Differentiate full-cost pricing from marginal cost pricing.

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

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

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

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

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

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

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

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

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

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

Gapenski’s Fundamentals 0f Healthcare Finance128visit. Total revenues are plotted in exhibit 5.2 as an upward-sloping solid line starting at the origin and having a slope of $100 per visit. If no visits occurred, total revenues would be zero; at 1 visit, total revenues would be $100; at 10 visits, total revenues would be $1,000; at 75,000 visits, total revenues would be $7,500,000; and so on. Note that the vertical dashed line is drawn at the point where total revenues equal total costs and the vertical dotted line is drawn at the base case volume estimate, 75,000 visits. We examine the significance of these two vertical lines in later sections.THE PROjECTED PROFIT AND LOSS STATEMENTTo begin the profit analysis, Atlanta Clinic’s managers forecast profit given the base case assumptions on costs, volume, and prices. Such a forecast is called a profit and loss (P&L) stat

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