Effectively gather financial and market information to guide strategic decision making and improve patient outcomes.

THE PROPOSAL IS ATTACHED

Effectively gather financial and market information to guide strategic decision making and improve patient outcomes.

Interpret financial and market information to guide strategic decision making and improve patient outcomes.

Act on financial and market information to guide strategic decision making and improve patient outcome

 

For your final case project, you are required to prepare a ‘pitch deck’ to support the launch of a new product or service that addresses a current problem or issue but also has direct connection to the health care industry. The overarching intent of this presentation is to obtain funding from a commercial or private financier. Thus, the final product should be professional, clear, appropriately structured, logical, and concise.

Prepare your response in PowerPoint format, suitable for presentation to a senior level executive. Note: All Excel work should be imported into the presentation in table format (in the body of the document) or enclosed as an Appendix within the same document.

The pitch deck should include (one slide each at a minimum) each of the following elements:

Cover Slide

Capture the audience’s attention

Problem being solved

What is the exact problem you are addressing, in simple words

Quantified, how big is this problem? Is it local or global?

Data backed with reliable sources or extensive research

Product or service concept

Key value proposition. What will make users come to you and stay?

In 1 line: what is it, who would uses it, why is it better?

Demo how it works visually: screen shots of user experience / dashboard / video demo 1 min max

User perspective: put the audience in a user’s shoe

Target market

Addressable market size (in USD)

Size of the pie – what market share are you targeting and when?

B2B and/or B2C distinction when applicable

Competition

Top main competitors you aim to grab market share from (direct and indirect)

Know all your competitors and all about them

What is your key differentiation?

Business model & pro-forma financials

What is / are your revenue stream(s)?

What is your cost structure?

Include a five-year proforma and highlight key elements that have significant impact on overall financial viability

Financing requirement

How much funding do you need?

To spend on what (by %)?

Timeline of development and launch

Short, mid and long term milestones from day 1

What happens after you receiving the funding?

Resources for the Final Project Assignment:

For guidance on how to construct a professional presentation, please see the link below.

https://www.wiley.com/network/researchers/promoting-your-article/6-tips-for-giving-a-fabulous-academic-presentation

Several example pitch deck presentations are available at the following links. Note: There is significant variation in these presentations. They are offered for inspiration and insight. Your project formatting requirements are as noted above.

Create A Winning Investor Pitch Deck: https://medium.com/swlh/how-to-create-a-winning-investor-pitch-deck-794022ac4c59

Pitch Deck Examples: https://slidebean.com/blog/startups-pitch-deck-examples

Healthcare Pitch Deck Examples: https://www.failory.com/pitch-deck/healthcare.PLEASE INCLUDE REFERENCE

Requirements: ANSWER ALL QUESTION WITH DETALIS

Product Proposal

Product Specifications

Topz Insulin Aspart is the suggested rapid-acting insulin for adults with type 2 diabetes. The patient applies this insulin at mealtime and registers instant results. The product replaces glucose variability, which helps restore the postprandial glucose level. This product will have outstanding outcomes without requiring higher insulin doses, relieving the patient’s financial burden.

Rationale and Competitors

The product seeks to resolve the overarching patient dissatisfaction with the current insulin brands. One complaint is the recent surge in insulin prices from $40 to $130 within ten years. This dose only lasts two weeks requiring higher out-of-pocket payment unfeasible for patients in low-income regions. Still, patients have a limited variety of brands, indicating a monopolized market. The greatest competitor is Novo Nordisk which has been in the market for a long. Others include Novolog FlexPen and Fiasp.

Market Analysis Overview

The new brand will also help resolve the gaps in easy access to the product without longer travel and extra costs. According to Biswas (2018), the global burden of diabetes will grow to 500 million cases from the current 4000 million by 2030. The caseload will indicate the demand rise by 20%. With the limited supply, the prices can rise, which forces adults with diabetes to ration their doses. A report by Herman & Kuo (2021) indicates that nearly one in two Americans cannot afford and access the required insulin dose. This report indicates future shortages which require a solution, including innovations of the new brands.

Location

Topz Insulin Aspart company will start operating in Brownsville, Texas. This region is strategic for this project from the market analysis perspective. Evidence indicates that Brownsville has the greatest prevalence of adults with diabetes at 16.9%. However, many live in poverty, meaning they cannot afford the higher insulin prices, which calls for an affordable and effective brand.

 

 

References

Biswas, S., (November 30, 2018). Is the world heading for an insulin shortage? BBC. Retrieved from

Herman, W. H., & Kuo, S. (2021). 100 Years of Insulin: Why is Insulin So Expensive and What Can be Done to Control Its Cost? Endocrinology and metabolism clinics of North America, 50(3S), e21–e34.

© Foundation of ACHE, 2018. Reproduction without permission is prohibited.89CASE13Pacific Healthcare is an investor-owned hospital chain that owns and operates nine hospitals in Washington, Oregon, and Northern California. Marcia Long, a recent graduate of a prominent health administration program, has just been hired by Washington Medical Center, Pacifi c’s largest hospital. Like all new management personnel, Marcia must undergo three months of intensive indoctrination at the system level before joining the hospital.Marcia began her indoctrination in January 2018. Her fi rst assignment at Pacifi c was to review its latest annual report. Th is was a stroke of luck for Marcia because her father owned several bonds issued by Pacifi c, and she was especially interested in whether her father had made a good invest-ment. To glean more information about the bonds, she examined Note E to Pacifi c’s consolidated fi nancial statements, which lists the company’s long-term debt obligations, including its fi rst mortgage bonds, installment contracts, and term loans. Exhibit 13.1 contains information on four of the fi rst-mortgage bonds listed in Pacifi c’s annual report. All four bonds pay interest semiannually. (For more information on bond ratings, see Standard & Poor’s website at www.standardandpoors.com or the Moody’s Investors Service website at www.moodys.com.)Pacifi c’s chief fi nancial offi cer, Hugo Welsh, found out about Marcia’s interest in the fi rm’s debt fi nancing. “Because you are so interested in our fi nancial structure,” he said, “I want you to do the bond valuation and make a presentation to our executive committee.” Hugo then asked Marcia to perform the calculations required to complete exhibit 13.2 and to think about some of the questions that members of the committee might ask her about the numbers.PACIFIC HEALTHCARE (A)BOND VALUATION

Cases in Healthcare Finance90EXHIBIT 13.1 Pacific Healthcare: Long-Term BondsFace Current Par Coupon Maturity Years to BondAmount Price Value Rate Date Maturity Rating$ 48,000,000 $ 800.00 $1,000 4.50% 12/31/2018 5 A+$ 32,000,000 $ 865.49 $1,000 8.25% 12/31/2028 15 A+$100,000,000 $1,220.00 $1,000 12.625% 12/31/2038 25 A+$ 64,000,000 $ 747.48 $1,000 7.375% 12/31/2038 25 A+EXHIBIT 13.2 Pacific Healthcare: Long-Term Bond Stated (Nominal) Yields Annual 2018 2018 1/1/2019 2018 2018Face Yield to Coupon Current Expected Capital Gain TotalAmount Maturity Payments Yield Price Yield Yield$ 48,000,000$ 32,000,000$100,000,000$ 64,000,000

1379FORECASTINGLearning ObjectivesAfter reading this chapter, students will be able to• articulate the importance of a good sales forecast,• describe the attributes of a good sales forecast,• apply demand theory to forecasts, and• use simple forecasting tools appropriately.Key Concepts• Making and interpreting forecasts are important jobs for managers.• Forecasts are planning tools, not rigid goals.• Sales and revenue forecasts are applications of demand theory.• Changes in demand conditions usually change forecasts.• Good forecasts should be easy to understand, easy to modify, accurate, transparent, and precise.• Forecasts combine history and judgment.• Assessing external factors is vital to forecasting.9.1 IntroductionMaking and interpreting forecasts are important jobs for managers. Sales forecasts are especially important because many decisions hinge on what the organization expects to sell. Pricing decisions, staffing decisions, product launch decisions, and other crucial decisions are based on the organization’s revenue and sales forecasts.Inaccurate or misunderstood forecasts can hurt businesses. The orga-nization can hire too many workers or too few. It can set prices too high or too low. It can add too much equipment or too little. At best, these sorts of forecasting problems will cut into profits; at worst, they may drive an orga-nization out of business.Lee.indd 1371/2/19 3:15 PM

Economics for Healthcare Managers138The consequences of bad or misapplied forecasts are particularly seri-ous in healthcare. For example, underestimating the level of demand in the short term may result in stock shortages at a pharmacy or too few nurses on duty at a hospital. In both cases, the healthcare organization will suffer financially and, more important, put patients at risk. It will suffer because the costs of meeting unexpected demand are high and because the long-term consequences of failing to meet patients’ needs are significant. The best out-come in this case will be unhappy patients; the worst outcome will be that physicians stop referring patients to the organization.Overestimating sales can also have serious long-term effects. A hospital may add too many beds because its census forecast was too high. This surplus will depress profits for some time because the facility will have hired staff and added equipment to meet its overestimated forecast, and the costs of hir-ing and paying new employees and buying new equipment will substantially exceed actual sales profits. In extreme cases, bad forecasts may drive a firm out of business. A facility that borrows heavily in anticipation of higher sales that do not materialize may be unable to repay those debts. Bankruptcy may be the only option.Sales and revenue forecasts are applications of demand theory. The fac-tors that change sales and revenues also change demand. The most important influences on demand are the price of the product, rivals’ prices for the prod-uct, prices for complements and substitutes, and demographics. Recognizing these influences can simplify forecasting considerably because it focuses our attention on tracking what has changed.9.2 What Is a Sales Forecast?A sales forecast is a projection of the number of units (e.g., bed days, visits, doses) an organization expects to sell. The forecast must specify the time frame, marketing plan, and expected market conditions for which it is valid.A forecast is a planning tool, not a rigid goal. Conditions may change. If they do, the organization’s plan needs to be reassessed. Good management usually involves responding effectively to changes in the environment, not forging ahead as though nothing has shifted. In addition, fixed sales goals create incentives to behave opportunistically (that is, for employees to try to meet their goals instead of the organization’s goals). For example, sales staff may harm the organization by making overblown claims of a product’s effectiveness to meet their sales goals, even though their actions will harm the company in the long run. Alternatively, sales managers may bid on unprofit-able managed care contracts just to meet goals.Whenever possible, a sales forecast should estimate the number of units expected to be sold, not revenues. The number of units to be sold Lee.indd 1381/2/19 3:15 PM

Chapter 9: Forecasting139determines staffing, materials, working capital, and other needs. In addition, costs often vary unevenly with volume. A small reduction in volume may save an entire shift’s worth of wages (thereby avoiding considerable cost), or an increase in sales may incur a small cost increase if it requires no additional staff or equipment.The dollar volume of sales can vary in response to factors that do not affect the resources needed to produce, market, or service the sales. Dis-counts and price increases are examples of such factors. Revenues can vary even though neither volume nor costs change. Finally, managers can easily forecast revenue given a volume forecast. In general, managers should build their revenue estimates on sales volume estimates.Good forecasts have five attributes. They should be1. easy to understand,2. easy to modify,3. accurate (i.e., they contain the most probable actual values),4. transparent about how variable they are, and5. precise (i.e., they give the analyst as little wiggle room as possible).These attributes often conflict. Managers may need to underplay how impre-cise simple forecasts are because their audience is not prepared to consider variation. As Aven (2013) points out, many decision makers are more com-fortable working with a single, precise estimate, even though it may be inac-curate. Precision and accuracy always conflict because a more precise forecast (80 to 85 visits per day) will always be less accurate than a less precise forecast (70 to 95 visits per day). Offering decision makers several precise scenarios is usually a good compromise. For example, busy decision makers generally can use a forecast such as “Our baseline forecast is 82 visits per day for the next three months, our low forecast is 75 visits per day, and our high forecast is 89 visits per day.”Forecasting Supply Use More and more healthcare institutions seek to reduce costs while increasing the quality of care. Accurate forecasts of the use of medical supplies represent an important element of this effort. Overordering supplies drives up costs, and under-ordering supplies also can drive up costs and compromise care. Case 9.1(continued)Lee.indd 1391/2/19 3:15 PM

Economics for Healthcare Managers1409.3 ForecastingAll forecasts combine history and judgment. History is the only real source of data. For example, sales can be forecasted only on the basis of data on past sales of a product, past sales of similar products, past sales by rivals, or past The stakes can be high. Caldwell Memorial Hos-pital, a 110-bed hospital in North Carolina, saved $2.62 million in less than six months by consolidat-ing and eliminating excess supplies (Belliveau 2016). The hospital used a Lean approach to inventory management, which involves streamlining and simplifying the inventory and ordering systems. In addition, a number of hospitals have expanded their use of just-in-time inventory management (Green 2015). This method reduces, but does not eliminate, the need for forecasting accuracy. Some supplies are highly specialized and are used intermittently, so they must be ordered well in advance. The savings can be substantial. Mercy Hos-pital in Chicago was able to reduce its inventory by 50 percent using just-in-time inventory management (Green 2015).Discussion Questions• What share of hospital costs do supplies represent?• Why would overordering supplies drive up costs?• Why would underordering supplies drive up costs?• Can you offer examples of Lean inventory management? Does it work well?• Can you offer examples of just-in-time inventory management? Does it work well?• Can you offer examples of supplies that have to be available at all times?• What are the main challenges to making accurate forecasts of supply use in hospitals?• How would you forecast supply use in the emergency department? Why?• How would you forecast supply use in hospital clinics? Why?• Would you use judgment in making these forecasts? Why?• Would you use statistical models in making these forecasts? Why?• How are supply chain forecasts different for hospitals than for retail? For manufacturing?Case 9.1(continued)Lee.indd 1401/2/19 3:15 PM

Chapter 9: Forecasting141sales in other markets. History is an imperfect guide to the future, but it is an essential starting point.Judgment is also essential. It provides a basis for deciding what data to use, how to use the data, and what statistical techniques, if any, to use. In many cases (e.g., introductions of new products or new competitive situ-ations), managers who have insufficient data will have to base their forecasts mainly on judgment.As mentioned in section 9.2, a forecast must specify the time frame, marketing plan, and expected market conditions for which it is valid. Changes in any of these factors will change the forecast.A forecast applies to a given period. Extrapolating to a longer or shorter period is risky; conditions may change. The time frame varies accord-ing to the forecast’s use. For example, a staffing plan may need a forecast for only the next few weeks. Additional staff can be hired over a longer time horizon. In contrast, budget plans usually need a forecast for the coming year. Organizations usually set their budgets a year in advance on the basis of projected sales. Strategic plans usually need a forecast for the next several years. Longer forecasts are generally less detailed and less reliable, but manag-ers know to take these factors into account when they develop and use them.Forecasts should be as short term as possible. A forecast for next month’s sales will usually be more accurate than forecasts for the distant future, which are likely to be less accurate because important facts will have changed. Your competitors today are likely to be your competitors in a month. Your competitors in two years are likely to be different from your competitors today, so a forecast based on current market conditions will be poor.Marketing plan changes will influence the forecast. A clinic that increases its advertising expects visits to increase. A forecast that does not consider this increase will usually be inaccurate. Increasing discounts to phar-macy benefits managers should result in increased sales for a pharmaceutical firm. Again, a forecast that does not account for additional discounts will usu-ally be deficient. Any major changes in an organization’s marketing efforts should change forecasts. If they do not, the organization should reassess the usefulness of its marketing initiatives.Changes in market conditions also influence forecasts. For example, a major plant closing would probably reduce a local plastic surgeon’s volume. Plant employees who had intended to undergo plastic surgery may opt to delay this elective procedure, and prospective patients who work for similar plants may defer discretionary spending in fear that they too may lose their jobs. Alternatively, a hospital closure will probably cause a competing hospital to forecast more inpatient days. Historical data have limited value in project-ing such an effect if a similar closure has not occurred in the past. Approval of a new drug by the Food and Drug Administration should cause a phar-maceutical firm to forecast a decrease in sales for its competing product. This Lee.indd 1411/2/19 3:15 PM

Economics for Healthcare Managers142sort of change in market conditions is familiar, and the firm’s marketing staff will probably draw on experience to predict the loss.Analysts routinely use three forecasting methods: percentage adjust-ment, moving averages, and seasonalized regression analysis. If the data are adequate and the market has not changed too much, seasonalized regression analysis is the preferred method. However, whether the data are adequate and whether the market has changed too much are judgment calls.Percentage adjustment increases or decreases the last period’s sales volume by a percentage the analyst deems sensible. For example, if a hospi-tal had an average daily census of 100 the previous quarter, and an analyst expects the census to fall an average of 1 percent per quarter, a reasonable forecast would be a census of 99. Because of its simplicity, managers often use percentage adjustment; however, this simplicity is also a shortcoming. In principle, a manager could choose an arbitrary percentage adjustment. Without some requirement that percentage adjustments be well justified, this approach may not yield accurate forecasts. For example, a manager might justify a request for a new position based on a forecast that average daily census will increase by 5 percent, even though the average daily census had been falling for the last 14 quarters. In addition, percentage adjustment does not allow for seasonal effects. (Seasonal effects are systematic tenden-cies for particular days, weeks, months, or quarters to have above- or below-average volume.)Demand theory can be used to add rigor to percentage adjustments. For example, if the price of a product has changed, an estimate of the per-centage change in sales can be calculated by multiplying the percentage change in price by the price elasticity of demand. So, if an organization has chosen to raise prices by 3 percent and faces a price elasticity of demand of −4, sales will drop by 12 percent. Similar calculations can be used if the price of a substitute, the price of a complement, or consumer income has changed.The moving-average method uses the average of data from recent periods to forecast sales. This method works well for short-term forecasts, although it tends to hide emerging trends and seasonal effects. Exhibit 9.1 shows census data and a one-year moving average for a sample hospital.Exhibit 9.1 also illustrates the calculation of a seasonalized regression format. Excel was used to estimate a regression model with a trend (a vari-able that increases in value as time passes) and three quarter indicators. The variable Q1 has a value of 1 if the data are from the first quarter; otherwise, its value is 0. Q2 equals 1 if the data are from the second quarter, and Q3 equals 1 if the data are from the third quarter. For technical reasons, the aver-age response in the fourth quarter is represented by the constant. A negative regression coefficient for trend indicates that the census is in a downward trend. The results also show that the typical third-quarter census is smaller percentage adjustment An adjustment that increases or decreases the average of the past n periods. (The adjustment is essentially a best guess of what is expected to happen in the next year.)moving averageThe unweighted mean of the previous n data points.seasonalized regression analysis A least squares regression that includes variables to identify subperiods (e.g., weeks) that historically have had above- or below-trend sales.Lee.indd 1421/2/19 3:15 PM

Chapter 9: Forecasting143QuarterCensusMoving AverageFirstSecondThirdTrend19910012109010231010013410700045104104.010056116105.301067100107.000178106106.800089103106.5100910107106.3010101190104.00011112105101.50001213102101.3100131494101.001014159897.8001151610499.800016179999.5100171810598.8010181994101.50011920102100.50002021100100.01002122100.3Seasonalized Regression ModelCoefficientt-statistic Intercept108.81140.90R2 = 0.55First quarter−3.968−1.53F(4,20) = 4.98Second quarter0.7320.27p = 0.01Third quarter−8.534−3.16Trend−0.334−2.16EXHIBIT 9.1Census Data for a Sample HospitalLee.indd 1431/2/19 3:15 PM

Economics for Healthcare Managers144than average because the coefficient for Q3 is large, negative, and statistically significant.The forecast based on seasonalized regression analysis is calculated as follows: 108.811 + (−0.334 × 22) + 0.732. Here, 108.811 is the estimate of the constant, −0.334 is the estimate of the trend coefficient, 22 is the quarter to which the forecast applies, and 0.732 is the estimate of the Q2 coefficient. Therefore, the seasonalized forecast is 102.2, slightly higher than the forecast based on the moving average. Overall the seasonalized forecast is a little more accurate than the one-year moving average. The mean absolute deviation for the regression is 2.3 for periods 5 through 21, and the mean absolute deviation for the moving average is 4.0.Exhibit 9.2 shows an overview of the forecasting process. The main message of this exhibit is that a forecast is one part of the overall product management process. In addition, the forecast will change as managers’ mean absolute deviation The average absolute difference between a forecast and the actual value. (It is absolute because it converts both 9 and −9 to 9. The Excel function =ABS( ) performs this conversion.)Assess internal and external factors.Developan initial forecast.Develop an initialmarketing strategyandthenmodifytheforecastandmarketing strategy until they are consistent.Monitorsales,internal factors, external factors, andthemarketing strategy.Modify theforecastand marketing strategiesasneeded.EXHIBIT 9.2 An Overview of the Forecasting Process Lee.indd 1441/2/19 3:15 PM

Chapter 9: Forecasting145assessments of relevant internal factors (e.g., cost and quality), external fac-tors (e.g., the competitive environment and payment levels), and the market-ing plan change.A naïve forecast uses the value for the last period as the forecast for the next period—in other words, a 0 percent adjustment forecast. Exhibit 9.3 shows an example of a naïve forecast. A moving-average forecast uses the average of the last n values, where n is the number of preceding values used in the forecast. For example, the first entry in the Two-Period Moving-Average Forecast column in exhibit 9.3 equals (189 + 217) ÷ 2, or 203.To compare forecasting techniques, analysts sometimes use the mean absolute deviation, which is the average of the forecast’s absolute deviations from the actual value. (When using the absolute deviation, it does not mat-ter if a value is higher or lower than the actual value; all the deviations are positive numbers.) For April through July, the naïve forecast in exhibit 9.3 has a mean absolute deviation of 12.0, and the two-period moving-average forecast has a mean absolute deviation of 12.1. From this perspective, the naïve forecast performs a little better.These (and other) mechanistic forecasting methods do not allow man-agers to explore how changes in the environment are likely to affect sales. How would changes in insurance coverage change sales? Naïve forecasts and moving-average forecasts are little help in such situations.9.4 What Matters?Assessment of external factors (i.e., factors beyond the organization’s con-trol) is vital to forecasting. General economic conditions are a prime example. Expected inflation and interest rates are good indicators of the state of the MonthSalesNaïve ForecastTwo-Period Moving-Average ForecastFebruary189March217189April211217203May239211214June234239225July243234236.5EXHIBIT 9.3Simple Forecasting Techniques: Naïve and Moving-Average ForecastsLee.indd 1451/2/19 3:15 PM

Economics for Healthcare Managers146economy. Local market conditions, such as business rents and local wages, also play an important role.Government actions also can have a major impact on healthcare firms. For example, changes in Medicare rates affect most healthcare firms. Alter-natively, regulations can have a significant effect on costs. Expansion of Med-icaid eligibility can have major effects on some hospitals and minor effects on others. Keep in mind that these sorts of changes will also affect most of your competitors, but forecasters would be ill advised to ignore changes in government policy.The plans of key competitors must also be considered. Closure of a competing clinic or hospital can increase volume significantly and quickly. Introduction of a generic drug can have a dramatic effect on a pharmaceuti-cal manufacturer. Changes in competitors’ pricing policies can have a major impact on sales.Technological change is always an important issue. If a rival gains a technological advantage, your sales can drop sharply. For example, if a rival introduces minimally invasive coronary artery bypass graft surgery, admis-sions to your cardiac unit will probably drop significantly until you adopt similar technology. In other cases, your own advances may affect sales of substitute products. For example, introduction of highly reliable magnetic resonance imaging may sharply reduce the demand for conventional colo-noscopy. Keep in mind, however, that if you do not introduce technologies that add value for your customers, someone else will. A decision not to introduce an attractive product because it will cannibalize sales is usually a mistake.Finally, although markets usually change slowly, differences in general market characteristics (e.g., median income and percentage with insurance coverage) may be important in forecasting sales of a new product.Assessment of internal factors (i.e., factors within an organization’s control) is also vital to forecasting. For example, existing production may limit sales, or production may have limited sales in the past. If so, changes in capacity or productivity need to be considered. Changes in the availability of resources and personnel can also have a powerful effect on sales. For many healthcare organizations, the entry or exit of a key physician can dramatically shape volume. In addition, changes in the size, support, composition, and organization of the sales staff can affect sales dramatically. For instance, a small drug firm may experience a large increase in sales if one of its products is marketed by a larger firm’s sales staff.Failures or improvements in key systems can also have dramatic effects on sales. Breakdowns in a clinic’s phone or scheduling system may drive away potential customers. Fixing the phone system, in contrast, might be the most effective marketing campaign the clinic ever launched.Lee.indd 1461/2/19 3:15 PM

Chapter 9: Forecasting147Mistakes to Avoid When Making ForecastsBusiness plans require a sales forecast. Scott Fishman, the CEO of Envisage, sees three common mistakes in business plans (Fishman 2015):• They forecast “hockey stick” revenue growth.• They forecast smoothly rising trend lines.• They lack convincing evidence of market size.A “hockey stick” forecast—a revenue graph shaped like a hockey stick—involves limited revenues initially followed by explosive growth. It is a potentially effective sales technique to use in discussions with executives and investors because it suggests that the business oppor-tunity might be extremely valuable. In contrast, smoothly rising trend lines do not seem plausible from an economic standpoint. The number of customers and their consump-tion of any product is typically finite. Furthermore, any true blockbuster product will attract competition.Every new product faces a complex environment: features and benefits, competitive environment, regulatory conditions, payment models, distribution, pricing, market positioning, and so forth. A genu-inely new product will have multiple unknowns in its market. If there are no unknowns, it is not really a new product. A convincing forecast demands market research, an honest recognition of what is not known, and a strategy for resolving some of the unknowns.Discussion Questions• What is problematic about a “hockey stick” forecast?• Can you find an example of a product that displayed “hockey stick” revenue growth? • What is problematic about a forecast with a smoothly rising trend line? • Can you find an example of a product that displayed smoothly rising revenue growth? • From an economic point of view, what is implausible about smoothly rising trend lines? Case 9.2(continued)Lee.indd 1471/2/19 3:15 PM

Economics for Healthcare Managers1489.5 ConclusionMaking and interpreting forecasts are important tasks for healthcare manag-ers. Not only are most crucial decisions based on sales forecasts, but also the consequences of overestimating or underestimating demand can be cata-strophic. Overestimating demand can put the financial future of an organiza-tion at risk, whereas underestimating demand can compromise the care of patients and harm the organization’s reputation.Analysts should apply demand theory to their sales forecasts to better recognize changes. Demand theory limits what analysts need to consider: the price of the product, the price of substitutes, and the price of complements. The key idea of demand theory is that the out-of-pocket price drives most consumer demand. The amount the consumer has to pay depends largely on the terms of the insurance contract. Is the product covered? What is the required copayment? Changes in the answers to these two questions can shift sales sharply. The same concerns affect the prices of substitutes. The most important substitutes are similar products offered by rivals, but other prod-ucts that meet some of the same needs should also be considered.Demographic factors are important. Population size, income per capita, the age distribution of the population, the ethnic makeup of the population, and the insurance coverage of the population are some examples. Although vital, demographic factors tend to be stable in the short term. Demographics are much more important in long-range forecasts.“Prediction is very difficult, especially if it’s about the future.” This saying, noted in chapter 4, reveals a core truth about forecasting: You often will be wrong. Knowing that, a shrewd manager will make decisions that can be modified as conditions change. The shrewd manager will also know which • Can you find an example of a product that wildly underperformed early forecasts? • Can you find an example of a product that wildly overperformed early forecasts? • What external factors might cause below-forecast sales? Above-forecast sales? • What internal factors might cause below-forecast revenues? Above-forecast revenues? • What are examples of new products with uncertain prospects in healthcare?Case 9.2(continued)Lee.indd 1481/2/19 3:15 PM

Chapter 9: Forecasting149data are likely to be the most problematic or most variable and will monitor those data carefully.Management decisions require sales forecasts. Off-the-cuff forecasts often fail to consider key factors and can lead to risky decisions. Imper-fect forecasts can be used to make decisions as long as you recognize that your predictions will sometimes be wrong and you structure your decisions accordingly.Exercises 9.1 The table lists visits for each of the four clinics operated by your system. You anticipate that volumes will increase by 4 percent next year. Forecast the number of visits for each clinic, and explain what assumptions underlie your forecasts. For example, are you sure that all the clinics can serve additional clients?PeriodClinic 1Clinic 2Clinic 3Clinic 4TotalThis year16,64041,60024,96033,280116,480Next year????121,139 9.2 Your data for the clinics in exercise 9.1 suggest that clinic 2 is operating at capacity and is highly efficient. Its output is unlikely to increase. Furthermore, clinic 4 has unused capacity but is unlikely to attract additional patients. How would these facts change your answer to the question in exercise 9.1? Continue to assume that overall volume will rise to 121,139. 9.3 You estimate that the price elasticity of demand for clinic visits is −0.25. You anticipate that a major insurer will increase the copayment from $20 to $25. This insurer covers 40,000 of your patients, and those patients average 2.5 visits per year. What is your forecast of the change in the number of visits? 9.4 A major employer has just added health insurance coverage for its employees. Consequently, 5,000 of your patients will pay a $30 copayment rather than the list price of $100 per visit. These patients average 2.2 visits per year. You believe the price elasticity of demand is between −0.15 and −0.35. What is your forecast of the change in the number of visits? 9.5 The following table shows data on asthma-related visits. Is there evidence that these visits vary by quarter? Can you detect a trend? Lee.indd 1491/2/19 3:15 PM

Economics for Healthcare Managers150A powerful test would be to run a multiple regression in Excel. (To do this, you will need the free Analysis ToolPak for your version of Excel. Microsoft [2018] offers guidance on how to load and use the Analysis ToolPak.) To test for quarterly differences, create a variable called Q1 that equals 1 if the data are for the first quarter and 0 otherwise, a variable called Q2 that equals 1 if the data are for the second quarter and 0 otherwise, and a variable called Q4 that equals 1 if the data are for the fourth quarter and 0 otherwise. (Because you will accept the default, which is to have a constant term in your regression equation, do not include an indicator variable for Quarter 3.) Also create a variable called Trend that increases by 1 each quarter.YearQ1Q2Q3Q420141,5131,06020151,4311,12399467920161,4858861,25697520171,2561,1561,1631,06220181,2001,0721,56353120191,0221,169 9.6 Your marketing department estimates that Medicare urology visits equal 5 − (1.0 × C) + (−6.5 × TO) + (5 × TR) + (0.01 × Y). Here, C denotes the Medicare copayment (now $20), TO is waiting time in your clinic (now 30 minutes), TR is waiting time in your competitor’s clinic (now 40 minutes), and Y is per capita income (now $40,000).a. How many visits do you anticipate?b. Medicare’s allowed fee is $120. What revenue do you anticipate?c. What might change your forecast of visits and revenue? 9.7 Because of fluctuations in insurance coverage, the average price paid out of pocket (P) by patients of an urgent care center varied, as the table shows. The number of visits per month (Q) also varied, and an analyst believes the two are related. The analyst also thinks the data show a trend. Run a regression of Q on P and Period to test these hypotheses. Then use the estimated parameters a, b, and c and the values of Month and P to predict Q (number of visits). The prediction equation is Q = a + (b × Month) + (c × P).Lee.indd 1501/2/19 3:15 PM

Chapter 9: Forecasting151Month123456789101112P$21$18$15$24$18$21$18$15$20$19$24$20Q193197256179231214247273223225198211 9.8 Use the data in exercise 9.7 to answer these questions: a. Calculate the naïve estimator, which is Qt = Qt − 1. b. Calculate the two-period moving-average forecast. c. Calculate the mean absolute deviation for the regression forecast, the naïve forecast, and the two-period moving-average forecast. d. Which forecast seems to perform the best? Why? 9.9 Sales data are displayed in the table. MonthSalesMonthSalesFebruary224January260March217February284April211March280May239April271June234May302July243June286August238July297September243August301October251September309November259October314December270a. Calculate the naïve estimator, which is Salest = Salest − 1.b. Calculate the two-period and three-period moving averages.c. Calculate the mean absolute deviation for each of the forecasting methods. 9.10 A pharmaceutical company produces a sinus medicine. Monthly sales (in thousands of doses) for the past three years are shown in the table on the next page.Lee.indd 1511/2/19 3:15 PM

Economics for Healthcare Managers152a. Develop a regression model that allows for trend and seasonal components. Obtain the Excel output for this model.b. Calculate a two-period moving-average forecast.c. Compare the mean absolute deviations for these approaches.d. Use one of these models to forecast sales for each month of year 3.ReferencesAven, T. 2013. “On How to Deal with Deep Uncertainties in a Risk Assessment and Management Context.” Risk Analysis 33 (12): 2082–91. Belliveau, J. 2016. “How a Small Hospital Developed Lean Supply Chain Manage ment.” RevCycle Intelligence. Published September 6. https://revcycle intelligence .com /news/how-a-small-hospital-developed-lean-supply-chain-management.Fishman, S. 2015. “3 Mistakes to Avoid When Forecasting the Market for Your Medical Device.” Med Device Online. Published September 21. www.med deviceonline.com/doc/mistakes-to-avoid-when-forecasting-the-market-for -your-medical-device-0001.Green, C. 2015. “Hospitals Turn to Just-in-Time Buying to Control Supply Chain Costs.” Healthcare Finance. Published May 6. www.healthcarefinancenews .com/news/hospitals-turn-just-time-buying-control-supply-chain-costs.Microsoft. 2018. “Use the Analysis ToolPak to Perform Complex Data Analysis.” Accessed September 18. https://support.office.com/en-us/article/use-the -analysis-toolpak-to-perform-complex-data-analysis-6c67ccf0-f4a9-487c-8dec -bdb5a2cefab6.JanFebMarAprMayJuneJulyAugSeptOctNovDec6,7888,0201,8484105862,2602,2328,0189,3846,9165,6986,9409,1367,4203,3501,9981,9723,5724,50610,47413,3588,2328,21810,2489,6287,8263,5282,1262,0703,7624,75411,01014,0408,6468,63410,782Lee.indd 1521/2/19 3:15 PM

54914FINANCIAL FORECASTINGLearning ObjectivesAfter studying this chapter, readers should be able to•describe in general terms the overall planning process forbusinesses,•use the constant growth method to forecast a business’s financialstatements, and•discuss the various methods used to forecast income statementitems and balance sheet accounts.IntroductionIn chapter 13, we saw how managers conduct analyses to assess a business’s financial condition. Now, we consider the planning actions managers can take to exploit a business’s strengths and overcome its weaknesses as they seek to meet its goals and objectives. Healthcare managers are vitally concerned with a business’s projected financial statements and with the effects of alternative operating policies on these statements. An analysis of such effects is the key ingredient of financial planning. However, a good financial plan cannot by itself ensure that a business will meet its goals; the plan must be backed up by a financial control system, both to make sure that the plan is carried out properly and to facilitate rapid adjustments if economic and operating condi-tions change from those built into the plan.Strategic PlanningFinancial plans, which are founded on financial forecasts, are developed in the framework of the business’s overall strategic plan. Thus, we begin our discussion with an overview of strategic planning. Note that strategic plan-ning in healthcare organizations is an important and complex managerial responsibility, and most schools offer entire courses on the subject. Our

Gapenski’s Understanding Healthcare Financial Management550purpose here is to acquaint you with some basic concepts directly related to financial forecasting.Mission StatementAn important part of any strategic plan is the mission statement, which defines the overall purpose of the organization. The mission can be defined specifi-cally or in general terms. For example, an investor-owned medical equipment manufacturer might state that its corporate mission is “to increase the intrin-sic value of the firm’s common stock.” Another might say that its mission is “to maximize the growth rate of earnings and dividends per share while minimizing risk.” Yet another might state that its principal goal is “to provide state-of-the-art diagnostic systems at the lowest attainable cost in order to maximize benefits to our customers, employees, and stockholders.”The mission statements of not-for-profit businesses are normally stated in different terms, although competition in the health services sector forces all businesses, regardless of ownership, to operate in a manner consistent with financial viability. For an example of a not-for-profit mission statement, con-sider the mission statement of Bayside Memorial Hospital, a not-for-profit acute care hospital:Bayside Memorial Hospital, along with its medical staff, is a recognized, innova-tive healthcare leader dedicated to meeting the needs of the community. We strive to be the best comprehensive healthcare provider in our service area through our commitment to excellence.This mission statement provides Bayside’s managers with an overall frame-work for development of the hospital’s goals and objectives.1Corporate GoalsThe mission statement contains the general philosophy and approach of the organization, but it does not provide managers with specific operational goals. Corporate goals set forth specific achievements for management to attain. Corporate goals generally are qualitative in nature, such as “keep-ing the firm’s research and development efforts at the cutting edge of the industry.” Multiple goals are established and revised over time as conditions change.Bayside divides its corporate goals into five major areas:1.Quality and customer satisfaction –To make quality performance the goal of each employee –To be recognized by our patients as the provider of choice in ourmarket area

Chapter 14: Financial Forecasting551 –To identify and resolve areas of patient dissatisfaction as rapidly aspossible2.Medical staff relations –To identify and develop timely channels of communication amongall members of the medical staff, management, and board ofdirectors –To respond in a timely manner to all medical staff concerns broughtto the attention of management –To make Bayside a more desirable location to practice medicine –To develop strategies to enhance the mutual commitment of themedical staff, administration, and board of directors for the benefitof the hospital’s stakeholders –To provide the highest-quality, most cost-effective medical carethrough a collaborative effort of the medical staff, administration,and board of directors3.Human resources management –To be recognized as the customer service leader in our market area –To develop and manage human resources to make Bayside the mostattractive work location in our market area4.Financial performance –To maintain a financial condition that permits us to be highlycompetitive in our market area –To develop the systems necessary to identify inpatient and outpatientcosts by unit of service5.Health systems management –To be a leader in applied technology based on patient needs –To establish new services and programs in response to patient needs –To be at the forefront of electronic health record technologyOf course, these goals occasionally conflict. When they do, Bayside’s senior managers have to make judgments regarding which takes precedence.Corporate ObjectivesOnce a business has defined its mission and goals, it must develop specific objectives designed to help it achieve its stated goals. Corporate objectives are generally quantitative in nature. For example, they may specify a target mar-ket share, a target return on equity, a target earnings per share growth rate, or a target economic value added. Furthermore, the extent to which corporate objectives are met is commonly used as a basis for managers’ compensation. To illustrate corporate objectives, consider Bayside’s financial performance

Gapenski’s Understanding Healthcare Financial Management552goal of maintaining a financial condition that permits the hospital to be highly competitive in its market area. These objectives are tied to that goal in 2019:•To exceed the hospital’s current 5.8 percent operating margin by 2022•To exceed the hospital’s current 7.5 percent total margin by 2022•To increase the hospital’s debt ratio to the range of 35 percent to 40percent by 2024•To maintain the hospital’s liquidity as measured by the current ratio inthe range of 2.0 to 2.5•To increase fixed asset utilization as measured by the fixed-asset-turnover ratio to 1.5 by 2024Corporate objectives give managers precise targets to shoot for. These objec-tives must support the organization’s mission and goals and must be chosen carefully so that they are challenging yet attainable.1.Briefly describe the nature and use of the following corporateplanning tools:a.Missionb.Goalsc.Objectives2.Why do financial planners need to be familiar with the business’sstrategic plan?SELF-TEST QUESTIONSOperational PlanningWhereas strategic planning provides general guidance along with specific goals and objectives, operational planning provides a road map for executing a business’s strategic plan. The key document in operational planning is the business’s operating plan, which contains the detailed guidance necessary to meet corporate objectives. Operating plans can be developed for any time horizon. Most firms use a five-year horizon, so the term five-year plan has become common. In a five-year plan, the plans are most detailed for the first year, and each succeeding year’s plan becomes less specific.To get a better feel for operational planning, consider exhibit 14.1, which contains Bayside’s annual planning schedule. This schedule shows that,

Chapter 14: Financial Forecasting553for Bayside and most other organizations, the planning process is essentially continuous. Next, exhibit 14.2 outlines the key elements of the hospital’s five-year plan, including an expanded section for finance. A full outline would require several pages, but the outline given provides some insight into the format and content of a five-year plan.For Bayside, much of the planning function takes place at the depart-ment level, with technical assistance from the marketing, planning, and financial staffs. Larger businesses with divisions begin the planning process at the divisional level. Each division has its own mission and goals as well as objectives designed to support its goals, and these plans are consolidated to form the corporate plan. A common practice in many health systems is using these plans as a way to measure managers’ success during the year; these plans typically take the form of a balanced scorecard, which is a tool that aligns high-level strategy with day-to-day operations measured by key performance indicators.Months ActionApril–May Marketing department analyzes national and local economic factors likely to influence Bayside’s patient volume and reimbursement rates. At this time, a preliminary volume forecast is prepared for each service line.June –July Operating departments prepare new project (capital budgeting) requirements as well as operating-cost estimates on the basis of the preliminary volume forecast.August–September Financial analysts evaluate proposed capital expenditures and department operating plans. Preliminary forecasted financial statements and cash budgets are prepared with emphasis on Bayside’s sources and uses of funds and on forecasted financial condition.October–November All previous input is reviewed, and the planning, financial, and departmental staffs draft the hospital’s five-year plan. Any new information developed during the planning process “feeds back” into earlier actions.December The hospital’s executive committee approves the five-year plan and submits it to the board of directors for final approval.EXHIBIT 14.1 Bayside Memorial Hospital: Annual Planning Schedule

Gapenski’s Understanding Healthcare Financial Management5541.What is the purpose of a business’s operating plan?2.What is the most common time horizon for operating plans?3.Briefly describe the contents of a typical operating plan.SELF-TEST QUESTIONSFinancial PlanningOne of the key elements of operational planning is financial planning, which includes financial forecasting, the focus of this chapter.Chapter 1 Organizational mission and goals Chapter 2 Organizational objectivesChapter 3 Projected business environmentChapter 4 Organizational strategiesChapter 5 Summary of projected business resultsChapter 6 Service line plansChapter 7 Functional area plansA.MarketingB.OperationsC.Finance1.Current financial condition analysis2.Capital investments and financinga.Capital budgetb.Financial plan3.Financial operationsa.Overall policyb.Cash budgetc.Cash and marketable securities managementd.Inventory managemente.Revenue cycle managementf.Short-term financingg.Long-term financing4.Budgeting and control (first year only)a.Revenue budgetb.Expense budgec.Operating budgetd.Control procedures5.Financial forecasta.Pro forma financial statementsb.Projected financial condition analysisEXHIBIT 14.2 Bayside Memorial Hospital: Partial Five-Year Plan Outline

Chapter 14: Financial Forecasting555The financial planning process can be broken down into the following five steps:1.Create sets of forecasted financial statements to analyze the effects ofalternative operating assumptions on the firm’s financial condition.These statements can also be used to monitor operations after the planhas been finalized and put into effect. Rapid awareness of deviationsfrom plans is essential to a good control system, and such a system isessential to organizational success in a changing world.2.Determine the specific financial requirements needed to support eachalternative set of operating assumptions. These financial requirementsmust include funds for new facilities and renovations as well as forinventory and receivables buildups, for research and educationalprograms, and for major marketing campaigns.3.Forecast the financing sources to be used over the next five years tosupport each alternative set of operating assumptions. This forecastinvolves estimating the funds that will be generated internally(primarily retentions) as well as those that must be obtained fromexternal sources (primarily contributions and debt financing). Anyconstraints on operating plans imposed by financial limitations shouldbe incorporated into the plans; examples include expected marketconditions or restrictions in debt covenants that limit the availability ofnew debt financing.4.Assess the projected financial implications of each alternative setof operating assumptions, including feasibility. To accomplish this,financial condition analysis (as described in chapter 13) is applied—butnow to forecasted data as opposed to historical data.5.Choose the operating alternative that will best meet the organization’sgoals and objectives. The assumptions inherent in this alternativeprovide the basis for the firm’s base case financial plan, whichconstitutes chapter 7.c of Bayside’s operating (five-year) plan (seeexhibit 14.2). The most critical part of the financial plan is based onforecasted financial statements, but the plan also contains guidancerelative to accounting procedures and other financial functions.Although our focus in this section is on financial planning, note that it is equally (or more) important to monitor the financial status of the business over time to make sure that the plan chosen is working out as expected. Of course, procedures must be in place for adjusting the base case plan if the forecasted economic conditions do not materialize. For example, if Bayside’s forecast on Medicare and Medicaid reimbursement used to develop the base case five-year plan proves to be too high or too low, the correct amounts

Gapenski’s Understanding Healthcare Financial Management556must be recognized and reflected in operational and financial plans as rapidly as possible.1.What are the five steps of the financial planning process?SELF-TEST QUESTIONRevenue ForecastsThe starting point, and most critical element, in the financial forecast is the revenue forecast. The reason revenue forecasts play such an important role is that all other elements of the financial forecast stem from the revenue fore-cast. If the revenue projection is erroneous, the rest of the financial forecast will be suspect.Revenue forecasts can be done in two ways: from the top or from the bottom. When businesses forecast from the top, they examine historical trends in aggregate (organizational) revenues and use them as the basis for forecasting future revenues. When businesses forecast from the bottom, they forecast revenues for individual services and then aggregate them to create the organizational forecast. Most large organizations use both methods and resolve inconsistencies as the last step in the process. In this way, the best possible forecasts are made.Forecasting from the TopWhen businesses forecast from the top, the revenue forecast generally starts with a review of organizational revenues over the past five to ten years, often expressed in graph form such as that in exhibit 14.3. The first part of the graph shows actual total operating revenues for Bayside from 2014 through 2018. Over these five years (four growth periods), total operating revenues (net patient service revenue plus premium revenue plus other revenue) grew from $86,477,000 to $112,050,000, or at a compound annual growth rate of 6.7 percent. Alternatively, a time-series regression can be applied to total operating revenue. We used a spreadsheet to perform a log-linear regression on all five years of operating revenue data, for a resulting annual growth rate of 6.9 percent.2 However, Bayside’s revenue growth rate accelerated in the second half of the historical period, primarily as a result of new capacity added in 2016. Furthermore, a new, aggressive marketing program was instituted in late 2017 that resulted in a growth rate in operating revenues in 2018 of more than 11 percent.On the basis of the recent trends in operating revenues, anticipated service introductions, and forecasts of local competition and reimbursement On the web at: ache.org/HAP/ PinkSong8e

Chapter 14: Financial Forecasting557trends, Bayside’s planning group projects a growth rate of 11 percent for 2019, which produces a total operating revenue forecast of $124,376,000.It is very important to recognize that the operating revenue forecast is driven by two elements: changes in volume (utilization) and changes in reimbursement rates. Whereas volume changes tend to have a large impact on facilities and staffing requirements and hence costs, reimbursement rate changes, unless they are either substantial or come as a result of a changing 20142015 2016 2017 2018 2019 EXHIBIT 14.3 Bayside Memorial Hospital: Historical and Projected Revenues (in thousands of dollars)(Projected)Year Total Operating Revenue2014 $ 86,4772015 90,5682016 95,3512017 102,0152018 112,0502019 (projected) 124,376

Gapenski’s Understanding Healthcare Financial Management558payer mix, do not have much of an effect on operating variables such as facilities and labor requirements. Thus, it is important for managers to recognize whether operating revenue changes are a result of changes in volume, which indicates that the business is experiencing real changes in patient services, or a result of reimbursement effects, which may have little or no impact on operations.If Bayside’s volume forecast is off the mark, the consequences can be serious. First, if the market for a particular service expands more than Bay-side has expected and planned for, the hospital will not be able to meet its patients’ needs. Potential customers will end up going elsewhere for services, and Bayside will lose market share and perhaps miss a major opportunity. On the other hand, if its projections are overly optimistic, Bayside could end up with too much capacity, which means excess facilities, equipment, inventory, and staff. This excess would mean low turnover ratios, high costs of labor and depreciation, and possibly layoffs. All of these factors would result in low profitability, which could degrade the hospital’s ability to compete in the future. If Bayside had financed the unneeded expansion primarily with debt, its problems would, of course, be compounded. Thus, an accurate volume forecast is critical to the well-being of any healthcare provider.Finally, note that the operating revenue forecast, like virtually any forecast, is actually the expected value of a probability distribution of pos-sible revenues. Because any forecast is subject to a greater or lesser degree of uncertainty, for financial forecasting purposes we are often just as interested in the degree of uncertainty inherent in the forecast (e.g., its standard devia-tion) as we are in the expected value.Forecasting from the BottomTo begin forecasting operating revenue from the bottom, Bayside divides its services into four major groups: (1) inpatient, (2) outpatient, (3) ancil-lary, and (4) other. Each of these categories is broken down into individual services; for example, neurosurgery is one of the services that is part of the overall inpatient services revenue forecast.Next, the level of population growth and disease trends are forecasted; for example, analysts predict the population growth in the hospital’s service area and any disease patterns that will affect the number of neurosurgeries performed. For an illustration, consider the data obtained from a state health agency, which show that 523 neurosurgeries were performed in Bayside’s service area in 2018. With a service area population of 756,508 in 2018, the neurosurgery rate in the service area was 69.1 per 100,000 people. With a population forecast of 788,700 for 2019, Bayside’s managers predict that (788,700 ÷ 100,000) × 69.1 = 545 neurosurgeries will be performed in its service area.

Chapter 14: Financial Forecasting559Bayside’s managers then look at the competitive environment. They consider such factors as the hospital’s inpatient and outpatient capacities, its competitors’ capacities, and new services or service improvements that Bay-side or its competitors might institute. For example, Bayside performed 127 neurosurgeries in 2018, so it had 24.3 percent of the neurosurgery market in that year. With an additional neurosurgeon now on the staff, increased marketing, and new managed care contracts, the hospital expects to increase its market share to 30 percent. Thus, Bayside’s forecast for neurosurgeries in 2019 is 0.30 × 545 = 164.Bayside’s managers then consider the impact of the hospital’s pricing strategy and reimbursement trends on the demand for services. For example, does the hospital have plans to raise neurosurgery charges to boost profit margins or to lower charges to gain market share and use excess capacity? Any potential impact of such pricing changes on neurosurgery volume must be worked into the forecasts. Because Bayside has reimbursement and utilization data on its neurosurgeries, it can easily convert the estimate of the number of procedures into a revenue estimate. The end result is a utilization and revenue forecast for neurosurgeries.Bayside creates a volume and revenue forecast for each individual ser-vice and then aggregates these forecasts by service group. Independently, the hospital forecasts operating revenues by service group using the procedures discussed in the previous section. The aggregate forecast based on individual service forecasts is then compared with the service group forecasts.Differences are reconciled, and the resultant revenue forecast for the hospital is then compared with the from-the-top forecast described earlier. Further refinement is often necessary, but the end result is a total operat-ing revenue forecast for the hospital, broken down by major groups and by individual services.1.What are two approaches to the total operating revenue forecast?2.Discuss some factors that must be considered when developing anoperating revenue forecast.3.Why is it necessary for planners to distinguish between volumechanges and reimbursement changes?SELF-TEST QUESTIONSCreating Forecasted Financial StatementsThe revenue forecast provides a starting point from which to create a busi-ness’s projected financial statements, which sometimes are called pro forma

Gapenski’s Understanding Healthcare Financial Management560financial statements, or just pro formas. Many techniques are used to create the pro formas, most of which are too complex or too detailed to discuss here. Thus, we focus more on concepts than on providing a cookbook approach to financial statement forecasting. We begin by discussing a concep-tual framework for financial statement forecasting. Then, we consider some issues inherent in the forecasting process.1.What is the starting point from which forecasted financialstatements are created?SELF-TEST QUESTIONConstant Growth ForecastingThe constant growth method—also called the percentage of revenues method or, more commonly, percentage of sales method—is a simple technique for creating pro forma financial statements. Although this method has limited value in prac-tice, it provides an excellent introduction to the forecasting process and lays the groundwork for understanding the more complex methods used in practice.AssumptionsThe constant growth method is based on two assumptions: (1) most income statement items and balance sheet accounts are tied directly to revenues, and (2) the current levels of most income statement items and balance sheet accounts are optimal for the current volume of services provided. The basic premise is that as revenues increase or decrease, so will most income state-ment items and balance sheet accounts. Furthermore, the changes in items and accounts will be proportional to the change in revenues. Given this premise, we assume that most income statement items and balance sheet accounts will grow at the same rate—the rate of revenue growth.Of course, revenue changes can be a result of either volume changes or reimbursement rate changes, which typically are driven by inflation. In most situations, revenue changes are a result of both factors. For example, Bayside’s 11 percent increase in total operating revenues projected for 2019 might be a result of a projected 6 percent increase in the volume of ser-vices provided and a 5 percent inflationary increase in reimbursement rates. Because many of the income statement items and balance sheet accounts are affected by volume and inflation changes, many financial statement variables would be expected to also increase by 11 percent. Variables that are tied to only volume or inflation would be expected to increase at a lower 6 percent or 5 percent rate. However, the constant growth method illustration that On the web at: ache.org/HAP/ PinkSong8e

Chapter 14: Financial Forecasting561follows assumes that all financial statement variables related to revenues are influenced by both volume and inflationary changes.IllustrationWe illustrate the constant growth method with Bayside, whose 2018 financial statements are given in column 1 of exhibits 14.4 and 14.5. We explain the other columns of these tables when we discuss the forecast for 2019.To begin the process, we assume (contrary to fact) that Bayside oper-ated its fixed assets (property and equipment) at full capacity to support the $112,050,000 in total operating revenue in 2018—that is, the hospital had no excess beds or outpatient facilities.3 Because we are assuming no excess capacity, if volume is to increase in 2019, Bayside will need to increase its fixed assets along with its current assets.If, as projected, Bayside’s total operating revenue increases to $124,376,000, what will its pro forma 2019 income statement and balance sheet look like, and how much external financing will the hospital require to support operations in 2019? The first step in using the constant growth method to forecast the business’s financial statements is to identify income statement items and balance sheet accounts that are assumed to vary directly with revenues. For illustrative purposes, the increased operating revenue forecast for 2019 is expected to bring corresponding increases in all of the income statement items except interest expense—that is, operating costs and administrative expenses are assumed to be tied directly to total operating rev-enue, but interest expense is a function of financing decisions. Furthermore, nonoperating income is also assumed to grow at the same rate.Under such naive assumptions, the 2019 first-pass forecasted (or pro forma) income statement is constructed as follows:•Place the forecasted constant growth rate—11.0 percent—in column 2of exhibit 14.4 for all items expected to increase with revenues. Itemscalculated in the forecasted income statement (such as total operatingcosts) and items not expected to increase proportionally with revenues(such as interest expense) have “NA” (not applicable) in column 2.•Forecast the 2019 first-pass pro forma amounts by multiplying eachapplicable 2018 value by the growth rate. For example, the 2019forecast for nursing services expenses is $58,285,000 × 1.11 =$64,696,000. Note that we generated the forecast with a spreadsheetmodel, so some of the amounts shown in the financial statements maybe slightly different from those obtained by using a calculator. Also,note that the format of the income statement was modified slightlyfrom that used in chapter 13 to place all of the revenue (income) itemsat the top of the statement.

Gapenski’s Understanding Healthcare Financial Management562EXHIBIT 14.4 Bayside Memorial Hospital: Historical and Projected Income Statements (in thousands of dollars)2019 ProjectionsGrowth First Second Third 2018 Rate (%) Pass Pass Pass (1) (2) (3) (4) (5)Total operating revenue $112,050 11.0% $124,376 $124,376 $124,376Nonoperating income 2,098 11.0 2,329 2,329 2,329 Total revenues $ 114,148 NA $126,704 $126,704 $126,704Expenses: Nursing services $ 58,285 11.0 $ 64,696 $ 64,696 $ 64,696Dietary services 5,424 11.0 6,021 6,021 6,021General services 13,198 11.0 14,650 14,650 14,650Administrative services 11,427 11.0 12,684 12,684 12,684Employee health and welfare 10,250 11.0 11,378 11,378 11,378Malpractice insurance 1,320 11.0 1,465 1,465 1,465Depreciation 4,130 11.0 4,584 4,584 4,584Interest expense 1,542 NA 1,542 1,820 1,842 Total expenses $105,576 NA $117,020 $117,297 $117,320Net income $ 8,572 NA $ 9,685 $ 9,407 $ 9,385

Chapter 14: Financial Forecasting563EXHIBIT 14.5 Bayside Memorial Hospital: Historical and Projected Balance Sheets (in thousands of dollars)2019 ProjectionsGrowth First Second Third 2018 Rate (%) Pass Pass Pass (1) (2) (3) (4) (5)Cash $ 2,263 11.0 $ 2,512 $ 2,512 $ 2,512Short-term investments 4,000 11.0 4,440 4,440 4,440Accounts receivable 21,840 11.0 24,242 24,242 24,242Inventories 3,177 11.0 3,526 3,526 3,526 Total current assets $ 31,280 NA $ 34,721 $ 34,721 $ 34,721Gross property and equipment $145,158 11.0 $161,125 $161,125 $161,125Accumulated depreciation 25,160 NA 29,744 29,744 29,744Net property and equipment $119,998 NA $131,381 $131,381 $131,381Total assets $151,278 NA $166,102 $166,102 $166,102Accounts payable $ 4,707 11.0 $ 5,225 $ 5,225 $ 5,225Accrued expenses 5,650 11.0 6,272 6,272 6,272Notes payable 2,975 11.0 3,302 3,302 3,302Current portion of long-term debt 2,150 11.0 2,387 2,387 2,387 Total current liabilities $ 13,332 NA $ 14,799 $ 14,799 $ 14,799Long-term debt $ 28,750 NA $ 28,750 $ 32,221 $ 32,499Capital lease obligations 1,832 11.0 2,034 2,034 2,034 Total long-term liabilities $ 30,582 NA $ 30,784 $ 34,255 $ 34,533Net assets (equity) $107,364 NA $117,049 $ 116,771 $116,749Total liabilities and net assets $151,278 NA $162,631 $165,824 $166,080

Gapenski’s Understanding Healthcare Financial Management564•Some items marked NA, such as interest expense, are carried over into2019 at their 2018 values. We know that the interest expense in 2019will be larger than in 2018 if Bayside has to borrow additional funds,but we cannot predict the amount of interest increase until the first-pass financial statements have been completed. The remaining incomestatement items marked NA, such as total expenses, are calculated byadding or subtracting other forecasted items.•When the first-pass income statement is completed (column 3 inexhibit 14.4), we see that the projected net income is $9,685,000.Note that an 11 percent increase in net income would be $8,572,000× 1.11 = $9,515,000. The forecasted amount is somewhat greater thanan 11 percent increase because interest expense was held at its 2018level.Let’s turn to the balance sheet. Because we assumed that Bayside was operating at full capacity in 2018, fixed assets as well as current assets must increase if revenues are to increase. More cash will be needed for transactions, receivables will be higher, additional inventory must be stocked, new facilities must be added, and so on.4To construct the first-pass pro forma balance sheet contained in col-umn 3 in exhibit 14.5, we proceed as follows:•All balance sheet accounts that are expected to increase with revenuesare forecasted in the same way as in the income statement. Forexample, consider the cash account. The 2019 forecast is created bymultiplying the 2018 value by the growth rate, so $2,263,000 × 1.11= $2,512,000, which is shown in column 3 of exhibit 14.5.•The forecasted 2019 depreciation expense from the income statementis added to the 2018 accumulated depreciation account on thebalance sheet to obtain the 2019 accumulated depreciation forecast:$4,584,000 + $25,160,000 = $29,744,000.•The long-term debt value initially is held at its 2018 value—$28,750,000. However, as explained in the next section, we assumethat any external financing required in 2019 will be obtained by issuingmore long-term debt. Alternatively, any excess funds generated wouldbe used to retire long-term debt. In effect, long-term debt is the“plug” variable in this illustration. It will be adjusted in the second andthird passes to make the balance sheet balance.•To forecast the equity amount, add the net income projected for 2019,all of which must be retained in the business, to the 2018 balance sheetequity amount: $9,685,000 + $107,364,000 = $117,049,000.

Chapter 14: Financial Forecasting565Finally, fill in the missing values in column 3 by adding or subtracting as necessary.The projected 2019 asset accounts sum to $166,102,000. This sum is less than an 11 percent increase because accumulated depreciation, which is a contra (negative) asset account, increased by about 18 percent. Thus, to support a revenue increase of 11 percent, Bayside must increase its assets from $151,278,000 to $166,102,000. The projected liability and equity accounts sum to $162,631,000. Again, this sum is less than an 11 percent increase because (1) long-term debt was held at its 2018 level and (2) the equity account increased by less than 11 percent.At this point, the balance sheet does not balance: Assets total $166,102,000, while only $162,631,000 of liabilities and equity is projected. Thus, we have a shortfall, or external financing requirement, of $3,471,000. This amount will have to be raised externally by bank borrowings and sell-ing securities. The organization could also change operating variables—such as charges (revenues) or expenses—to generate more net income and hence more retained earnings.The External Financing PlanAssuming no change in operating variables, Bayside can use short-term notes payable, long-term debt, increased solicitations (contributions), or a combination of these sources to make up the $3,471,000 shortfall. Ordinar-ily, Bayside would base this choice on its target capital structure, the rela-tive costs of different types of securities, maturity matching considerations, its ability to increase contributions above the forecasted level, and so on. The decision as to how this shortfall will be financed is called the external financing plan.Our simplistic forecast assumes that Bayside will raise the required external funds by issuing additional long-term debt. Because Bayside is financing permanent assets, its use of long-term debt to meet external financing needs indicates that it is taking the matching approach to its debt maturity structure (see chapter 10). However, the use of additional debt capital will change the first approximation income statement for 2019 as set forth in column 3 of exhibit 14.4 because more debt will lead to higher interest expense. Bayside’s managers are forecasting that new long-term debt will carry an interest rate of 8 percent. Thus, $3,471,000 of new long-term debt will increase the interest expense projected for 2019 by 0.08 × $3,471,000 = $278,000.The projected income statement and balance sheet, including financ-ing feedback effects, are shown in column 4 (second pass) of exhibits 14.4 and 14.5. We see that although $3,471,000 was added to Bayside’s liabilities,

Gapenski’s Understanding Healthcare Financial Management566the hospital is still $166,102,000 − $165,824,000 = $278,000 short in meet-ing its external financing requirement. This new, but much smaller, shortfall is a result of the added interest expense; $278,000 of new interest expense decreases net income by a like amount. Hence, the equity balance falls to $117,049,000 − $278,000 = $116,771,000.The process can be repeated yet again by adding an additional $278,000 of external (long-term debt) financing to create a third-pass income statement and balance sheet. As shown in column 5 (third pass) of exhibits 14.4 and 14.5, the projected equity balance would be further reduced by additional interest requirements, but the balance sheet would be closer to being in balance because more long-term debt would be added to the liabilities side. Successive iterations would continue to reduce the discrepancy. If the budget process were computerized, an exact solu-tion could be quickly reached. Even if the process is stopped after just a few iterations, the projected statements would generally be very close to being in balance. They would certainly be close enough for practical pur-poses, given the large element of uncertainty inherent in the projections themselves.The base case pro forma financial statements, along with the cor-responding financial condition analysis discussed in chapter 13, are then reviewed by Bayside’s executive committee for consistency with the hospi-tal’s financial objectives. Generally, the committee will make changes to the initial assumptions that will result in a new set of pro forma financial state-ments, which are then analyzed and reviewed until the forecast is finalized.The forecasting process undertaken by Ann Arbor Health Care, a for-profit hospital, is similar to that performed by Bayside. The only real difference is that a for-profit business uses stock rather than fund financing. This fact presents three complications. First, Ann Arbor may pay dividends, so net income must be reduced by the forecasted dividend payment to find the amount of capital that is retained in the firm and, hence, flows to the balance sheet. Second, Ann Arbor has the option of issuing common stock to meet its external financing needs. Third, the financing feedback effect must be expanded to include the additional dividend payments, if required, on any new common stock issued.Finally, note that forecasted financial statements must be checked for internal consistency; that is, accumulated depreciation on the balance sheet must be consistent with the depreciation expense shown on the income statement, and the equity reported on the balance sheet must be consistent with the retentions shown on the income statement. It is imperative that pro forma statements recognize the dependencies between the income statement items and balance sheet accounts.

Chapter 14: Financial Forecasting5671.Briefly describe the mechanics of the constant growth forecastingmethod.2.Why is the external financing plan so important in the planningprocess?3.Do you think most healthcare businesses use the constant growthmethod to develop pro forma financial statements, or do you thinkthey use some other methodology?SELF-TEST QUESTIONSFactors That Influence the External Financing RequirementThe external financing requirement is one of the key pieces of information gleaned from the forecasted financial statements. If the business is unable to fund this requirement, it must alter its plans for the future. The six factors that have the greatest influence on the external financing requirement are (1)projected revenue growth rate, (2)capacity utilization, (3) capital intensity,(4)profitability, (5) dividend policy (forinvestor-owned businesses), and (6) abilityto attract contribution capital (for not-for-profit firms). In this section, we discusseach of these factors in detail.The faster Bayside’s revenues are forecasted to grow, the greater the exter-nal financing need. The reasoning here is that increases in revenues normally require increases in assets because growing rev-enues typically imply growing volumes or inflationary pressures. If revenues are not projected to grow, no new assets will be needed, but any projected asset increases require financing of some type. Some of the required financing will come from spontaneously generated liabilities, such as accruals. Also, assuming a positive profit margin (and for investor-owned firms, a payout ratio of less than 100 percent), the firm will generate some retained earnings.Sustainable Growth RateThe maximum growth rate that a business can sustain without requiring external financing is called the sustainable growth rate. In Bayside’s case, this rate is 8.6 percent, which we estimated using a spreadsheet forecasting model by find-ing the revenue growth rate that Bayside could achieve with no external financing. At growth rates of 8.6 percent or less, Bayside will need no external financing; all required funds can be obtained by spontaneous increases in current liability accounts plus retained earnings, and the hospital will even generate surplus capital. How-ever, if Bayside’s projected revenue growth rate is 8.7 percent or greater, it must seek outside financ-ing, and the greater the projected growth rate, the greater its external financing requirement will be. Although there are formulas that can be used to estimate the sustainable growth rate, it is easier (and potentially more accurate) to use the finan-cial forecasting model for this purpose.

Gapenski’s Understanding Healthcare Financial Management568If the revenue growth rate is low enough, spontaneously generated funds plus retained earnings will be sufficient to support the asset growth. However, if the growth rate exceeds a certain level, external financing will be needed. If management foresees difficulties in raising this capital—perhaps because it has no more debt capacity—then the feasibility of the firm’s expan-sion plans may have to be reconsidered.Capacity UtilizationIn determining Bayside’s external financing requirement for 2019, we assumed that the hospital’s fixed assets were being fully used. Thus, any sig-nificant increase in revenues would require an increase in fixed assets. What would happen if Bayside had been operating its fixed assets at less than full capacity? Assume that Bayside’s managers consider 90 percent occupancy to be full capacity. Because the hospital had 57.9 percent occupancy in 2018, it was operating at 57.9 ÷ 90 = 64% of capacity. Under this condition, fixed assets could remain constant until revenues reach the level at which fixed assets are being fully used. This level is defined as capacity sales and is calcu-lated as follows:Key Equation 14.1: Capacity Sales==Utilizationrate(%ofcapacity)ActualrevenueCapacitysales,soCapacitysalesActualrevenueUtilizationrate.Because Bayside had been operating at 64 percent of capacity, its capacity sales without any new fixed assets would be $112,050,000 ÷ 0.64 = $175,078,125. In reality, Bayside can easily increase its operating revenue to $124,376,000 with no increase in fixed assets. Thus, its external financing requirement would decrease by $161,125,000 − $145,158,000 = $15,967,000 (the projected increase in gross property and equipment), and when Bayside’s actual utilization rate is considered, its forecast would show surplus capital in 2019.Capital IntensityThe amount of assets required per dollar of sales (total assets/sales) is often called the capital intensity ratio, which is the reciprocal of the

Chapter 14: Financial Forecasting569total-asset-turnover ratio. Capital intensity has a major effect on the amount of external capital required to support any level of sales growth. If the capital intensity ratio is low, such as for home health care businesses, revenues can grow rapidly without using much outside capital. However, if the firm is capital intensive, such as a hospital, even a small growth in volume might require a great deal of outside capital if the firm is operating at full capacity.ProfitabilityProfitability is also an important determinant of external financing require-ments—the higher the profit margin, the lower the external financing requirement, other factors held constant. Bayside’s profit (total) margin in 2018 was 7.5 percent. Suppose its profit margin increased to 10 percent through higher reimbursements and better expense control. This increase would cause net income—and hence retained earnings—to increase, which in turn would decrease Bayside’s need for external financing.Dividend PolicyFor investor-owned firms, dividend policy also affects external capital requirements. If Ann Arbor foresees difficulties in raising external capital when it forecasts its 2019 financial statements, it might want to consider a reduction in its dividend payout ratio. However, before making this decision, management should consider the possible negative effects of a dividend cut on stock price.Ability to Attract Contribution CapitalOne of the major sources of equity financing for not-for-profit businesses is contribution capital. Unrestricted contributions are listed as revenues on the income statement in the year they become available for use in the organization; hence, they increase forecasted equity and decrease the need for external financing. Clearly, organizations that are able to raise large amounts of charitable contributions are able to grow without using as much external debt financing as organizations that obtain few contribu-tions. For this reason, many organizations operate an affiliated foundation, whose sole purpose is to raise funds for the organization through events and funding campaigns. Note that the earnings on some restricted contri-butions (endowments) typically are also available to help fund a business’s asset growth.

Gapenski’s Understanding Healthcare Financial Management5701.How do the following factors affect the external financingrequirement?a.Projected revenue growth rateb.Capacity utilizationc.Capital intensityd.Profitabilitye.Dividend policy (for investor-owned firms)f.Ability to attract contribution capital (for not-for-profit firms)SELF-TEST QUESTIONProblems with the Constant Growth MethodFor the constant growth method to produce accurate forecasts, each item and account that is assumed to grow with revenues must increase at the same rate as revenues. Unfortunately, such a situation rarely exists. Here are some of the problems with the constant growth approach that are encountered in real-world forecasting.Price-Driven Revenue GrowthEarlier we emphasized that revenue growth can occur as a result of volume or pricing (reimbursement) changes. If revenue growth occurs solely as a result of reimbursement rate changes that were not caused by inflation, there will be no direct impact on some income statement items (e.g., labor expenses) or on some balance sheet items (e.g., inventories, payables, fixed asset require-ments). Because the constant growth method ties most items and accounts directly to dollar revenues, it can produce misleading forecasts when non-inflationary reimbursement rate changes—rather than volume changes—are driving the revenue forecast.Of course, if the reimbursement changes were made because of infla-tion effects, there will likely be an inflationary impact on costs. However, in most cases, the effect of inflation will not be neutral—that is, the impact will differ across items and accounts.Economies of ScaleThere are economies of scale in the use of many kinds of assets, and when they occur, the asset growth rates are less than volume growth rates. For example, healthcare businesses typically need to maintain base stocks of dif-ferent inventory items, even when volume levels are low. As volume expands, so do inventories. But inventories tend to grow less rapidly than volume

Chapter 14: Financial Forecasting571does, so the use of a constant growth rate would overstate the amount of inventory required.Lumpy AssetsIn many industries, practical considerations dictate that a business must add fixed assets in large, discrete units. For example, in the hospital field, it is not economically feasible to add, say, five beds, so when hospitals expand capac-ity, they typically do so in relatively large increments. When capacity volume is reached, even a small increase in volume would require a hospital to signifi-cantly increase its fixed assets, so a small projected volume increase can bring with it a very large increase in fixed asset requirements.Suboptimal RelationshipsAll of the asset projections in a forecast should be based on target, or optimal, relationships between revenues and assets, not on the relationships that actu-ally exist. For example, in 2018 Bayside had $3,177,000 in inventories. Our constant growth forecast projected inventories of $3,526,000 in 2015. The projection assumed that the current inventory level was optimal for the actual revenues realized. However, if the 2018 inventory level was suboptimal—say, too large—it might be possible to grow revenues by 11 percent with no increase in inventories. Conversely, if the inventory level was too small in 2018, the actual level of inventories required in 2019 would be greater than the forecast.If any of the problems noted here are encountered in practice (and many of them are), the simple constant growth method should not be used. Rather, other techniques must be used to forecast asset and liability levels and the resulting external financing requirement. Some of these methods are discussed in the following section.1.Describe several conditions under which the constant growthmethod can produce questionable results.2.Do these conditions often exist in real-world forecasting?SELF-TEST QUESTIONSReal-World ForecastingWe have emphasized that the constant growth method is not used in actual forecasting situations. The overall approach of first forecasting the firm’s income statement, then its balance sheet, then its external financing require-ment, and so on, is used, but techniques other than constant growth are used

Gapenski’s Understanding Healthcare Financial Management572to forecast the specific income statement items and balance sheet accounts. In this section, we discuss four forecasting techniques commonly used in practice: (1) simple linear regression, (2) curvilinear regression, (3) multiple regression, and (4) specific item forecasting.Simple Linear RegressionSimple linear regression often is used to estimate asset requirements. For example, consider Bayside’s inventories and total operating revenue over the past five years and the regression plot shown in exhibit 14.6. The estimated regression equation, as found using a spreadsheet, is as follows (in thousands of dollars):Inventories = $1,372 + (0.0160 × Total operating revenue).The plotted points are close to the regression line. In fact, the correla-tion coefficient between inventories and sales is +0.99, which indicates that there is a strong linear relationship between these two variables. Why might this be the case for Bayside? According to the economic ordering quantity (EOQ) model (discussed in chapter 15), inventories should increase with the square root of revenues, which will cause the regression to be nonlinear (the true regression line would rise at a decreasing rate). However, Bayside has greatly expanded its number of service lines over the past decade, and the base stocks associated with these new services have caused inventories to increase. Also, inflation has had a similar impact on revenues and inventory levels. These three influences—(1) economies of scale in existing services, (2) base stocks for new services, and (3) inflationary effects—offset each other, and the result is the observed linear relationship between inventories and sales.We can use the estimated relationship between inventories and rev-enues to forecast the 2015 inventory level. Because 2015 total operating rev-enue is projected at $124,376,000, 2015 inventories should be $3,362,000:Inventories= $1,372 + (0.0160 × $124,376)= $1,372 + $1,990= $3,362.This forecast is $3,526,000 − $3,362,000 = $164,000 less than our earlier forecast based on the constant growth method. The difference occurs because the constant growth method assumes that the ratio of inventories to revenues remains constant—or, in other words, the regression line passes

Chapter 14: Financial Forecasting573through the origin. However, as seen in exhibit 14.6, the ratio actually declines because the inventory regression line does not pass through the origin.We can run linear regressions on all the items on the income statement and all the accounts on the balance sheet that need to be forecasted to deter-mine items and accounts that produce a high correlation (i.e., have a strong linear relationship) and therefore may be forecasted using this technique. Then, we can use these relationships in exhibits 14.4 and 14.5 in place of the Inventories($)Total OperatingRevenue ($)EXHIBIT 14.6 Bayside Memorial Hospital: Linear Regression on Inventories (in thousands of dollars)Note: Table values were calculated on a spreadsheet; rounding differences will occur if a calcu-lator is used.Year Total Operating Revenue Inventories2014 $86,477 $2,7522015 90,568 2,8382016 95,351 2,8962017 102,015 2,9812018 112,050 3,177Inventories = $1,372 + (0.0160 × Total operating revenue).

Gapenski’s Understanding Healthcare Financial Management574constant growth rates to create new pro forma financial statements based on linear regressions.Curvilinear RegressionSimple linear regression is based on the assumption that a straight-line rela-tionship exists between a particular variable and revenues, or some other vari-able. Although linear relationships between financial statement variables and revenue frequently do exist, these relationships often assume other forms. For example, if the EOQ relationship had dominated the inventory–revenue relationship, the correct plot of inventory versus revenue would be a concave curve rather than the straight line shown in exhibit 14.6. If we forecasted the inventory level needed to support revenue growth using a linear relationship, our forecast would be too high.In their databases, healthcare businesses have historical data in the aggregate and by division, service line, and so on. They also have or can eas-ily obtain certain types of data for other firms in the sector. These data can be analyzed using software based on advanced statistical techniques (1) to determine whether a relationship is curvilinear or linear and (2) to estimate the curvilinear relationship, should one exist. Once the best-fit relationship has been estimated, it can be used to project future levels of items such as inventories, given the revenue forecast. Often, a plot of the data will sug-gest a nonlinear relationship. The data—inventories in this case—can then be converted to logarithms if the regression points appear to slope down-ward or raised to a power if the slope of the points seems to be increasing. The graphics capabilities of spreadsheets can be used to identify nonlinear relationships.Multiple RegressionIf the relationship between a variable (such as inventories) and revenues is such that the individual points are widely scattered about the regression line (i.e., the correlation coefficient is low) but a curvilinear relationship does not appear to exist, there is a good chance that factors in addition to revenue affect the level of that variable. For example, inventory levels might be a func-tion of both revenue level and the number of different services offered (or products sold). In this case, we would obtain the best forecast for inventory level by using multiple regression techniques to regress inventories against both revenue and the number of services offered. The projected inventories would then be based on forecasts of number of services in addition to total revenue. Most computer installations now have complete regression software packages that make multiple and curvilinear regression techniques easy to

Chapter 14: Financial Forecasting575apply. Many spreadsheet programs can perform multiple regression analysis as well.Specific Item ForecastingAnother technique often most useful in practice is to develop a specific model for each income statement item and balance sheet account that must be forecasted. For example, salaries can be projected using payroll records and expected salary increases, receivables can be forecasted by using the pay-ments pattern approach, gross fixed assets can be forecasted on the basis of the firm’s capital budget, and depreciation can be forecasted on the basis of the firm’s aggregate depreciation schedule. (We discuss the payments pattern approach to receivables management in chapter 15.) Of course, projected volume typically remains an important element behind each of these specific item forecasts.Specific item forecasting is especially useful when revenues and costs are affected by different forces and hence are expected to grow at different rates. In today’s healthcare environment, this is probably the rule rather than the exception.Comparison of Forecasting MethodsThe constant growth method assumes that most financial statement variables are directly related to revenue. It is the easiest approach to use, but its fore-casts are often of questionable value. Simple linear regression differs from the constant growth method in that regression does not assume a constant relationship to revenue. Use of this technique can improve the forecasts of many financial statement variables. Note, too, that curvilinear and multiple regression techniques can provide especially accurate forecasts when relation-ships either (1) are not linear or (2) depend on other variables in addition to sales. Finally, specific item forecasting based on other decision models related to a specific line item can be used.As we move down the list of forecasting methods, accuracy may or may not increase, but the costs of creating the forecasts are sure to increase. The need to employ more complicated, and consequently more costly, methods varies from situation to situation. As in all situations, the costs of using more refined techniques must be balanced against the benefits obtained. Unfor-tunately, there is no assurance that the use of more sophisticated forecasting methods will produce better forecasts. Furthermore, more complicated fore-casting methods often hide the assumptions inherent in the forecast. As with much of healthcare financial management, judgment and common sense are necessities in this process.

Gapenski’s Understanding Healthcare Financial Management5761.Identify several techniques that can be used instead of constantgrowth forecasting.2.Which techniques do you think produce the most accurate forecasts?Which techniques do you think are the most costly to use?SELF-TEST QUESTIONSUse of Financial Forecasting Models in PracticeIn practice, almost all healthcare businesses use some type of financial fore-casting model. Such models are used to show the effects of different volume and reimbursement rates, different relationships between volume and oper-ating assets, and even different assumptions about reimbursement rates and input costs (e.g., labor, materials). Plans are then made regarding fulfillment of any projected external financing requirements—through short-term bank loans; selling long-term bonds; or, in the case of investor-owned firms, sell-ing new common stock. Pro forma balance sheets, income statements, and statements of cash flows are generated under the different financing plans, and key risk/return ratios (e.g., current ratio, debt-to-assets assets ratio, times-interest-earned ratio, return on assets, return on equity) are calculated.Depending on how these projections look, management may need to modify the initial forecast assumptions. For example, management might conclude that the projected volume growth rate must be cut because external financing requirements exceed the firm’s ability to raise money, or manage-ment might decide to raise more funds internally, if possible. Alternatively, the firm might investigate service processes that require fewer fixed assets, or it might consider the possibility of contracting out some services rather than offering them in-house.The most important benefit of a financial forecasting model is the ability to estimate the effects of changing both basic assumptions and specific financial policies. The forecasting process can be repeated over and over, each time creating a new scenario that changes one or more of the basic operating assumptions inherent in the model. For example, what if there is a significant reduction in Medicare reimbursement rates? What if a large managed care contract is lost to a competitor? What if nurses strike during the coming year? What if a competitor opens a new outpatient surgery center? Changes in basic assumptions about Medicare reimbursement, labor costs, or competi-tors’ actions have a significant effect on volume, reimbursement rates, cost relationships, profit margins, and so on. Using a forecasting model, manag-ers can quickly develop forecasts to match numerous scenarios, although the

Chapter 14: Financial Forecasting577forecasts are only as good as the managers’ ability to predict the impact of each scenario on key forecasting parameters.Managers can also use forecasting models to assess the impact of changes to financial variables, such as changing the source of external financ-ing or interest rate forecasts. This ability is a powerful tool in preparing for the future. Unfortunately, the analysis can encompass many combinations of operating assumptions and financial policies, so a large number of different sets of pro forma financial statements can easily be created. As a result, a great deal of managerial insight is required to evaluate the alternative fore-cast results.One way to reduce the number of possible scenarios is to perform a sensitivity analysis to determine the effect of each assumption; assump-tions that have little effect on the key financial condition ratios need not be changed from their base case levels. Another approach to reducing the number of scenarios is to perform a Monte Carlo simulation analysis. For example, instead of specifying volume, reimbursement levels, labor costs, and so on at discrete levels, probability distributions can be specified. The key results would then be presented as distributions rather than point estimates.51.Why do computerized forecasting models play such an importantrole in corporate management?SELF-TEST QUESTIONFinancial ControlsFinancial forecasting and planning are vital to corporate success, but planning is for naught unless the business has a control system that both (1) ensures implementation of the planned policies and (2) provides timely informa-tion that permits operational adjustments if the assumed market conditions change. In a financial control system, the key question is not “how is the firm doing in 2019 compared to 2018?” Rather, it is “how is the firm doing in 2019 in comparison to the forecasts, and if results differ from those expected, what can we do to get back on track?”The basic tools of financial control are budgets and forecasted finan-cial statements. These documents set forth expected performance; hence, they express management’s targets. These targets are compared to actual corporate performance—on a daily, weekly, or monthly basis—to determine the variances, which in this context are the differences between realized values and target values. Thus, the control system identifies areas in which

Gapenski’s Understanding Healthcare Financial Management578performance is not meeting target levels. If a business’s actual results are better than its targets, we might conclude that its managers are doing a great job, but it could also mean that the targets were set too low and, thus, should be raised in the future. Conversely, failure to meet the financial tar-gets could mean that market conditions are changing, that some managers are not performing up to par, or that the targets were set initially at unreal-istic, unattainable levels. In any event, some action should be taken, and, if the situation is deteriorating rapidly, taken quickly. By focusing on variances, managers can “manage by exception,” concentrating on operations most in need of improvement.Entire textbooks have been written on financial controls. Here, we want to emphasize that financial controls are as critical to financial perfor-mance as are financial planning and forecasting. Also note that financial control systems are not costless. Thus, control system costs must be balanced against the savings the system aims to produce.1.What are the purposes of a financial control system?2.What basic financial control tools do businesses use, and how dothey work?SELF-TEST QUESTIONSChapter Key ConceptsThis chapter describes how firms forecast their financial statements and estimate their future financing requirements. Here are its key concepts:•The primary planning documents are strategic plans, operatingplans, and financial plans.•Financial forecasting generally begins with a forecast of the firm’srevenues, in terms of both volume and reimbursement rates, forsome future period.•Pro forma, or projected, financial statements are developed toestimate a business’s future financial condition and externalfinancing requirements.•The constant growth method of forecasting financial statementsis based on the assumptions that (1) most income statementitems and balance sheet accounts vary directly with revenues(continued)

Chapter 14: Financial Forecasting579and (2) the business’s income statement items and balance sheet accounts are optimal for its current level of revenues.•A business can determine its external financing requirementby estimating the amount of assets necessary to support theforecasted level of revenues and then subtracting from thatamount the forecasted total claims. The business can then planto raise the necessary funds through bank borrowing, by issuingsecurities, or both.•Additional external capital means additional interest anddividends, which lowers the amount of forecasted retainedearnings. Thus, raising external funds creates a financing feedbackeffect that must be incorporated into the forecasting process.•Six factors have the greatest impact on the external financingrequirement:1.The higher a firm’s projected revenue growth rate, the greaterits need for external financing.2.The greater the capacity utilization, the greater theorganization’s need for external financing.3.The greater the capital intensity, the greater the need forexternal capital.4.The higher the profitability, the lower the need for externalcapital.5.The larger a for-profit business’s dividend policy, the greaterits need for external funds.6.Finally, the greater a not-for-profit firm’s ability to attractcontribution capital, the smaller its need for external capital.•The constant growth method typically is inadequate to dealwith real-world situations such as price-driven revenue growth,economies of scale, lumpy assets, and suboptimal relationships.•Simple linear regression, curvilinear regression, multiple regression,and specific item forecasting techniques can be used to forecast assetrequirements when the constant growth method is not appropriate.•Businesses use financial planning models to forecast theirfinancial statements and external financing needs.•Financial controls should be an integral part of a firm’s planningsystem.(continued)(continued from previous page)

Gapenski’s Understanding Healthcare Financial Management580Chapter Models, Problems, and MinicasesThe following ancillary resources in spreadsheet format are available for this chapter:•A chapter model that shows how to perform many of the calculationsdescribed in the chapter•Problems that test your ability to perform the calculations•A minicase that is more complicated than the problems and tests yourability to perform the calculations in preparation for a caseThese resources can be accessed online at ache.org/HAP/PinkSong8e.Selected CaseOne case in Cases in Healthcare Finance, sixth edition, is applicable to this chapter: case 25: River Community Hospital (B), which focuses on the cre-ation of pro forma financial statements in a hospital setting. (This case is best used as a follow-up to case 1, which is a financial statement analysis of the same hospital.)Selected BibliographyHill, L. E. 2016. “Pioneering a Rolling Forecast.” Healthcare Financial Management 70 (11): 58–62.The type of forecasting described in this chapter is important for several reasons. First, if the projected operating results are unsatisfac-tory, management can go back to the drawing board, reformulate its plans, and develop more reasonable targets for the coming year. Sec-ond, it is possible that the funds required to meet the forecast simply cannot be obtained; if so, it is better to know this in advance and to scale back the projected level of operations than to suddenly run out of cash and have operations grind to a halt. Third, even if the required funds can be raised, it is desirable to plan for their acquisition well in advance.(continued from previous page)

Chapter 14: Financial Forecasting581Kolman, C. M. 2017. “Transforming Healthcare Analytics to Manage Costs.” Healthcare Financial Management 71 (6): 28–33.Moore, K. D., and D. Coddington. 2016. “Integrating Health Care’s Many Levels of Thinking.” Healthcare Financial Management 70 (10): 80–81.Skinner, J., R. Higbea, D. Buer, and C. Horvath. 2018. “Using Predictive Analytics to Align ED Staffing Resources with Patient Demand.” Healthcare Financial Management 72 (2): 56–61.Selected WebsitesThe following websites pertain to the content of this chapter: •For information on the Institute of Business Forecasting & Planning(IBF), see www.ibf.org.•For a great deal of valuable information on forecasting, see www.forecastingprinciples.com.Notes1.Many businesses have one or two statements that complement themission statement. A vision statement focuses on what the businessaspires to be, rather than on what it is today. A values statement liststhe core priorities that define the organization’s culture.2.In a log-linear regression, the operating revenue amounts areconverted to natural logarithms and regressed against time. The slopecoefficient of the regression line, which is 0.0669 = 6.69% in thiscase, is the continuous growth rate over the five-year period. Thecontinuous growth rate is converted to a compound annual growthrate as follows:e0.0669 − 1 ≈ 6.9%.3.This assumption does not imply that Bayside’s 2019 occupancy ratewas 100 percent. A hospital is operating at full capacity when itsaverage occupancy is somewhere between 80 percent and 90 percent.A few times during the year, a hospital may operate at 100 percentcapacity, but most hospital managers prefer to maintain a reservecapacity to meet emergency situations.4.Some assets, such as short-term investments, are not tied directlyto operations and hence would not vary directly with revenues. In

Gapenski’s Understanding Healthcare Financial Management582fact, Bayside can reduce its short-term investments to zero, thereby reducing any external financing requirements. However, the naive methodology applied here assumes that most balance sheet accounts would automatically increase with revenues.5.This is a good time to mention the basic axiom of computer modeling:GIGO (which means “garbage in, garbage out”). Stated another way,the output of a financial model is no better than the assumptions andinputs used to construct it, so when you build models, proceed withcaution. Note, though, that one advantage of computer modelingis that it brings the key assumptions out into the open, where theirrealism can be examined. One strong advocate of models made thisstatement: “Critics of our models generally attack our assumptions,but they forget that, in their own forecasts, they simply assume theanswer.”

Chapter 14: Financial Forecasting583Integrative ApplicationThe ProblemChapel Hill Orthopedics (CHO) is a large for-profit group practice that specializes in treating sports injuries. Here are its latest financial statements:2018 Income Statement (in thousands of dollars)Revenues$18,000Operating costs 15,263 EBIT$ 2,737Interest 1,017 EBT$ 1,720Taxes (30%)516Net income$ 1,204Dividends (60%)$ 722Addition to retained earnings$ 482EBIT: earnings before interest and taxes; EBT: earnings before taxes2018 Balance Sheet (in thousands of dollars)Cash$ 1,800Accounts payable$ 5,200Receivables5,400Notes payable1,400Inventories 8,600Accruals 800Total current assets$ 15,800Total current liabilities$ 7,400Net fixed assets 10,600Long-term debt5,000Common stock2,000Retained earnings 12,000Total assets$26,400Total liabilities and equity$26,400The best revenue growth estimate for 2019 is 10 percent. Also, any exter-nal financing required will be obtained by adding new short-term debt (notes payable) having an interest rate of 8 percent. Fixed assets (property and equip-ment) are being used at 80 percent of capacity. CHO’s managers must now forecast its financial statements for 2019 to estimate the practice’s external financing requirement. It has a line of credit with a local bank that is capped at

Gapenski’s Understanding Healthcare Financial Management584$2,000,000, of which CHO has already used $1,400,000. The primary purpose of the forecast is to determine whether the credit line is adequate for 2019. Will the practice have to seek additional financing sources?The AnalysisFirst, note that Capacity sales (revenues) = 2018 revenue ÷ Utilization rate = $18,000,000 ÷ 0.80 = $22,500,000. Because growth is expected to be 10 per-cent, 2019 revenues = $18,000,000 × 1.10 = $19,800,000, which is far less than capacity sales of $22,500,000. Thus, CHO can attain the new revenue level with-out the requirement for additional property and equipment (net fixed assets).Forecasted Income Statement for 2019 (in thousands of dollars)2018Growth %1st Pass2nd Pass3rd PassRevenues$18,00010%$19,800$19,800$19,800Operating costs15,26310%16,78916,78916,789 EBIT$ 2,737Interest 1,017NA 1,017 1,051 1,051 EBT$ 1,720$ 1,994$ 1,960$ 1,959Taxes (30%) 516 598 588 588Net income$ 1,204$ 1,396$ 1,372$ 1,371Dividends (60%)$ 722$ 837$ 823$ 822Addition to RE$ 482$ 558$ 549$ 549EBIT: earnings before interest and taxes; EBT: earnings before taxes; RE: retained earnings

Chapter 14: Financial Forecasting585Forecasted Balance Sheet for 2019(in thousands of dollars)2018Growth (%)1st Pass2nd Pass3rd PassCash$ 1,80010$ 1,980$ 1,980$ 1,980Receivables5,400105,9405,9405,940Inventories8,600109,4609,4609,460 Total current assets$ 15,800$ 17,380$ 17,380$ 17,380Net fixed assets10,600NA 10,600 10,600 10,600Total assets$26,400$27,980$27,980$27,980Accounts payable$ 5,20010$ 5,720$ 5,720$ 5,720Notes payable1,400NA1,4001,8221,831Accruals 80010 880 880 880 Total current liabilities$ 7,400$ 8,000$ 8,422$ 8,431Long-term debt5,000NA5,0005,0005,000Common stock2,000NA2,0002,0002,000Retained earnings 12,000 12,558 12,549 12,549Total liabilities and equity$26,400$27,558$ 27,971$27,980External financing requirement$422$9$0Added interest expense$34$1$0Note the following points:1.We know that the interest expense in 2019 will be larger than in 2018 ifCHO has to borrow additional funds, but we cannot predict the amount ofincrease until the first pass is completed.2.Because any financing required is borrowed as notes payable at an interestrate of 8 percent, notes payable is the “plug” variable that will be adjustedin the second and third passes to make the balance sheet balance.3.Long-term debt and common stock remain at their 2018 levels becausethose financing sources will not be used to obtain any needed capital.4.After the first-pass forecast, interest expense is $1,017 from 2018; notespayable is $1,400 from 2018; retained earnings is $12,000 plus additions

Gapenski’s Understanding Healthcare Financial Management586of $558 for a total of $12,558; and the external financing requirement is total assets of $27,980 minus total liabilities and equity of $27,558, which amounts to $422. Finally, $422 in added short-term debt (notes pay-able) having an 8 percent interest rate will result in $422 × 0.08 = $34 in added interest in the second pass. (Note that the solution was created on a spreadsheet that carries calculations to 15 significant digits, so rounding differences occur in the solution data presented here.)5.After the second pass, interest expense is $1,017 from the first pass plusadded interest expense of $34 from the new notes payable, for a total of$1,051. This added expense reduces the net income by $24 and the addi-tion to retained earnings by $9, which adds that amount to the externalfinancing requirement, thus requiring additional notes payable and interestexpense.6.After the third pass, total assets equal total liabilities and equity and theexternal financing requirement is zero.The DecisionThe forecast for 2019 predicts a total external financing requirement of $422,000 +$9,000 = $431,000, which increases the notes payable amount to $1,400,000+$431,000 = $1,831,000. Because the current line of credit is capped at$2,000,000, it appears that it will be sufficient for 2019. However, note that,like all forecasts, there is uncertainty in the results—perhaps a great deal ofuncertainty. Thus, CHO’s managers decided to renegotiate the line of credit witha $2,500,000 maximum to ensure that funds will be available in the event theactual need for external financing exceeds the forecast amou

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