONS1. Under capitation, what is the difference between a CVP graph with the number of visits on the x-axis and one with the number of mem-bers on the x-axis?2. What is unique about the per-visit contribution margin under capi-tation? How would you convert this to a per-member contribution margin?3. Why is utilization management so important in a capitated environment?4. Why is the number of members important in a capitated environment?ExHIBIT 5.6Atlanta Clinic: Profit Analysis Based on Number of Members4,967,462LossRevenuesandCosts($)ProfitTotal CostsFixedCosts17,2910Volume(Number of Members)TotalRevenues($400perMember)00_Reiter_Song (2354) Book.indb 1423/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis143fixed costs as the same flat, dashed line as before. However, the variable cost rate based on number of enrollees is not the same as the variable cost rate based on number of visits. Per-member variable cost must be estimated from two factors: the variable cost rate of $28.18 per visit and the expected utilization of four visits per year. The combination of the two is 4 × $28.18 = $112.72, which is the clinic’s expected variable cost per member.Expressed on a per-member basis, the contribution margin is now Revenue per member – Variable cost per member = $400 – $112.72 = $287.28, rather than the −$28.18 when volume is measured by the number of visits. With a positive contribution margin, additional members translate to additional profitability.Note that under capitation, utilization volume is a component of the variable cost rate and hence total variable costs. Thus, utilization management becomes an important cost-control tool. Furthermore, if both utilization and per-visit costs can be reduced, the clinic can reap greater benefits (profits) than is possible under fee-for-service reimburse-ment. Of course, control of fixed costs is always financially prudent, regardless of the type of reimbursement.Also note that capitated revenues are driven by the number of members rather than the amount of services provided. Thus, capitation contracts must bring in a large number of enrollees. A large number of enrollees both increases revenues to providers and reduces risk. Risk reduction occurs because only a few high-utilization enrollees can create costs that exceed total capitated revenues if the number of patients is small.5.9 THE IMPACT OF COST STRUCTURE ON FINANCIAL RISKThe financial risk of a healthcare provider, at least in theory, is minimized by having a cost structure that “matches” its revenue structure. To illustrate, consider a clinic with all payers SELF-TEST QUESTIONS1. Under capitation, what is the difference between a CVP graph with the number of visits on the x-axis and one with the number of mem-bers on the x-axis?2. What is unique about the per-visit contribution margin under capi-tation? How would you convert this to a per-member contribution margin?3. Why is utilization management so important in a capitated environment?4. Why is the number of members important in a capitated environment?00_Reiter_Song (2354) Book.indb 1433/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance144using fee-for-service reimbursement, which means revenues are directly related to volume. If the clinic’s cost structure consisted of all variable costs (no fixed costs), then each visit would incur costs but also create revenues. Assuming that the per-visit revenue amount exceeds the variable cost rate (the per-visit cost), the clinic would lock in a profit on each visit. The total profitability of the clinic would be uncertain, as it is tied to volume, but the ability of the clinic to generate a profit would be guaranteed.To illustrate, if Atlanta Clinic’s costs were all variable, then its variable cost rate at 75,000 visits would be $94.41. Thus, the contribution margin would be $100 – $94.41 = $5.59, and because there are no fixed costs to cover, that amount would flow directly to profit on every visit (even the first one). Of course, the amount of profit would be uncertain as it depends on volume, but the clinic would not lose money.At the other extreme, consider a clinic that is totally capitated. In this situation, assuming a fixed number of covered lives, the clinic’s revenue stream is fixed regardless of visit volume. Now, to match the revenue and cost structures, the clinic must have all fixed (no variable) costs. If the annual capitated (fixed) revenue exceeds annual fixed costs, the clinic has a guaranteed profit at the end of the year, assuming that visit volume does not increase beyond the relevant range.Applying this concept to Atlanta Clinic, if its $7,080,962 in total costs at 75,000 visits were all fixed, and it received $7,500,000 in capitated revenues, it would lock in a profit of $419,038. Volume could be higher or lower than 75,000 visits, but the profit would remain the same as long as visit volume did not exceed the relevant range, requiring the clinic to increase fixed costs.In both illustrations, the key to minimizing risk (ensuring a predictable profit) is to create a cost structure that matches the revenue structure: variable costs for fee-for-service revenues and fixed costs for capitated revenues. Of course, real-world problems occur when a provider tries to implement a cost structure that matches its revenue structure. First, few providers are reimbursed solely on a fee-for-service or capitated basis; most providers encounter a mix of reimbursement methods. Still, most providers are either predominantly fee-for-service or predominantly capitated.Second, providers do not have complete control over their cost structures. Providers cannot create cost structures with all variable or all fixed costs. Nevertheless, a manager can take actions to make the existing cost structure compatible with the revenue structure so that it carries less risk. For example, assume a medical group practice is reimbursed almost exclusively on a per-procedure basis. To minimize financial risk, the practice can pay physi-cians on a per-procedure basis and use per-procedure leases for diagnostic equipment. The greater the proportion of variable costs in the practice’s cost structure, the lower its financial risk (see “For Your Consideration: Matching Cost and Revenue Structures”).00_Reiter_Song (2354) Book.indb 1443/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis145Jen concluded that Big Sky’s cost structure (not including physician compensation) could be expressed as follows: Total costs = Fixed costs + Total variable costs = Fixed costs + (Variable cost rate×Volume) = $850,000 + ($15×10,000 visits) = $850,000 + $150,000 = $1,000,000.FOR YOUR CONSIDERATIONMatching Cost and Revenue StructuresHealthcare providers can lower their financial risk by matching the cost structure to the revenue structure. For example, providers that are primarily reimbursed on a fee-for-service basis can lower risk by converting as many fixed costs as possible to variable costs. Conversely, providers that are primarily reimbursed on a capitated basis can lower risk by converting variable costs to fixed costs.Assume that you are the business manager of a large cardiology group practice. Virtually all of the practice’s revenues are paid on a fee-for-service basis. However, the practice’s two largest cost categories (labor and diagnostic equipment) are predominantly fixed. You are concerned about the potential for falling volumes in the future and want to take some actions to reduce the financial risk of the practice.What cost structure (fixed vs. variable costs) is optimal for the practice? How can labor costs be adjusted to improve the cost structure? How can equipment costs be adjusted? Suppose the change in cost structure will increase overall practice costs at next year’s expected volume. Does this fact influence your risk reduction actions?SELF-TEST QUESTIONS1. Explain this statement: To minimize financial risk, match the cost structure to the revenue structure.2. What cost structure would minimize risk if a provider had all fee-for-service reimbursement? If it were entirely capitated?3. What are the real-world constraints on creating matching cost structures?THEME WRAP-UP: Profit analysis00_Reiter_Song (2354) Book.indb 1453/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance146By analyzing the practice’s revenues, she determined that each patient visit brings in, on average, $160. Thus, the base case P&L statement looks like this:Total revenues ($160×10,000) $1,600,000Total variable costs ($15×10,000) 150,000 Total contribution margin $1,450,000Fixed costs 850,000Profit $ 600,000Here, the profit represents the amount available for compensation to the two derma-tologist owners, less any funds that must be reinvested in the practice. Such reinvestments might be needed to update facilities or purchase new equipment, or they might be used to create a reserve fund to meet future requirements.The profit analysis for Big Sky can also be expressed in this equation format:Total revenues – Total variable costs – Fixed costs = Profit ($160×Volume) – ($15×Volume) – $850,000 = Profit.Solving this equation permits Jen to analyze profitability under different assumptions. For example, at 9,000, 10,000 (base case), and 11,000 visits: ($160×9,000) – ($15×9,000) – $850,000 = Profit $1,440,000 – $135,000 – $850,000 = $455,000. ($160×10,000) – ($15×10,000) – $850,000 = Profit $1,600,000 – $150,000 – $850,000 = $600,000. ($160×11,000) – ($15×11,000) – $850,000 = Profit $1,760,000 – $165,000 – $850,000 = $745,000.The higher the volume, the greater the amount available for physician compensation and reinvestment in the practice.Profit analysis also allows Jen to vary inputs other than volume. Suppose the variable cost rate is actually $20 rather than $15. Under that assumption, and assuming the base case volume of 10,000 visits, profit falls from $600,000 to $550,000.($160×10,000) – ($20×10,000) – $850,000 = Profit $1,600,000 – $200,000 – $850,000 = $550,000.It should be obvious to you, and Jen, that she now has an important tool to help plan for and manage Big Sky’s future.00_Reiter_Song (2354) Book.indb 1463/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis147This chapter explains how managers rely on managerial accounting information to help make pricing decisions and to conduct profit analyses. Here are the key concepts: ➤Price takers have to accept, more or less, the prices set in the marketplace for their services, including the prices set by government payers. ➤Price setters provide services that can be differentiated from others, by either market share, quality, or other differences, such that they have the ability to set the prices on some or all of their services. ➤Full-cost pricing permits businesses to recover all costs, including both fixed and variable and direct and indirect, while marginal cost pricing typically recovers only variable costs. ➤Target costing is a concept that takes the prices paid for healthcare services as a given and then determines the cost structure necessary for financial success given the prices set. ➤Profit analysis, sometimes called cost-volume-profit (CVP) analysis, is an analytical technique to determine the effects of volume changes on revenues, costs, and profit. ➤A projected profit and loss (P&L) statement is a profit forecast that uses estimated values for volume, price, and costs. ➤Breakeven analysis is used to estimate the volume needed (or the value of some other variable) for the organization to achieve a profit goal. ➤Accounting breakeven occurs when revenues equal accounting costs (profit equals zero), while economic breakeven occurs when revenues equal accounting costs plus some profit target. ➤Contribution margin is the difference between per unit price and the variable cost rate, or per-unit revenue minus per-unit variable cost. Thus, contribution margin is the per-unit dollar amount available to first cover an organization’s fixed costs and then to contribute to profits. ➤In marginal analysis, the focus is on the incremental (marginal) profitability associated with increasing (or decreasing) volume. ➤A capitated environment dramatically changes the situation for providers vis-à-vis a fee-for-service environment. In essence, a capitated provider takes on the insurance function and hence bears utilization risk. ➤The keys to provider success in a capitated environment are to (1) manage (reduce) utilization and (2) increase the number of members covered.KEY CONCEPTS00_Reiter_Song (2354) Book.indb 1473/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance148 ➤To minimize financial risk, a provider should strive to attain a cost structure that matches its revenue structure.Our coverage of managerial accounting continues in chapter 6 with a discussion of planning and budgeting. 5.1 a. Using a hospital to illustrate your answer, explain the difference between a price setter and a price taker. b. Can most providers be classified strictly as price setters or price takers? 5.2 Explain the essential differences between full-cost pricing and marginal cost pricing strategies. 5.3 What would happen financially to a healthcare organization over time if its prices were set at full costs? At marginal costs? 5.4 What is price shifiting (cross-subsidization)? 5.5 a. What is target costing? b. Suppose a hospital were offered a capitation rate for a covered population of $40 per member per month. Briefly explain how target costing would be ap-plied in this situation. 5.6 a. What is profit cost-volume-profit (CVP) analysis? b. Why is it so useful to healthcare managers? c. What is a profit and loss (P&L) statement? 5.7 a. Define contribution margin. b. What is its economic meaning? 5.8 a. Write out and explain the equation for volume breakeven. b. What is the difference between accounting breakeven and economic breakeven? 5.9 What are the critical differences in profit analysis when conducted in a capitated environment versus a fee-for-service environment? 5.10 How does a provider’s incentive differ when it moves from a fee-for-service to a capitated environment? 5.11 a. What cost structure is best when a provider is capitated? Explain. b. What cost structure is best when a provider is reimbursed primarily by fee-for-service payers? Explain.END-OF-CHAPTER QUESTIONS00_Reiter_Song (2354) Book.indb 1483/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis149 5.1 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 $5.00 Annual direct fixed costs $500,000 Annual overhead allocation $50,000 Expected annual utilization 10,000 visits a. What per-visit price must be set for the service to break even? To earn an an-nual profit of $100,000? b. Repeat part a, but assume that the variable cost per visit is $10. c. Return to the data given in the problem. Again repeat part a, but assume that direct fixed costs are $1,000,000. d. Repeat part a assuming both a $10 variable cost and $1,000,000 in direct fixed costs. 5.2 The Audiology Department at Randall Clinic offers many services to the clinic’s pa-tients. The three most common, along with cost and utilization data, are as follows:ServiceVariable Cost per ServiceAnnual Direct Fixed CostsAnnual Number of VisitsBasic examination$ 5$50,0003,000Advanced examination730,0001,500Therapy session1040,000500 a. What is the fee schedule for these services, assuming that the goal is to cover only variable and direct fixed costs? b. Assume that the Audiology Department is allocated $100,000 in total over-head by the clinic, and the department director has allocated $50,000 of this amount to the three services listed earlier. What is the fee schedule, assum-ing that these overhead costs must be covered in addition to the variable and direct fixed costs? (To answer this question, assume that the allocation of the $50,000 in overhead costs to each of the three services is made on the basis of the number of visits.) c. Assume that these three services must make a combined profit of $25,000. Now, what is the fee schedule? (To answer this question, assume that the profit require-ment is allocated to each of the three services in the same way as overhead costs.)END-OF-CHAPTER PROBLEMS00_Reiter_Song (2354) Book.indb 1493/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance150 5.3 Allied Laboratories is combining some of its most common tests into one-price packages. One such package will contain three tests that have the following vari-able costs:Test ATest BTest CDisposable syringe$3.00$3.00$3.00Blood vial0.500.500.50Forms0.150.150.15Reagents0.800.601.20Sterile bandage0.100.100.10Breakage/losses0.050.050.05When the tests are combined, only one syringe, form, and sterile bandage will be used per patient. Furthermore, only one charge for breakage or losses will apply. Two blood vials are required, and reagent costs will remain the same (reagents are required for all three tests). a. As a starting point, what is the price of the combined test assuming marginal cost pricing? b. Assume that Allied wants a contribution margin of $10 per test. What price must be set to achieve this goal? c. Allied estimates that 2,000 of the combined tests will be conducted during the first year. The annual direct fixed and allocated overhead costs total $40,000. What price must be set to cover full costs? What price must be set to produce a profit of $20,000 on the combined test? 5.4 Consider the CVP graphs below for two providers operating in a fee-for-service environment:Provider AProvider B00_Reiter_Song (2354) Book.indb 1503/23/18 2:52 PM

Chapter 5: Pricing Decisions and Profit Analysis151 a. Assuming the graphs are drawn to the same scale, which provider has the greater fixed costs? The greater variable cost rate? The greater per-unit revenue? b. Which provider has the greater contribution margin? c. Which provider needs the higher volume to break even? d. How would the graphs change if the providers were operating in a discounted fee-for-service environment? In a capitated environment? 5.5 Consider the data in the following exhibit for three independent healthcare organizations:RevenuesTotal Variable CostsFixed CostsTotal CostsProfita.$2,000$1,400?$2,000?b.?1,000?1,600$2,400c.4,000?$600?400Fill in the missing data indicated by question marks. 5.6 Assume that a radiology group practice has the following cost structure:Fixed costs$500,000Variable cost per procedure25Charge (revenue) per procedure100Furthermore, assume that the group expects to perform 7,500 procedures in the coming year. a. Construct the group’s base case projected P&L statement. b. What is the group’s contribution margin? What is its breakeven point (in num-ber of procedures)? c. What volume is required to provide a pretax profit of $100,000? A pretax profit of $200,000? d. Sketch out a CVP analysis graph depicting the base case situation. e. Now, assume that the practice contracts with one HMO for all 7,500 procedures and the plan proposes a 20 percent discount from charges. Answer questions a, b, c, and d again under these conditions. 5.7 General Hospital, a not-for-profit acute care facility, has the following cost structure for its inpatient services: Fixed costs$10,000,000Variable cost per inpatient day200Charge (revenue) per inpatient day1,00000_Reiter_Song (2354) Book.indb 1513/23/18 2:52 PM

Gapenski’s Fundamentals 0f Healthcare Finance152The hospital expects to have a patient load of 15,000 inpatient days next year. a. Construct the hospital’s base case projected P&L statement. b. What is the hospital’s breakeven point (in number of inpatient days)? c. What volume is required to provide a profit of $1,000,000? A profit of $500,000? d. Now, assume that 20 percent of the hospital’s inpatient days come from a man-aged care plan that requests a 25 percent discount from charges. Should the hospital agree to the discount proposal? Assume that the managed care plan will contract with a different provider if the hospital does not agree to the discount (i.e., the hospital will lose the inpatient days associated with the contract). 5.8 You are considering starting a walk-in clinic. Your financial projections for the first year of operations are as follows:Revenues (10,000 visits)$400,000Wages and benefits220,000Rent5,000Depreciation30,000Utilities2,500Medical supplies50,000Administrative supplies10,000Assume that all costs are fixed except supply costs, which are variable. Further-more, assume that the clinic must pay taxes at a 30 percent rate. a. Construct the clinic’s projected P&L statement. b. What number of visits is required to break even? c. What number of visits is required to provide you with an after-tax profit of $100,000? 5.9 Grandview Clinic has fixed costs of $2 million and an average variable cost rate of $15 per visit. Its sole payer, an HMO, has proposed an annual capitation payment of $150 for each of its 20,000 members. Past experience indicates that the population served will average two visits per year. a. Construct the base case projected P&L statement on the contract. b. Sketch two CVP analysis graphs for the clinic—one with number of visits on the x-axis, and one with number of members on the x-axis. Compare and contrast these graphs with the one in problem 5.6, part d. c. What is the clinic’s per-visit contribution margin on the contract? How does this value compare with the value in problem 5.6, part b? d. What profit gain can be realized if the clinic can lower per-member utilization to 1.8 visits?00_Reiter_Song (2354) Book.indb 1523/23/18 2:52 PM

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