Q1. Marshall Healthcare System, a non-taxpaying entity, is planning to purchase imaging
equipment, including an MRI equipment, for its new imaging center. This equipment is expecting to generate the following cash flows.
Determine the payback for the new MRI machine and should the project be accepted or rejected? Explain
(2.5 Marks)
| Years 0 1 2 3 4 5 |
| Initial ($ 15,000,000)
Investment Net operating cash flows $2,000,000 $4,000,000, $5,000,000 $8,000,000 $16,000,000 |
Q2. Compare the Strengths and Weakness of Pay back method and NPV ( Net Present Value).
Instructions:
Format the assignment according to APA reference
Financial Management of Health Care Organizations
To our families, for their love and patience
To our students and colleagues for their invaluable insights and
feedback.
Financial Management of
Health Care Organizations
An Introduction to Fundamental Tools, Concepts, and
Applications
S e c o n d E d i t i o n
William N. Zelman
University of North Carolina, Chapel Hill
Michael J. McCue
Virginia Commonwealth University
Alan R. Millikan
Duke University Health System
Noah D. Glick
Integrated Healthcare Information Services, Inc.
© 2003 by William N. Zelman, Michael J. McCue, Alan R. Millikan, and Noah D. Glick
BLACKWELL PUBLISHING
350 Main Street, Malden, MA 02148-5020, USA
108 Cowley Road, Oxford OX4 1JF, UK
550 Swanston Street, Carlton, Victoria 3053, Australia
The right of William N. Zelman, Michael J. McCue, Alan R. Millikan, and Noah D. Glick to be
identified as the Authors of this Work has been asserted in accordance with the UK Copyright,
Designs, and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or
otherwise, except as permitted by the UK Copyright, Designs, and Patents Act 1988, without the
prior permission of the publisher.
First published 2003 by Blackwell Publishing Ltd
Reprinted 2004 (twice)
Library of Congress Cataloging-in-Publication Data has been applied for
ISBN 0-631-23098-X (hbk)
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For further information on
Blackwell Publishing visit our website:
www.blackwellpublishing.com
Brief Contents
Preface xvii
Acknowledgments xxii
1 The Context of Health Care Financial Management 1
2 Health Care Financial Statements 20
3 Principles and Practices of Health Care Accounting 75
4 Financial Statement Analysis 103
5 Working Capital Management 155
6 The Time Value of Money 191
7 The Investment Decision 226
8 Capital Financing for Health Care Providers 274
9 Using Cost Information to Make Special Decisions 305
10 Budgeting 345
11 Responsibility Accounting 393
12 Provider Cost Finding Methods 418
13 Provider Payment Systems 444
Glossary 481
Web Links of Interest for Health Care Financial Management 495
Index 500
Contents
Preface xvii
Acknowledgments xxii
1 The Context of Health Care Financial Management 1
Introduction 1
Rising Health Care Costs 3
The Payment System 4
Technology 5
The Aging Population 6
Prescription Drug Costs 7
Chronic Diseases 7
Compliance and Litigation 8
The Uninsured 9
Efforts to Control Costs 10
Efforts by Payors to Control Health Care Costs 10
DRGs 13
Capitation 13
Global Payments 14
APCs 14
Cutting Delivery Costs 14
Shift to Outpatient Services 14
Cost Accounting Systems 15
Information Services Technology 15
Mergers and Acquisitions 16
Reengineering/Redesign 17
Cost Control Issues with Ethical Overtones 17
Summary 17
Key Terms 19
Questions and Problems 19
2 Health Care Financial Statements 20
Introduction 21
The Balance Sheet 23
Assets 26
Current Assets 26
Non-current Assets 29
Liabilities 32
Current Liabilities 32
Non-current Liabilities 34
Net Assets 34
Stockholders’ Equity 35
Notes to Financial Statements 37
The Statement of Operations 37
Unrestricted Revenues, Gains, and Other Support 39
Net Patient Service Revenues 39
Premium Revenues 41
Other Revenues 42
Net Assets Released from Restriction 42
Expenses 43
Depreciation and Amortization 43
Interest 44
Provision for Bad Debts 44
Other Expenses 44
Operating Income 44
Other Income 44
Excess of Revenues over Expenses 45
Below the Line Items 45
Change in Net Unrealized Gains and Losses on Other than Trading Securities 45
Increases in Long-lived Unrestricted Net Assets 46
Transfers to Parent 47
Extraordinary Items 47
Increase in Unrestricted Net Assets 47
The Statement of Changes in Net Assets 47
Changes in Unrestricted Net Assets 48
Changes in Temporarily Restricted Net Assets 48
Changes in Permanently Restricted Net Assets 49
The Statement of Cash Flows 49
Cash Flows from Operating Activities 50
Cash Flows from Investing Activities 52
Cash Flows from Financing Activities 52
Cash and Cash Equivalents at the End of the Year 52
Summary 54
Key Terms 55
Key Equations 55
viii Contents
Questions and Problems 56
Appendix A: Illustrative Set of Financial Statements for Sample Not-For-Profit
Hospital and For-Profit Hospital and Notes to Financial Statements 64
3 Principles and Practices of Health Care Accounting 75
Introduction 76
The Books 77
The Cash and Accrual Bases of Accounting 77
The Cash Basis of Accounting 78
The Accrual Basis of Accounting 78
An Example of the Effects of Cash Flows on Profit Reporting Under
Cash and Accrual Accounting 78
Recording Transactions 80
Rules for Recording Transactions 82
The Recording Process 84
Developing the Financial Statements 90
The Balance Sheet 90
Assets 90
Liabilities 90
Net Assets 90
The Statement of Operations 90
Unrestricted Revenues, Gains, and Other Support 92
Operating Expenses 92
Operating Income and Excess of Revenues over Expenses 93
Increase in Unrestricted Net Assets 93
The Statement of Changes in Net Assets 93
The Statement of Cash Flows 93
Summary 94
Key Terms 96
Questions and Problems 96
4 Financial Statement Analysis 103
Introduction 104
Horizontal Analysis 108
Trend Analysis 109
Vertical (Common-size) Analysis 110
Ratio Analysis 112
Categories of Ratios 112
Key Points to Consider When Using and Interpreting Ratios 113
Liquidity Ratios 117
Profitability Ratios 123
Activity Ratios 129
Capital Structure Ratios 132
Capital Structure Summary 136
Contents ix
Summary of Newport Hospital’s Ratios 137
Summary 137
Key Terms 140
Key Equations 140
Questions and Problems 142
5 Working Capital Management 155
Introduction 156
The Working Capital Cycle 156
Working Capital Management Strategies 157
Asset Mix Strategy 158
Financing Mix Strategy 158
Cash Management 160
Sources of Temporary Cash 160
Bank Loans 160
Trade Credit/Payables 162
Billing, Collections, and Disbursement Policies, and the Concept of Float 165
Investing Cash on a Short-term Basis 170
Treasury Bills (T-bills) 172
Negotiable Certificates of Deposit (CDs) 172
Commercial Paper 172
Money Market Mutual Funds 172
Forecasting Cash Surpluses and Deficits – The Cash Budget 173
Cash Inflows 173
Cash Outflows 175
Ending Cash Balance 175
Accounts Receivable Management 175
Methods to Monitor Accounts Receivable 176
Methods to Finance Accounts Receivable 178
Factoring 178
Pledging Receivables as Collateral 178
Laws and Regulation for Billing Compliance 179
HIPAA 179
Summary 181
Key Terms 183
Key Equations 183
Questions and Problems 183
6 The Time Value of Money 191
Introduction 192
The Future Value of a Dollar Invested Today 192
Using a Formula to Calculate Future Value 194
Using Tables to Compute Future Value 196
Using a Spreadsheet to Calculate Future Value 197
x Contents
The Present Value of an Amount to Be Received in the Future 197
Using a Formula to Calculate Present Value 198
Using Tables to Compute Present Value 199
Using a Spreadsheet to Calculate Present Value 200
Annuities 200
The Future Value of an Ordinary Annuity 200
Using Tables to Calculate the Future Value of an Ordinary Annuity 201
Using a Spreadsheet to Calculate the Future Value of an Ordinary Annuity 201
The Future Value of an Annuity Due 202
The Present Value of an Ordinary Annuity 203
Using Tables to Calculate the Present Value of an Ordinary Annuity 203
Using a Spreadsheet to Calculate the Present Value of an Ordinary Annuity 204
The Present Value of an Annuity Due 204
Special Situations to Calculate Future or Present Value and Other Excel Functions 205
1. What if the interest rate is not expressed as an annual rate? 205
2. How to compute periodic loan payments using Excel 206
3. How to calculate the compounded growth rate 206
4. How to calculate the present value of perpetual annuities 208
5. How to solve for the interest rate of a loan with fixed loan payments 209
Summary 209
Key Terms 211
Key Equations 211
Questions and Problems 211
Appendix B: Future and Present Value Tables 217
7 The Investment Decision 226
Introduction 227
The Objectives of Capital Investment Analysis 229
Non-financial Benefits 229
Financial Returns 229
Ability to Attract Funds in the Future 230
Analytic Methods 231
The Payback Method 232
Analysis 232
Strengths and Weaknesses of the Payback Method 233
Net Present Value 234
NPV – Using the Small Hospital as an Example of NPV Analysis 235
Decision Rules Regarding NPV 238
Using Spreadsheets to Calculate NPV 238
Strengths and Weaknesses of the NPV Method 239
Internal Rate of Return (IRR) 239
Equal Cash Flows 240
Unequal Cash Flows 240
Decision Rules with IRR 241
Strengths and Weaknesses of IRR Analysis 241
Contents xi
Using an NPV Analysis for a Replacement Decision 241
Illustrative Example 242
Solution 243
Summary 243
Key Terms 248
Key Equation 248
Questions and Problems 248
Appendix C: Technical Concerns Regarding Net Present Value 256
Appendix D: Adjustments for Net Working Capital 259
Appendix E: Tax Implications for For-profits in a Capital Budgeting Decision 261
Appendix F: Comprehensive Capital Budgeting Replacement Cost Example 262
8 Capital Financing for Health Care Providers 274
Introduction 275
Equity Financing 276
Debt Financing 277
Sources of Debt Financing by Maturity 277
Sources of Debt Financing by Type of Interest Rate: Fixed and Variable Interest 279
Selected Types of Health Care Debt Financing 279
Bank Term Loans 279
Conventional Mortgages 280
Pooled Equipment Financing 280
FHA Program Loans 280
Bonds 280
Bond Issuance Process 283
Public versus Private Placement 283
The Steps in the Bond Issuance Process 284
Selected Roles of Underwriters and Trustees 289
Lease Financing 290
Operating Lease 291
Capital Lease 291
Analysis of the Lease versus Purchase Decision 291
Summary 294
Key Terms 296
Key Equations 296
Questions and Problems 296
Appendix G: Bond Valuation and Loan Amortization 300
9 Using Cost Information to Make Special Decisions 305
Introduction 306
Breakeven Analysis 307
Using the Breakeven Approach to Determine Prices, Charges,
and Reimbursement 307
Breakeven Analysis: The Role of Fixed Costs 308
xii Contents
Breakeven Analysis: The Role of Variable Costs 311
Using the Breakeven Equation 314
Expanding the Breakeven Equation to Include Indirect Costs and Required Profit 314
The Breakeven Chart 316
A Shortcut to Calculating Breakeven: The Contribution Margin 320
Effects of Capitation on Breakeven Analysis 322
Product Margin 325
Multiple Services 326
Multiple Payors 328
Applying the Product Margin Paradigm to Making Special Decisions 328
Make-or-buy Decisions 328
Adding-or-dropping a Service 330
Expanding-or-reducing a Service 331
Summary 333
Key Terms 334
Key Equations 335
Questions and Problems 335
10 Budgeting 345
Introduction 346
The Planning/Control Cycle 346
Strategic Planning and Planning 346
Controlling Activities 347
Organizational Approaches to Budgeting 348
Participation 349
Budget Models 351
Budget Detail 355
Budget Modifications 357
Types of Budgets 360
The Statistics Budget 360
The Operating Budget 361
The Cash Budget 365
The Capital Budget 365
Pro Forma Financial Statements and Ratios 367
An Extended Example of How to Develop a Budget 367
The Statistics Budget 367
Developing Volume Projections 367
Converting Visit Projections to Weighted Visits 369
The Operating Budget 371
The Revenue Budget 371
The Expense Budget 374
The Supplies Budget 378
The Administrative and General Expense Budget 384
The Cash Budget 384
The Capital Budget 386
Contents xiii
Summary 386
Key Terms 388
Key Equation 388
Questions and Problems 388
11 Responsibility Accounting 393
Introduction 394
Decentralization 394
Advantages of Decentralization 394
Time 395
Information Relevance 395
Quality 395
Speed 395
Talent 396
Motivation and Allegiance 396
Disadvantages of Decentralization 396
Loss of Control 396
Decreased Goal Congruence 396
Increased Need for Coordination and Formal Communication 397
Lack of Managerial Talent 397
Types of Responsibility Centers 397
Service Centers 397
Cost Centers 398
Profit Centers 398
Traditional Profit Centers 398
Capitated Profit Centers 399
Administrative Profit Centers 399
Investment Centers 400
Measuring The Performance of Responsibility Centers 400
Responsibility, Authority, and Accountability 401
Performance Measures 402
Budget Variances 402
Revenue Variances 403
Step 1. Develop the Flexible Budget Estimate for Revenues 405
Step 2. Calculate the Revenue Variance Due to Changes in Volume
and Rate 406
Expense Variances 407
Step 1. Explain the Amount of Variance Due to Fixed Costs 407
Step 2. Develop a Flexible Expense Budget 409
Step 3. Calculate the Expense Variance Due to Changes in Volume
and Other Factors 409
Summary of the Example 410
Beyond Variances 411
Other Financial Performance Measures 412
Summary 412
xiv Contents
Key Terms 414
Key Equations 414
Questions and Problems 414
12 Provider Cost Finding Methods 418
Introduction 418
The Cost-to-charge Ratio 419
The Step-down Method 419
Allocating Utilities 420
Allocating Administrative Costs 422
Allocating Laboratory 423
Fully Allocated Cost 423
Activity-based Costing 424
Costing Terminology 428
An Example 430
Summary 437
Key Terms 438
Questions and Problems 438
13 Provider Payment Systems 444
Introduction 445
Historical Perspective on Payment Systems 446
The “Early” Years (1929–1965) 446
Blue Cross and Blue Shield Established 447
The “Middle” Years (1965–1983) 448
Increasing Concerns About Costs and Access 449
Medicare and Medicaid 449
The “Later” Years (1984 to the Present) 450
DRGs 451
Flat Fee Systems 452
Other Payors Follow Suit 454
Managed Care and Risk Sharing 455
The Future Is Now 466
Regulation 466
The Patients’ Bill of Rights 467
The Continued Search for Quality in the New Millennium 468
Health Care Enters the Digital Age: Technological Advancements
Enable Efficiencies 469
Information Technology 470
Summary 472
Key Terms 473
Questions and Problems 473
Questions from Appendix H 475
Appendix H: Payment Systems 476
Contents xv
Glossary 481
Web Links of Interest for Health Care Financial Managment 495
Index 500
xvi Contents
Preface
This book offers an introduction to the most used tools and techniques of health care financial
management. It contains numerous examples from a variety of providers, including health
maintenance organizations, hospitals, physician practices, home health agencies, nursing units,
surgical centers, and integrated health care systems. The book avoids complicated formulas and
uses numerous spreadsheet examples so that they can be adapted to problems in the workplace.
For those desiring to go beyond the fundamentals, many chapters have additional information
included in appendices. Each chapter begins with a detailed outline and concludes with a
detailed summary, followed by a set of questions and problems. Finally, a number of perspectives
are included in every chapter. Perspectives are intended to provide additional insight into
the topic – examples from the real world. In some cases these are abstracted from professional
journals and in other cases they are statements from practitioners – in their own words.
The book begins with an overview of some of the key factors affecting the financial management
of health care organizations in today’s environment. Chapters 2, 3, and 4 focus on the
financial statements of the organization. Chapter 2 presents an introduction to the financial
statements of health care organizations. The financial statements are (perhaps along with the
budget) the most important financial documents of a health care organization, and the bulk of
the chapter is designed to help understand these statements, how they are created, and how
they link together.
Chapter 3 provides an introduction to health care financial accounting. This chapter focuses
on the relationship between the actions of health care providers and administrators and the
financial condition of the organization, how the numbers on the financial statements are
derived, the distinction between cash and accrual bases of accounting – and the importance of
actually defining what is meant by “cost.” By the time students complete Chapters 2 and 3,
they will have been introduced to a large portion of the terms used in health care financial management.
Building on Chapters 2 and 3, Chapter 4 focuses on interpreting the financial statements of
health care organizations. Three approaches to analyzing statements are presented: horizontal,
vertical, and ratio analysis. Great care has been taken to show how the ratios are computed and
how to summarize the results.
Chapter 5 focuses upon the management of working capital: current assets and current liabilities.
This chapter emphasizes the importance of cash management and provides many practical
techniques for managing the inflows and outflows of funds through an organization,
including managing the billing and collections cycle, and paying off short-term liabilities.
Chapter 6 introduces one of the most important concepts in long-term decision-making – the
time value of money. Chapter 7 builds on this concept, incorporating it into the investment
decision by presenting several techniques to analyze investment decisions: the payback method,
net present value, and internal rate of return. Examples are given for both not-for-profit and
for-profit organizations.
Once an investment has been decided upon, it is important to determine how the assets will
be financed, which is the focus of Chapter 8, Capital Financing. Whereas Chapter 5 deals with
issues of short-term financing, Chapter 8 focuses on long-term investments, with a particular
emphasis on issuing bonds.
Chapters 9 through 12 introduce topics typically covered in a managerial accounting course.
Chapter 9 focuses on the concept of cost and using cost information for short-term decisionmaking
– including fixed cost, variable cost, and breakeven analysis. In addition to covering the
key concepts, it offers a set of rules to guide decision makers in making financial decisions.
Chapter 10 explores budget models and the budgeting process. Several different budget models
are introduced, including program, performance, and zero-based budgeting. The chapter
ends with an example of how to prepare each of the five main budgets: statistics budget, revenue
budget, expense budget, cash budget, and capital budget. It also includes examples for
various types of payors, including flat fee and capitation.
Chapter 11 deals with responsibility accounting. It discusses the different types of responsibility
centers and focuses on the performance measurement in general and budget variance
analysis in particular. Chapter 12 discusses methods used by health care providers to determine
their costs, primarily focusing on the step-down method and Activity Based Costing. The book
concludes with a new chapter, Chapter 13, Provider Payment Systems. This chapter, parts of
which were combined with Chapter 12 in the first edition, describes the evolution of the payment
system in the United States as well as the specifics of various approaches to managing care
and paying providers.
Major Changes in the Second Edition
In addition to the specific changes listed for each chapter, the following enhancements were
made throughout the text:
A listing of key terms and key equations at the end of each chapter; each set of key
terms now becomes the first question for each chapter.
An expansion of the use of marginal definitions and key points; all marginal definitions
are key terms, and vice versa.
More questions and problems for almost every chapter; where possible, problems are
provided in pairs so that the first can be used as an example, and the second can
become part of an assignment.
Updated perspectives throughout the text.
xviii Preface
Chapter 1: The Context of Health Care Financial Management
To acknowledge the numerous changes that have occurred in the health care arena since the
previous edition, several enhancements were made to Chapter 1. Specifically, the concepts of
Ambulatory Payment Classifications (APCs) and the Health Insurance Portability and
Accountability Act (HIPAA) are introduced. Rising health care costs includes a discussion of
prescription drugs, litigation was expanded to include compliance, and AIDS was expanded to
chronic diseases in general. Numerous new tables have been added to illustrate the trends being
discussed (e.g. cost increases), and the end of the chapter now includes a set of questions that
might lead to classroom or online discussions.
Chapter 2: Health Care Financial Statements
The chapter has been expanded to include an abbreviated financial statement from an investorowned
organization. In addition, an abbreviated set of notes to financial statements has been
added so that the student may see their importance to the overall understanding of the balance
sheet and income statement. Four new perspectives have replaced the perspectives in the first
edition. The questions at the end of the chapter have been updated and three new questions
have been added. In addition, 12 new problems at the end of the chapter have been added.
Chapter 3: Principles and Practices of Health Care Accounting
The main example that the chapter is centered on has been updated, and less emphasis has been
placed on the intricacies of accounting for donations. Four new perspectives have replaced the
perspectives in the first edition. The number of questions has been expanded from four to ten
and five new transaction problems have been added.
Chapter 4: Financial Statement Analysis
Using data from Solucient Incorporated Inc., the benchmark ratios were both updated and
expanded to include hospitals of various sizes. The perspectives in the previous edition were
replaced with five new ones. In addition, three more questions and seven more ratio analysis
problems were added. Four of these are relatively complex, requiring ratio, vertical, and horizontal
analyses of the balance sheet and income statement.
Chapter 5: Working Capital Management
The chapter has been expanded to include compliance with laws and regulations for health care
organizations as set forth by HIPAA. The section on the analysis of working capital strategies
has been shortened. Five new perspectives have replaced the perspectives in the previous
Preface xix
edition. Six new questions and six new problems have been developed; several relating to the
development of a cash budget are quite involved.
Chapter 6: The Time Value of Money
The chapter places more emphasis on the use of electronic spreadsheets and less emphasis on
using tables to make financial calculations. The content has been expanded to include both payment
and rate functions. Eighteen additional present and future value problems have been
added. The appendices have been modified.
Chapter 7: The Investment Decision
Changes were made to clarify how to handle depreciation and interest expenses when converting
from accrual-based financial statements to cash flows. In addition, a section
has been added to help explain the application of IRR. Five new perspectives have
replaced the perspectives in the first edition. One question and 13 new problems have been
added. Three of the new problems use complex cash flow development for tax-paying
entities.
Chapter 8: Financing the Organization
The discussion of equity financing and pooled financing has been expanded, an exhibit
has been expanded, and another exhibit has been developed which provides a listing of
key financial ratios for rated hospital bonds in the year 2000. A diagram of the bond rating
process has been added, and the discussion on bond amortization has been shifted to
an appendix. Five new exhibits replace the exhibits in the first edition. Ten new problems,
in the areas of bond valuation, loan amortization, and leasing financing, have been
added.
Chapter 9: Using Cost Information to Make Special Decisions
The material on the breakeven equation has been updated to help the student understand how
to apply the basic breakeven equation in cases where direct and indirect costs and/or a desired
profit are of concern. The material in the appendix in the first edition which discussed a caution
pertaining to the use of unit cost has been integrated into the chapter. Six new perspectives
replace the perspectives used in the previous edition. The last three problems are more
complex.
xx Preface
Chapter 10: Budgeting
The budget numbers have been updated, primarily to reflect changes in labor rates. Five new
perspectives have been added to replace the perspectives used in the previous edition. The
problem section includes new problems.
Chapter 11: Responsibility Accounting
The discussion on volume and rate variances has been improved and new problems have been
added.
Chapter 12: Provider Cost Finding Methods
The section on activity-based costing has been greatly expanded and now contains an extended
example comparing traditional costing to activity-based costing. The step-down method
example has been refined. Provider payment systems, which was a section of this chapter in the
previous edition, is now a separate chapter. Four new perspectives replace the perspectives
used in the first edition. The problems relating to costing have been expanded.
Chapter 13: Provider Payment Systems
This is a new chapter containing material that was previously contained in Chapter 12 in the
first edition. The material has been greatly reorganized to emphasize the history of payment
systems in the United States, with an emphasis on the dynamics among payors, providers, and
employers. Some of the methods discussed in the first edition have been moved to an appendix.
The chapter contains five new perspectives and its own set of questions and problems.
Glossary
The glossary has been completely updated, and includes each term defined in the text as a marginal
definition and key term.
Preface xxi
Acknowledgments
We attempted throughout the book to challenge and enlighten. Quantitative as well as qualitative
issues are presented in an effort to help the reader better understand the wide range of
issues considered under the topic health care financial management. We could not have completed
this task without our new coauthor, Noah Glick, who has contributed greatly and selflessly
to both the first and second editions. We would also like to acknowledge the contributions
of: Jason Marks for his review of many of the chapters, exhibits, and problems contained in this
text; Matthew Ayotte for his expertise and input into both the format and content of our new
chapter on provider payment systems; Lauren Hesler for her excellent secretarial help under
pressure; Scott Broome and Angela Nelson for their review and suggestions on the budgeting
chapter; Solucient Incorporated for giving us permission to use their data to construct the standards
used in Chapter 4; and the many students over the past several years who pointed out
errors, offered suggestions and improvements, and provided new ways to solve problems.
Most of all, we would like to thank our families for their encouragement and support, and
for their understanding during the countless hours we were not available to them.
The authors and publishers gratefully acknowledge the following for permission to reproduce
copyright material:
Perspective 1–1 “Health Care Institutions Need More than Efficiency” (abridged by authors),
by James Barba: Capital District Business Review (Albany) from the December 11, 2000 print
edition. © 2000 American City Business Journals Inc.
Perspective 1–2 Abstract from “Living with Change” (abridged by authors), by Chris Gay:
Wall Street Journal, October 18, 1999, Eastern Edition.
Perspective 1–3 “Hospital M & A Activity Slow in 2000 as Health Care Industry Begins to
Stabilize” (abridged by authors), © 2001 PR Newswire Association, Inc. March 29, 2001.
Perspective 1–4 “A 2020 Vision for American Health Care” (abridged by authors),
Commonwealth Fund, www.cmwf.org, December 11, 2000.
Perspective 1–5 “Conflicting Demands” (abridged by authors), by Barbara Kirchheimer.
Reprinted with permission from Modern Healthcare, August 27, 2001. © 2001 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 2–1 “Buying on Credit” (abridged by authors), by Deanna Bellandi. Reprinted
with permission from Modern Healthcare, June 18, 2001. © 2001 Crain Communications, Inc.,
360 N Michigan Avenue, Chicago, IL 60601.
Perspective 2–2 “HMOs: Some Profits, More Losses” (abridged by authors), by Ashley
Gibson: The Business Journal of Charlotte, July 12, 2001. © American City Business Journals,
Inc.
Perspective 2–3 “Charity Finances Healthcare” (abridged by authors), by Mary Chris
Jaklevic. Reprinted with permission from Modern Healthcare, July 31, 2000. © 2000 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 2–4 “An Industry Barometer” (abriged by authors), by Cinda Becker, Reprinted
with permission from Modern Healthcare, June 18, 2001. © 2001 Crain Communications, Inc.,
360 N Michigan Avenue, Chicago, IL 60601.
Chapter 2 Appendix “Abbreviated Notes to Financial Statements for Sample Not-For-
Profit Hospital, Dec 31, 20X1 and 20X0,” permission from the Audit and Accounting Guide,
Health Care Organizations (new edn), New York: American Institute of Certified Public
Accountants, Inc., June 1 1996.
Perspective 3–1 “E-claims Trim Costs, Aid Growth” (abridged by authors), by John
Morrissey. Reprinted with permission from Modern Healthcare, October 2, 2000, © 2000 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 3–2 “Internal Investigations” (abridged by authors), by Mary Chris Jaklevic.
Reprinted with permission from Modern Healthcare, September 4, 2000. © 2000 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 3–3 “Revenue Stopper” (abridged by authors), by Mary Chris Jaklevic.
Reprinted with permission from Modern Healthcare, July 2, 2000, © 2000 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 3–4 “Former HBO Execs Indicted for Fraud” (abridged by authors), by Jeff
Tieman. Reprinted with permission from Modern Healthcare, October 2, 2000, © 2000 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 3–5 “Debunking Oxford” (abridged by authors), by David Stires. From Fortune
magazine, March 19 2001. © 2001 Time, Inc.
Perspective 4–1 “100 Top Hospitals: Benchmarks for Success, 1999” (abridged by authors),
© 1999 HCIA, L.L.C.
Perspective 4–2 “The Comparative Performance of US Hospitals: The Sourcebook”
(abridged by authors), © 2000 HCIA, L.L.C. and Deloitte & Touche LLP.
Perspective 4–4 “The Comparative Performance of US Hospitals: The Sourcebook”
(abridged by authors), © 2000 HCIA, L.L.C. and Deloitte & Touche LLP.
Perspective 4–5 “How Health Plans in Phoenix, Arizona Benchmark against Local Market
and National Market Ratios” (abridged by authors), Interstudy Publications Quarterly
Newsletter, Volume 1, Issue 1.
Perspective 5–1 “Stocks are Risky Rx for Hospitals” (abridged by authors), by Dennis
Walters. From Chicago Sun-Times, October 29, 2000. © Chicago Sun-Times, Inc.
Perspective 5–2 “Funds Management” (abridged by authors), by David Feldheim. From
The Bond Buyer, September 26, 2000. © 2000 The Bond Buyer, Inc.
Perspective 5–3 “Billing Scam Hits Hospitals” (abridged by authors), by Mark D. Somerson
and Mary Beth Lane. From The Columbus Dispatch, October 28, 2000. © 2000 Columbus
Dispatch.
Acknowledgments xxiii
Perspective 5–4 “Health Plans Create a Rival for WebMD” (abridged by authors), by Ann
Carrns. From The Wall Street Journal, November 15, 2000. © 2000 Dow Jones & Company,
Inc.
Perspective 5–5 “Report Predicts Huge HIPAA Price Tag” (abridged by authors), by
Barbara Kirchheimer. Reprinted with permission from Modern Healthcare, October 2, 2000. ©
2000 Crain Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 6–1 “Has the Market Gone Mad?” (abridged by authors), by Shawn Tully.
From Fortune magazine, January 24, 2000. © 2000 Time, Inc.
Perspective 7–1 “Doctors, St Joseph Get New Tool” (abridged by authors), by Winthrop
Quigley. From Albuquerque Journal, September 7, 2000. © 2000 Albuquerque Journal.
Perspective 7–2 “McKesson HBOC Announces Next-Generation, Integrated Clinical
Solution to Improve Patient Safety and Reduce Cost of Care” (abridged by authors). From
Business Wire, July 16, 2001. © 2001 Business Wire, Inc.
Perspective 7–3 “New Beckley Clinic to Help Thousands” (abridged by authors). From The
Sunday Gazette Mail, May 6, 2001. © 2001 Charleston Newspapers.
Perspective 7–4 “Carolina’s HealthCare System Gains $326,000 Profit for First Quarter”
(abridged by authors), by Mike Stobbe. From The Charlotte Observer, June 20, 2001. © 2001
Knight Ridder/Tribune Business News. © 2001 The Charlotte Observer.
Perspective 7–5 “CEO of Nashville, TN-based Healthcare Company Defends Integrity”
(abridged by authors), by Bob Gary, Jr. From Chattanooga Times and Free Press, April 26, 2001.
© 2001 Knight Ridder/Tribune Business News. © 2001 Chattanooga Times/Free Press.
Perspective 8–1 “Ailing Stocks Land E-Health Companies in Sick Bay” (abridged by
authors), by Robert McCough and Ann Carrns. From The Wall Street Journal, April 10, 2000.
Perspective 8–2 “The Fall of the House of AHERF” (abridged by authors), by Lawton R.
Burns, John Cacclamani, James Clement, and Welman Aquino. From Health Affairs,
January/February 2000, Volume 19, Number 1.
Perspective 8–3 “Buying on Credit” (abridged by authors), by Deanna Bellandi. Reprinted
with permission from Modern Healthcare, June 28, 2001. © 2001 Crain Communications, Inc.,
360 N Michigan Avenue, Chicago, IL 60601.
Perspective 8–4 “An Updated Approach to Rating Not-For-Profit Health Care
Organizations” (abridged by authors), from Moody’s Rating Methodology Handbook: Public
Finance: Nov. 2000, © 2000 Moody’s Investors Service, Inc.
Perspective 8–5 “Ratings firms see fewer downgrades” (abridged by authors), by Mary Chris
Jaklevic. Reprinted with permission from Modern Healthcare, January 29, 2001. © 2001 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 9–1 “Drkoop.com Lays off Third of Work Force,” by Associated Press, August
31, 2000. From Boston Globe, © 2000 Globe Newspaper Company.
Perspective 9–2 “Targeting Disease Treatment Could Save States Thousands in Medicaid
Costs” (abridged by authors). From AHA News, August 28, 2000.
Perspective 9–3 “Length of Stay Has Minimal Impact on the Cost of Hospital Admission”
(abridged by authors), by P. A. Taheri, D. A. Butz, and L. J. Greenfield. From Journal of the
American College of Surgeons, 2000, Aug, 191(2): 123–30. © 2000 American College of
Surgeons.
Perspective 9–4 “Speedy Recovery” (abridged by authors), by Laura Johannes. From The
Wall Street Journal, August 29, 2000. © 2000 Dow Jones & Company, Inc.
xxiv Acknowledgments
Perspective 9–5 “Practices with the Best Practices” (abridged by authors), by Mary Chris
Jaklevic. Reprinted with permission from Modern Healthcare, February 8, 1999, © 1999 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 9–6 “Mission to Stop Restocking Ambulances” (abridged by authors), by Joel
Burgess. From Times-News Online, September 14, 2000. © 2000 Times-News.
Perspective 10–2 “Services for Poor Put at Risk” (abridged by authors), by Bonnie
Rochman. From The News & Observer, July 28, 2000. © 2000 The News & Observer Pub. Co.
Perspective 10–3 “Beth Israel to Cut Back Services” (abridged by authors), by Liz
Kowalczyk. From The Boston Globe, September 27, 2000. © 2000 Globe Newspaper Company.
Perspective 10–4 “Hospital Makes Work Hour Cuts Voluntary” (abridged by authors), by
Jill Doss-Raines. From The Lexington Dispatch, July 26, 2000. © 2000 The-Dispatch.
Perspective 10–5 “Shortage of Nurses Looming?” (abridged by authors), by Sara Lindau.
From The Pilot, August 21, 2000. © 2000 The Pilot LLC.
Perspective 11–1 “Hospital to Shed Its Network of Physician Groups,” by Jean P. Fisher.
From Knight-Ridder Tribune Business News: The News & Observer, August 16, 2001.
Perspective 11–2 “Reviving Ailing Hospitals” (abridged by authors), by Ron Shinkman.
Reprinted with permission from Modern Healthcare, April 9, 2001. © 2001 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 11–3 “Blue All Over” (abridged by authors), by Barbara Kirchheimer.
Reprinted with permission from Modern Healthcare, June 25, 2001. © 2001 Crain
Communications, Inc., 360 N Michigan Avenue, Chicago, IL 60601.
Perspective 12–1 “House Committee on Public Health Recommendations Relating to
Hospital Charity Care & Hospital System Sales, Conversions, Partnerships and Mergers”
(abridged by authors), From Consumers Union, June 28, 2000. © 2000 Consumers Union.
Perspective 12–2 “Review of Partial Hospitalization Services and Audit of Medicare Cost
Report for Community Behavioral Services, a Florida Community Mental Health Center”
(abridged by authors), by June Gibbs Brown, Inspector General, January 5, 1998. From the
Department of Health and Human Services, Region IV, PO Box 2047, Atlanta, GA 30301.
Perspective 12–3 “Activity Based Costing” (abridged by authors), by Gary Shows. © 2000
Robert Luttman & Associates.
Perspective 12–4 “Cost for Pricing at Blue Cross and Blue Shield of Florida” (abridged by
authors), by Kenneth L. Thurston, Dennis M. Deleman and John B. MacArthur. From
Management Accounting Quarterly, Spring 2000. © 2000 Management Accounting Quarterly.
Perspective 13–1 “The World’s Health Care: How Do We Rank?” Susan Landers, AMNews
staff. August 28, 2000.
Perspective 13–2 “An Opinion of Managed Care,” Sacramento Business Journal, December
17, 1999.
Perspective 13–3 “HIPAA Opinion” (abridged by authors), by Jeff Tieman, Modern
Healthcare, March 26, 2001; exhibit, Jeff Tieman, Modern Healthcare, July 16, 2001 (chart
source Sheldon Dorenfest and Associates, same article).
Perspective 13–5 “Innovations through Information” (abridged by authors), by Matthew
Ayotte, Strategic Planning, Duke University Medical Center, August 2001.
Exhibit 1–2 “The Consumer Price Index vs. Medical Care Inflation,” from US Labor
Department, Bureau of Labor Statistics (July 2000).
Exhibit 1–3 “Annual Health Care Expenditures in the United States,” from Health Care
Financing Administration (July 2000).
Acknowledgments xxv
Exhibit 1–7 “Rising Number of Uninsured,” from US Census Bureau (July 2000).
Exhibit 1–8 “Uncompensated Care Costs for the Uninsured,” from American Hospital
Association (July 2000).
Exhibit 1–9 “Annual Number of Surviving Hospitals,” from American Hospital Association
(July 2000).
Exhibit 2–3 “Annotated Balance Sheet for Sample Not-For-Profit Hospital.” Permission
from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Exhibit 2–4 “Asset Section of the Balance Sheet from Exhibit 2–3 with an Emphasis on
Current Assets,” reprinted with permission from Audit and Accounting Guide: Health Care
Organizations, copyright © 1996 by the American Institute of Certified Public Accountants,
Inc.
Exhibit 2–6 “Asset Section of the Balance Sheet from Exhibit 2–3 with an Emphasis on
Non-current Assets,” reprinted with permission from Audit and Accounting Guide: Health Care
Organizations, copyright © 1996 by the American Institute of Certified Public Accountants,
Inc.
Exhibit 2–8 “Liabilities Section of the Balance Sheet from Exhibit 2–3,” reprinted with permission
from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Exhibit 2–9 “Net Assets Section of the Balance Sheet from Exhibit 2–3,” reprinted with permission
from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Exhibit 2–11 “Illustration of the Owners’ Equity Section of the Balance Sheet for an
Investor-owned Health Care Organization,” adapted from AICPA Audit and Accounting Guide,
Health Care Organizations (new edn), New York: American Institute of Certified Public
Accountants, Inc., June 1, 1996.
Exhibit 2–14 “Annotated Statement of Operations for Sample Not-For-Profit Hospital,”
reprinted with permission from Audit and Accounting Guide: Health Care Organizations, copyright
© 1996 by the American Institute of Certified Public Accountants, Inc.
Exhibit 2–15 “Abbreviated Statement of Operations from Exhibit 2–14 Emphasizing
Revenues, Gains, and Other Support,” reprinted with permission from Audit and Accounting
Guide: Health Care Organizations, copyright © 1996 by the American Institute of Certified
Public Accountants, Inc.
Exhibit 2–17 “Abbreviated Statement of Operations from Exhibit 2–14 Emphasizing
Expenses,” reprinted with permission from Audit and Accounting Guide: Health Care
Organizations, copyright © 1996 by the American Institute of Certified Public Accountants,
Inc.
Exhibit 2–18 “Statement of Operations from Exhibit 2–14 Emphasizing Items that Do Not
Contribute to Excess of Revenues over Expenses,” adapted from AICPA Audit and Accounting
Guide, Health Care Organizations (new edn), New York: American Institute of Certified Public
Accountants, Inc., June 1, 1996.
Exhibit 2–19 “Calculation of Increase in Unrestricted Net Assets,” reprinted with permission
from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
xxvi Acknowledgments
Exhibit 2–20 “Statement of Changes in Net Assets for Sample Not-For-Profit Hospital,”
reprinted with permission from Audit and Accounting Guide: Health Care Organizations, copyright
© 1996 by the American Institute of Certified Public Accountants, Inc.
Exhibit 2–21 “Annotated Statement of Cash Flows for Sample Not-For-Profit Hospital,”
reprinted with permission from Audit and Accounting Guide: Health Care Organizations, copyright
© 1996 by the American Institute of Certified Public Accountants, Inc.
Exhibit A–1 “Balance Sheet for Sample Not-For-Profit Hospital,” reprinted with permission
from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Exhibit A–2 “Statement of Operations for Sample Not-For-Profit Hospital,” reprinted with
permission from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by
the American Institute of Certified Public Accountants, Inc.
Exhibit A–3 “Statement of Changes in Net Assets for Sample Not-For-Profit Hospital,”
reprinted with permission from Audit and Accounting Guide: Health Care Organizations, copyright
© 1996 by the American Institute of Certified Public Accountants, Inc.
Exhibit A–4 “Statement of Cash Flows for Sample Not-For-Profit Hospital,” reprinted with
permission from Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by
the American Institute of Certified Public Accountants, Inc.
Exhibit A–5 “Consolidated Income Statement for Columbia/HCA Healthcare
Corporation,” from Columbia/HCA’s 10-K report from SEC.
Exhibit A–6 “Consolidated Income Statement for Columbia/HCA Healthcare
Corporation,” from Columbia/HCA’s 10-K report from SEC.
Exhibit A–7 “Consolidated Income Statement for Columbia/HCA Healthcare
Corporation,” from Columbia/HCA’s 10-K report from SEC.
Exhibit 8–5 “Selected Not-for-profit Hospital Industry Bond Ratings and Medians: 2000,”
from Standard & Poor’s Median Health Care Ratios, October 19, 2000.
Exhibit 13–3 “Medicare and Medicaid Entitlement Programs,” from http://www.hcfa.gov
August 2000.
Exhibit 13–4 “Examples of Diagnostic Related Groups,” from http://www.hcfa.gov August
2000.
Exhibit 13–5 “Percent Increase in Medicare Expenditures (IP and OP) 1970–1998,” from
http://www.hcfa.gov, August 2000.
Exhibit 13–6 “Healthcare Expenditures as a Percent of GNP 1940–2000,” from
http://www.hcfa.gov, August 2000.
The publishers apologize for any errors or omissions in the above list and would be grateful to
be notified of any corrections that should be incorporated in the next edition or reprint of this
book.
Acknowledgments xxvii
bIntroductionc
Never before have health care professionals faced such complex issues and practical difficulties
trying to keep their organizations financially viable (see Perspective 1–1). With
C h a p t e r O n e
THE CONTEXT OF HEALTH CARE
FINANCIAL MANAGEMENT
Learning Objectives
After completing this chapter, you will be able to:
c Identify key factors that have led to rising health care costs.
c Identify key approaches to controlling health care costs.
c Identify key ethical issues resulting from attempts to control costs.
Introduction
Rising Health Care Costs
The Payment System
Technology
The Aging Population
Prescription Drugs
Chronic Diseases
Compliance and Litigation
The Uninsured
Efforts to Control Costs
Efforts by Payors to Control Health Care
Costs
DRGs
Capitation
Global Payments
APCs
Cutting Delivery Costs
Shift to Outpatient Services
Cost Accounting Systems
Information Services Technology
Mergers and Acquisitions
Reengineering/Redesign
Cost Control Issues with Ethical
Overtones
Summary
Key Terms
Chapter Outline
turbulent changes taking place in payment, delivery, and social systems, health care professionals
are faced with trying to meet their organization’s health-related mission in an
environment of extreme cost pressure. In order to provide a context for the topics covered
in this text, this chapter highlights key issues affecting health care providers. It is
organized into three sections: rising health care costs, efforts to control costs, and cost
control issues with ethical overtones (see Exhibit 1–1).
2 Financial Management of Health Care Organizations
Perspective 1–1
Health Care Institutions Need More than Efficiency
In the past decade, few sectors of the American economy have been as whipsawed as has the health care industry.
On one hand, US health consumers continue to demand the highest quality, most accessible care. On the other, current
public policy, expressed as dramatically lower payment for care delivered, has caused academic medical centers
and community hospitals alike to hemorrhage financially, putting many institutions on the brink of bankruptcy and
patient care at serious risk.
Calls for improved economic efficiencies in the American health care system predate early Clinton Administration
initiatives.The rise of HMOs was one attempt to use a third party to control costs. But have quality and access been
diminished for the sake of controlled economics? The evidence strongly suggests that it has.
In 1997, spurred by the dual ambitions to further constrict health care costs and diminish the federal contribution
to national health care, Congress passed the Balanced Budget Act.The BBA was designed to reduce Medicare
payments to medical centers and hospitals by $48 billion over five years. But an updated figure by the Congressional
Budget Office actually estimated the cuts at $71 billion.While perhaps unintended, the result has been the growing
disabling of the American hospital system.
The examples are widespread. In Boston, each of the five academic medical centers is losing tens of millions of
dollars annually. The same applies for the eight academic medical centers in the New York metropolitan area.The
Association of American Medical Colleges, with 125 member institutions, predicts more than two-thirds of this
nation’s academic medical centers will run seriously in the red in the year 2000.
Source: James Barba, Chairman of the Board of Directors, President and Chief Executive Officer of Albany Medical
Center. Health Care Quarterly, December 11, 2000.
Cost Control Issues
With Ethical Overtones
Rising Health Care Costs
Efforts to Control Costs
Exhibit 1–1 Organization of this Chapter
bRising Health Care Costsc
Many factors have led to rising health care costs, which have increased faster than has
general inflation over the past decades (see Exhibit 1–2). Though the average life
expectancy of the general population has only risen by three years over this time
period, the cost to keep people healthy has increased sixfold (Exhibit 1–3). The
remainder of this section briefly discusses some of the key factors that have
The Context of Health Care Finanacial Management 3
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$1,000
$1,100
$1,200
$1,300
TOTAL HEALTH CARE
EXPENDITURES ($BILLIONS)
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
YEAR
Exhibit 1–3 Annual Health Care Expenditures in the United States
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
YEAR
PERCENT INCREASE
Consumer Price Index
Medical Care Inflation
Exhibit 1–2 The Consumer Price Index versus Medical Care Inflation
Source: US Labor Department, Bureau of Labor Statistics, July 2000.
Source: Health Care Financing Administration, July 2001.
contributed to the higher cost of health care: the payment (reimbursement) system,
technology, the aging population, chronic diseases, prescription drug costs, litigation,
and the uninsured (see Exhibit 1–4).
The Payment System
The introduction of Medicare and Medicaid in 1965 was designed in large part to
guarantee health care coverage to the country’s most vulnerable populations: the poor
and the elderly. Unfortunately, many people at the time failed to recognize that these
“Great Society” programs would become the impetus for two interrelated problems
that have persisted ever since: rising health care costs far beyond those that were ever
predicted, and an increased expectation that access to a high level of affordable health
care is a right for all citizens. Since the mid-1960s, the health care payment system in
the United States has undergone major changes. The role of the provider has gradually
shifted from price-setter to price-taker. The role of the federal government has
changed from being a small participant before the mid-1960s to being a major force in
both setting amounts of payment and defining payment systems. As the federal government
has attempted to control its costs, its inpatient payment systems have evolved
from charge-based to cost-based to flat-fee, toward capitation, and now toward mixed
systems (see Exhibit 1–5). In 2000, the federal government also introduced a new payment
system for outpatient services, called APCs (Ambulatory Payment
Classifications), which changed the basis of payment for outpatient services from
flat-fee for individual services to fixed reimbursement for bundled services. The federal
government, of course, is not the only payor, but its policies greatly influence the
practices of other payors, including state governments.
4 Financial Management of Health Care Organizations
Ambulatory Payment
Classifications
(APCs): Enacted by the
federal government in
2000, a prospective
payment system for
outpatient services,
similar to DRGs, which
reimburses a fixed
amount for a bundled
set of services.
The
Payment
System
Technology
Rising Costs
Aging
Population
Chronic
Diseases
Compliance
& Litigation
The
Uninsured
Prescription
Drug Costs
Exhibit 1–4 Selected Factors Contributing to the Rising Costs of Health Care
As discussed in depth in Chapter 13, in charge-based and cost-based systems,
the provider plays a major role in setting prices. In flat-fee and capitated payment
arrangements, the provider assumes an increased financial risk, while the payor
potentially has more control over its costs. A major problem caused by payors trying
to control their cost has been cost-shifting: providers attempting to pass on
costs not paid for by one payor onto other payors. This has resulted in a dramatic
shift in costs to the private sector, a nearly 500 percent increase over the past
two decades: $142.5 billion in 1980 versus $626.4 billion in 1998 (US Health Care
Financing Administration, 1999). As a result, employers and insurers are following
the government’s lead and becoming increasingly more involved in managing
care.
Technology
No one can deny the benefits of health care technology, but the associated costs have
become tremendous. Premature infants, and infants with gross birth defects, who
would not have survived just a decade ago, can now survive, but can generate upwards
of half a million dollars in the intensive care unit alone, and possibly more afterwards
due to developmental disabilities. The total cost in the first year of life for a premature
infant can easily surpass $1 million.
Transplants have saved countless lives, and procedure count more than doubled
in number in less than 15 years, from 11,163 in 1985 to 25,141 in 1998 (US
Department of Health and Human Services, 1999). Many feel that it has not been
the individual cost of a transplant, but only the lack of donors that has limited the
number of transplants performed. The rise in living-donor transplants (as
opposed to cadaverous transplants) has led to more growth in this rapidly evolving
field, but these procedures now involve two (or more) living patients who will
be operated on, rather than just one. The use of other, more advanced technologies
– and their associated costs – have significantly increased as well. For example,
the number of MRIs (magnetic resonance imagers) per capita in the United
States far exceeds the figure for any other country in the world, as do the figures
for CAT (computerized axial tomography) scanners, cardiac catheterization procedures,
etc. On the other hand, the United States has become “the place to go”
for foreigners who do not have access to these types of advanced technologies in
their own countries.
The Context of Health Care Finanacial Management 5
Cost-shifting: When
providers try to get one
payor to pay for costs
which have not been
covered by another
payor. A common
example is a provider’s
trying to compensate
for low Medicaid
payments by increasing
charges to a private
insurer.
Early 1960s
Fee-for-Service
Mid-1960s
Cost-Based
Reimbursement
Mid-1980s
Prospective
Payment (DRGs)
Late 1990s
Capitation and
Global Payments
2000s
APCs and ?
Exhibit 1–5 The Evolution of Payment Systems in the United States Since 1960
The Aging Population
The average life expectancy of Americans has risen only slightly over the past few
decades: from 69.5 to 73.6 for males, and from 77.2 to 79.4 for females (1977–1997,
both sets of figures). In the meantime, the overall population has aged significantly,
and there are more elderly Americans than ever before. In fact, by the mid-1990s, the
age group 85 and older was the fastest growing segment of the population, and the elderly
tend to be the heaviest users of health care services. Whereas the leading causes of
death in the early part of the last century were sudden illnesses (generally curable
today), the current reasons for mortality include more chronic, long-term (and expensive)
illnesses, such as heart disease and cancer (see Exhibit 1–6). If a person lives long
enough, he or she has a high probability of succumbing to a chronic illness.
The combination of age and technology has increased costs in other ways, too. For
example, joint replacements to restore mobility are immensely popular among the elderly,
but can become very expensive, especially if complications arise. Though the
benefit of such procedures is remarkable in human terms, these technologies have
added costs to the system.
The increased need for long-term care for the elderly has also led to increased
health care costs. As more working families find that they cannot take care of their
aging parents’ physical needs, the costs of long-term care become their burden and
society’s burden. In fact, over half of all Medicaid expenditures in the late 1990s went
to elderly patients in nursing homes. A less expensive alternative is home health and
live-in nursing aides, but these options are not always covered by insurance and can
be unaffordable to the average family: 24-hour nursing coverage, whether home-based
or facility-based, now averages well over $100 per day per individual.
6 Financial Management of Health Care Organizations
Other
47%
Cancer
23%
Heart
Disease
30%
Exhibit 1–6 Major Causes of Death and Their Approximate Occurrences in 1999
Source: K. D. Kochanek, B. L. Smith, and R. N.Anderson,“Deaths: Preliminary Data for 1999,” National Vital Statistics Reports, 49(3),
2001, 1–48.
Prescription Drug Costs
A major reason why the population has aged and has survived longer from debilitating
chronic diseases has been the advent of increasingly effective – albeit costly –
drugs (see Perspective 1–2). A key issue in the 2000 presidential election focused on
how to make these prescription medications more affordably to the elderly. Drug manufacturers
have received widespread criticism for stifling competition and raising
prices, especially as compared to the prices being offered in other countries. However,
the manufacturers counter that they can spend hundreds of millions of dollars in
research on one drug, and they need to recoup their investments (as well as their
investments in numerous other failed drugs that never reached the market). Without
the incentive to do research by being granted a patent on new medications (and thus
monopoly control), drug manufacturers contend that they would not bring as many
promising new drugs to market. While the battle rages on, retail sales of prescription
drugs in the United States increased by over 75 percent in just five years from 1995
to 1999, from $68.6 billion to over $121.7 billion (National Association of Chain Drug
Stores, 1999).
Chronic Diseases
While chronic diseases are often associated with the elderly, long-term ailments may
affect younger segments of the population as well. Sometimes these diseases can be
The Context of Health Care Finanacial Management 7
Perspective 1–2
Living with Change – Open Your Wallets
All the technology means we’ll be spending less on health care in the years ahead, right? Fat chance. “If the economy
continues to grow as it has in this decade, one could see substantial increases in health-care spending with no change
in the share of GDP,” says Elliott Fisher, a professor of medicine at Dartmouth Medical School in Hanover, NH.
But few doubt we’ll be spending more on health in per capita terms. Measured in 1997 dollars, per capita spending
on health care rose to $3,925 in 1997 from $765 in 1960, according to the HCFA. Between 1960 and 1990, the
health-care component of the consumer price index rose an average of 1.8 percentage of this decade, to as small as
0.4 point, or 22%, in 1997. But it has widened sharply since then.
The ever-expanding array of medical technology – devices and drugs – also drives up health-care costs.While in
many industries technology tends to reduce labor costs, in medicine it tends to raise them. “You have more-complex
equipment introduced in health care, and you can’t have an unskilled person running it,” says Paul Starr, a
Princeton University sociology professor and author of “The Social Transformation of American Medicine,” a history
of the profession. Some technological innovations clearly save money; penicillin, for instance, has spared us whoknows-
how-many hospital stays. “But relatively little health-care technology has been like that,” says Mr Starr.
“There’s been much more health-care technology that’s raised labor costs.”
Source: Chris Gay,Wall Street Journal, October 18, 1999.
Copyright Dow Jones & Company Inc., New York.
cured, but at other times, only treated. Acquired Immune Deficiency Syndrome, or
AIDS, became widespread in the 1980s, and a total of 733,374 cases were reported in
the United States between 1981 and 1999 (US Centers for Disease Control and
Prevention, 1999). It is a long-term illness that can easily cost $100,000 over the life of
a patient, not to render a cure, but only to improve the quality of life and provide palliative
support. Other diseases, such as diabetes, liver failure, and cancer, can also affect
younger people, who may end up needing expensive treatments for a lifetime. Still
other conditions, such as mental illness or debilitating back pain, are expensive to treat
and costly in terms of lost productivity. Days of disability have held steady at nearly 4
billion per year: 4.2 billion in 1980 versus 3.8 billion in 1996 (US National Center for
Health Statistics, 1996).
Compliance and Litigation
Three interrelated factors have greatly contributed to the rise in healthcare costs:
1) compliance, which is the need to comply with governmental regulations, whether
they be for provision of care, billing, privacy, security, etc. A noteworthy example of
extraordinary compliance costs would be the Health Insurance Portability and
Accountability Act, or HIPAA (discussed below and described in more detail in
Chapter 13); 2) increased insurance premiums that providers have to pay insurers
to cover the cost of defending against lawsuits and paying large jury awards; and 3) the
increased use of defensive medicine by practitioners – excessive tests and procedures,
oftentimes unnecessary care, simply to ensure that nothing be overlooked should
a lawsuit ever arise. And once a patient has undergone a test or procedure, the
provider is liable to be aware of and to follow up on all the results, even if the original
service were unnecessary.
Partially due to concerns over access to health care services as a result of cost-control
measures by insurers, the federal government enacted HIPAA in 1996. HIPAA
was introduced: to improve the portability and continuity of health insurance coverage;
to ensure confidentiality in health care information storage and retrieval; to combat
waste, fraud, and abuse in the health insurance and delivery systems; to promote
the use of medical savings accounts; to improve access to long-term care; and to simplify
the administration of health insurance. Compliance is mandatory by all health
care institutions before the year 2005. Though individual state regulations can override
HIPAA regulations if they more strictly ensure access to and coverage for health
care services, HIPAA imposes minimum standards that must be met by all institutions
doing business in any state.
The cost impact of litigation by patients and their families on health care providers
cannot be directly measured, but it is generally believed to be quite significant. On the
one hand, patients have a right to expect a reasonable and safe level of care that is dictated
by medical necessity, not by profit margins. On the other hand, what is reasonable
care seems open to considerable debate, especially on a case-by-case basis. Under
tighter reimbursement policies, providers are forced or encouraged to restrict potentially
unnecessary tests, while opening themselves up to possible legal battles. The
subject of whether or not managed care plan enrollees should be allowed to sue their
8 Financial Management of Health Care Organizations
Compliance: The need
to abide by
governmental
regulations, whether
they be for the
provision of care,
billing, privacy, security,
etc.
Health Insurance
Portability and
Accountability Act
(HIPAA): A set of
federal compliance
regulations enacted in
1996 to ensure
standardization of
billing, privacy, and
reporting as
institutions enter a
paperless age.
Defensive Medicine:
The tendency of health
care practitioners to do
more testing and to
provide more care for
patients than might
otherwise be
necessary, simply to
protect themselves
against potential
litigation.
HMO or employer has become a heated topic of discussion, as some contend it will
ultimately drive costs up even further. Although the legal relationship between
provider organizations and their participating providers is beyond the scope of this
text, it should be emphasized that litigation and compliance add costs which are not
direct (i.e., hands-on) patient care.
The Uninsured
The number of uninsured individuals has risen considerably (see Exhibit 1–7). By the
turn of the century, the number of people with no health insurance coverage at some
time during the year was approximately 40 million (the number continuously fluctuates
as people add or drop coverage). This is due to several factors, including: 1) health
insurance premiums have become too costly for many individuals, even if they are
working; 2) individuals have been screened out of insurance policies because of “preexisting
conditions”; 3) employers, feeling they cannot afford to continue to provide
health insurance as a benefit, have either scaled back their benefits or eliminated them
altogether by hiring part-time rather than full-time workers; 4) due to budget restrictions,
the federal government and the states have tightened Medicaid eligibility criteria,
typically too far below the official federal poverty level for most families to
qualify; and 5) individuals have learned that they will be taken care of by providers,
especially community hospitals, if they show up at the door (specifically the emergency
room), even if they can’t pay. Some low-risk people may avoid insurance altogether
and assume they will be taken care of if ever need be. Most hospitals are legally
The Context of Health Care Finanacial Management 9
30
35
40
45
50
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
YEAR
NUMBER OF UNINSURED
(MILLIONS)
Exhibit 1–7 Number of Uninsured
Source: US Census Bureau, July 2001.
obligated to accept these individuals once they have entered the premises. This puts
a tremendous burden on health care facilities, especially community hospitals, to continue
to provide indigent care, because they can no longer pass on their costs to other
payors (see Exhibit 1–8).
bEfforts to Control Costsc
The impact of rising health care costs has had drastic consequences upon the ability of
providers to survive financially (see Exhibit 1–9). Hence, keen interest has been fostered
by payors and providers to control this rise. The following sections describe measures
undertaken to control costs.
Efforts by Payors to Control Health Care Costs
Rising health care costs have forced private and public payors to try a variety of
approaches to limit their financial risk. Increasingly, employers and payors have
drawn upon their position as the supplier of patients to manage care as well as to manage
payments. This has forced hospital administrators to accept payment arrangements
that greatly affect the relationships among patients, providers, and payors.
10 Financial Management of Health Care Organizations
$0
$2
$4
$6
$8
$10
$12
$14
$16
$18
$20
$22
UNCOMPENSATED CARE
COSTS ($BILLIONS)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
YEAR
Exhibit 1–8 Uncompensated Care Costs for the Uninsured
Source:American Hospital Association, July 2001.
The most commonly used methods by payors to control costs are introduced below
and illustrated in Exhibit 1–10. These approaches are discussed in more detail in
Chapter 13.
l Retrospective Review: reviewing services after they have been performed and
only reimbursing for those services deemed medically necessary by the payor.
l Concurrent Review: monitoring appropriateness and medical necessity of a
hospital stay while the patient is in the hospital, and implementing discharge
planning.
l Preadmission Certification and Second Opinions: requiring prior
approval or review of services to determine appropriateness of care.
l Prospective Payments: predetermining payments for services in advance
based upon common use of resources for that service.
l Gatekeepers: requiring a patient to obtain a referral from his or her primary
care physician, the “gatekeeper,” before going to see a specialist.
l CON (Certificate of Need): requiring providers to have their capital
expenditures (over a certain dollar amount) preapproved by an independent
state agency to avoid unnecessary duplication of services (not implemented in
all states).
l Provider Networks: requiring a patient to select from a preapproved list of
providers.
The Context of Health Care Finanacial Management 11
4,500
4,600
4,700
4,800
4,900
5,000
5,100
5,200
5,300
5,400
5,500
NUMBER OF HOSPITALS
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
YEAR
Exhibit 1–9 Annual Number of Surviving Hospitals
Prospective Payment
System: The payment
system used by
Medicare to reimburse
providers a
predetermined amount.
Several payment
methods fall under the
umbrella of PPS,
including: DRGs
(inpatient admissions);
APCs (outpatient
visits); RBRVS
(professional services);
and RUGs (skilled
nursing home care).
DRGs were the first
category to fall under
this type of
predetermined
payment arrangement.
Source:American Hospital Association, July 2001.
l Deductibles and Copayments: requiring patients to pay for part of their
own care up to a given amount (deductible) or for a portion of each service they
receive (copayment).
l Steerage and Discounts: agreeing to send patients to providers in return
for discounted services.
l Case Rates and Per Diems: setting reimbursement depending on the type
of case (medical, surgical, maternity, etc.) or setting rates per inpatient day
based on the type of case (per diems).
l Penalties: charging HMO patients a penalty for seeking care outside the
HMO network without preapproval. Providers may also be penalized by
HMOs for not following managed care rules. Such penalties include reducing
or withholding incentive pay.
l Point of Care: allowing capitated patients to seek care outside the HMO for
an increase in premium.
Because of the enormity of their impact, two payment systems designed to control
costs demand special attention: DRGs and capitation. Other payment systems which
are emerging, such as global payments and APCs, are also discussed.
12 Financial Management of Health Care Organizations
Retrospective
Review
Deductibles/
Copayments
Cost Control
Concurrent
Review
Preadmission
Certification &
2nd Opinions
Gatekeepers
&
Point of Care
Provider
Networks
Steerage &
Discounts
Prospective
Payments
Case Rates
& Per Deims
Penalties CON
Exhibit 1–10 Selected Methods Implemented by Payors to Control Costs
DRGs
In an effort to control Medicare inpatient costs, the Reagan administration introduced the
prospective payment concept in 1984. Under this plan, the government created nearly
500 different categories of illnesses called Diagnosis Related Groups, or DRGs, and
reimbursed a fixed amount based upon the patient’s discharge diagnosis. The goal was to
shift the degree of responsibility to the provider to be more efficient, since with few
exceptions (called “outliers”), the provider would receive a fixed reimbursement for a
patient in a particular category, regardless of the services provided. Several major problems
arose from the DRG-based system, which led to searches for alternatives:
l Reimbursement rates did not keep pace with health care inflation, which rose
at approximately 11 percent per year through the 1980s and into the early
1990s. Though the health care inflation rate slowed in the late 1990s, it has
since picked up again and still exceeds the overall rate of inflation. This trend
caused many facilities to lose money on Medicare patients, which encouraged
those facilities to steer Medicare patients to other providers.
l Providers began to engage in what became known as “DRG creep,” a
noticeable (possibly illegal) trend toward patients’ being placed into higherpaying
DRGs. This led to increased costs.
l Many hospitals find fixed reimbursements to be inconvenient. For example,
a patient is admitted for pneumonia, but during the patient’s stay, the
hospital discovers another problem, poor hearing. If the hospital performs
audiology services during the patient’s inpatient stay (which would be very
convenient), the hospital would not get additional reimbursement for
those services because the reimbursement amount is based only upon the
patient’s discharge diagnosis: pneumonia. To get compensated for audiology
services, the hospital must discharge the patient and then bring him back to
the hospital later as an outpatient, which has a different and separate
payment mechanism. (And even then, to prevent such occurrences, the
federal government enacted a “72-hour rule,” which in effect states that
additional services received within 72 hours of a discharge are considered part of
the preceding inpatient visit, and thus are not eligible for separate
reimbursement.)
Capitation
One of the newer methods to control costs is capitation, whereby the provider receives
a set payment to provide health care services to a population for a defined time period.
This type of engagement works best with large populations, sometimes referred to as
risk pools, where risk can be spread out and managed better. Typically, the payment
rate is set on a per member per month (PMPM) basis. Under this type of arrangement,
the provider receives a fixed amount of money at the beginning of each month (based
upon the number of enrollees) and agrees to provide all covered services necessary for
The Context of Health Care Finanacial Management 13
Diagnosis Related
Groups (DRGs): A
system to classify
inpatients based upon
their diagnoses. In the
most pervasive system,
which is used by
Medicare, there are
approximately 500
different diagnostic
categories.
Capitation: A system
which pays providers a
specific amount in
advance to care for the
health care needs of a
population over a
specific time period.
Providers are usually
paid on per member
per month (PMPM)
basis. The provider then
assumes the risk that
the cost of caring for
the population will not
exceed the aggregate
PMPM amount
received.
those enrollees during that month. Though there are various arrangements to limit
financial risk, under a completely capitated arrangement, the burden of cost containment
rests entirely on the provider.
Global Payments
Under most of today’s payment systems, each provider is paid separately. Under a
global payment system, a single price is agreed upon for several providers as a unit (i.e.
the hospital, physicians, home health agency, etc.), who have bid a set price for a contract.
Payors reduce risk by knowing in advance the amount that they will have to pay.
Providers, on the other hand, are able to keep the profit if they can provide all services
for less than the negotiated global payment. However, they are at risk for any loss. A particularly
interesting problem arises in how the providing parties decide to split any
profits or losses on the contract. Global pricing tends to increase: 1) the need for
providers to cooperate; and 2) the need to scrutinize practice patterns. Regardless, it can
be highly susceptible to unusually complicated and/or high cost patients, called outliers.
APCs
APCs, or Ambulatory Payment Classifications, are similar to and based upon the same
concept as DRGs, but reimburse fixed amounts for bundled outpatient services rather
than for inpatient services. Implemented in the year 2000 as part of the Balanced
Budget Act of 1997 (but modified according to the Balanced Budget Refinement Act
of 1999), APCs were an effort by the government to control rising outpatient costs.
With few exceptions, nearly all outpatient services and supplies were categorized into
groupings, each with a fixed reimbursement based upon a hospital’s wage index.
Because APCs are still relatively new, the impact that APCs have had on providers has
not yet been fully researched and realized. Many facilities are believed to be having a
difficult time adjusting, both to the provision of outpatient care, and to the fact that
they had previously relied on outpatient revenues to help to compensate for financial
losses in other areas.
Cutting Delivery Costs
Faced with restrictions on payments, providers have become increasingly concerned
with controlling costs. Some of the major trends that have resulted are: the shift to
outpatient services; new cost accounting systems; improved information services technology;
mergers and acquisitions; and reengineering/redesign.
Shift to Outpatient Services
Many hospitals are offering an increasing number of services on an outpatient basis
that have traditionally been performed on an inpatient basis, especially surgical ser-
14 Financial Management of Health Care Organizations
Risk Pools: A generally
large population of
individuals who are all
insured under the
same arrangement,
regardless of working
status. Health care
utilization – and
therefore cost – is
more stable for larger
groups than it is for
smaller groups, which
makes larger groups’
cost more predictable
for insurers.
Global Payments: A
system to pay
providers whereby the
fees for all providers
(i.e. hospitals,
physicians, home
health care agencies)
are included in a single
negotiated amount.
This is sometimes
called “bundling” of
services. In non-global
payment systems, each
provider is paid
separately.
vices. In fact, a hospital today commonly performs more than half of all of its surgical
cases on an outpatient basis. This has caused problems, however, for many hospitals
which were primarily designed to provide inpatient surgical services, including:
1) inadequate preoperative and postoperative holding areas for extended time periods;
2) inefficient processes for preoperative work-up testing, as outpatients must find
their own way to various departments throughout the hospital, such as labs and X-ray;
and 3) inefficient OR operations, since hospitals must rely on outpatients to arrive at
the hospital on time in the early morning, instead of retrieving patients from their
inpatient beds when requested. Other less invasive outpatient procedures still have
many of the same problems. This shift to outpatient services has forced hospitals to
invest in facility enhancements to accommodate their changing needs, and many hospitals
find themselves in a bind for funds as well as space.
Cost Accounting Systems
Most hospital accounting systems have a strong billing and collections component,
but a very weak cost accounting system. In fact, this is due in large part to the history
of reimbursement. Financial incentives were in place to maximize reimbursement, not
to control costs. Now that the environment has changed, providers have found it
increasingly important to know their precise costs. As a result, there has been a major
movement to separate cost accounting systems from financial accounting systems, and
to move away from traditional allocation-based cost systems to activity-based cost systems
(discussed in depth in Chapter 12). Though an expensive endeavor, declining
reimbursement is forcing hospitals to invest in more sophisticated cost accounting
systems.
Information Services Technology
With the rapid advances in computer hardware and software applications, many
institutions have invested in the latest information technologies in an effort to receive
the most accurate information as quickly as possible. Most applications revolve
around materials management, budgeting, accounts payable, payroll, and human
resource needs. It is essential for institutions to track the flow of materials through
their organizations, and to purchase and pay for supplies in the most cost-effective
manner. Hospitals can keep funds longer and reduce inventory costs by incorporating
“just-in-time” ordering techniques. If they can follow the flow of materials through
their organization, they can better track costs and have better reporting and control
over their budgets.
Computerization of medical records and information security is also an evolving
field requiring significant investments. While institutions are aware of the inefficiencies
of trying to manually maintain paper records, eventually many feel they will be
forced by competition and by the federal government to resort to a paperless system.
And in conjunction with this notion comes investments in telemedicine, the ability to
perform services from a distance. Presumably, all these advancements are ultimately
The Context of Health Care Finanacial Management 15
designed to save costs and/or lead to better provision of services, but these multi-million
dollar investments have to be made now.
Mergers and Acquisitions
Many facilities have invested heavily in mergers and acquisitions under the premise that
consolidation of services reduces costs. An acquisition could be as small as acquiring a
physician group practice, or as large as merging all the health care institutions in a specific
market area. The financial impact of such measures can be tremendous, and health
care professionals must have a keen understanding of the local markets and organizational
cultures before engaging in such practices. (See Perspective 1–3.) Oftentimes
mergers fail or lose money, such as the break-up of Stanford and UCSF medical cen-
16 Financial Management of Health Care Organizations
Perspective 1–3
Hospital M&A Activity Slow in 2000 as Health Care Industry Begins to Stabilize
In 2000, for the third year in a row, the number of US hospital mergers and acquisitions declined, with 22 percent
fewer deals announced than in the previous year, according to Irving Levin Associates, Inc., a health care research
and publishing firm.
In its seventh edition of “The Health Care Acquisition Report,” Levin reports that in 2000, the hospital sector had
the greatest number of mergers and acquisitions for the year of any health care services industry segment.Year 2000
hospital M&A activity dropped from 110 deals reported in 1999, 139 deals in 1998, 197 deals in 1997, and 163 deals
in 1996.The largest deal of the year was more than 4 times larger than the largest deal of 1999.
While M&A volume decreased, health care stocks and especially hospital stocks improved markedly during the
year 2000.“The outlook for 2001 is positive. Reimbursement relief was obtained for certain segments of the industry
after two years of suffering from The Balanced Budget Act of 1997. Now the health care industry is beginning to
stabilize,” stated Kathy Hammell, editor of the report. Hospitals account for the largest share of the more than $1
trillion that Americans spend annually on health care.
For the first time in seven years, for profit hospital acquisitions surpassed non-profit acquisitions in terms of number
of hospitals, with 69% of acquisitions involving for profit and only 31% involving non-profit hospitals. Indicative
of the rise in corporate acquisitions was the largest deal of the year – the $2.4 billion acquisition of Quorum Health
Group by Triad, a spin-off from Columbia/HCA (now HCA-The Healthcare Company), historically a major player in
the hospital acquisition market. None of the largest acquirers in 2000 or 1999 were affiliated with Roman Catholic
institutions, contrary to the prior year. “While considerably more attention has been focused on the corporate
acquisitions of the past five years, this industry will continue to be dominated by nonprofit entities,” stated Stephen
M. Monroe, a partner at Irving Levin Associates, Inc.
Transaction volume in the managed care sector also dropped in 2000, reflecting the declining financial health of
that sector.There were 49 managed care transactions announced, compared to 66 deals in 1999, 62 deals in 1998
and 57 deals in 1997. In the past five years, six managed care deals exceeded a transaction value of $1 billion, but no
deals have exceeded this level in the past two years.
Source: Irving Levin Associates, Inc.
Copyright 2001 PR Newswire Association, Inc., March 28, 2001
http://www.prnewswire.com
ters in San Francisco. Other acquisitions, such as those involving Columbia/HCA,
were done illegally and resulted in forced break-ups, fines, and jail sentences.
Reengineering/Redesign
As a major measure to cut costs in the last decade, facilities have been learning how to
redesign their work processes in order to operate more effectively and efficiently. This
involves process analysis, layout redesign, work redesign, total quality management,
care mapping, and layoff of unnecessary personnel.
bCost Control Issues with Ethical Overtonesc
Given the myriad efforts to control costs, health care administrators are increasingly
faced with ethical dilemmas trying to balance cost with quality and access. Numerous
studies have found a direct correlation among income, access, and health status.
Administrators must keep in mind that they do not produce widgets, but rather an
essential service, often to vulnerable populations. There are literally hundreds of
questions with ethical overtones that arise because of pressures to cut costs. Among
the most common are:
l How to control costs without cutting quality.
l How to control costs, yet expand access to services, especially in remote or
inner-city areas.
l How to control costs and provide services to those who cannot pay.
l How to control costs but offer expensive treatments to special populations,
such as the terminally ill or premature infants.
l How to control costs and still offer services that are typically reimbursed
below cost, such as certain types of transplants or other special surgical
procedures.
l How to control costs and not over-restrict the use of specialty care.
l How to ration health care services based upon medical effectiveness.
l How to weigh societal benefits against individual benefits when there are
limited resources.
Perspective 1–4 shows the struggles that health care institutions are facing in regard
to several topics discussed in the chapter.
bSummaryc
The health care administrator today and in the future will be faced with numerous complex
issues to consider while making financial decisions. Many factors have led to the
rise in increasing health care costs: an aging population, increasingly “high-tech” care,
The Context of Health Care Finanacial Management 17
Care Mapping: a
process which specifies
in advance the
preferred treatment
regimen for patients
with particular
diagnoses. This is also
referred to as a clinical
pathway, clinical
protocol, or practice
guideline.
prescription drug costs, chronic illnesses, compliance, legal concerns, and the ever rising
number of uninsured patients. Numerous efforts have been made to counter this
rise: changes in reimbursement and the shifting of risk to the providers, a shift towards
greater use of outpatient services and shorter inpatient stays, more efficient administrative
technologies, mergers and acquisitions, and redesign/reengineering of services in
general. But the administrator must constantly maintain a high ethical standard in all
decisions, because the health and survival of the population is in the balance.
The remainder of this text focuses on health care financial management topics such
as how to analyze financial statements, manage internal funds, make sound business
investments, borrow funds, analyze costs, and prepare a budget. It also provides more
in-depth analyses of how regulations and restrictions affect how health care institutions
must operate. While this knowledge is essential in the financial decision-making
process, the health care administrator always needs to carefully weigh non-financial
factors as well.
18 Financial Management of Health Care Organizations
Perspective 1–4
Conflicting Demands: Hospitals’ Financial Struggles Pose Legal Obstacle Course for Board Members
Gone are the days when funding a new wing at a hospital was enough to earn someone a seat on its board of directors.
To compete with their for-profit competitors, today’s not-for-profit hospitals and systems require financially
savvy directors who realize that doing good in the community is not enough to keep a hospital afloat.
In an increasingly litigious environment marked by several high-profile hospital bankruptcies, greater state involvement
in hospital closures, and increasingly aggressive creditors, hospital board members more frequently are a target
of blame for a hospital’s financial demise, legal experts say.
If a hospital is approaching insolvency, should a board be focusing on how to continue to provide care for its community?
Should it be doing what is best financially for the corporate owner of the hospital? Or should it be concentrating
primarily on how to bring in the most cash to pay its creditors? As it turns out, the answers to these
fundamental questions are about as clear as mud and vary from state to state, legal experts say.
Take the example of the 30-bed Manhattan Eye, Ear, and Throat Hospital, which tried to exit the acute-care business
and sell its real estate assets for $41 million several years ago, only to be challenged in the courts by New York
Attorney General Eliot Spitzer. In December 1999, the New York Supreme Court prohibited the hospital’s board of
trustees from going forward with the deal, despite six months of deliberations, the hiring of a financial adviser, and
consideration of alternative bids. The reason, according to Justice Bernard Fried, was that the board breached its
fiduciary responsibilities by not considering competing offers that would have allowed the hospital to continue its
mission as a specialty facility.
The threat to a not-for-profit hospital’s endowment when it approaches insolvency brings board members into
the fray. James Schwartz, a partner at Manatt, Phelps & Phillips, Los Angeles, who has represented not-for-profit systems,
says board members’ shifting duties during insolvency will likely become a major issue in coming years. It could
hit California especially hard as hospitals struggle to find the capital to comply with the state’s seismic retrofitting
mandates, he says. “An awful lot of hospitals are looking at that situation, and to my knowledge, nobody has been
giving them much guidance,” he says.
Source: Barbara Kirchheimer, Modern Healthcare,August 27, 2001.
bQuestions and Problemsc
1. Definitions. Define the following terms:
a. Ambulatory Payment Classifications (APCs).
b. Capitation.
c. Care Mapping.
d. Compliance.
e. Cost-shifting.
f. Defensive Medicine.
g. Diagnosis Related Groups (DRGs).
h. Global Payments.
i. Health Insurance Portability and Accountability Act (HIPAA).
j. Prospective Payment System.
k. Risk Pools.
2. Increased Costs. List several factors which have led to the rise in increased
costs.
3. Cost Control. List several efforts that have been enacted by payors to
control costs.
4. Cost Control. List several efforts which have been attempted by providers
to control costs.
5. Ethics. What are some of the ethical issues that must be considered when
making any financial decisions?
6. Capitation. Explain how and to whom capitation shifts the burden of risk.
7. Litigation. Explain the ramifications of allowing/disallowing an individual
to be able to sue his or her HMO.
8. Drugs. Is the granting of patents good for the development of new drugs?
Why or why not?
9. Ethics. If an uninsured individual needed expensive medical treatment and did
not have the means to pay for it, should the treatment be provided? Would the
answer be influenced by the financial status of the institution asked to provide
the service? Would the answer be any different if the individual were uninsured
voluntarily (e.g. “I’ll take my chances and hope nothing happens”) or
involuntarily (e.g. “It’s either health insurance or food for my children”)?
10. Ethics. Should private for-profit institutions be forced to accept patients
who will not reimburse satisfactorily? Why or why not?
The Context of Health Care Finanacial Management 19
Ambulatory Payment
Classifications (APCs)
Capitation
Care Mapping
Compliance
Cost-shifting
Defensive Medicine
Diagnosis Related Groups
(DRGs)
Global Payments
Health Insurance Portability
and Accountability Act
(HIPAA)
Prospective Payment System
Risk Pools
bKey Termsc
C h a p t e r Tw o
HEALTH CARE FINANCIAL
STATEMENTS
Learning Objectives
After completing this chapter, you will be able to:
Identify the four basic financial statements common to all organizations.
Identify and read the four basic financial statements particular to not-for-profit, business-oriented health care
organizations: the balance sheet, the statement of operations, the statement of changes in net assets, the
statement of cash flows.
Introduction
The Balance Sheet
Assets
Current Assets
Cash and Cash Equivalents
Short-term Investments
Assets Limited as to Use
Patient Accounts Receivable, Net of Estimated
Uncollectibles
Supplies, Prepaid Expenses, and Other Current
Assets
Non-current Assets
Assets Limited as to Use
Long-term Investments
Properties and Equipment, Net
Other Assets
Liabilities
Current Liabilities
Current Portion of Long-term Debt
Accounts Payable and Accrued Expenses
Estimated Third-party Payor Settlements
Other Current Liabilities
Non-current Liabilities
Net Assets
Stockholders’ Equity
Notes to Financial Statements
The Statement of Operations
Unrestricted Revenues, Gains, and Other
Support
Net Patient Service Revenues
Premium Revenues
Other Revenues
Net Assets Released from Restriction
Expenses
Depreciation and Amortization
Interest
Provision for Bad Debts
Other Expenses
Chapter Outline
(Continues)
Introduction
Creditors, investors, and governmental and community agencies often require considerable
information in order to make judgments about the financial performance
of health care organizations. For instance, in order to decide whether to lend
money to a home health agency, a lender may want to know how much debt the
agency already has, how much cash it has available, and how much profit it is earning.
Similarly, in order to make regulatory decisions, a governmental agency may
want to know how much charity care is being offered or what the profit margin is
for a group of providers. So that standardized financial information needed by outside
parties is regularly available, almost all businesses are required to produce four
different financial statements at least annually.
Balance Sheet.
Income Statement (or Statement of Operations).
Statement of Changes in Owners’ Equity (or Statement of Changes In Net
Assets).
Statement of Cash Flows.
As shown in Perspectives 2–1 and 2–2, the financial statements are not only of
interest internally, but may also be of general interest to outside parties. Though the
general format of these statements remains the same, they are often modified to reflect
the idiosyncrasies of particular industries (e.g. transportation, energy, health care). In
health care, four additional subsets of rules apply, depending upon the type of organization:
(1) governmental entities; (2) not-for-profit, business-oriented organizations;
(3) not-for-profit, non-business-oriented organizations; and (4) investor-owned. The
Health Care Financial Statements 21
Operating Income
Other Income
Excess of Revenues over Expenses
Below the Line Items
Change in Net Unrealized Gains and Losses on
Other than Trading Securities
Increases in Long-lived Unrestricted Net Assets
Transfers to Parent
Extraordinary Items
Increase in Unrestricted Net Assets
The Statement of Changes in Net Assets
Changes in Unrestricted Net Assets
Changes in Temporarily Restricted Net
Assets
Changes in Permanently Restricted Net
Assets
The Statement of Cash Flows
Cash Flows from Operating Activities
Cash Flows from Investing Activities
Cash Flows from Financing Activities
Cash and Cash Equivalents at the End of
the Year
Summary
Key Terms
Key Equations
Questions and Problems
Appendix A: Illustrative Set of Financial
Statements for Sample Not-For-Profit
Hospital and For-Profit Hospital and
Notes to Financial Statement
Chapter Outline (Contd)
22 Financial Management of Health Care Organizations
focus of this text is primarily not-for-profit, business-oriented health care organizations,
which are referred to hereafter as not-for-profit health care organizations. Other
types of organizations have a high degree of overlap with the material presented here.
Exhibit 2–1 presents a comparison of the basic financial statements used by
investor-owned and not-for-profit health care organizations.
The remainder of this chapter discusses the financial statements and terms used
by health care organizations. A complete set of the financial statements discussed
Perspective 2–1
Buying on Credit: Hospital Systems Post Modest Increase in Their Long-term Liabilities
Hospital acquisitions, medical office buildings, transportation systems and equipment purchases all helped to
increase the amount of long-term liabilities of the nation’s healthcare systems last year. Hospital systems overall
reported a 6% increase in long-term liabilities to $95 billion last year compared with $89.6 billion in 1999,
according to Modern Healthcare’s 25th annual Hospital Systems Survey (June 4, p. 36). A total of 211 hospital
systems provided long-term liability data. Of those, 135 not-for-profit systems reported a 3.3% increase in longterm
liabilities to $41 billion last year from $39.7 billion in 1999, while 12 for-profit systems recorded an
increase of 7.2% to $12.8 billion last year from $11.9 billion in 1999. Public systems, 21 of them, reported the
largest increase in long-term liabilities, 10.2%, to almost $11 billion last year from just under $10 billion in 1999.
Long-term liabilities can include notes, mortgages, capital leases, bonds and obligations under continuing-care
contracts.The survey polls systems that own, lease or sponsor at least two acute-care hospitals, and all findings
are based on self-reported data.The numbers seem to indicate that healthcare organizations took advantage of
a favorable borrowing market in the past year thanks to attractive long-term interest rates, a trend that has continued
so far this year. . . .
Unlike for-profit chains, which can raise money without increasing debt thanks to the equities markets, the
not-for-profits are limited to borrowing in one way or another because they don’t have investors, says Brian
McGough, managing director at Banc One Capital Markets in Chicago. He says there were three main reasons
systems increased their long-term liabilities last year: not-for-profits borrowing to finance acquisitions of other
not-for-profit facilities; not-for-profit systems buying hospitals divested by for-profit companies; and investments
in technology, especially costs related to addressing the anticipated Y2K computer problems.
Source: Deanna Bellandi, Modern Healthcare, June 18, 2001.
http://www.modernhealthcare.com/archive/article.php3?article=7348
Financial Statements Used by Financial Statements Used by
Investor-owned Health Care Organizations Not-for-profit Health Care Organizations
Balance Sheet Balance Sheet
Income Statement Statement of Operations
Statement of Changes in Owners’ Equity Statement of Changes in Net Assets
Statement of Cash Flows Statement of Cash Flows
Exhibit 2–1 A Comparison of Generally Used Financial Statements for Investor-Owned and Not-For-Profit
Health Care Organizations
Health Care Financial Statements 23
in this chapter can be found in Appendix A, adapted from the American Institute
of Certified Public Accountants’ Audit and Accounting Guide: Health Care
Organizations, 1996.
The Balance Sheet
The balance sheet of investor-owned organizations presents a summary of the organization’s
assets, liabilities, and shareholders’ equity (see Exhibit 2–2). Similarly, the
balance sheet of a not-for-profit health care organization presents a summary of the
organization’s assets, liabilities, and net assets. (These terms and the relationship
among them will be discussed in more detail shortly.) The balance sheet is similar to
a snapshot of the organization, for it captures what the organization looks like at a particular
point in time, usually the last day of the accounting period (i.e. quarter, halfyear,
fiscal year). Exhibit 2–3 presents an illustration of a balance sheet and serves as
an overview of this section of the text.
As with all four financial statements, the balance sheet is organized into three major
sections: heading, body, and notes (see Exhibit 2–2). At the top of the balance sheet
(and each of the other financial statements) is a three-line heading that includes the
name of the organization, the name of the statement, and two dates.
The name of the organization is important because it provides the reader with the
name of the specific entity being summarized. This is not as trivial as it might seem.
One health care organization may produce financial statements for more than one
entity, depending upon the degree of control and/or economic interest. For example,
Perspective 2–2
HMOs: Some Profits, More Losses
It was a case of the rich getting richer and the poor getting poorer among HMOs in the Carolinas last year, analysts
say. Health maintenance organizations owned by Blue Cross & Blue Shield of N.C. Inc., Cigna Healthcare of N.C. Inc.
and United Healthcare of N.C. Inc. registered significant increases in pretax net income from 1999 to 2000. The
Wellness Plan of N.C. Inc., now existing under Carolinas HealthCare System to serve only Medicaid patients, saw a
tiny dip in membership last year but a $19 million increase in pretax net losses to $27.5 million. . . .
“From an HMO perspective, life is a little tougher than it was a few years ago because physician groups have gotten
bigger and stronger,” says Will Latham, of Charlotte-based Latham Consulting Group.“At the same time, hospitals
have better learned to negotiate and create a challenge for HMOs.”
Aetna U.S. Healthcare of the Carolinas Inc. gained more than 8,200 members in 2000 but lost $13.7 million more
in pre-tax net income. Its medical and hospital costs shot to $128.5 million in 2000, rising from $84.4 million in 1999,
and its administrative costs more than doubled. . . . Last year, Blue Cross & Blue Shield had one of its best financial
years, says spokeswoman Michelle Vanstory. . . . She credits much of her company’s success to new Chief Executive
Robert Greczyn and program offerings such as AltMed Blue, an alternative medicine program, exercise incentives and
the strength of the Blue Cross brand. . . .
Source:Ashley M. Gibson, The Business Journal of Charlotte,April 23 2001
a hospital may produce its own balance sheet or it may be included with other affiliated
entities (e.g. managed care, outpatient services, home health). If more than one
entity is being summarized, then the report is called a consolidated or combined
balance sheet and the names of the entities being summarized are in the notes.
Below the name of the organization, the term Balance Sheet appears in the heading
to differentiate it from the other financial statements. Finally, two dates are shown. As
mentioned earlier, the balance sheet reports what the organization looks like at a particular
point in time, usually the last day of the accounting period (i.e. quarter, halfyear,
fiscal year). Two dates are often shown so that the reader can compare two
successive periods. This is called a comparative balance sheet.
24 Financial Management of Health Care Organizations
Heading Name of Investor-Owned Organization Name of Not-For-Profit Organization
Balance Sheet Balance Sheet
Dates Dates
Body Assets Assets
Current Assets Current Assets
Non-Current Assets Non-Current Assets
Total Assets Total Assets
Liabilities Liabilities
Current Liabilities Current Liabilities
Non-Current Liabilities Non-Current Liabilities
Total Liabilities Total Liabilities
Shareholders’ Equity1 Net Assets1
Common Stock Unrestricted
Retained Earnings Temporarily Restricted
Total Shareholders’ Equity Permanently Restricted
Total Liabilities and Shareholders’ Equity Total Net Assets
Total Liabilities and Net Assets
Notes Key pertinent information including: Key pertinent information including:
Accounting policies Accounting policies
Payment arrangements with third parties Payment arrangements with third parties
Asset restrictions Asset restrictions
Property and equipment Property and equipment
Long-term debt Long-term debt
Pension obligations Pension obligations
1A major difference between the balance sheet of an investor-owned and a not-for-profit health care organization is in the owners’ equity
section. In an investor-owned organization, the section is organized to show the shareholders’ ownership stake in the corporation. In a notfor-
profit health care organization, the section is termed Net Assets and is organized to show the degree of donor restriction on the assets.
Exhibit 2–2 Overview of the Main Balance Sheet Sections of Investor-owned and Not-for-profit Health Care
Organizations
Assets are resources
that the organization
owns, typically
recorded at their
original costs.
The balance sheet reports what the organization’s assets, liabilities and equity are at a particular point in time,
usually the last day of the accounting period (i.e. quarter, half-year, fiscal year).
The balance sheet provides a snapshot of the organization’s assets,
liabilities and net assets as of a point in time.
Title: Gives the name of the organization, the name of the financial
statement, and two dates for which the information is being provided.
Assets: The resources of the organizations which are eventually used
to provide service and generate revenues.
Current assets: Assets which will be used or consumed within a
year.
• Cash and cash equivalents: Coin, currency and checks held
within the organization or in financial institutions such as
banks.
• Short-term investments: Temporary investment accounts
which allow the organization to earn interest and have ready
access to cash.
• Assets limited as to use: The current portion of monies set
aside for specific purposes, such as to insure debt repayment.
• Patient accounts receivable net of estimated uncollectibles:
Money owed to the organization as a result of delivering service
to patients, less an estimate of how much will not be collected.
Uncollectibles: The amount owed to the organization
which it expects it will probably not ever receive.
• Other current assets: A summary category which may
contain smaller accounts.
Inventory: The supplies used to run the organization and
provide services.
Prepaid expenses: Amounts the organization has paid in
advance, such as rent, and insurance.
Non-Current Assets: Assets which will benefit the organization for
periods longer than a year, such as major equipment and buildings.
• Assets limited as to use: Monies set aside for specific
purposes such as to ensure debt repayment, less the amount
needed this accounting period.
• Long-term investments: Investments, such as stocks, bonds
and land, which the organization expects to realize a profit from
over a period longer than one year.
• Property and equipment, net: The buildings and machinery
(e.g., x-ray machine) of the organization, less the amount it has
been depreciated (“used up”) to date, called accumulated
depreciation.
Total assets: The sum of current and non-current assets.
Liabilities: The financial obligations of the organization to pay its
creditors.
Current liabilities: The financial obligations which must be paid
within one year.
• Current portion of long-term debt: That portion of multi-year
debt which is due this year.
• Accounts payable and accrued expenses: Amounts due this
year to suppliers, employees, and others for goods and services
which have been received but not yet paid for.
• Estimated third-party payor settlements: An estimate of the
amount which must be returned to third parties for overpayment
of claims.
• Other: All other current liabilities not listed above. A major
component may be deferred revenue: Money that has been
received, but not yet earned (e.g., money received in advance
from managed care organizations: it will be earned as time
passes).
Non-Current liabilities: The financial obligations which must be
paid-off over a time period longer than one year (e.g. a capital leases).
• Long-term debt, net of current portion: The amount of multiyear
debt due in future years.
Net Assets: Assets – Liabilities. This section has traditionally been
called Stockholders’ Equity in investor-owned organizations and Fund
Balance in not-for-profit organizations.
•Unrestricted Net Assets: The amount of the net assets which
have no outside restrictions on them.
•Temporarily restricted net assets: Assets which have
restrictions on their use which will be removed either with the
passage of time or the occurrence of some event.
•Permanently restricted net assets: Assets which have
restrictions on their use which will not be removed.
*An unannotated form of this statement can be found in Appendix A
of this chapter.
Source: Reprinted with permission from the Audit and Accounting
Guide: Health Care Organizations, copyright ©1996 by the American
Institute of Certified Public Accountants, Inc.
Assets 20X1 20X0
Current Assets:
Cash and Cash Equivalents $4,758 $5,877
Short-Term Investments 15,836 10,740
Assets Limited as to Use 1,300
Patient Accounts Receivable, Net Estimated
Uncollectibles of $2,500 in 20X1 and $2,400 in 20X0 15,100 14,194
Supplies 2,000 2,000
Prepaid Expenses 670 856
Total Current Assets 39,334 34,967
Non-Current Assets
Assets Limited as to Use 18,949 19,841
Less Amount Required to Meet Current Obligations (970) (1,300)
17,979 18,541
Long-Term Investments 4,680 4,680
Long-Term Investments Restricted for Capital Acquisition 320 520
Properties and Equipment, Net 51,038 50,492
Other Assets 1,695 1,370
Total Non-Current Assets 75,712 75,603
Total Assets $115,046 $110,570
Liabilities and Net Assets
Current Liabilities
Current Portion of Long-Term Debt $1,470 $1,750
Accounts Payable and Accrued Expenses 5,818 5,382
Estimated Third-Party Payor Settlements 2,143 1,942
Deferred Revenues 1,969 2,114
Total Current Liabilities 11,400 11,188
Non-Current Liabilities
Long-Term Debt, Net of Current Portion 23,144 24,014
Other 3,953 3,166
Total Non-Current Liabilities 27,097 27,180
Total Liabilities 38,497 38,368
Net Assets
Unrestricted 70,846 66,199
Temporarily Restricted 2,115 2,470
Permanently Restricted 3,588 3,533
Total Net Assets 76,549 72,202
Total Liabilities and Net Assets $115,046 $110,570
Sample Not-For Profit Hospital
Balance Sheet
December 31, 20X1 and 20X0 (in ‘000)
970
1
2
3
4
1
5
6
7
2
3
4
5
6
7
Exhibit 2–3 Annotated Balance Sheet for Sample Not-For-Profit Hospital
The three major sections comprising the body of the balance sheet are assets, liabilities,
and net assets (see Exhibits 2–2 and 2–3). The balance sheet derives its name
from the fact that the assets always equal the sum of the liabilities plus the owners’
equity (called shareholders’ equity in investor-owned health care organizations and net
assets in not-for-profit health care organizations). The relationship among the three
major sections of the balance sheet is expressed by the basic accounting equation:
Assets = Liabilities + Owners’ Equity
In investor-owned organizations, the equation becomes:
Assets = Liabilities + Shareholders’ Equity
In not-for-profit, business-oriented health care organizations, the equation
becomes:
Assets = Liabilities + Net Assets
In Exhibit 2–3 for the year 20X1, the assets equal $115,046,000 and the liabilities
plus the net assets also equal $115,046,000 ($38,497,000 plus $76,549,000).
Incidentally, until mid-1996, not-for-profit health care organizations used the term
fund balance instead of net assets, while governmental organizations such as states,
cities, and local counties continue to use fund accounting.
Assets
The assets of an organization are the resources it owns. Most assets are recorded at
their original cost. Assets are divided into two categories, current assets and noncurrent
assets (see Exhibit 2–4).
Current Assets
Current Assets are assets that will be used or consumed within one year (see Exhibit
2–4). They help turn the capacity of the organization (i.e. buildings and equipment)
into service. Current assets include:
Cash and Cash Equivalents.
Short-term Investments.
Assets Limited as to Use.
Patient Accounts Receivable, Net of Estimated Uncollectibles.
Supplies, Prepaid Expenses and Other Current Assets.
How quickly an asset can be turned into cash is called its liquidity, and current
assets are always listed in the order noted, which is based upon their relative liquidity
in the general business world. Though this order generally reflects the liquidity of
many non-health care providers, there are a number of health care providers who find
26 Financial Management of Health Care Organizations
Liabilities are the
financial obligations of
the organization (i.e.
debts).
Net Assets is the
difference between an
organization’s assets
and liabilities (assets
minus liabilities).
Basic Accounting
Equation: Assets =
Liabilities + Net Assets
Fund Balance: A term
used until 1996 for
owners’ equity by notfor-
profit health care
organizations. It was
replaced with the
present term, net
assets, for nongovernmental,
not-forprofit
organizations.
Liquidity: A measure
of how quickly an asset
can be converted into
cash.
Health Care Financial Statements 27
their Patient Accounts Receivable (the money owed to them for services rendered to
patients) is their least liquid current asset. Still, by convention, this generally accepted
order is followed in the listing of current assets.
Because of their liquidity, current assets require special internal control procedures
to ensure that they are handled appropriately and efficiently. For instance, a generally
accepted internal control procedure in health care organizations is to have different
people send out the bills, open the incoming mail, and record payments – a procedure
which, if not followed, lends itself to considerable opportunities for mishandling of
funds. Another internal control procedure is to restrict access to supplies and medicines.
This leads to a discussion of each of the current asset accounts.
Cash and Cash Equivalents
Cash and cash equivalents are the most liquid current assets (see Exhibit 2–4). This
account is composed of actual money on hand as well as money equivalents, such as
Exhibit 2–4 Asset Section of the Balance Sheet from Exhibit 2–3 with an Emphasis on Current Assets
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Assets 20X1 20X0
Current Assets:
Cash and Cash Equivalents $4,758 $5,877
Short-Term Investments 15,836 10,740
Assets Limited as to Use 970 1,300
Patient Accounts Receivable, Net of Estimated
Uncollectibles of $2,500 in 20X1 and $2,400 in 20X0 15,100 14,194
Supplies 2,000 2,000
Prepaid Expenses 670 856
Total Current Assets 39,334 34,967
Non-Current Assets
Assets Limited as to Use 18,949 19,841
Less Amount Required to Meet Current Obligations (970) (1,300)
17,979 18,541
Long-Term Investments 4,680 4,680
Long-Term Investments Restricted for Capital Acquisition 320 520
Properties and Equipment, Net 51,038 50,492
Other Assets 1,695 1,370
Total Non-Current Assets 75,712 75,603
Total Assets $115,046 $110,570
Cash (or cash equivalents) is the most liquid asset on the balance sheet.
savings and checking accounts. It excludes cash that has restrictions regarding withdrawal
or for use for other than current operations.
Short-term Investments
Short-term investments include certificates of deposit, commercial paper, and treasury
bills. These temporary investment accounts allow a health care facility to earn interest
on idle cash and, at the same time, provide almost immediate access to cash for unexpected
situations. Short-term investments are discussed in greater detail in Chapter 5.
Assets Limited as to Use
The cash and short-term investments listed above in the current assets section are generally
available for management to use to carry out its duties. In addition, a health care
organization may have other cash, marketable securities, or other current assets that can
be used only under special conditions. For example, in taking out a loan, a health care
organization may agree to set aside an amount of funds equal to six months’ worth of loan
payments. Current assets that fall into this category are classified as Assets Limited as to
Use (see Exhibit 2–4). The Assets Limited as to Use accounts for Sample Not-For-Profit
Hospital’s current assets are $1,300,000 in 20X0 and $970,000 in 20X1.
Patient Accounts Receivable, Net of Estimated Uncollectibles
Gross Patient Accounts Receivable is the amount owed the health care organization
at full charges. However, many payors, such as Medicaid, insurance companies, large
employers, and managed care organizations are given discounts, called contractual
allowances. By subtracting Contractual Allowances and Charity Care Discounts
from Gross Patient Accounts Receivable, what remains is Patient Accounts
Receivable. Patient Accounts Receivable represents the actual amount the health care
organization has the right to collect.
Along with reporting patient accounts receivable (but not gross patient accounts
receivable) on the balance sheet, health care organizations also present an estimate of
how much of their Patient Accounts Receivable they likely will not be able to collect.
This estimate is called the Allowance for Uncollectibles.
Assuming Gross Patient Accounts Receivable were $24,800,000, Discounts and
Contractual Allowances were $7,200,000, and Allowance for Uncollectibles was
$2,500,000, Patient Accounts Receivable, Net of Uncollectibles for 20X1 would be
$15,100,000, as shown in Exhibit 2–5.
By convention, the total amount of Patient Accounts Receivable, in this case
$17,600,000, is commonly omitted on the balance sheet, since it can be derived by
adding the Allowance for Uncollectibles and the Patient Accounts Receivable, Net of
Estimated Uncollectibles.
Supplies, Prepaid Expenses, and Other Current Assets
Because of their relatively small size, supplies and prepaid expenses are often
grouped together under the title Other Current Assets. Two accounts often found in
this category are Supplies and Prepaid Assets (see Exhibit 2–4). Supplies include the
28 Financial Management of Health Care Organizations
Charity Care
Discounts: Discounts
from Gross Patients
Accounts Receivable
given to those who
cannot pay their bills.
day-to-day supplies used by the organization in the provision of health care services,
including food, drugs, office, and medical supplies. Another name for supplies is
inventory. A common mistake is to confuse Supplies and Equipment. Supplies refers
to small-dollar items that will be “used up” or fully consumed within at least one year,
such as pharmaceuticals and office supplies. Equipment refers to relatively expensive
items that will be used over a long period of time, such as buildings and radiology
equipment. Prepaid Assets, also called Prepaid Expenses, include items the health care
organization has paid for in advance, such as rent and insurance. Although they are not
tangible, they are still assets – in the form of rights the organization has purchased. For
instance, by paying its rent in advance, the organization has a right to use a building for
a specified period. To the extent that supplies and prepaid expenses are relatively large,
they may be broken out and reported separately rather than grouped together.
Non-current Assets
Whereas current assets will be used or consumed within one year, non-current assets
will be used or consumed over periods longer than one year (see Exhibit 2–6). Noncurrent
assets are relatively costly items that allow the organization to deliver service
over time. Whereas current assets require special management attention because of
their liquidity and transportability, non-current assets require special attention
because of their cost and the extensive time horizon it takes to plan, acquire, and manage
them. Non-current assets are commonly organized into the following categories:
Health Care Financial Statements 29
Non-current Assets:
The resources of the
organization that will
be used or consumed
over periods longer
than one year.
Account Title Amount Explanation
Gross Patient Accounts Receivable $24,800 The amount owed to the organization, based on
full charges. This amount is not reported on
financial statements, because it does not represent
how much the health care organization is really
owed because of discounts and allowances.
− Discounts and Allowances 7,200 Includes discounts given to third parties (largescale
purchasers of health care services) and
discounts for charity care.
Patient Accounts Receivable 17,600 Gross charges less discounts and allowances.
− Allowance for Uncollectibles 2,500 An estimate of how much of Patient Accounts
Receivable will likely not be collectible.
Patient Accounts Receivable,
Net of Estimated Uncollectibles $15,100 The amount expected to be collected.
Exhibit 2–5 Calculation of Patient Accounts Receivable, Net of Estimated Uncollectibles
Supplies are sometimes called inventory.
30 Financial Management of Health Care Organizations
Assets Limited as to Use.
Long-term Investments.
Property and Equipment, Net.
Other Assets.
Assets Limited as to Use
With the exception of donor-restricted funds, which are reported elsewhere, this
section reports the amount of the assets that have been set aside for long-term purposes
and are thus not available for general use. The balance sheet presentation of
Assets Limited as to Use must separate internally designated and externally designated
amounts either on the statements themselves or in the notes to the financial
statements. In the case of Sample Not-For-Profit Hospital in 20X1, this category
contains two items: the board has set aside $12,000,000 in order to purchase buildings
or equipment, and as part of a loan agreement, the organization has placed
Exhibit 2–6 Asset Section of the Balance Sheet from Exhibit 2–3 with an Emphasis on Non-current Assets
Assets 20X1 20X0
Current Assets:
Cash and Cash Equivalents $4,758 $5,877
Short-term Investments 15,836 10,740
Assets Limited as to Use 970 1,300
Patient Accounts Receivable, Net of Estimated
Uncollectibles of $2,500 in 20X1 and $2,400 in 20X0 15,100 14,194
Supplies 2,000 2,000
Prepaid Expenses 670 856
Total Current Assets 39,334 34,967
Non-current Assets
Assets Limited as to Use 18,949 19,841
Less Amount Required to Meet Current Obligations (970) (1,300)
17,979 18,541
Long-term Investments 4,680 4,680
Long-term Investments Restricted for Capital Acquisition 320 520
Properties and Equipment, Net 51,038 50,492
Other Assets 1,695 1,370
Total Non-current Assets 75,712 75,603
Total Assets $115,046 $110,570
The terms “non-current” and “long-term” are often used interchangeably.
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
$6,949,000 with a trustee which will be used to pay off the loan (see Exhibit 2–6).
Notice that this category begins by presenting all Assets Limited as to Use, and then
subtracts the amount required to meet current obligations, which is reported under
Current Assets.
Long-term Investments
Long-term Investments are investments with a maturity of more than one year.
Securities include various types of stocks and bonds and are discussed in more detail
in Chapter 8. Since long-term investments should be classified according to their
intended purpose, $4,680,000 is shown in the general account Long-Term
Investments and $320,000 is shown in the account Long-Term Investments
Restricted for Capital Acquisition.
Properties and Equipment, Net
This category of assets represents the major capital investments in the facility. There
are three types of assets included in this category: land, plant, and equipment. Plant
refers to buildings (fixed, immovable objects), land refers to property, and equipment
includes a wide variety of durable items from beds to CAT scanners. Land, plant, and
equipment are recorded on the organization’s books at cost, and over time, plant and
equipment (but not land!) are depreciated. Depreciation is an estimate of how much
the plant or equipment has been “used up” during the accounting period.
The word “net” in “Properties and Equipment, Net” means that the total amount of
depreciation taken up to this point in time has been subtracted from the original cost.
To derive Properties and Equipment, Net, the total amount of depreciation taken since
the asset was put into use (called Accumulated Depreciation) is subtracted from the
original cost of the asset (called Plant and Equipment). Assuming the original cost is
$91,161,000 and accumulated depreciation is $40,123,000, Properties and Equipment,
Net would be calculated as shown in Exhibit 2–7.
By convention, plant and equipment are always kept on the books in their own
accounts at their original cost until the assets are modified or sold. Similarly, the total
amount of depreciation is kept in a separate account, Accumulated Depreciation. In
this way, those looking at the balance sheet are always able to know: (1) the original
Health Care Financial Statements 31
Account Title Amount Explanation
Properties and Equipment $91,161 The original cost of the land, plant, and equipment.
Less: Accumulated Depreciation 40,123 An estimate of the amount the assets have been “used up.” It
is equal to the total amount of depreciation taken since the
organization acquired the assets. By convention, plant and
equipment depreciate, land does not.
Properties and Equipment, Net $51,038 The original cost minus the amount the assets have been
depreciated (used up).
Exhibit 2–7 Calculation of Properties and Equipment, Net
Accumulated
Depreciation is the
total amount of
depreciation taken on
an asset since it was
put into use.
Depreciation: A
measure of how much
a tangible asset (such
as plant or equipment)
has been “used up” or
consumed.
32 Financial Management of Health Care Organizations
cost of the assets; (2) how much they have been depreciated; and (3) their current book
value (original cost less depreciation).
Other Assets
Other Assets is a catchall account used for those non-current assets not included in
the other categories of non-current assets.
Liabilities
The preceding section focused on how assets are presented on the balance sheet. We
now turn to a discussion of the liabilities of a health care organization. Liabilities are
the obligations of a health care provider to pay its creditors. As with assets, liabilities
are divided into two categories: current and non-current (see Exhibit 2–8).
Current Liabilities
Current liabilities are the financial obligations that, due to their contractual terms, will
be paid within one year. Common account categories include:
Current Portion of Long-term Debt.
Accounts Payable and Accrued Expenses.
Estimated Third-party Payor Settlements.
Other Current Liabilities.
Each of these accounts is discussed below.
Liabilities and Net Assets 20X1 20X0
Current Liabilities
Current Portion of Long-term Debt $1,470 $1,750
Accounts Payable and Accrued Expenses 5,818 5,382
Estimated Third-party Payor Settlements 2,143 1,942
Deferred Revenues 1,969 2,114
Total Current Liabilities 11,400 11,188
Non-current Liabilities
Long-term Debt, Net of Current Portion 23,144 24,014
Other 3,953 3,166
Total Non-current Liabilities 27,097 27,180
Total Liabilities 38,497 38,368
Exhibit 2–8 Liabilities Section of the Balance Sheet from Exhibit 2–3
Current Liabilities:
Financial obligations
due within one year.
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations,
copyright © 1996 by the American Institute of Certified Public Accountants, Inc.
Health Care Financial Statements 33
Current Portion of Long-term Debt
This account contains the amount of the organization’s long-term debt that is expected to
be paid off within one year. For example, if a home health agency has executed a five-year
note payable, the principal amount due this year is reported in this account. The remainder
is listed under non-current liabilities. This information is sometimes reported in the
account Notes Payable, which reports the amount of short-term (less than one year) obligations
for which a formal note has been signed.
Accounts Payable and Accrued Expenses
Accounts Payable are obligations to pay suppliers who have sold the health care organization
goods or services on credit. Accrued Expenses are expenses that arise in the
normal course of business which have not yet been paid. Included in this category are
salaries, wages, and interest. Sometimes accrued expenses are presented in separate
accounts, such as:
Salaries and Wages Payable.
Interest Payable.
Estimated Third-party Payor Settlements
This account represents an estimate of funds to be repaid to third-party payors.
Third-party payors are organizations such as insurance companies and governmental
agencies that pay on behalf of patients. This account is necessary because much
of the payment process is done using estimates. For example, Medicare (actually, a
contractor acting on its behalf) makes periodic payments to a hospital, based on the
claims (i.e. bills) it has received and processed. However, the actual rate payable by
Medicare to the hospital for some services may not be known until the hospital’s fiscal
year has been completed and a “cost report” has been submitted to Medicare. As
Medicare and Medicaid become more and more fully prospective, settlements
should diminish significantly. The amount that appears on the balance sheet under
Estimated Third-Party Payor Settlements is an estimate of how much the hospital
will need to return to the third parties due to overpayments by the third parties.
The estimate is based in large part on the history of such transactions. In addition
to amounts based on claims submitted, Estimated Third-party Payor Settlements
may also include advances from third parties to support the day-to-day needs of the
organization (see Chapter 5). If the provider’s experience indicates that third parties
need to pay the organization instead, the account Estimated Third-Party Payor
Settlements would appear as a current asset similar to accounts receivable, rather
than as a current liability.
Third-party Payors:
Commonly referred to
as third parties, these
are organizations that
pay on behalf of
patients.
Accrued expenses are liabilities, and are reflected in the balance sheet and not in the statement of operations.
34 Financial Management of Health Care Organizations
Other Current Liabilities
Other Current Liabilities includes all current liabilities not elsewhere presented in the
current liabilities section. The accounts summarized in this category may be
presented on their own lines or they may be detailed in the notes if they are material
in amount. Increasingly, a major item in this account is Deferred Revenues.
Deferred Revenues are fees that have been collected in advance. Although its name
implies it is a revenue, it is in fact an obligation. For example, health care organizations
receive capitation payments from managed care organizations. Capitated payments
are often in the form of a specific amount per member per month (PMPM) and
require that the health care organization receiving the capitated payment provide a
range of services for the population covered by these payments. When the health care
organization receives the capitated payment, it incurs an obligation to provide service.
Thus, it records the amount received as an obligation (liability). After the obligation
is satisfied (the time the payment covers has passed), the deferred revenue is taken out
of the Deferred Revenue account and recorded as revenue.
Non-current Liabilities
Non-current Liabilities are obligations that will be paid back over a period longer than
one year. Most long-term liabilities fall into two categories: Mortgages Payable and
Bonds Payable.
Net Assets
The final category of the balance sheet is Net Assets (see Exhibit 2–9). The term net
assets is used to show the community’s interest in the assets of the organization. In an
investor-owned organization, it equals the stockholders’ interest in the organization’s
assets. It is equal to the organization’s assets minus its liabilities. Thus, in not-forprofit
health care organizations, the terms in the basic accounting equation are
rearranged to derive Net Assets as follows:
Net Assets = Assets − Liabilities
Using the year 20X1 in Exhibit 2–3 as an example, by subtracting the amount of
total liabilities ($38,497,000) from the value of the total assets ($115,046,000), Net
Assets equals $76,549,000.
Non-current
Liabilities: The
financial obligations
not due within one
year.
For not-for-profit health care providers, the net assets section of the balance sheet is analogous to the owner’s
equity section of a for-profit organization’s balance sheet.
Although the terms assets and liabilities are used consistently, numerous names have been used for the third
section of the balance sheet, including: owners’ equity, stockholders’ equity, net assets, and fund balance. In any
case, the amount reported is equal to the difference between assets and liabilities.
In the presentation of net assets on the balance sheet, not-for-profit health care
organizations must categorize net assets into three categories of restrictions:
Unrestricted Net Assets.
Temporarily Restricted Net Assets.
Permanently Restricted Net Assets.
All net assets not restricted by donors are considered Unrestricted Net Assets. Net assets
that are restricted by donors, on the other hand, must be shown on the balance sheet as
temporarily or permanently restricted (see Exhibit 2–10 and Perspective 2–3). An example
of a temporary restriction is the donation of land by the county with the provision that the
hospital cannot sell it for five years. An example of a permanent restriction is an endowment
that allows the health care organization to spend the interest, but never the principal.
Stockholders’ Equity
Investor-owned health care organizations use a different form of presentation of the
owners’ equity section of the balance sheet (see Exhibit 2–11). The terms used in the
shareholders’ equity section (i.e. par value of the stock, excess of par value and retained
earnings) are quite technical and beyond the scope of this text.
Health Care Financial Statements 35
20X1 20X0
Net Assets
Unrestricted 70,846 66,199
Temporarily Restricted 2,115 2,470
Permanently Restricted 3,588 3,533
Total Net Assets 76,549 72,202
Exhibit 2–9 Net Assets Section of the Balance Sheet from Exhibit 2–3
Temporarily Restricted
Donated land that cannot be sold for five years
Permanently Restricted
An endowment in which only the interest can be spent
Exhibit 2–10 Examples of Types of Restrictions on Assets
Stockholders Equity for investor-owned organizations represents the stock and retained earnings.
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations,
copyright © 1996 by the American Institute of Certified Public Accountants, Inc.
36 Financial Management of Health Care Organizations
20X1 20X0
Shareholders’ Equity:
Common stock, $10 par value; authorized 5,000 shares; issued
and outstanding 3,500 shares $35,000 $35,000
Excess of par value 35,000 35,000
Retained Earnings 6,549 2,202
Total Shareholders’ Equity $76,549 $72,202
Exhibit 2–11 Illustration of the Owners’ Equity Section of the Balance Sheet for an Investor-owned Health Care
Organization
Perspective 2–3
Charity Finances Healthcare: Donors Are Opening Wallets to Pay for Million-dollar Projects
America’s rich tradition of healthcare philanthropy, which waned with the advent of health insurance, is undergoing
a revitalization. While philanthropy constitutes a tiny portion of healthcare revenue, some institutions increasingly
rely on donations to fund capital projects, research, education, and outreach programs.With operating profits evaporating,
philanthropy is becoming a vital funding source and a major concern of hospital chief executives.
“For many years when hospitals were running 5% margins and sometimes 10% margins, philanthropic income was
icing on the cake and nobody paid much attention to it,” says James DeLauro, vice president of fund development
at San Francisco-based Catholic Healthcare West. “But now you’ve got hospitals struggling to make 1% margins,
which is not enough to rebuild and keep up with technology.”
A noble cause. Though stingy health plans and soaring costs have tarnished the image of healthcare as a charitable
enterprise, some hospital leaders are working to reinforce the image of local healthcare as a noble cause. Max
Poll, president and chief executive officer of Scottsdale (Ariz.) Healthcare, spends 20% to 25% of his time on fundraising
efforts, such as meeting with potential donors over lunch or giving facility tours. Some weeks, he says, it’s as
much as half of his time.
The two-hospital system, with revenue of $350 million, typically raises $6 million to $7 million per year.The money
has gone to an array of activities, including cancer care and research, a neighborhood outreach bus, capital projects such
as a new women’s and children’s facility, bone density scanners, and nursing scholarships. Still, hospitals generally are
struggling to capture their share of the nation’s increasing philanthropic wealth. Healthcare fundraising hasn’t kept pace
with giving in other sectors during the past decade. Giving to all charities has increased nearly 44% to a total of nearly
$191 billion since 1990, but the health sector saw an inflation-adjusted increase of 35%, to less than $18 billion.
Healthcare giving suffered in the mid- to late 1990s as a result of for-profit hospital conversions and the creation
of regional systems, which alienated contributors, according to the Association for Healthcare Philanthropy, a group
that represents fund-raising professionals. Often, the structuring of new foundations was an afterthought in the creation
of new systems, says AHP President and CEO William McGinly.
Source: Mary Chris Jaklevic, Modern Healthcare, July 31, 2000, p. 26.
Source:Adapted from AICPA Audit and Accounting Guide, Health Care Organizations (new edition). New York NY:American
Institute of Certified Public Accountants, Inc., June 1, 1996.
Notes to Financial Statements
The notes to the balance sheet are grouped together with the notes of all other financial
statements and presented after the financial statements. Although notes might be considered
in texts to present somewhat superfluous information, they are an integral part of
the financial statements. Since the information in the body of the statement is presented
in summary form, additional key information must be presented in the notes. Notes often
contain such information as the accounting policies followed by the health care organization,
how charity care is determined, the composition of investments, which assets are
restricted, the depreciation method used, the market value as well as the initial cost of
investments, the maturity and interest rates of the long-term debt, the amount of professional
liability insurance for malpractice, and whether there are suits filed against the
organization that may adversely affect the financial position of the organization. Exhibit
A–8 provides a detailed example of notes in a set of financial statements.
The Statement of Operations
As opposed to the balance sheet, which summarizes the organization’s total assets, liabilities,
and net assets at a particular point in time, the statement of operations is a
summary of the organization’s revenues and expenses over a period of time (see Exhibit
2–12). The time period is usually the time between statements, such as a quarter, halfyear,
or fiscal year. The statement of operations is analogous to, but different from, an
income statement of a for-profit organization (see Exhibit 2–13). Appendix A contains
an example of the financial statements for a for-profit organization. Perspective 2–4
illustrates how the financials of a maker of equipment for the health care industry is
used as a barometer of the health care industry as a whole.
Health Care Financial Statements 37
Notes to the
financial statements:
Notes which follow the
four financial
statements that
provide the reader with
key information. The
notes for all four
financial statements
appear together after
all four statements
have been presented.
They are an integral
part of the financial
statements.
The balance sheet presents a
snapshot of the organization
as of a point in time.
The statement of operations
presents a summary of
revenues and expenses
over a period of time.
Exhibit 2–12 Comparison of the Time Frame Covered by the Balance Sheet and Statement of Operations
The statement of operations uses the accrual basis of accounting, which summarizes how much the organization
earned and the resources it used to generate that income during a period of time. It does not use the
cash basis of accounting, which focuses on the cash that actually came in and went out. This is discussed in
detail in the next chapter.
The body of the income statement for investor-owned health care organizations is
organized into five sections:
Operating Income.
Non-operating Income.
Net Income Before Taxes.
Provision for Taxes.
Net Income After Taxes.
The body of the statement of operations for not-for-profit health care organizations
includes the following major sections:
Operating Income.
Other Income.
Excess of Revenues, Gains and Other Support over Expenses.
Other Items.
Increase in Unrestricted Net Assets.
Exhibit 2–14 is an example of a statement of operations for a not-for-profit health care
organization.
This statement does not represent how much cash came into the organization or
how much cash went out. Rather, it represents how much the organization earned, its
gains and other sources of revenue, and the resources it used during the accounting
period. The principle behind focusing on tracking cash and tracking resource use is
discussed in detail in Chapter 3.
38 Financial Management of Health Care Organizations
Investor-Owned Not-For-Profit
Title Income Statement Statement of Operations
Body Revenues Unrestricted Revenues, Gains and Other Support
− Expenses − Expenses
Operating Income Operating Income
+ Other Income + Other Income
Operating Earnings Before Income Taxes Excess of Revenues, Gains, and Other Support over
Expenses
− Income Taxes ± Other
Net Income Increase in Unrestricted Net Assets
Exhibit 2–13 Comparison of the Heading and Major Sections of the Body of the Income Statement for Investorowned
and Not-for-profit Health Care Organizations
The statement of operations does not represent the cash flow of the organization. Instead, it represents how
much the organization earned, its gains and other sources of revenue and the resources it used during the
accounting period
Unrestricted Revenues, Gains, and Other Support
This section of the statement of operations represents what most people think of as the revenues
of the organization (see Exhibit 2–15). Revenues refer to the amounts earned by the
organization; Gains come about by selling assets for more than their value on the books
(such as selling a building or other investment); and Other Support includes such items as
appropriations from governmental organizations and unrestricted donations. Usually Net
Patient Service Revenue and Premium Revenue make up the largest portion of
Unrestricted Revenues, Gains and Other Support in not-for-profit business organizations.
Net Patient Service Revenues
Gross Patient Service Revenues are the amount the health care organization would
have earned if everyone paid full price. However, as discussed under Patient
Health Care Financial Statements 39
Perspective 2–4
An Industry Barometer
Nestled in the gentle rolling slopes of southern Indiana along a sleepy stretch of the interstate between Indianapolis
and Cincinnati, Batesville is to hospital beds and caskets what the Middle East is to oil. Hillenbrand Industries, the
deferential company that makes it all happen for this Tudor-style village, found its fortune in the sick and expired.
From its Batesville home, the Fortune 500 company operates two major divisions: Hill-Rom, the hospital bed manufacturer
that first “brought the home to the hospital,” and Batesville Casket, a company known for no longer calling its
products “coffins.” . . . For years, Hillenbrand has reigned as the undisputed leader in the two major markets. Despite –
or because of – these positions, the two units have struggled and thrived along with the industries they supply. . . .
People will always get sick and die, but both businesses have their financial downside, especially Hill-Rom.When
economics demand that hospitals shed beds and shorten lengths of stay, the town of Batesville suffers from the fallout.
As hospitals’ capital budgets go, so goes Hill-Rom.“We are kind of like looking at the mercury in the thermometer,”
says Paul Joyce, Hill-Rom’s executive director for North American sales and service administration.
As a result, any clues concerning the long-term survival of the hospital industry might be gleaned from Hill-Rom.
Hospital executives may take heart that “after a few rough years,” Hill-Rom’s outlook is brightening after some internal
belt-tightening and external loosening in hospital reimbursements, finds Dhulsini de Zoysa, an analyst with
Salomon Smith Barney. . . .
The company’s financials have remained firmly in the black. Hillenbrand does not break out net income for its
operating units, but in 1999, according to its annual report, Hill-Rom earned a gross profit of $402 million on $1.09
billion in revenue from healthcare sales and rentals. Gross profit grew 13% to $454 million on $1.1 billion in 2000.
Revenue of $766 million in healthcare sales in 1999 grew to $800 million last year, while revenue from rentals slipped
to $312 million in 2000 from $324 million in 1999. Hill-Rom officials say declining revenue in rentals reflects the
struggles in the long-term-care and home-care industries. . . .
Source: Cinda Becker, Modern Healthcare, June 18, 2001.
As explained in detail in Chapter 3, revenues represent amounts earned by the organization, not the amount of
cash it received during the period.
The Statement of Operations (also called the statement of
activities) provides a summary of the organization’s
revenues and expenses over a period of time.
Title: Gives the name of the organization, the name of
the financial statement, and two periods of time for
which information is being provided.
Unrestricted Revenues, Gains, and Other Support:
The income of the organization derived from providing
patient service, the sale of assets for more than their book
value, contributions, appropriations and assets released
from restriction.
• Net Patient Service Revenues: Revenues earned
from patient care minus the amounts the
organization does not expect to collect because of
contractual discounts.
• Premium Revenues: Revenues earned from
capitated contracts.
• Other Revenues: Revenues derived from such.
sources as support services, investments, and
certain contributions.
• Net Assets Released from Restriction: funds
formerly restricted by a donor, now available for
general use to run the organization.
Expenses: Expenses are a measure of the resources used
to generate revenue. (Those expenses listed which are
self-evident have not been defined.)
• Depreciation and Amortization: Measures of the
use of long-lived assets during the accounting
period.
• Provision for Bad Debts: An estimate of the
amount of money owed the organization which it
estimates will not be collected.
• Other: A catch-all category for miscellaneous
expenses and losses including utilities, rent,
telephone, travel, etc.
Operating Income: Unrestricted Revenues, Gains, and
Other Support minus Expenses and Losses.
Traditionally, it is a measure of the income earned from
healthcare-related endeavors.
Other Income: Income earned from other than
healthcare-related endeavors.
Excess of Revenues over Expenses: Operating Income
plus Other Income. This is analogous to Net Income in
for-profit entities.
Change in Net Unrealized Gains and Losses on Other
than Trading Securities: Changes in the fair value of
assets other than trading securities.
Net Assets Released from Restrictions Used for
Purchase of Property and Equipment: Assets which
were previously restricted by a donor, which must now
be used to purchase properly and equipment. Since they
are for the purchase of long-lived assets, they are not
considered revenue.
Contributions from Sample Hospital Foundation for
Property Acquisitions: Self explanatory. Since they are
for the purchase of long-lived assets, they are not
considered revenue.
Transfer to Parent: Transfer of assets from a subsidiary
to their parent company.
Extraordinary Item: An extremely unusual and
infrequent expense.
Increase in Unrestricted Net Assets: The increase in
unrestricted net assets during the period. It includes
operating income, contributions of long-lived assets,
transfers to parent and extraordinary items. Restricted
revenues are not shown on this financial statement until
they become unrestricted.
*An unannotated form of this statement can be found in
Appendix A of this chapter.
Source: Reprinted with permission from the Audit and
Accounting Guide: Health Care Organizations, copyright
© 1996 by the American Institute of Certified Public
Accountants, Inc.
20X1 20X0
Unrestricted Revenues, Gains, and Other Support
Net Patient Service Revenue $85,156 $78,942
Premium Revenue 11,150 10,950
Other Revenues 2,601 5,212
Net Assets Released from Restriction Used for Operations 300 0
Total Revenues, Gains and Other Support 99,207 95,104
Expenses
Salaries and Benefits 53,900 49,938
Medical Supplies and Drugs 26,532 22,121
Insurance 8,089 8,526
Depreciation and Amortization 4,782 4,280
Interest 1,752 1,825
Provision for Bad Debts 1,000 1,300
Other Expenses 2,000 1,300
Total Expenses 98,055 89,290
Operating Income 1,152 5,814
Other Income
Investment Income 3,900 3,025
Excess of Revenues over Expenses 5,052 8,839
Change in Net Unrealized Gains and Losses 300 375
on Other than Trading Securities
Net Assets Released from Restrictions Used 200 0
for Purchase of Property and Equipment
Contribution from Sample Hospital Foundation 235 485
for Property Acquisitions
Transfers to Parent (640) (3,000)
Increase in Unrestricted Net Assets, 5,147 6,699
Before Extraordinary Item
Extraordinary Loss (Debt Extinguishment) (500)
Increase in Unrestricted Net Assets $4,647 $6,699
Sample Not-For Profit Hospital
Statement of Operations
For the Years Ended December 31, 20X1 and 20X0 (in ‘000)
1
2
3
4
1
2
3
4
5
6
7
8
9
10
11
12
5
6
7
8
9
10
11
12
0
Exhibit 2–14 Annotated Statement of Operations for Sample Not-For-Profit Hospital
Accounts Receivable, many payors receive discounts, called Contractual
Allowances. In addition, most health care organizations also provide some free care
to indigent patients, called Charity Care. In reporting Net Patient Service
Revenue, a health care organization must subtract amounts both for contractual
allowances and for charity care. Thus, the amount reported on the statement of
operations is Net Patient Service Revenue, which equals Gross Patient Service
Revenues minus Contractual Allowances and Charity Care. For instance, assuming
that Gross Patient Service Revenues were $130,284,000, Contractual Allowances
$34,898,000, and Charity Care $10,230,000, then the Net Patient Service Revenue
for 20X1 would be calculated as shown in Exhibit 2–16.
Premium Revenues
Premium Revenues are revenues earned from capitated contracts. They are not earned
solely through the delivery of service, but rather through a combination of the passage
of time (during which time the organization is available to provide service when necessary)
and actually delivering service as agreed to during the contract period.
Health Care Financial Statements 41
Exhibit 2–15 Abbreviated Statement of Operations from Exhibit 2–14 Emphasizing Revenues, Gains, and Other
Support
20X1 20X0
Unrestricted Revenues, Gains, and Other Support
Net Patient Service Revenue $85,156 $78,942
Premium Revenue 11,150 10,950
Other Revenues 2,601 5,212
Net Assets Released from Restriction Used for Operations 300
Total Revenues, Gains and Other Support 99,207 95,104
Expenses
Salaries and Benefits 53,900 49,938
Medical Supplies and Drugs 26,532 22,121
Insurance 8,089 8,526
Depreciation and Amortization 4,782 4,280
Interest 1,752 1,825
Provision for Bad Debts 1,000 1,300
Other Expenses 2,000 1,300
Total Expenses 98,055 89,290
Operating Income 1,152 5,814
Other Income
Investment Income 3,900 3,025
Excess of Revenues over Expenses 5,052 8,839
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Other Revenues
Other Revenues are derived from four major sources: appropriations and grants, support
services, income from investments, and revenues from contributions.
Appropriations are monies provided by government agencies on an ongoing basis,
usually for operating purposes. Grants are funds given to a health care organization
for special purposes, usually for a limited time. Support Services include such things
as parking fees, cafeteria sales, and revenue from the gift shop. Income from
Investments includes unrestricted interest, dividends, and gains from the sale of unrestricted
investments. Although some health care organizations report their revenues
from support services and investments in this category, it is also possible to report
them under Other Income, which is listed after Operating Income (see Exhibit 2–15).
This separates revenues earned through health care related activities (termed
“Operating Income”) and those earned from other than health care related activities
(called “Non-Operating Income”).
Net Assets Released from Restriction
Net Assets Released from Restriction are funds transferred to unrestricted accounts
from temporarily restricted net assets. The income earned from restricted investments
and even the investments themselves may be released to unrestricted accounts
as certain requirements are met. For example, a donor may stipulate that the release
of his or her contribution not occur until after the health care provider raises the
required matching funds for a new service line. Net assets released from restrictions
that are used to purchase capital items (plant and equipment) are not considered
42 Financial Management of Health Care Organizations
Account Title Amount Explanation
Gross Patient Service Revenues $130,284 The amount the health care organization earned at full retail
price. This amount cannot be reported on financial
statements, since it does not recognize that all payors do not
pay full charges.
− Contractual Allowances 34,898 Discounts given to third parties (large-scale purchasers of
health care services).
− Charity Care Discounts 10,230 The amount of full charges the organization will not attempt
to collect because the patient has been certified as unable to
pay. This amount is usually reported only in the footnotes.
Net Patient Service Revenue $85,156 Full price less contractual allowances and charity care
discounts. This amount is reported on the financial
statements, for it is felt to be a more realistic estimate of how
much revenue the health care organization has actually
earned.
Exhibit 2–16 Calculation of Net Patient Service Revenue
revenues, gains, or other support. They must be reported later in the statement of
operations, below Excess of Revenues over Expenses.
Expenses
Though most of the expenses listed in Exhibit 2–17 are self-evident, several of them
are discussed briefly here.
Depreciation and Amortization
Depreciation and Amortization reflect the amount of a non-current asset used during
the accounting period. Depreciation is a measure of how much a tangible asset (such as
Health Care Financial Statements 43
Exhibit 2–17 Abbreviated Statement of Operations from Exhibit 2–14 Emphasizing Expenses
20X1 20X0
Unrestricted Revenues, Gains, and Other Support
Net Patient Service Revenue $85,156 $78,942
Premium Revenue 11,150 10,950
Other Revenues 2,601 5,212
Net Assets Released from Restriction Used for Operations 300
Total Revenues, Gains and Other Support 99,207 95,104
Expenses
Salaries and Benefits 53,900 49,938
Medical Supplies and Drugs 26,532 22,121
Insurance 8,089 8,526
Depreciation and Amortization 4,782 4,280
Interest 1,752 1,825
Provision for Bad Debts 1,000 1,300
Other Expenses 2,000 1,300
Total Expenses 98,055 89,290
Operating Income 1,152 5,814
Other Income
Investment Income 3,900 3,025
Excess of Revenues over Expenses 5,052 8,839
On the statement of operations, expenses are a measure of the amount of resources used or consumed in
providing a service, not cash outflows. Using this definition, assets are just expenses waiting to happen!
Depreciation and amortization are non-cash expenses.
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
a building or equipment) has been “used up” during the accounting period. For example,
if a facility buys new examining room equipment for $10,000 and expects it to last
10 years, the accountant might record $1,000 depreciation each year on the assumption
that one-tenth of the equipment is “used up” each year. Amortization is a measure of
how much of an asset (such as debt issuance cost, capital leases, and goodwill) has been
“used up” during the accounting period. Both expenses are non-cash expenses.
Interest
Interest is the cost of borrowing money. If interest is 10 percent per year, then the cost
of borrowing $1,000 for one year is $100.
Provision for Bad Debts
Just as a retail business considers bad debts a cost of doing business, so do not-forprofit
health care organizations. Provision for Bad Debts, also called Bad Debt
Expense or Uncollectibles Expense, is the estimate of Patient Accounts Receivable
that will not be collected. It does not include charity care or contractual allowances,
for they have already been deducted to derive Patient Accounts Receivable.
Other Expenses
Other Expenses is a catchall category for miscellaneous operating expenses. This category
includes all general and administrative expenses, rent, utilities, and contracted services not
included in the other categories. Though they are grouped in this example, they may be
reported separately.
Operating Income
Operating Income is the income derived from the organization’s main line of business:
health care. It is calculated by subtracting Expenses from Unrestricted Revenues,
Gains and Other Support. In Exhibit 2–14, Operating Income of $1,152,000 in 20X1
is calculated by subtracting Total Expenses of $98,055,000 from Unrestricted
Revenues, Gains and Other Support of $99,207,000.
Other Income
Other income includes income earned from activities other than the organization’s main
line of business. Though there is discretion as to what constitutes operating and nonoperating
items, interest income, food sales to the public, and parking income are often
considered non-operating.
44 Financial Management of Health Care Organizations
Operating Income:
Income derived from
the organization’s main
line of business.
Amortization: The
allocation of the
acquisition cost of debt
to the period which it
benefits.
Health Care Financial Statements 45
Excess of Revenues over Expenses
Excess of Revenues over Expenses is analogous to Net Income (profit) in a for-profit
entity. However, not-for-profit business entities are prohibited from using the more
common term, net income. This item, traditionally referred to as the bottom line in forprofit
entities, is not actually the bottom line in the statement of operations, because
accounting rules favor treating not-for-profit, business-oriented health care entities
more like traditional not-for-profit organizations than like their for-profit competitors.
Thus, there is an emphasis on the change in unrestricted net assets rather than
what is traditionally called net income.
Excess of Revenues over Expenses is derived by adding Operating Income and
Other Income. In Exhibit 2–17, this is done by adding Operating Income of
$1,152,000 and Investment Income of $3,900,000 to get an Excess of Revenues over
Expenses of $5,052,000.
Below the Line Items
In addition to the items that contribute to Excess of Revenues over Expenses, several
items must appear on the statement of operations below Excess of Revenues over
Expenses (see Exhibit 2–18). These are generically referred to as “below the line”
items, and include:
Change in Net Unrealized Gains and Losses on Other than Trading Securities.
Net Assets Released from Restrictions used for Purchase of Property and
Equipment.
Contributions to Acquire Long-lived Capital Assets.
Transfer to parent.
Extraordinary Loss.
Change in Net Unrealized Gains and Losses on Other than Trading
Securities
Although the guidelines pertaining to this item are quite complex, for most not-forprofit
health care organizations the amount reported here is the change, since the last
balance sheet, in the market value of stocks held for investment. It is called unrealized,
because until the asset is disposed of (i.e. sold), the gain or loss only occurs on the
books. Once the investment is disposed of, the gain or loss becomes a realized gain or
loss.
For example, assume that on the last day of last year an organization purchased
$1,000,000 of stock for investment. One year later, the stock is worth $1,300,000. The
organization must report a $300,000 unrealized gain. On the other hand, if the stocks
were sold for $1,300,000 during the last year, the organization would report a
$300,000 realized gain under either Revenues, Gains, and Other Support or Other
Net Income:
Equivalent to Excess of
Revenues over
Expenses.
46 Financial Management of Health Care Organizations
Income. Note that because of this, realized gains affect Excess of Revenues over
Expenses, whereas unrealized gains do not.
Increases in Long-lived Unrestricted Net Assets
Most increases in unrestricted long-term assets resulting from donations are not considered
increases in Revenues, Gains, and Other Support. Rather, they are reported
below Excess of Revenues over Expenses in separate accounts. Two examples in the
Sample Not-For-Profit Hospital case are:
Net Assets Released from Restrictions Used for Purchase of Property and
Equipment.
Contributions for the Acquisition of Plant and Equipment.
Exhibit 2–18 Statement of Operations from Exhibit 2–14 Emphasizing Items that Do Not Contribute to Excess
of Revenues over Expenses
20X1 20X0
Expenses
Salaries and Benefits 53,900 49,938
Medical Supplies and Drugs 26,532 22,121
Insurance 8,089 8,526
Depreciation and Amortization 4,782 4,280
Interest 1,752 1,825
Provision for Bad Debts 1,000 1,300
Other Expenses 2,000 1,300
Total Expenses 98,055 89,290
Operating Income 1,152 5,814
Other Income
Investment Income 3,900 3,025
Excess of Revenues over Expenses 5,052 8,839
Change in Net Unrealized Gains and Losses on Other than Trading Securities 300 375
Net Assets Released from Restrictions Used for Purchase of Property and Equipment 200
Contribution From Sample Hospital Foundation for Property Acquisitions 235 485
Transfers to Parent (640) (3,000)
Increase in Unrestricted Net Assets, before Extraordinary Item 5,147 6,699
Extraordinary Loss (Debt Extinguishment) (500)
Increase in Unrestricted Net Assets $4,647 $6,699
Rather than being reported in Revenues, Gains, and Other Support, increases relating to the donation of unrestricted
net assets for capital acquisitions are reported below Excess of Revenues over Expenses.
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
Transfers to Parent
Another item that affects net assets, but not Excess of Revenues over Expenses, is the
transfer of assets to corporate headquarters. In 20X1, Sample Not-For-Profit
Hospital transferred $640,000 to its parent corporation.
Extraordinary Items
Extraordinary Items reflect unusual and infrequent gains or losses from such things
as paying off loans early, and acts of nature such as hurricanes or earthquakes.
Increase in Unrestricted Net Assets
The final section of the statement of operations is Increase in Unrestricted Net Assets,
which is derived by adding or subtracting the remaining items from Net Income, as
shown in Exhibit 2–19. There is a subtotal before the extraordinary item so that readers
of the financial statements can judge the organization’s performance both before
and after taking it into account.
The Statement of Changes in Net Assets
A third financial statement is the statement of changes in net assets. Its purpose is to
explain why there was a change from one year to the next in the net asset section of
the balance sheet (Exhibit 2–3). There are two major reasons why the net asset section
of the balance sheet changes from year to year: increases (decreases) in unrestricted
Health Care Financial Statements 47
Excess of Revenues over Expenses 5,052
+ Change in Net Unrealized Gains and Losses on Other than Trading Securities 300
+ Net Assets Released from Restrictions Used for Purchase of Property and Equipment 200
+ Contribution from Sample Hospital for Property Acquisitions 235
− Transfers to Parent (640)
Increase in Unrestricted Net Assets, before Extraordinary Item 5,147
− Extraordinary Loss (Debt Extinguishment) (500)
Increase in Unrestricted Net Assets $4,647
Exhibit 2–19 Calculation of Increase in Unrestricted Net Assets
The statement of changes in net assets repeats some of the information found on the statement of operations
to explain changes in unrestricted net assets, but adds additional information about changes in restricted net
assets.
48 Financial Management of Health Care Organizations
net assets (as shown on the statement of operations, Exhibit 2–14), and changes in
restricted net assets, which are not included on the statement of operations. Thus, the
statement of changes in net assets goes beyond the statement of operations by summarizing
all the changes in net assets over the year.
Like the other statements, the statement of changes in net assets has a descriptive
heading, a body, and notes. The body of the statement of changes in net assets is
organized to represent the changes in each of the three categories of restrictions of
net assets: unrestricted, temporarily restricted, and permanently restricted (see
Exhibit 2–20). The information in the first section, Unrestricted Net Assets, summarizes
the information from the statement of operations. The information in the
remainder of the statement of changes in net assets reflects changes in restricted
accounts.
To illustrate, the Statement of Changes in Net Assets explains how unrestricted net
assets, temporarily restricted net assets, and permanently restricted net assets of
Sample-Not-For-Profit-Hospital (see Exhibit 2–3) changed from 20X0 to 20X1.
Changes in Unrestricted Net Assets
Unrestricted Net Assets (see Exhibit 2–20) come directly from the statement of
operations. During the year 20X1, Sample Not-For-Profit Hospital made
$5,052,000, had an unrealized gain of $300,000 on its investments, received a
$235,000 donation of funds to be used for property acquisitions, transferred
$640,000 to its parent corporation, released from restriction $200,000 worth of
temporarily restricted net assets to be used for the purchase of property and
equipment, and lost $500,000 from debt extinguishment, producing an increase in
unrestricted net assets of $4,647,000.
Changes in Temporarily Restricted Net Assets
During 20X1, Sample Not-For-Profit Hospital received $140,000 in restricted contributions
to pay for charity care, made $5,000 (net) in unrealized and realized gains
on temporarily restricted investments, and released $500,000 from temporary restrictions.
Since it is to be used for operations, $300,000 of the $500,000 is shown as an
increase in Unrestricted Revenues, Gains and Other Support on the statement of
operations under the category Net Assets Released from Restriction Used for
Operations (see Exhibit 2–14). The $200,000 is also shown below Excess of Revenues
over Expenses in the Net Assets Released from Restrictions Used for Purchase of
Properties and Equipment account since it is to be used for the acquisition of longlived
assets.
The “unrestricted” section of the statement of changes in net assets shows how the various items on the statement
of operations contributed to the changes in unrestricted net assets.
Health Care Financial Statements 49
Changes in Permanently Restricted Net Assets
For Sample Not-For-Profit Hospital, the only two changes in permanently restricted
net assets in 20X1 were an increase of $50,000 for a permanently restricted endowment
and $5,000 (net) in unrealized and realized gains on permanently restricted
assets (see Exhibit 2–20).
The Statement of Cash Flows
The fourth and final major financial statement is the statement of cash flows, which
answers the question “Where did cash come from and where did it go?” Though the statement
of operations (income statement) may be thought to answer this question, it does
not. As noted earlier, it answers the questions “How much was earned?” (not “How much
Sample Not-For-Profit Hospital
Statement of Changes in Net Assets For the Years Ended December 31, 20X1 and 20X0 (in ’000)
20X1 20X0
Unrestricted Net Assets
Excess of Revenues over Expenses $5,052 $8,839
Net Unrealized Gains on Investments Other than Trading Securities 300 375
Contribution from Sample Hospital Foundation for Property Acquisition 235 485
Transfers to Parent (640) (3,000)
Net Assets Released from Restrictions Used for Purchase of Properties and Equipment 200
Increase in Unrestricted Net Assets before Extraordinary Item 5,147 6,699
Extraordinary Loss from Extinguishment of Debt (500)
Increase in Unrestricted Net Assets 4,647 6,699
Temporarily Restricted Net Assets
Contributions for Charity Care 140 996
Net Realized and Unrealized Gains on Investments 5 8
Net Assets Released from Restrictions (500)
Increase (Decrease) in Temporarily Restricted Net Assets (355) 1,004
Permanently Restricted Net Assets
Contributions for Endowment Funds 50 411
Net Realized and Unrealized Gains on Investments 5 2
Increase in Permanently Restricted Net Assets 55 413
Increase in Net Assets 4,347 8,116
Net Assets, Beginning of Year 72,202 64,086
Net Assets, End of Year $76,549 $72,202
Exhibit 2–20 Statement of Changes in Net Assets for Sample Not-For-Profit Hospital
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the
American Institute of Certified Public Accountants, Inc.
cash came in?”) and “What resources were used?” (not “How much cash went out?”).
Hence, the statement of cash flows was developed to report the cash inflows and outflows.
Like the other statements, the statement of cash flows has a descriptive heading,
a body, and notes (see Exhibit 2–21). The statement of cash flows covers the same
time period as does the statement of operations and the statement of changes in net
assets.
The body of the statement is organized into the following sections:
Cash Flows from Operating Activities.
Cash Flows from Investing Activities.
Cash Flows from Financing Activities.
Net Increase (Decrease) in Cash and Cash Equivalents.
The statement also discloses key non-cash transactions such as the issuance of stock for
debt payment or for the acquisition of a company. Though there are two alternative
forms of this statement, the most common, called the indirect method, has been
presented here. The other format is called the direct method. The first section of this
statement is cash flows from operating activities.
Cash Flows from Operating Activities
This section identifies the cash inflows and outflows resulting from the normal operations
of the organization. Since most organizations do not have this information readily
available, they derive it by starting with the increase (decrease) in net assets from
the statement of changes in net assets, and then make adjustments to convert this
accrual-based information into cash flows.
Assume for the purposes of illustration that the organization began with no assets
or liabilities. During the first week in operation, only two transactions occurred:
$150,000 worth of services rendered, and patients paid $50,000 of this amount. Thus,
the balance sheet would show Cash of $50,000, Patient Accounts Receivable of
$100,000 and Net Assets of $150,000. Hence, the increase in net assets since the last
period was $150,000 (see Exhibit 2–22).
However, to estimate cash flows from operations, net assets must be adjusted for
changes in accounts that really do not result in cash inflows or outflows. In this case,
the $100,000 that is still owed from the $150,000 in Changes in Net Assets is subtracted
to determine how much cash actually came in ($150,000 – $100,000 =
$50,000). This process occurs in order to convert the Changes in Net Assets account,
which was derived using the accrual basis of accounting, into an estimate of actual
cash flows: Net Cash Provided from Operating Activities.
50 Financial Management of Health Care Organizations
Cash Flows from Operating Activities identifies cash flow from normal operations of the organization.
The Statement of Cash Flows provides a summary of the cash
inflows and outflows form one year to the next.
Title: Gives the name of the organization, the name of the
financial statement and two periods for which the information is
being provided.
Cash Flows from Operating Activities: This section explains
the changes in cash resulting from the normal operating activities
of the organization. It begins by presenting the change in net
assets from the statement of changes in net assets. However, since the
statement of changes in net assets was prepared on the accrual basis of
accounting to show revenues when earned, not when cash was
received, and expenses when resources were used rather than
when they were paid, the remainder of this section makes
adjustments to convert the changes in current assets and
liabilities and other operating accounts to actual cash flows. This
is explained in more detail in the next chapter.
Cash Flows from Investing Activities: This section explains
cash inflows and outflows of the organization resulting from
investing activities such as purchasing and selling investments,
or investing in itself such as purchasing or selling plant,
property, or equipment.
Cash Flows from Financing Activities: This section explains
cash inflows and outflows resulting from financing activities
such as obtaining grants and endowments, or from borrowing or
paying back long-term debt. It also includes transfers to and from
the parent corporation.
Net Increase (Decrease) in Cash and Cash Equivalents: The
total of cash flows from operating, investing and financing
activities.
Cash and Cash Equivalents at Beginning of Year: The
amount of cash and cash equivalents which the organization had
at the beginning of the year.
Cash and Cash Equivalents at End of Year: The total of net
increases in cash and cash equivalents at the end of the year. It is
the same number that appears under this title on the balance
sheet.
Supplemental Information: Additional information of use to
the reader of the statement.
An unannotated form of this statement can be found in Appendix A of this chapter.
20X1 20X0
Cash Flows From Operating Activities
Change in Net Assets $4,347 $8,116
Adjustments to Reconcile Change in Net Assets to
Net Cash Provided by Operating Activities:
Extraordinary Loss from Debt Extinguishment 500
Depreciation 4,782 4,280
Net Realized and Unrealized Gains on Investments,
Other than Trading (450) (575)
Transfers to Parent 640 3,000
Provision for Bad Debt 1,000 1,300
Restricted Contributions and Investment Income Received (55) (413)
Increase (Decrease) in:
Patient Accounts Receivable (1,906) (2,036)
Trading Securities 215
Other Current Assets 186 (2,481)
Other Assets (325) (241)
Increase (Decrease) in:
Accounts Payable and Accrued Expenses 436 679
Estimated Third-Party Payor Settlements 201 305
Other Current Liabilities (145) (257)
Other Liabilities 787 (128)
Net Cash Provided by Operating Activities 10,213 11,549
Cash flows from investing activities:
Purchases of Investment (3,769) (2,150)
Capital Expenditures (4,728) (5,860)
Net Cash Used in Investing Activities (8,497) (8,010)
Cash flows from financing activities:
Transfer to Parent (640) (3,000)
Proceeds from Restricted Contributions and Restricted
Investment Income 55 413
Payments on Long-Term Debt (24,700) (804)
Payments on Capital Lease Obligations (150) (100)
Increase in Long-Term Debt 22,600 500
Net Cash Used in Financing Activities (2,835) (2,991)
Net Increase (Decrease) in Cash and Cash Equivalents (1,119) 548
Cash and Cash Equivalents at Beginning of Year 5,877 5,329
Cash and Cash Equivalents at End of Year $4,758 $5,877
Supplemental Disclosures and Cash Flow Information:
The Hospital entered into capital lease obligations in the amount of $600,000 for
new equipment in 2001.
Cash paid for interest (net of amount capitalized) in 2001 and 2000 was
$1,780,000 and $1,856,000 respectively.
See accompanying notes to financial statements.
Sample Not-For-Profit Hospital
of Cash (For the Years Ended December 31, 20X1 and 20X0 (in ‘000)
An unannotatedform of this statement can be found in Appendix A of this chapter.
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations,
copyright © 1996 by the American Institute of Certified Public Accountants, Inc.
Statement of Cash Flows (Indirect Method)
For the Years Ended December 31, 20X1 and 20X0 (in ‘000)
1
2
3
4
5
6
7
8
1
2
4
5
6
7
8
3
Exhibit 2–21 Annotated Statement of Cash Flows for Sample Not-For-Profit Hospital
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the American Institute of Certified Public
Accountants, Inc.
Cash Flows from Investing Activities
The second section of the statement of cash flows is Cash Flows from Investing
Activities. This section shows cash inflows and outflows from such accounts as:
Purchase of Plant, Property, and Equipment.
Purchase of Long-term Investments.
Proceeds from Sale of Plant, Property and Equipment.
Proceeds from Sale of Long-term Investments.
Information found in this section is derived from changes in the Non-Current
Assets section of the balance sheet from one period to the next. It reports both the
purchase and/or sale of outside investments and the purchase and/or sale of noncurrent
assets, such as plant and equipment, which will be used to provide services.
In the latter case, the organization is investing in itself.
Cash Flows from Financing Activities
In this section of the statement of cash flows, we identify the changes in cash flows
resulting from financing activities. These include:
Transfers to and from Parent.
Proceeds from Selected Contributions.
Proceeds from Issuance of Long-term Debt.
Repayment of Long-term Debt.
Interest from Restricted Investments if Interest Income Is Also Restricted.
Cash and Cash Equivalents at the End of the Year
This is the “bottom line” of the statement of cash flows and is the same as the Cash and
Cash Equivalents amount that appears on the balance sheet. The latter is calculated by
adding the net increase (decrease) in cash and cash equivalents for the year to the beginning
balance of the cash and cash equivalents. The net increase (decrease) in Cash and
Cash Equivalents for the year on the statement of cash flows is computed by adding
52 Financial Management of Health Care Organizations
Investing by an organization includes investing in itself (such as when an organization buys new equipment).
Repayment and Issuance of Long-term Debt are identified in Cash Flow from Financing Activities within the
Statement of Cash Flows.
Sample Not-For-Profit Hospital
Balance Sheet
January 7, 20X1 and January 1, 20X1
1/7/20X1 1/1/20X1 1/7/20X1 1/1/20X1
Cash $50,000 $0 Liabilities $0 $0
Patient Accounts Receivable 100,000 0
Net Assets 150,000 0
Total Assets $150,000 $0 Liabilities and Net Assets $150,000 $0
Sample Not-For-Profit Hospital
Statement of Cash Flows
For the Period Ended January 7, 20X1
1/7/20X1 1/1/20X1
Cash Flows from Operating Activities
Changes in Net Assets $150,000 $0
Increase in Patient Accounts Receivable 100,000 0
Net Cash Provided by Operating Activities $50,000 $0
Exhibit 2–22 Deriving Net Cash Provided by Operating Activities by Adjusting Change in Net Assets for Items that Do Not Affect Cash Flows
together the cash flows from the operating, investing, and financing activities, respectively.
In Exhibit 2–21, the Cash and Cash Equivalents at the end of 20X1 is $4,758,000.
Summary
This chapter examined the four major statements of not-for-profit, business-oriented
health care organizations: the balance sheet, the statement of operations, the statement
of changes in net assets, and the statement of cash flows. Each of these statements is
organized in the same fashion, with a heading, a body, and notes. The notes are
grouped together and presented after all four statements have been provided. They
are considered an integral part of the financial statements.
The balance sheet presents a snapshot of the organization at a point in time (usually
the last day of the year). The body of the balance sheet has three major sections:
assets, liabilities, and net assets. The balance sheet is so named because assets =
liabilities + owners’ equity. This fundamental accounting equation is expressed
as assets = liabilities + shareholders’ equity in investor-owned health care organizations
and assets = liabilities + net assets in not-for-profit, business-oriented
health care organizations.
Assets are the resources of the organization, liabilities are the obligations of the
organization to pay its creditors, and net assets are the difference between assets and
liabilities. Assets are divided into two main sections: current and non-current.
Current assets will be used or consumed within one year. Non-current assets will provide
benefit to the organization for periods longer than one year. Assets limited as to
use are noted separately from those without such restrictions.
Liabilities are also classified into current and non-current categories. Current liabilities
are those that must be paid within one year. Non-current liabilities will be due in more
than one year. If part of a liability, such as a mortgage, is due within one year and the rest
is due beyond one year, then the part due within one year is classified in the current section,
and the remainder is presented under non-current liabilities. Revenues received in
advance, such as capitated fees, are liabilities, classified as deferred revenues. They are
considered liabilities because the organization has the obligation to deliver service. They
are not recognized as revenues until they are earned.
Net assets are the owners’ interest in the entity’s assets. The owners of notfor-
profit entities are generally assumed to be the community. Net assets are presented
in three categories: unrestricted, temporarily restricted, and permanently restricted.
Unrestricted net assets are not constrained by donors. Restricted net assets are
funds that have limitations imposed on them by outside donors.
The statement of operations is analogous to, but not quite the same as, the
traditional income statement. Rather than showing how much cash came in or went
out, the body of the statement of operations summarizes the changes in unrestricted
net assets during a period of time (usually a year). Excess of revenues over expenses is
comparable to, but not the same as, the bottom line (net income) in for-profit health
care organizations. It is determined by adding operating income and other (nonoperating)
income. Operating income comprises the organization’s unrestricted revenues,
gains, and other support less its expenses. Operating income is the income
54 Financial Management of Health Care Organizations
derived from the primary line of business, in this case health care related services,
whereas non-operating income is income from all other sources. In addition to the
accounts that comprise excess of revenues over expenses, there are a number of
“below the line” items that affect the change in unrestricted net assets, but not excess
of revenues over expenses. These generally relate to donations of long-lived assets,
realized and unrealized gains or losses on other than trading securities, and transfers
to parent. Occasionally, there may be an extraordinary item.
The third financial statement is the statement of changes in net assets, which is called
the statement of changes in owners’ equity in for-profit entities. It summarizes why the
net asset account changed during the period covered by the statement of operations, by
showing why each of the three main categories of net assets changed: unrestricted net
assets, temporarily restricted net assets, and permanently restricted net assets.
The final financial statement of not-for-profit health care organizations is the statement
of cash flows. Its purpose is to summarize where the organization’s cash came
from and how it was spent during the year. It summarizes cash flows in three major
categories: cash flows from operating activities, cash flows from investing activities,
and cash flows from financing activities. This statement is necessary since the statement
of operations is based on the accrual basis of accounting and keeps track of earnings
and resources when used, but not actual cash flows.
Key Equations
General Accounting Equation: Assets = Liabilities + Owners’ Equity
Basic Accounting Equation (not-for-profit entities): Assets = Liabilities + Net
Assets
Basic Accounting Equation (for-profit entities): Assets = Liabilities + Shareholders’
Equity
Health Care Financial Statements 55
Accumulated Depreciation
Amortization
Assets
Basic Accounting Equation
Charity Care Discounts
Current Assets
Current Liabilities
Depreciation
Fund Balance
Liabilities
Liquidity
Net Assets
Net Income
Non-current Assets
Non-current Liabilities
Notes to the Financial
Statements
Operating Income
Owners’ Equity
Shareholders’ Equity
Third-party Payors
Key Terms
Questions and Problems
1. Definitions. Define the following terms:
a. Accumulated Depreciation.
b. Amortization.
c. Assets.
d. Basic Accounting Equation.
e. Charity Care Discounts.
f. Current Assets.
g. Current Liabilities.
h. Depreciation.
i. Fund Balance.
j. Liabilities.
k. Liquidity.
l. Net Assets.
m. Net Income.
n. Non-current Assets.
o. Non-current Liabilities.
p. Notes to the Financial Statements.
q. Operating Income.
r. Owners’ Equity.
s. Shareholders’ Equity.
t. Third-party Payors.
2. Financial Statement Terminology.
a. What are each of the major financial statements commonly called in forprofit
health care organizations and in not-for-profit health care
organizations?
b. Describe the three major sections common to all financial statements.
3. Balance Equation. State the primary accounting equation that describes the
balance sheet of a not-for-profit, business-oriented health care organization.
4. Balance Sheet. The following questions relate to the balance sheet.
a. What is the name of this statement in not-for-profit health care
organizations?
b. What are its main sections in investor-owned health care organizations?
c. What are its main sections in not-for-profit health care organizations?
d. What are patient accounts receivable?
e. What is deferred revenue?
f. What are restricted net assets?
5. Statement of Operations. The following questions relate to the statement
of operations of not-for-profit health care organizations.
a. What is the analogous for-profit statement called? What are the main
sections of the statement of operations?
b. What are revenues, gains, and other support?
c. What are expenses and losses?
56 Financial Management of Health Care Organizations
d. Funds released from restricted net assets to unrestricted net assets are
presented in what section of the statement of revenue, expenses, and
other activities?
6. Statement of Changes in Net Assets. The following questions relate to
the statement of changes in net assets.
a. What is the traditional name for this statement?
b. What is the purpose of this statement?
c. What are the main sections of this statement?
d. Discuss the difference between permanently restricted and
temporarily restricted net assets.
7. Statement of Cash Flows. The following questions relate to the statement
of cash flows of a not-for-profit health care organization.
a. What are its main sections?
b. What is the purpose of this statement?
8. Financial Statement Element. Where in the financial statements would
there be important explanatory information?
9. Financial Statement Element. In what financial statement would one
identify the purchase of long-term investments?
10. Accounting Methodologies. How does the accrual basis of accounting
differ from the cash basis of accounting?
11. Balance Sheet. The following are account balances as of September 30,
20X1 for Zachary Hospital. Prepare a balance sheet at September 30,
20X1 (hint: Net Assets will also need to be calculated).
Gross Plant, Property and Equipment $6,000,000
Cash $180,000
Net Accounts Receivable $650,000
Accrued Expenses $35,000
Supplies $100,000
Long-term Debt $5,000,000
Accounts Payable $130,000
Accumulated Depreciation $100,000
12. Balance Sheet. The following are account balances as of September 30,
20X1 for Shoemaker Hospital. Prepare a balance sheet at September 30,
20X1 (hint: Net Assets will also need to be calculated).
Gross Plant, Property, and Equipment $6,000,000
Accrued Expenses $35,000
Cash $180,000
Net Accounts Receivable $650,000
Accounts Payable $130,000
Long-term Debt $5,000,000
Supplies $100,000
Accumulated Depreciation $100,000
Health Care Financial Statements 57
13. Statement of Operations. The following are annual account balances as of
September 30, 20X1 for Vantage Hospital. Prepare a statement of operations
for the 12-month period ending September 30, 20X1.
Net Patient Revenues $840,000
Transfer to Parent Corporation $10,000
Net Assets Released from Restriction for Operations $120,000
Depreciation Expense $50,000
Labor Expense $230,000
Interest Expense $12,000
Supply Expense $88,000
14. Statement of Operations. The following are annual account balances as of
September 30, 20X1 for Uptown Hospital. Prepare a statement of operations
for the twelve-month period ending September 30, 20X1.
Net Patient Revenues $960,000
Supply Expense $65,000
Net Assets Released from Restriction for Operations $35,000
Depreciation Expense $45,000
Transfer to Parent Corporation $12,000
Interest Expense $16,000
Labor Expense $400,000
15. Multiple Statements. The following are account balances as of September
30, 20X1 for Hightower Outpatient Center. Prepare: (a) balance sheet;
(b) statement of operations; and (c) statement of changes in net assets for
September 30, 20X1.
Insurance Expense $25,000
Cash $100,000
Net Patient Revenues $600,000
Net Accounts Receivable $560,000
Ending Balance, Temporarily Restricted Net Assets $25,000
Wages Payable $50,000
Prepaid Expenses $20,000
Long-term Debt $493,000
Supply Expense $80,000
Gross Plant, Property, and Equipment $500,000
Net Assets Released from Temporary Restrictions $15,000
Depreciation Expense $5,000
General Expense $100,000
Transfer to Parent Corporation $15,000
Beginning Balance, Unrestricted Net Assets $495,000
Accounts Payable $100,000
Beginning Balance, Temporarily Restricted Net Assets $40,000
Interest Expense $8,000
Labor Expense $350,000
58 Financial Management of Health Care Organizations
Accumulated Depreciation $10,000
Restricted Net Assets $25,000
Unrestricted Net Assets $527,000
16. Multiple Statements. The following are account balances at September 30,
20X1 for Valley Medical Center. Prepare: (a) balance sheet; (b) statement of
operations; and (c) statement of changes in net assets for September 30, 20X1.
Administrative Expense $350,000
Cash $20,000
Net Patient Revenues $960,000
Gross Accounts Receivable $225,000
Ending Balance, Temporarily Restricted Net Assets $8,000
Wages Payable $35,000
Prepaid Expenses $5,000
Long-term Debt $650,000
Supply Expense $200,000
Gross Plant, Property, and Equipment $800,000
Net Assets Released from Temporary Restriction $35,000
Less Uncollectibles in Accounts Receivable $15,000
Inventory $20,000
Premium Revenues $150,000
Long-term Investments, Unrestricted $35,000
Depreciation Expense $15,000
General Expense $100,000
Transfer to Parent Corporation $5,000
Beginning Balance, Unrestricted Net Assets $474,000
Accounts Payable $78,000
Beginning Balance, Temporarily Restricted Net Assets $43,000
Interest Expense $8,000
Labor Expense $700,000
Accumulated Depreciation $45,000
Long-term Investments, Restricted $8,000
Ending Balance, Unrestricted Net Assets $247,000
Accrued Expense $65,000
Temporary Investments $45,000
Other Revenues $6,000
Current Portion of Long-term Debt $15,000
17. Statement of Cash Flows. The following are account balances at
December 31, 20X1 for Southern Memorial Hospital. Prepare a statement
of cash flows for year ended December 31, 20X1. (Hint: the amounts have
been stated as positive or negative numbers as they affect cash flow.)
Decrease in Prepaid Expenses $2,000
Payments on Long-term Debt ($30,000)
Cash and Cash Equivalents at Beginning of the Year $40,000
Increase in Inventory ($5,000)
Health Care Financial Statements 59
Increases in Long-term Debt $200,000
Decrease in Accrued Expenses ($1,000)
Change in Net Assets ($30,000)
Sale of Long-term Investments $750,000
Increase in Other Current Liabilities $4,000
Depreciation $150,000
Payments on Capital Lease ($25,000)
Purchases of Equipment ($1,000,000)
Increase in Net Account Receivables ($30,000)
Increase in Accounts Payable $20,000
18. Statement of Cash Flows. The following are account balances (in ’000) at
December 31, 20X1 for Lionville Hospital. Prepare a statement of cash flows
for the year ended December 31, 20X1. (Hint: the amounts have been stated
as positive or negative numbers as they affect cash flow.)
Increase in Prepaid Expenses ($3,000)
Increase in Accrued Expenses $8,000
Cash and Cash Equivalents at Beginning of the Year $65,000
Increase of Capital Lease Obligation $85,000
Proceeds from Restricted Contribution $155,000
Change in Net Assets $50,000
Increase in Net Account Receivables ($90,000)
Sale of Equipment $40,000
Decrease in Other Current Liabilities ($3,000)
Depreciation $75,000
Increase in Inventory ($13,000)
Purchase of Long-term Investments ($75,000)
Payments on Long-term Debt ($90,000)
Decrease in Accounts Payable ($15,000)
19. Multiple Statements. The following are account balances for Burlington
HMO (in ’000). Prepare: (a) balance sheet; and (b) income statement for the
year ended December 31, 20X0.
Income Tax Benefit of Operating Loss $7,500
Net Property and Equipment $22,000
Physician Services Expense $35,000
Premium Revenue $90,000
Marketing Expense $8,000
Compensation Expense $17,000
Interest Income and Other Revenue $20,000
Outside Referral Expense $15,000
Medicare Revenue $25,000
Occupancy and Depreciation Expense $4,000
Current Portion of Long-term Debt $3,200
Accounts Receivable $6,100
Emergency Room Expense $7,000
60 Financial Management of Health Care Organizations
Inpatient Services Expense $131,000
Interest Expense $3,000
Medicaid Revenue $5,000
Owners’ equity $13,300
Cash and Cash Equivalents $2,800
Long-term Debt $14,400
Other Administrative Expense $3,000
20. Multiple Statements. The following are account balances (in ’000) at
September 30, 20X1 for HMO Scotland. Prepare: (a) balance sheet; and
(b) income statement.
Income Tax Expense $2,100
Prepaid Expense $2,000
Physician Services Expense $38,000
Long-term Investments $12,000
Premium Revenues $118,000
Cash and Cash Equivalents $68,000
Marketing Expense $12,500
Compensation Expense $23,000
Other Non-current Assets $2,800
Interest Income and Other Revenue $4,500
Accrued Expense $3,300
Outside Referral Expense $7,500
Claims Payable – Medical $37,000
Medicare Revenues $13,000
Inventory $3,500
Occupancy and Depreciation Expense $5,500
Owners’ equity $66,600
Emergency Room Expense $3,200
Net Property and Equipment $13,000
Premium Receivables $12,000
Inpatient Service Expense $22,000
Notes Payable $4,500
Interest Expense $2,500
Unearned Premium Revenues $1,500
Medicaid Revenues $3,000
Long-term Debt $3,400
Other Administrative Expense $6,500
Other Receivables $3,000
21. Multiple Statements. The following are account balances at September 30,
20X1 for Appleton Medical Center. Prepare: (a) balance sheet; (b) statement
of operations; and (c) statement of changes in net assets for September 30,
20X1.
Inventory $12,000
Net Patient Revenues $898,000
Health Care Financial Statements 61
Gross Plant, Property, and Equipment $655,000
Net Accounts Receivable $235,000
Ending Balance, Temporarily Restricted Net Assets $20,000
Wages Payable $45,000
Long-term Debt $248,100
Supply Expense $82,000
Net Assets Released from Temporary Restriction $8,000
Depreciation Expense $12,000
General Expense $122,000
Insurance Expense $26,000
Cash and Cash Equivalents $85,000
Transfer to Parent Corporation ($8,900)
Beginning Balance, Unrestricted Net Assets $234,000
Accounts Payable $76,000
Beginning Balance, Temporarily Restricted Net Assets $28,000
Interest Expense $4,200
Labor Expense $322,000
Accumulated Depreciation $125,000
Long-term Investments Restricted $90,000
Ending Balance, Unrestricted Net Assets $562,900
22. Multiple Statements. The following are account balances at September 30,
20X1 for Shively Medical Center. Prepare: (a) balance sheet; (b) statement of
operations; and (c) statement of changes in net assets for September 30, 20X1.
Inventory $10,000
Net Patient Revenues $1,000,000
Gross Plant, Property, and Equipment $755,000
Net Accounts Receivable $225,000
Ending Balance, Temporarily Restricted Net Assets $6,000
Wages Payable $25,000
Long-term Debt $445,000
Supply Expense $60,000
Net Assets Released from Temporary Restriction $12,000
Depreciation Expense $45,000
General Expense $200,000
Insurance Expense $35,000
Cash and Cash Equivalents $50,000
Transfer to Parent Corporation ($13,000)
Beginning Balance, Unrestricted Net Assets $200,000
Accounts Payable $66,000
Beginning Balance, Temporarily Restricted Net Assets $18,000
Interest Expense $6,000
Labor Expense $400,000
Accumulated Depreciation $125,000
Long-term Investments Restricted $80,000
Ending Balance, Unrestricted Net Assets $453,000
62 Financial Management of Health Care Organizations
23. Multiple Statements. The following are account balances at September 30,
20X1 for El Paso Outpatient Center. Prepare: (a) balance sheet; (b) statement of
operations; and (c) statement of changes in net assets for September 30, 20X1.
Insurance Expense $35,000
Cash $75,000
Net Patient Revenues $980,000
Net Accounts Receivable $850,000
Ending Balance, Temporarily Restricted Net Assets $23,000
Wages Payable $24,000
Prepaid Expense $25,000
Long-term Debt $581,000
Supply Expense $75,000
Gross Plant, Property, and Equipment $735,000
Net Assets Released from Temporary Restriction $17,000
Depreciation Expense $12,000
General Expense $125,000
Transfer to Parent Corporation ($11,000)
Beginning Balance, Unrestricted Net Assets $500,000
Accounts Payable $85,000
Beginning Balance, Temporarily Restricted Net Assets $40,000
Interest Expense $3,000
Labor Expense $344,000
Accumulated Depreciation $125,000
Long-term Investments Restricted $45,000
Ending Balance, Unrestricted Net Assets $892,000
Health Care Financial Statements 63
64 Financial Management of Health Care Organizations
Appendix A
Illustrative Set of Financial Statements for Sample Not-For-Profit Hospital
and For-Profit Hospital, and Notes to Financial Statements
Sample Not-For-Profit Hospital
Balance Sheet
December 31, 20X1 and 20X0 (in ’000)
Assets 20X1 20X0
Current Assets:
Cash and Cash Equivalents $4,758 $5,877
Short-Term Investments 15,836 10,740
Assets Limited as to Use 970 1,300
Patient Accounts Receivable, Net Estimated
Uncollectibles of $2,500 in 20X1 and $2,400 in 20X0 15,100 14,194
Supplies 2,000 2,000
Prepaid Expenses 670 856
Total Current Assets 39,334 34,967
Non-Current Assets
Assets Limited as to Use 18,949 19,841
Less Amount Required to Meet Current Obligations (970) (1,300)
17,979 18,541
Long-Term Investments 4,680 4,680
Long-Term Investments Restricted for Capital Acquisition 320 520
Properties and Equipment, Net 51,038 50,492
Other Assets 1,695 1,370
Total Non-Current Assets 75,712 75,603
Total Assets $115,046 $110,570
Liabilities and Net Assets
Current Liabilities
Current Portion of Long-Term Debt $1,470 $1,750
Accounts Payable and Accrued Expenses 5,818 5,382
Estimated Third-Party Payor Settlements 2,143 1,942
Deferred Revenues 1,969 2,114
Total Current Liabilities 11,400 11,188
Non-Current Liabilities
Long-Term Debt, Net of Current Portion 23,144 24,014
Other 3,953 3,166
Total Non-Current Liabilities 27,097 27,180
Total Liabilities 38,497 38,368
Net Assets
Unrestricted 70,846 66,199
Temporarily Restricted 2,115 2,470
Permanently Restricted 3,588 3,533
Total Net Assets 76,549 72,202
Total Liabilities and Net Assets $115,046 $110,570
Exhibit A–1 Balance Sheet for Sample Not-For-Profit Hospital
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the American Institute of
Certified Public Accountants, Inc.
Health Care Financial Statements 65
Sample Not-For-Profit Hospital
Statement of Operations
For the Years Ended December 31, 20X1 and 20X0 (in ‘000)
20X1 20X0
Unrestricted Revenues, Gains, and Other Support
Net Patient Service Revenue $85,156 $78,942
Premium Revenue 11,150 10,950
Other Revenues 2,601 5,212
Net Assets Released from Restriction Used for Operations 300
Total Revenues, Gains and Other Support 99,207 95,104
Expenses
Salaries and Benefits 53,900 49,938
Medical Supplies and Drugs 26,532 22,121
Insurance 8,089 8,526
Depreciation and Amortization 4,782 4,280
Interest 1,752 1,825
Provision for Bad Debts 1,000 1,300
Other Expenses 2,000 1,300
Total Expenses 98,055 89,290
Operating Income 1,152 5,814
Other Income
Investment Income 3,900 3,025
Excess of Revenues over Expenses 5,052 8,839
Change in Net Unrealized Gains and Losses on Other than Trading Securities 300 375
Net Assets Released from Restrictions Used for Purchase of Property and Equipment 200
Contribution From Sample Hospital Foundation for Property Acquisitions 235 485
Transfers to Parent (640) (3,000)
Increase in Unrestricted Net Assets, before Extraordinary Item 5,147 6,699
Extraordinary Loss (Debt Extinguishment) (500)
Increase in Unrestricted Net Assets $4,647 $6,699
Exhibit A–2 Statement of Operations for Sample Not-For-Profit Hospital
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the American Institute of
Certified Public Accountants, Inc.
Sample Not-For-Profit Hospital
Statement of Changes in Net Assets
For the Years Ended December 31, 20X1 and 20X0 (in ‘000)
20X1 20X0
Unrestricted Net Assets
Excess of Revenues over Expenses $5,052 $8,839
Net Unrealized Gains on Investments Other than Trading Securities 300 375
Contribution from Sample Hospital Foundation for Property Acquisition 235 485
(Continues)
Exhibit A–3 Statement of Changes in Net Assets for Sample Not-For-Profit Hospital
66 Financial Management of Health Care Organizations
Transfers to Parent (640) (3,000)
Net Assets Released from Restrictions Used for Purchase of Properties and Equipment 200
Increase in Unrestricted Net Assets before Extraordinary Item 5,147 6,699
Extraordinary Loss from Extinguishment of Debt (500)
Increase in Unrestricted Net Assets 4,647 6,699
Temporarily Restricted Net Assets
Contributions for Charity Care 140 996
Net Realized and Unrealized Gains on Investments 5 8
Net Assets Released from Restrictions (500)
Increase (Decrease) in Temporarily Restricted Net Assets (355) 1,004
Permanently Restricted Net Assets
Contributions for Endowment Funds 50 411
Net Realized and Unrealized Gains on Investments 5 2
Increase in Permanently Restricted Net Assets 55 413
Increase in Net Assets 4,347 8,116
Net Assets, Beginning of Year 72,202 64,086
Net Assets, End of Year $76,549 $72,202
Sample Not-For-Profit Hospital
Statement of Cash Flows (Indirect Method)
December 31, 20X1 and 20X0 (in ‘000)
20X1 20X0
Cash Flows From Operating Activities
Change in Net Assets $4,347 $8,116
Adjustments to Reconcile Change in Net Assets to
Net Cash Provided by Operating Activities:
Extraordinary Loss from Debt Extinguishment 500
Depreciation 4,782 4,280
Net Realized and Unrealized Gains on Investments, Other than Trading (450) (575)
Transfers to Parent 640 3,000
Provision for Bad Debt 1,000 1,300
Restricted Contributions and Investment Income Received (55) (413)
(Increase) Decrease in:
Patient Accounts Receivable (1,906) (2,036)
Trading Securities 215
Other Current Assets 186 (2,481)
Other Assets (325) (241)
Increase (Decrease) in:
Accounts Payable and Accrued Expenses 436 679
Estimated Third-Party Payor Settlements 201 305
Other Current Liabilities (145) (257)
Other Liabilities 787 (128)
Net Cash Provided by Operating Activities 10,213 11,549
Exhibit A–3 (Contd)
Exhibit A–4 Statement of Cash Flows for Sample Not-For-Profit Hospital
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the American Institute of
Certified Public Accountants, Inc.
(Continues)
Health Care Financial Statements 67
Cash Flows From Investing Activities
Purchases of Investment (3,769) (2,150)
Capital Expenditures (4,728) (5,860)
Net Cash Used in Investing Activities (8,497) (8,010)
Cash Flows From Financing Activities
Transfer to Parent (640) (3,000)
Proceeds from Restricted Contributions and Restricted Investment Income 55 413
Payments on Long-Term Debt (24,700) (804)
Payments on Capital Lease Obligations (150) (100)
Increase in Long-Term Debt 22,600 500
Net Cash Used in Financing Activities (2,835) (2,991)
Net Increase (Decrease) in Cash and Cash Equivalents (1,119) 548
Cash and Cash Equivalents at Beginning of Year 5,877 5,329
Cash and Cash Equivalents at End of Year $4,758 $5,877
Supplemental Disclosures and Cash Flow Information:
The Hospital entered into capital lease obligations in the amount of $600,000 for new equipment in 2001.
Cash paid for interest (net of amount capitalized) in 2001 and 2000 was $1,780,000 and $1,856,000 respectively.
See accompanying notes to financial statements.
Columbia/HCA Healthcare Corporation
Consolidated Income Statement
For the Years Ended December 31, 1999 and 1998 (in millions)
1999 1998
Revenues $16,657 $18,681
Operating expenses:
Salaries and benefits 6,749 7,811
Supplies 2,645 2,901
Other operating expenses 3,196 3,771
Provision for doubtful accounts 1,269 1,442
Depreciation and amortization 1,094 1,247
Interest expense 471 561
Equity in earnings of affiliates (90) (112)
Gains on sales of facilities (297) (744)
Impairment of long-lived assets 220 542
Restructuring of operations and investigation related costs 116 111
Total operating expenses 15,373 17,530
Income from continuing operations before minority interests 1,284 1,151
Minority interests in earnings of consolidated entities 57 70
Income from continuing operations before income taxes 1,227 1,081
Provision for income taxes 570 702
Net Income $657 $379
Exhibit A–5 Consolidated Income Statement for Columbia/HCA Healthcare Corporation
Source: Reprinted with permission from the Audit and Accounting Guide: Health Care Organizations, copyright © 1996 by the American Institute of
Certified Public Accountants, Inc.
Source: Columbia/HCA’s 10-K report from SEC.
Exhibit A–4 (Contd)
68 Financial Management of Health Care Organizations
Columbia/HCA Healthcare Corporation
Consolidated Balance Sheet
December 31, 1999 and 1998 (in millions)
ASSETS 1999 1998
Current assets:
Cash and cash equivalents $190 $297
Accounts receivable, less allowances for doubtful accounts of $1,567 and $1,645 1,873 2,096
Inventories 383 434
Income taxes receivable 178 149
Other 973 887
Total current assets 3,597 3,863
Property and equipment, at cost:
Land 813 925
Buildings 6,108 6,708
Equipment 6,721 7,449
Construction in progress 442 562
14,084 15,644
Accumulated depreciation (5,594) (6,195)
Net Plant and equipment 8,490 9,449
Investments of insurance subsidiary 1,457 1,614
Investments in and advances to affiliates 654 1,275
Intangible assets, net of accumulated amortization of $644 and $596 2,319 2,910
Other 368 318
Total Assets $16,885 $19,429
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable $657 $784
Accrued salaries 403 425
Other accrued expenses 1,112 1,282
Long-term debt due within one year 1,160 1,068
Total current liabilities 3,332 3,559
Long-term debt 5,284 5,685
Professional liability risks, deferred taxes and other liabilities 1,889 1,839
Minority interests in equity of consolidated entities 763 765
Stockholders’ equity:
Common stock $0.01 par; authorized 1,600,000,000 voting shares and
50,000,000 nonvoting shares; outstanding 543,272,900 voting shares
and 21,000,000 nonvoting shares (1999) and 621,578,300 voting shares and
21,000,000 nonvoting shares (1998) 6 6
Capital in excess of par value 951 3,498
Other 8 11
Accumulated other comprehensive income 53 80
Retained earnings 4,599 3,986
Total stockholders’ equity 5,617 7,581
Total Liabilities & Stockholders’ equity $16,885 $19,429
Exhibit A–6 Consolidated Balance Sheet for Columbia/HCA Healthcare Corporation
Source: Columbia/HCA’s 10-K report from SEC.
Health Care Financial Statements 69
Columbia/HCA Healthcare Corporation
Consolidated Statement of Cash Flows
For the Years Ended December 31, 1999 and 1998 (in millions)
1999 1998
Cash flows from continuing operating activities:
Net income (loss) $657 $379
Adjustments to reconcile net income (loss) to net cash
provided by continuing operating activities:
Provision for doubtful accounts 1,269 1,442
Depreciation and amortization 1,094 1,247
Income taxes (66) 351
Gains on sales of facilities (297) (744)
Impairment of long-lived assets 220 542
Loss from discontinued operations 0 153
Increase (decrease) in cash from current assets and liabilities:
Accounts receivable (1,463) (1,229)
Inventories and other assets (119) (39)
Accounts payable and accrued expenses (110) (177)
Other 38 (9)
Net cash provided by continuing operating activities 1,223 1,916
Cash flows from investing activities:
Purchase of property and equipment (1,287) (1,255)
Acquisition of hospitals and health care entities 0 (215)
Spin-off of facilities to stockholders 886 0
Disposal of hospitals and health care entities 805 2,060
Change in investments 565 (294)
Investment in discontinued operations, net 0 677
Other (44) (3)
Net cash provided by (used in) investing activities 925 970
Cash flows from financing activities:
Issuance of long-term debt 1,037 3
Net change in commercial paper and revolving bank credit 200 (2,514)
Repayment of long-term debt (1,572) (147)
Issuances (repurchases) of common stock, net (1,884) 8
Payment of cash dividends and redemption of preferred stock purchase rights (44) (52)
Other 8 3
Net cash provided by (used in) financing activities (2,255) (2,699)
Change in cash and cash equivalents (107) 187
Cash and cash equivalents at beginning of period 297 110
Cash and cash equivalents at end of period $190 $297
Exhibit A–7 Consolidated Statement of Cash Flows for Columbia/HCA Healthcare Corporation
Source: Columbia/HCA’s 10-K report from SEC.
Abbreviated Notes to Financial Statements for Sample Not-For-Profit
Hospital, December 31, 20X1 and 20X0
1. Description of Organization and Summary of Significant Accounting Policies
ORGANIZATION
The Sample Not-For-Profit Hospital (the Hospital), located in City, State, is a not-for-profit acute
care hospital. The Hospital provides inpatient, outpatient, and emergency care services for residents
of northeastern State. Admitting physicians are primarily practitioners in the local area. The
Hospital was incorporated in State in 20X0 and is affiliated with the Sample Health System.
US E OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities, and disclosure of contingent assets and liabilities, at the date of
the financial statements, and the reported amounts of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include certain investments in highly liquid debt instruments with
original maturities of three months or less.
The Hospital routinely invests its surplus operating funds in money market mutual funds.
These funds generally invest in highly liquid US government and agency obligations.
INVESTMENTS
Investments in equity securities with readily determinable fair values, and all investments in
debt securities are measured at fair value in the balance sheet. Investment income or loss
(including realized gains and losses on investments, interest, and dividends) is included in the
excess of revenues over expenses, unless the income or loss is restricted by donor or law.
Unrealized gains and losses on investments are excluded from the excess of revenues over
expenses, unless the investments are trading securities.
ASSETS LIMITED ASTO USE
Assets limited as to use primarily include assets held by trustees under indenture agreements,
and designated assets set aside by the Board of Trustees for future capital improvements, over
which the Board retains control, and which it may at its discretion subsequently use for other
purposes. Amounts required to meet current liabilities of the hospital have been reclassified in
the balance sheet at December 31, 20X1 and 20X0.
PROPERTY AND EQUIPMENT
Property and equipment acquisitions are recorded at cost. Depreciation is provided over the
estimated useful life of each class of depreciable asset and is computed using the straight-line
method. Equipment under capital lease obligations is amortized on the straight-line method
over the shorter period of the lease term or the estimated useful life of the equipment. Such
amortization is included in depreciation and amortization in the financial statements. Interest
cost incurred on borrowed funds during the period of construction of capital assets is capitalized
as a component of the cost of acquiring those assets.
70 Financial Management of Health Care Organizations
Exhibit A–8
Gifts of long-lived assets such as land, buildings, or equipment are reported as unrestricted
support, and are excluded from the excess of revenues over expenses, unless explicit donor
stipulations specify how the donated assets must be used. Gifts of long-lived assets with explicit
restrictions that specify how the assets are to be used, and gifts of cash or other assets that
must be used to acquire long-lived assets, are reported as restricted support. Absent explicit
donor stipulations about how long those long-lived assets must be maintained, expirations of
donor restrictions are reported when the donated or acquired long-lived assets are placed in
service.
TEMPORARILY AND PERMANENTLY RESTRICTED NET ASSETS
Temporarily restricted net assets are those whose use by the Hospital has been limited by
donors to a specific time period or purpose. Permanently restricted net assets have been
restricted by donors to be maintained by the Hospital in perpetuity.
EXCESS OF REVENUESOVER EXPENSES
The statement of operations includes excess of revenues over expenses. Changes in
unrestricted net assets which are excluded from excess of revenues over expenses,
consistent with industry practice, include unrealized gains and losses on investments other
than trading securities, permanent transfers of assets to and from affiliates for other than
goods and services, and contributions of long-lived assets (including assets acquired using
contributions which by donor restriction were to be used for the purposes of acquiring such
assets).
NET PATIENT SERVICE REVENUE
The Hospital has agreements with third-party payors that provide for payments to the Hospital
at amounts different from its established rates. Payment arrangements include prospectively
determined rates per discharge, reimbursed costs, discounted charges, and per diem payments.
Net patient service revenue is reported at the estimated net realizable amounts from patients,
third-party payors, and others for services rendered, including estimated retroactive adjustments
under reimbursement agreements with third-party payors. Retroactive adjustments are
accrued on an estimated basis in the period the related services are rendered and adjusted in
future periods, as final settlements are determined.
PREMIUM REVENUE
The Hospital has agreements with various health maintenance organizations (HMOs) to
provide medical services to subscribing participants. Under these agreements, the Hospital
receives monthly capitation payments based on the number of each HMO’s participants,
regardless of services actually performed by the Hospital. In addition, the HMOs make feefor-
service payments to the Hospital for certain covered services based upon discounted fee
schedules.
CHARITY CARE
The Hospital provides care to patients who meet certain criteria under its charity care policy
without charge or at amounts less than its established rates. Because the Hospital does not pursue
collection of amounts determined to qualify as charity care, they are not reported as revenue.
DONOR-RESTRICTED GIFTS
Unconditional promises to give cash and other assets to the Hospital are reported at fair value
at the date the promise is received. Conditional promises to give and indications of intentions
to give are reported at fair value at the date the gift is received. The gifts are reported as either
Health Care Financial Statements 71
temporarily or permanently restricted support if they are received with donor stipulations that
limit the use of the donated assets. When a donor restriction expires – that is, when a stipulated
time restriction ends or purpose restriction is accomplished – temporarily restricted net
assets are reclassified as unrestricted net assets and reported in the statement of operations as
net assets released from restrictions. Donor-restricted contributions whose restrictions are met
within the same year as received are reported as unrestricted contributions in the accompanying
financial statements.
ESTIMATED MALPRACTICE COSTS
The provision for estimated medical malpractice claims includes estimates of the ultimate costs
for both reported claims and claims incurred but not reported.
INCOME TAXES
The Hospital is a not-for-profit corporation and has been recognized as tax-exempt pursuant to
Section 501(c)(3) of the Internal Revenue Code.
2. Net Patient Service Revenue
The Hospital has agreements with third-party payors that provide for payments to the Hospital
at amounts different from its established rates. A summary of the payment arrangements with
major third-party payors follows.
MEDICARE
Inpatient acute care services rendered to Medicare program beneficiaries are paid at prospectively
determined rates per discharge. These rates vary according to a patient classification system
that is based on clinical, diagnostic, and other factors. Inpatient non-acute services, certain
outpatient services, and defined capital and medical education costs related to Medicare beneficiaries
are paid based on a cost reimbursement methodology. The Hospital is reimbursed for
cost reimbursable items at a tentative rate, with final settlement determined after submission of
annual cost reports by the Hospital and audits thereof by the Medicare fiscal intermediary.
Beginning in 20X0, the Hospital claimed Medicare payments based on an interpretation of certain
“disproportionate share” rules. The intermediary disagreed and declined to pay the excess
reimbursement claimed under that interpretation. Through 20X0, the Hospital has not included
the claimed excess in net patient revenues pending resolution of the matter. In 20X1, the
intermediary accepted the claims and paid the outstanding claims, including $950,000 applicable
to 20X0 and $300,000 applicable to 20X1 and prior, which has been included in 20X0 net
revenues.
MEDICAID
Inpatient and outpatient services rendered to Medicaid program beneficiaries are reimbursed
under a cost reimbursement methodology. The Hospital is reimbursed at a tentative rate with
final settlement determined after submission of annual cost reports by the Hospital and audits
thereof by the Medicaid fiscal intermediary.
The Hospital also has entered into payment agreements with certain commercial
insurance carriers, health maintenance organizations, and preferred provider organizations.
The basis for payment to the Hospital under these agreements includes prospectively determined
rates per discharge, discounts from established charges, and prospectively
determined daily rates.
72 Financial Management of Health Care Organizations
3. Investments
ASSETS LIMITED ASTO USE
The composition of assets limited as to use at December 31, 20X1 and 20X0 is set forth in the
following table. Investments are stated at fair value.
20X1 20X0
Internally designated for capital acquisition:
Cash $545,000 $350,000
US Treasury Obligations 11,435,000 12,115,000
Interest Receivable 20,000 35,000
12,000,000 12,500,000
Held by trustee under indenture agreement:
Cash and short-term investments 352,000 260,000
US Treasury obligation 6,505,000 7,007,000
Interest receivable 92,000 74,000
6,949,000 7,341,000
Total $18,949,000 $19,841,000
OTHER INVESTMENTS
Other investments, stated at fair value, at December 31, 20X1 and 20X0, include:
20X1 20X0
Trading:
US Corporate Bonds $1,260,000 $1,475,000
Other
US Treasury Obligations 19,266,000 14,233,000
Interest receivable 310,000 232,000
20,836,000 15,940,000
Less:
Long-term investments 4,680,000 4,680,000
Long-term investments restricted for Capital acquisitions 320,000 520,000
Total $15,836,000 $10,740,000
Investment income and gains for assets limited as to use, cash equivalents, and other investments
are comprised of the following for the years ending September 30, 20X1 and 20X0:
20X1 20X0
Income:
Interest Income $3,585,000 $2,725,000
Realized gains on sales of securities 150,000 200,000
Unrealized gains on trading securities 165,000 100,000
$3,900,000 $3,025,000
Other Changes in Unrestricted Net Assets:
Unrealized gains on other than trading securities $300,000 $375,000
Health Care Financial Statements 73
4. Property and Equipment
A summary of property and equipment at September 30, 20X1 and 20X0 follows.
20X1 20X0
Land $3,000,000 $3,000,000
Land improvements 472,000 472,000
Buildings and improvements 52,047,000 53,975,000
Equipment 29,190,000 26,260,000
Equipment under capital lease obligations 2,851,000 2,752,000
Less accumulated depreciation and amortization 40,123,000 38,000,000
Construction in progress 3,601,000 2,033,000
Property and Equipment (Net) $51,038,000 $50,492,000
Depreciation expense for the years ended December 31, 20X1 and 20X0 amounted to
approximately $4,782,000 and $4,280,000. Accumulated amortization for equipment under
capital lease obligations was $689,000 and $453,000 at December 31, 20X1 and 20X0, respectively.
Construction contracts of approximately $7,885,000 exist for the remodeling of Hospital
facilities. At December 31, 20X1, the remaining commitment on these contracts approximated
$4,625,000.
5. Charity Care
The amount of charges forgone for services and supplies furnished under the Hospital’s
charity policy aggregated approximately $4,5000,000 and $4,100,000, in 20X1 and 20X0,
respectively.
Source: Adopted with permission from the Audit and Accounting Guide: Health Care
Organizations, Copyright © 1996 by the American Institute of Certified Public Accountants,
Inc.
74 Financial Management of Health Care Organizations
C h a p t e r T h r e e
PRINCIPLES AND PRACTICES OF
HEALTH CARE ACCOUNTING
Learning Objectives
After completing this chapter, you will be able to:
Record financial transactions.
Understand the basics of accrual accounting.
Summarize transactions into financial statements.
Introduction
The Books
The Cash and Accrual Bases of Accounting
The Cash Basis of Accounting
The Accrual Basis of Accounting
An Example of the Effects of Cash Flows on
Profit Reporting Under Cash and Accrual
Accounting
Recording Transactions
Rules for Recording Transactions
The Recording Process
Developing the Financial Statements
The Balance Sheet
Assets
Liabilities
Net Assets
The Statement of Operations
Unrestricted Revenues, Gains, and Other
Support
Operating Expenses
Operating Income and Excess of Revenues over
Expenses
Increase in Unrestricted Net Assets
The Statement of Changes in Net Assets
The Statement of Cash Flows
Summary
Key Terms
Questions and Problems
Chapter Outline
Introduction
The financial viability of a health care organization results from numerous decisions
made by various people, including care givers, administrators, boards, lenders, community
members, and politicians.
These decisions eventually result in an organization’s acquiring and using resources
to provide services, to incur obligations, and to generate revenues. One of the major
roles of accounting is to record these transactions and report the results in standardized
format to interested parties. This chapter shows how a series of typical transactions
at a health center are recorded on the books, and how these records are used to
produce the four major financial statements for a not-for-profit, business-oriented
health care organization. The recording and reporting process can be quite time consuming,
but changes are continually being made to automate it. (See Exhibit 3–1 and
Perspective 3–1.)
76 Financial Management of Health Care Organizations
Transaction
Occurs
Information
recorded in the
accounting system
The information is reported in the
four fundamental financial statements
Statement of Cash Flows
Changes in Net Assets
Balance Sheet
Statement of Operations
Exhibit 3–1 The Accounting Process: Recording and Reporting the Substance of Financial Transactions
Perspective 3–1
E-claims Trim Costs, Aid Growth
Intermountain Health Care’s physician-practice division was thriving.You could tell by the number of clerks bent over
their computer keyboards, posting claims payments to patient accounts in 72 separate practices across Utah. It took
27 people to handle the postings, reconcile payments with the charges and bill patients for the difference.“That’s all
they did.” For starters, says Wierz, implementing electronic transaction formats in the billing process can play a big
part in “eliminating a lot of handwork, a lot of manual transactions.” That directly attacks the twin beasts of overhead
expense – bulging payroll and rejected claims – by requiring fewer people to do the detail work and cutting
down on manual mistakes that result in claims denials. The benefits, as chronicled at Intermountain, can be quantified
in fewer full-time-equivalent employees and more productivity per employee.
Source: John Morrissey, Modern Healthcare, October 2, 2000.
The Books
As transactions of a health care organization occur (such as the purchase of supplies), they
are recorded chronologically in a “book” called a journal. Today, this “book” is more
likely to be a computer than a journal requiring manual entries. Periodically (simultaneously
with most computer programs), these transactions are summarized by account (i.e.
Cash, Equipment, Revenues, etc.) into another book called a ledger. With these two
books, the organization has both a chronological listing of transactions and the current
balance in each account (see Exhibit 3–2). The totals for each account in the ledger are
used to prepare the four financial statements. Although this procedure is quite simple to
conceptualize, ensuring the financial statements are prepared accurately and in a timely
manner is quite involved, as Perspective 3–1 shows.
There is a fairly standard set of account categories used by all health care organizations,
which is listed in a book entitled chart of accounts. The accounts that are used
in the financial statements in Chapter 2 comprise an important part of the standard set
of account categories (though there may be subcategories in each one).
The Cash and Accrual Bases of Accounting
Before introducing examples of recording and reporting transactions, we discuss the
difference between cash and accrual accounting. The cash basis of accounting
focuses on the flows of cash in and out of the organization, whereas the accrual basis
of accounting focuses on the flows of resources and the revenues those resources
help to generate. This discussion begins with a focus on the cash basis of accounting,
Principles and Practices of Health Care Accounting 77
Transaction
Occurs
Information
recorded in the
accounting system
Chronological
Listing
Journal
Ledger
The information is reported
in the four fundamental
financial statements
Listed by Account
Cash
Receivables
Supplies
Etc
Statement of Cash Flows
Stament of Operations
Balance Sheet
Exhibit 3–2 Role of the Journal and Ledger in Recording and Reporting Financial Transactions
for it is more intuitive. The focus then turns to the accrual basis of accounting, which
is the system the accounting profession applies to health care organizations.
The Cash Basis of Accounting
The cash basis of accounting records transactions similarly to the way most people
keep their personal checkbooks: revenues are recorded when cash is received, and
expenses are recorded when cash is paid out (see Exhibit 3–3). For example, if an
organization delivers a service to a patient, the revenue from that patient is recorded
when received. Expenses are recorded as they are paid (such as when the staff are
paid). The advantages of this method of accounting are: 1) cash flows can be tracked;
and 2) it is simple. Its main disadvantages are: 1) it does not match revenues with the
resources used to generate those revenues; and 2) the financial reports under the cash
basis of accounting are susceptible to managerial manipulation. Incidentally, one of
the functions of auditors is to give assurance that the statements have been prepared
according to generally accepted accounting principles (GAAP) (see Perspective 3–2).
The Accrual Basis of Accounting
The accrual basis of accounting overcomes the disadvantages of the cash basis of
accounting by recognizing revenues when they are earned and expenses when
resources are used (see Exhibit 3–3). The advantages of the accrual basis of accounting
are that: 1) it keeps track of revenues generated and resources used as well as cash
flows; 2) it matches revenues with the resources used to generate those revenues; and
3) the financial statements provide a broader picture of the provider’s operation. Its
main disadvantages are that: 1) it is more difficult to implement; and 2) it, too, is open
to manipulation, often by bending accounting rules. Keeping track of revenues and
resource use can be a technologically intensive endeavor (see Perspective 3–3).
An Example of the Effects of Cash Flows on Profit
Reporting Under Cash and Accrual Accounting
Exhibit 3–4 illustrates how the cash basis of accounting is vulnerable to management’s
manipulation of revenues and expenses. Assume a health care organization earned $12,000
in revenues and had $4,000 in expenses. In Scenario 1, management wants to show a high
profit, so although it collects full payment of $12,000, it delays paying its bills until after
78 Financial Management of Health Care Organizations
Cash Basis of Accounting Accrual Basis of Accounting
Revenues Are Recognized When Cash Is Received When Revenues Are Earned
Expenses Are Recognized When Cash Is Paid Out When Resources Are Used
Exhibit 3–3 Comparison of the Cash and Accrual Bases of Accounting
Accrual Basis of
Accounting: An
accounting method
which aligns the flow
of resources and the
revenues those
resources helped to
generate. It records
revenues when
earned and resources
when used,
regardless of the
flow of cash in or out
of the organization.
This is the standard
method in use today.
Cash Basis of
Accounting: An
accounting method
which tracks when
cash was received
and when cash was
expended, regardless
of when services
were provided or
resources were used.
Principles and Practices of Health Care Accounting 79
Perspective 3–2
Internal Investigations: Healthcare Systems Are Deploying More Internal Auditors to Monitor All
Aspects of Operations
A recent survey published by the Healthcare Financial Management Association found that from 1990 to 1998, the
duties and responsibilities of healthcare internal auditors shifted from verifying and analyzing data to assessing operations
to supporting managerial decision making. The same survey found that more internal audit directors had
earned the status of certified public accountant or certified internal auditor, a status granted by the Institute of
Internal Auditors.
“Healthcare is probably one of the biggest growth areas for internal auditors,” says Michael Fabrizius, Bon Secours’
vice president of internal audit. Internal auditors can assess technology, review corporate compliance programs, oversee
the transition to new Medicare payment schemes and coordinate coding and billing, Fabrizius says. Bon Secours
President and Chief Executive Officer Christopher Carney says an important factor in Bon Secours’ financial success
is its heavy use of internal auditors to monitor all aspects of financial and operational performance.
The system’s team of 20 internal auditors nose through everything from corporate compliance programs to managed-
care collections to billing functions at ancillary sites, looking for opportunities to reduce financial risk. Bon
Secours officials say the internal audit department, with an annual budget exceeding $1 million in salaries and travel,
saves more money for the system than it consumes.“They really become consultants to Management to help us
do a better job,” Carney says. Some organizations that lack dedicated internal auditors have hired consultants to
perform some of the same functions. Last fall, Newtown Square, Pa.-based Catholic Health East hired accounting
firm Deloitte & Touche to assess the effectiveness of its corporate compliance programs and provide consistency in
financial and accounting reporting by its 32 hospitals.
Source:Adapted from Mary Chris Jaklevic, Modern Healthcare, September 4, 2000, p. 64.
Situation: During the accounting period, a health care organization has earned $12,000 in revenues, and
consumed $4,000 in resources.
Assume 3 scenarios:
1. Management wants to show a high profit, so although it collects full payment of $12,000, it delays paying its
bills until after the end of the accounting period.
2. Management wants to show low profit, perhaps to encourage more donations. It pays the bills, $4000, but
discourages patients and third parties from paying until after the end of the accounting period.
3. Accrual basis of accounting rules are followed, and the organization records revenues earned of $12,000, and
resources used to generate those revenues of $4,000.
Scenario 1 Scenario 2 Scenario 3
Revenues Reported $12,000 $0 $12,000
Expenses Reported $0 $4,000 $4,000
Profit Reported $12,000 ($4,000) $8,000
Points:
1. Management can manipulate reported profits through its payment and collection policies under the cash basis
of accounting.
2. Revenues are not necessarily matched with the resources used to generate those revenues under the cash basis
of accounting.
Exhibit 3–4 Illustration of Management Manipulation under the Cash Basis of Accounting
the end of the accounting period; therefore, the reported profit is $12,000. In Scenario 2,
management wants to show low profit (perhaps so it can encourage more donations). In
this case, management pays all of its bills, $4,000, but sends out its own bills late so that
payment is not received from patients and third parties until after the end of the accounting
period; reported profit under this scenario is −$4,000. Scenario 3 follows the accrual
basis of accounting rules and records revenues earned of $12,000 and resources used to
generate those revenues of $4,000, which shows a profit of $8,000. Thus, under accrual
accounting the organization cannot influence reported profit by accelerating or slowing
cash inflows and outflows. Revenues must be recorded when they are earned and expenses
recorded when resources are used. Perspectives 3–4 and 3–5 exhibit the importance of
accurate record keeping, and show how systems can go astray.
Generally accepted accounting principles recommend that health care organizations
use the accrual basis of accounting. This does not mean that having information
about cash flows is any less important than is having information about revenues and
the resources used to generate those revenues.
Recording Transactions
Assume Windmill Point Outpatient Center is a not-for-profit, business-oriented, health
care organization which had the transactions summarized in Exhibit 3–5 during 20X1, its
80 Financial Management of Health Care Organizations
Perspective 3–3
Revenue Stopper: Bungled Billing System Conversions Are Plaguing the Hospital Industry
Like many hospitals and healthcare systems, University of Chicago Hospitals rushed to install Y2K-compliant patient
accounting software. The goal was to protect the system’s cash flow by ensuring that it could continue to bill for
services and collect revenue without a hiccup after Jan. 1, 2000. . . .
For about two months after the new system went live in February 1999, the medical center struggled to generate
bills. Normally, the academic medical center produced 70,000 claims monthly.The average time it took to collect a
payment ballooned from about 45 days to nearly 70. Because the software had not been fully customized and tested,
less than 40% of claims that were issued were complete and accurate, according to staff who worked on the project.
The result was a cash crunch, with collections 6.3% below budgeted projections for the 1999 fiscal year.
To meet expenses, the hospital took out a bank line of credit, which cost it more than $1 million in interest and
delayed some capital projects. . . . Though not widely reported, bungled billing system conversions have clogged cash
flows at many hospitals, which often installed new systems to avoid problems associated with the turnover to the
year 2000. In the industry, stories abound of patient-accounting departments that were unable to generate bills for
months or were forced to write off millions of dollars in revenue because data needed to submit a clean claim could
not be converted to new software. . . . Billing glitches can lead to credit downgrades, layoffs and even bankruptcy. . . .
Even a small spike in the number of days it takes hospitals to collect money can drain millions of dollars, eroding
investment income and impairing access to capital markets.
Source:Adapted from Mary Chris Jaklevic, Modern Healthcare, July 2, 2001, p. 36.
Principles and Practices of Health Care Accounting 81
Perspective 3–4
Former HBO Execs Indicted for Fraud
Two former executives of McKesson HBOC were indicted late last week in what was called one of the largest financial
reporting frauds in US history.The government accused the pair of falsely inflating company revenue from 1997
to 1999 by hundreds of millions of dollars.
A 17-count indictment announced late last week by federal prosecutors in San Francisco alleges that Albert
Bergonzi, 50, and Jay Gilbertson, 40, former HBO & Co. co-president and cochief operating officer, “systematically
defrauded HBO shareholders and the investing public” in a scheme that resulted in shareholder losses of $9 billion.
Bergonzi and Gilbertson shared the top post at Atlanta-based HBO before it was acquired by San
Francisco-based drug distributor McKesson Corp. in January 1999 for $14 billion and renamed McKesson
HBOC.
“This case is the poster child for the devastating effect of financial fraud by corporate management,” US Attorney
Robert Mueller said in a written statement.“The defendants violated the antifraud, internal controls, and books and
records provisions of the federal securities laws,” SEC officials said in a written statement.The SEC also alleges that
“Gilbertson violated the rule against lying to auditors.” A Wall Street darling throughout the 1990s, HBO’s shady
accounting practices first came to light in April 1999, when an annual review by auditors unveiled the first signs of
irregularities. Shares slid almost 50% on the news to $34 per share from $65 per share, socking a $9 billion punch
to McKesson HBOC’s market value in a single day. According to the indictment, Bergonzi and Gilbertson went to
great lengths to help HBO meet or beat Wall Street analysts’ expectations of the company’s performance.
Source:Adapted from Jeff Tieman, Deanna Bellandi, and Ed Lovern, Modern Healthcare, October 2, 2000, p. 2.
Perspective 3–5
Debunking Oxford. Oxford Health Has Convinced Wall Street It Has Pulled off a Turnaround that Is
Nothing Short of Legendary. This Legend – Like Many – May not Be True
But as the company’s financial statements reveal, there may also be a more troubling reason for Oxford’s low loss
ratio.The insurer has been steadily releasing money from its reserve for future medical claims. Specifically, it has been
letting money out of a reserve for what’s known as incurred-but-not-reported claims, or IBNR. In HMO accounting,
IBNR is an actuarial estimate of medical claims that plan members have incurred (for doctor’s visits, diagnostic
tests, surgical procedures, etc.) but that have not hit the books because the provider or member has not yet reported
the claim to the insurer. Some have expressed concern that Oxford is feeding off its reserve, which is meant to
pay for patients’ medical care. But on Wall Street, there are few raised eyebrows. Instead, the practice is considered
more evidence of Payson’s magical touch.“I don’t know of any other HMO that has consistently been able to release
its reserves,” marvels analyst Robert Mains of Advest, a financial advisory firm in Hartford, Conn., who rates Oxford’s
stock a buy. He says releases from reserves demonstrate how impressive Oxford is as a “medical-cost-containment
story” since they indicate that the company’s medical expenses have been lower than it had estimated.
But here’s the problem:The amount that’s released reduces the “health-care expense” component in calculating
the medical-loss ratio, making that MLR look better. In translation, Oxford’s cost of care looks cheaper than it actually
is. It’s a fine tactic, but one that works for only a limited time.
Source: David Stires, Fortune Magazine, March 19, 2001.
first year of operation. Exhibit 3–6 presents the journal and ledger entries to record the
transactions listed in Exhibit 3–5. Since the transactions are recorded chronologically by
row, the rows serve as the journal. Since each account has its own column summarized at
the bottom, the columns serve as a ledger. These transactions are being recorded in part
so that the four financial statements can be prepared. These statements allow interested
parties to make informed judgments about the financial health of the organization.
Rules for Recording Transactions
Two rules must be followed to record transactions under the accrual basis of accounting:
1. At least two accounts must be used to record a transaction.
a. Increase (decrease) an asset account whenever assets are acquired (used).
b. Increase (decrease) a liability account whenever obligations are incurred
(paid for).
82 Financial Management of Health Care Organizations
1. The center received $600,000 in unrestricted contributions.
2. The center obtained a $500,000 bank loan at 6% interest; $20,000 in principal is due this year.
3. The center purchased $450,000 of plant and equipment (P&E). It paid cash for the purchase.
4. The center purchased $100,000 of supplies on credit. The vendor expects payment within 30 days.
5. The center provided $500,000 of non-discounted, billable services to non-capitated patients. Payment has not
yet been received.
6. On the first day of the year, the center received $250,000 in capitation payment from an HMO. This means
an HMO paid the center $250,000 in advance on a per member per year (PMPY) basis to provide for the
health care needs of its enrollees over the next year.
7. In the provision of services to all patients, the center incurred $300,000 in labor expenses, which it paid for in
cash.
8. In the provision of services to all patients, the center used $80,000 of supplies.
9. The center paid $10,000 in advance for one year’s insurance.
10. The center paid for $90,000 of the $100,000 of supplies purchased in Transaction 4.
11. Patients or their third parties paid the center $400,000 of the $500,000 they owed (see Transaction 5).
12. During the year, the center made a $50,000 cash payment toward its bank loan; $20,000 was for principal and
$30,000 was to pay the full amount of interest due.
13. The center transferred $25,000 to its parent corporation.
At the end of the year, the center recognized the following:
14. Since the last payday, employees have earned wages of $35,000.
15. Equipment has depreciated $45,000.
16. The $10,000 of insurance premium was for one year. That time has now expired.
17. The Health Center has fulfilled the health care service obligation it took on for the $250,000 in capitated
payments for one year (Transaction 6), which has now expired. This revenue is now considered earned.
18. $20,000 of the note payable in Transaction 2 is due within the next year.
19. Bad debt is estimated to be $5,000.
20. $60,000 is set aside for the beginning of the next fiscal year to be used towards purchase of new computer
equipment.
Exhibit 3–5 Sample Transactions for Windmill Point Outpatient Center, January 1, 20X1 to December 31, 20X1
Assets
Limited
as to Use
Allowance
for Doubtful
Accounts
Plant &
Equipment
(P&E)
Revenues,
Gains and
Other Support
Accounts
Receivable
Prepaid
Expenses
Long-term
Investments
Accumulated
Depreciation
Current
Liabilities
Deferred
Revenues
Non-Current
Liabilities
Transfer
to Parent
Unrestricted
Net Assets
Restricted
Net Assets Transaction Cash Supplies Expenses
Beginning Balance $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0
1 Contribution 600,000 600,000
2 Long-term bank loan 500,000 20,000 480,000
3 Purchased P & E with cash −450,000 450,000
4 Purchased supplies on credit 100,000 100,000
5 Patient services on credit 500,000 500,000
6 Received HMO capitation 250,000 250,000
7 Paid labor −300,000 −300,000
8 Used supplies −80,000 −80,000
9 Prepaid insurance −10,000 10,000
10 Paid cash for supplies −90,000 −90,000
11 Patients paid accounts 400,000 −400,000
12 Paid bank loan & interest −50,000 −20,000 −30,000
13 Transferred funds to parent
Adjustments
−25,000 −25,000
14 Wages earned but not paid 35,000 −35,000
15 Depreciation −45,000 −45,000
16 Expired insurance −10,000 −10,000
17 Capitation earned −250,000 250,000
18 Current portion of Debt 20,000 −20,000
19 Bad debt −5,000 −5,000
20 Board funds set aside −60,000 60,000
Balances after adjustments 765,000 60,000 100,000 −5,000 20,000 0
0
450,000 −45,000 65,000 0
460,000 1,350,000 −505,000 −25,000 0
0
−505,000
Operating income 845,000 845,000
Closing income from operations
to unrestricted net assets 845,000
Transfer to parent −25,000
820,000
Ending Balances 765,000 60,000 100,000 −5,000 20,000 0
0
450,000 −45,000 65,000 0
460,000
Balances with
Summarized Net Assets $765,000 $60,000 $100,000 −$5,000 $20,000 $0 $0 $450,000 −$45,000 $65,000 $0 $460,000 $820,000 $0
Summary:Total Assets =1,345,000
Liabilities + Net Assets =1,345,000
Current Assets = 940,000
Non-Current Assets = 405,000
NET ASSETS ASSETS
Windmill Point Outpatient Clinic
Journal and Ledger
For the Period January 1 – December 31, 20X1.
LIABILITIES
Exhibit 3–6 Listing of Financial Transactions for Windmill Point Outpatient Center
84 Financial Management of Health Care Organizations
c. Increase a revenue, gain, or other support account when revenues are
earned, a gain occurs, or other support is received.
d. Increase an expense account when an asset is used. Net Assets increase
when Unrestricted Revenues, Gains, and Other Support increase, and
Net Assets decrease when Expenses occur.
There are additional rules which must be followed for donations; however,
these rules can become quite complex and are beyond the scope of this text.
2. After each transaction, the fundamental accounting equation must
be in balance:
Assets = Liabilities + Net Assets
The Recording Process (see Exhibit 3–6)
1. The center received $600,000 in unrestricted contributions.
a. Since cash was received, Cash (an asset) is increased by $600,000.
b. Since an unrestricted contribution for operating purposes was
received, Revenues, Gains, and Other Support is increased by
$600,000. If Exhibit 3–6 were not constrained for space, the
transaction would be more accurately recorded in a subcategory of
Revenues, Gains, and Other Support, called Other Revenue.
2. The center obtained a $500,000 bank loan at 6 percent interest;
$20,000 in principal is due this year.
a. Since cash was received, Cash (an asset) is increased by $500,000.
b. Since the center borrowed $500,000, it must recognize this as a liability.
The part due this year ($20,000) is a current liability. The part not due
this year ($480,000) is a non-current liability. Thus, Notes Payable under
current liabilities is increased by $20,000, and Notes Payable under noncurrent
liabilities is increased by $480,000.
A common error is to record interest expense at this time. Since interest is a “usage”
fee, interest is recognized as the borrower keeps the funds, not when the borrowing
takes place. (This is shown in Transaction 12.)
Under accrual accounting, revenues are recognized when earned. Since the receipt of an unrestricted donation
that can be used for operating purposes is not earned in the same sense that patient revenues are, such donations
are recorded in the related account Other Revenue, under Revenue, Gains, and Other Support.
Notice that although cash was received, no revenues were recognized. Under accrual accounting, revenues are
recognized when they are earned. In this case, the cash received did not represent earnings, just the borrowing
of funds. Also note that this transaction involved three accounts, not just two: Cash, Current Liabilities, and Non-
Current Liabilities. However, the fundamental accounting equation still remains in balance.
3. The center purchased $450,000 of properties and equipment (P&E).
It paid cash for the purchase.
a. Since cash was paid, Cash (an asset) is decreased by $450,000.
b. Since properties and equipment were purchased, Properties and
Equipment (an asset) is increased by $450,000.
4. The center purchased $100,000 of supplies on credit. The vendor
expects payment within 30 days.
a. Since supplies increased, Supplies (an asset) is increased by $100,000.
b. Since the vendor is owed $100,000, and the payment is due within 30
days, the current liability, Accounts Payable, is increased by $100,000.
5. The center provided $500,000 of non-discounted, billable services to
non-capitated patients. Payment has not yet been received.
a. Although the patients received services, they have not paid. Therefore,
Accounts Receivable (an asset) is increased by $500,000 to show that the
organization has a right to collect the money it is owed.
b. Since revenue was earned by providing services, Patient Revenues, a net
asset sub-account, is increased by $500,000.
6. On the first day of the year, the center received $250,000 in capitation
pre-payment from an HMO. This means the HMO paid the center
$250,000 in advance on a per member per year (PMPY) basis to take
care of the medical needs of all its enrollees over the next year.
a. Since cash was received, Cash (an asset) is increased by $250,000.
b. The center has an obligation to provide services to the capitated
patients. Therefore, Deferred Revenues (a liability) is increased by
$250,000.
Principles and Practices of Health Care Accounting 85
Notice that although cash was paid, no expense was recognized. Under accrual accounting, expenses are recognized
as assets are used, and the center has not yet used the plant and equipment. (This is shown in
Transaction 15.)
Notice that although supplies were purchased, no supplies expense was recognized. Under accrual accounting,
expenses are recognized when resources are used or consumed, and the center has not yet used the supplies.
(This is shown in Transaction 8.)
Under accrual accounting, revenues are recognized when earned. Therefore, although no cash was received, revenues
are increased because the service was performed.
Under accrual accounting, revenues are recognized when they are earned. Although cash was received, the revenues
will only be earned as the “coverage period” expires. (This is shown in Transaction 17.)
7. In the provision of services to all patients, the center incurred $300,000 in
labor expenses, which it paid for in cash.
a. Since cash was paid out, Cash (an asset) is decreased by $300,000.
b. Since labor, a resource, was used, Expenses, a net asset, is increased.
Since expenses decrease net assets, it is recorded as a negative
number.
8. In the provision of services to all patients, the center used $80,000 of supplies.
a. The organization now has $80,000 less in supplies. Therefore, Supplies (an
asset) is decreased by $80,000.
b. Since $80,000 of supplies has been used, Supplies Expense is increased
by $80,000. Since expenses decrease net assets, it is recorded as a negative
number.
9. The center paid a $10,000 premium in advance for one year’s insurance
coverage.
a. Since cash was paid out, Cash (an asset) is decreased by $10,000.
b. $10,000 purchased the right to be covered by insurance for the entire year.
Therefore, Prepaid Insurance (an asset) is increased by $10,000.
10. The center paid for $90,000 of the $100,000 of supplies purchased in
Transaction 4.
a. Since cash was paid, Cash (an asset) is decreased by $90,000.
b. Since it no longer owes $90,000 of the $100,000 liability, Accounts Payable (a
liability) is decreased by $90,000.
86 Financial Management of Health Care Organizations
Since cash was paid in recognition of the use of resources, expenses would have been recognized under either
the cash or accrual basis of accounting.
Although no cash was paid, the expense is recognized because resources have been used. Recall that no
expense was recognized when the resource was purchased in Transaction 4.
Under accrual accounting, expenses are recognized when assets are used. Thus, although cash has been paid
out, no expense was recognized. The expense will be recognized as the right to be covered by insurance is “used
up” (with the passage of time). (This is shown in Transaction 16.)
Although cash has been paid out, no expense was recognized since no resources were used.
11. Patients or their third parties paid the center $400,000 of the $500,000 they
owed (see Transaction 5).
a. Since cash was received, Cash (an asset) is increased by $400,000.
b. Since payment has been received, the organization no longer has the right to
collect this $400,000 from patients. Therefore, Accounts Receivable (an asset)
is decreased by $400,000.
12. During the year, the center made a $50,000 cash payment toward its bank
loan; $20,000 was for principal and $30,000 was to pay the full amount of
interest due.
a. Since cash was paid out, Cash (an asset) is decreased by $50,000.
b. Since $20,000 of the loan has been paid off, Notes Payable (a liability) is
decreased by $20,000.
c. Since the center paid $30,000 for the use of the $500,000 loan (6 percent
interest rate), Interest Expense (a net asset) is increased by $30,000. Since
expenses decrease net assets, it is recorded as a negative.
13. The center transferred $25,000 to its parent corporation.
a. Since cash was paid out, Cash (an asset) is decreased by $25,000.
b. Since the organization now has $25,000 less assets, Transfer to Parent (a
net asset) is decreased by $25,000 dollars. This is recorded as a negative
because it has the effect of decreasing Unrestricted Net Assets (like expenses
that are also recorded as negatives).
14. Since the last payday, employees have earned wages of $35,000.
a. Since the center owes its employees $35,000, it must recognize this obligation
by increasing Wages Payable (a liability) by $35,000.
b. Since the center used $35,000 of labor, it must increase Labor Expense (a liability)
by $35,000. Since expenses decrease net assets, the increase in expenses is
recorded as a negative number.
Principles and Practices of Health Care Accounting 87
Notice that although cash was received, no revenues were recognized. Under accrual accounting, revenues are
recognized when they are earned. The revenue was recognized when it was earned in Transaction 5.
Remember, interest expense was not recognized when the loan was taken in Transaction 2. Interest, the right to
use someone else’s money, is recognized over time, as the loan is outstanding.
Although cash has been paid out, no expense is recognized since no resources were used.
Although no cash was paid, the expense was recognized because labor resources have been used.
15. Equipment has depreciated $45,000.
a. To keep a cumulative record of the amount of depreciation taken on the
assets, the center must increase Accumulated Depreciation (a contra-asset
account) by $45,000. An increase in a contra-asset account results in a decrease
in the value of the assets. Thus, the accumulated depreciation is subtracted
from the amount in the equipment account to find the book value of the
equipment.
b. Since the organization has “used up” $45,000 of the equipment, it must
increase Depreciation Expense (a net asset account) by $45,000. Since
expenses decrease net assets, the increase in expenses is recorded as a negative
number.
16. The $10,000 of insurance coverage was for one year. That time has now
expired.
a. Since the organization no longer has the $10,000 of insurance coverage it
purchased, it must decrease Prepaid Insurance (an asset) by $10,000.
b. Since the organization “used up” the right it purchased to be covered by
insurance for one year, it must increase the Insurance Expense account by
$10,000. The expense is recognized as the resource is used, not when the
insurance is purchased (see Transaction 9). Since expenses decrease net assets,
the increase in expenses is recorded as a negative number.
17. The Center has fulfilled its health care service obligations under the
$250,000 capitated arrangement in transaction 6. This revenue is now
considered earned.
a. The center no longer has the obligation to provide service to these HMO enrollees.
Therefore, it must reduce Unearned HMO Revenues (a liability) by $250,000.
b. By covering the health care needs of the HMO enrollees for one year, the center
earned $250,000. Therefore, Revenues, Gains, and Other Support are increased
by $250,000. The specific account that would be increased under Revenues,
Gains, and Other Support is Premium Revenues. Incidentally, note that revenue
was not recognized when the cash was received (see Transaction 6).
88 Financial Management of Health Care Organizations
Although no cash was paid, the insurance expense is recognized because the right to be covered by insurance
has been “used up.”
Contra-asset: An
asset which, when
increased, decreases
the value of a related
asset on the books.
Two primary examples
are Accumulated
Depreciation, which is
the contra-asset to
Properties and
Equipment, and the
Allowance for
Uncollectibles, which
is the contra-asset to
Accounts Receivable.
Although no cash was received, revenues are recognized when earned.
Although no cash was paid, the depreciation expense is recognized because resources have been used.
18. $20,000 of the note payable is due within the next year.
a. Since the organization must pay $20,000 next year, the center must increase
Notes Payable (a current liability) by $20,000.
b. Since it no longer owes $20,000 over the long term, the center decreases Notes
Payable (a non-current liability) by $20,000.
19. Bad debt is estimated to be $5,000.
a. The estimate of how much of the accounts receivable will not be paid is placed
in a contra-asset account called the Allowance for Uncollectibles. Therefore, the
Allowance for Uncollectibles is increased by $5,000. By increasing the allowance
for uncollectibles, Net Patient Accounts Receivable is decreased.
b. By estimating uncollectibles, the organization is recognizing that there are
certain patient accounts receivable it will not be able to collect. This is part of
doing business. Essentially, the organization is “using up” the right to collect the
funds without actually collecting anything. It recognizes this use of resources by
increasing Bad Debt Expense by $5,000. Since expenses decrease net assets, the
increase in expenses is recorded as a negative number.
20. $60,000 is set aside by the Board to be used next year to help purchase a
new information system.
a. Since Cash was set aside, Cash (an asset) is decreased by $60,000.
b. Since the Board designated these funds for a specific use next year, Assets
Limited as to Use (a current asset) is increased by $60,000.
Principles and Practices of Health Care Accounting 89
Although no cash was paid, the bad debt expense (Provision for Bad Debt) is recognized in the same time
period as the earning occurred. If the organization did not recognize this expense at this time, it would be
matching one year’s bad debt with the revenues earned in a future year.
Because no resource has been consumed, there is no expense.
The terms Allowance for Doubtful Accounts, Allowance for Uncollectible Accounts, and Allowance for Bad Debt
are used interchangeably in practice. Similarly, the terms Provision for Bad Debt and Bad Debt Expenses are used
interchangeably in practice. In this text, the terms “Allowance for Uncollectibles” and “Bad Debt Expense” are
used throughout.
If nothing else were done, the value of the Allowance for Uncollectibles would grow indefinitely. To avoid this,
when deemed uncollectible, specific accounts are written off, and both the Allowance for Uncollectibles and
Accounts Receivable are reduced by an equal amount.
Developing the Financial Statements
Once the transactions have been analyzed and recorded, the organization can develop
the four financial statements: the balance sheet, the statement of operations, the statement
of changes in net assets, and the statement of cash flows.
The Balance Sheet
The balance sheet presents the assets, liabilities, and net assets for a health care
provider (see Exhibit 3–7). To construct a balance sheet for Windmill Point
Outpatient Clinic, the information from the transaction-recording sheet (see Exhibit
3–6) is used to develop a snapshot of the organization’s financial position at year’s end.
Assets
For Windmill Point Outpatient Center, Total Current Assets ($940,000) equals the
sum of all Cash ($765,000), Assets Limited as to Use ($60,000), Net Accounts
Receivable ($95,000: Accounts Receivable of $100,000 less the Allowance for
Uncollectibles of $5,000), Supplies ($20,000), and Prepaid Assets ($0). The Properties
and Equipment, Net is $405,000. This is computed by taking the original purchase of
$450,000 and subtracting the $45,000 of accumulated depreciation. Thus, Total
Assets are $1,345,000, which is the sum of current and non-current assets.
Liabilities
Windmill Point Outpatient Center has a balance of $65,000 in current liabilities:
$10,000 for supplies ($100,000 purchased minus $90,000 paid for); $35,000 in wages
payable; and $20,000, the current portion of the long-term debt. There are no
deferred revenues but there is $460,000 of the long-term portion of the loan remaining,
which is a non-current liability. The sum of these accounts, $525,000, is the total
liabilities.
Net Assets
Net assets equal $820,000. This net asset balance is computed by summing the beginning
balance of $0, plus the increase in unrestricted net assets of $820,000 and $0 in
temporarily restricted and permanently restricted net assets.
The Statement of Operations
As with the balance sheet, the information in Exhibit 3–6 is used to develop a statement
of operations for Windmill Point Outpatient Center (see Exhibit 3–8).
90 Financial Management of Health Care Organizations
Windmill Point Outpatient Center Balance Sheet
For the Periods Ending December 31, 20X1 and 20X0
12/31/20X1 12/31/20X0 12/31/20X1 12/31/20X0
Current Assets Current LLiabilities
Cash $765,000 $0 Accounts Payable $10,000 $0
Gross Accounts Receivable 100,000 Wages Payable 35,000 0
(less Allowance for Uncollectibles) (5,000) Notes Payable 20,000 0
Net Accounts Receivable 95,000 0
Total Current Liabilities 65,000 0
Supplies 20,000 0
Assets Limited as to Use 60,000
Prepaid Expenses 0
0
Non-Current Liabilities 460,000 0
Total Current Assets 940,000 0
Total Liabilities 525,000 0
Non-Current Assets
Long-Term Investments (Net) 0
Net Assets
Plant, Property & Equipment 450,000 0
Unrestricted 820,000 0
(less Accumulated Depreciation) (45,000) 0
Temporarily Restricted 0
0
Net Plant, Property & Equipment 405,000 0
Permanently Restricted 0
0
Total Non-Current Assets 405,000 Total Net Assets 820,000 0
Total Assets $1,345,000 $0 Total Liabilities & Net Assets $1,345,000 $0
Exhibit 3–7 Balance Sheet for Windmill Point Outpatient Center
However, since the transactions that comprise this statement were recorded in an
abbreviated form, it is necessary to refer also to the first column of Exhibit 3–6 to
identify the specific nature of the transactions classified under Unrestricted
Revenues, Gains, and Other Support as well as Expenses.
Unrestricted Revenues, Gains, and Other Support
The revenues of Windmill Point Outpatient Center are classified into three categories:
net patient revenues earned from non-capitated patients ($500,000); premium
revenue earned from capitated patients ($250,000); and unrestricted contributions,
which are presented in the category Other Revenue ($600,000). These revenues total
$1,350,000.
Operating Expenses
Operating Expenses are costs that are incurred in the day-to-day operation of the
business. Exhibit 3–8 shows that the operating expense of $505,000 is made up of
92 Financial Management of Health Care Organizations
Windmill Point Outpatient Center
Statement of Operations
For the Periods Ending December 31, 20X1 and 20X0
12/31/20X1 12/31/20X0
Revenues
Unrestricted Revenues, Gains and Other Support
Net Patient Revenue $500,000 $0
Premium Revenue 250,000 0
Other Revenue 600,000 0
Total Revenues 1,350,000 0
Expenses
Labor Expense 335,000 0
Supplies Expense 80,000 0
Interest Expense 30,000 0
Insurance Expense 10,000 0
Provision for Bad Debt 5,000 0
Depreciation and Amortization 45,000 0
Total Expenses 505,000 0
Operating Income 845,000 0
Excess of Revenues Over Expenses 845,000 0
Contribution of Long-Lived Assets 0 0
Transfers to Parent (25,000) 0
Increase in Unrestricted Net Assets $820,000 $0
Exhibit 3–8 Statement of Operations for Windmill Point Outpatient Center
$335,000 labor expense ($300,000 paid for and $35,000 not yet paid for); $80,000 supplies
expense; $30,000 interest expense; $10,000 insurance expense; $5,000 provision
for bad debt; and $45,000 depreciation expense.
Operating Income and Excess of Revenues over Expenses
Operating Income is the difference between Unrestricted Revenues, Gains, and Other
Support and Expenses. For Windmill Point Outpatient Center, operating income is
$845,000. Since there are no “non-operating income” items, this is also equal to
Excess of Revenues over Expenses, the net income of the organization.
Increase in Unrestricted Net Assets
As shown in Exhibit 3–8, the increase in unrestricted net assets, $820,000, for
Windmill Point Outpatient Center is operating income ($845,000) minus the transfers
to parent ($25,000).
The Statement of Changes in Net Assets
The third financial statement is the statement of changes in net assets, or the statement
of changes in owners’ equity or stockholders’ equity for a for-profit business. Its purpose
is to explain the changes in net assets from one period to the next (see Exhibit
3–9). This statement reflects increases and decreases in net assets for both restricted
and unrestricted net asset accounts. For Windmill Point Outpatient Center, the ending
balance of net assets, $820,000, is the sum of the beginning total net asset account
for the year, $0, plus the changes in unrestricted net assets for the year, $820,000 (from
the statement of operations), plus changes made to restricted net asset accounts, $0.
The Statement of Cash Flows
Since accrual accounting is used, the statement of operations provides information
about how much revenue was generated and the amount of resources used to generate
those revenues. However, the statement of operations does not tell how much cash
came into the organization and how much went out. That is the purpose of the statement
of cash flows (see Exhibit 3–10). The construction of the statement of cash flows
is beyond this introductory text. Most standard introductory accounting texts can
provide more detailed information.
This statement is organized into three major sections: cash flows from operating
activities, cash flows from investing activities, and cash flows from financing activities.
Whereas the sections on investing and financing activities are relatively straightforward,
the section on cash flows from operating activities is not. The latter begins with
Principles and Practices of Health Care Accounting 93
changes in net assets and then makes adjustments required by the accrual basis of
accounting.
Cash flows from investing activities include cash transactions involving the purchase
or sale of properties and equipment, and the purchase or sale of long-term investments.
Cash flows from financing activities include changes in non-current liability accounts,
such as an increase or decrease in long-term debt (including the current portion), any
increase in temporarily or permanently restricted assets, and the recognition of the transfer
of cash funds to the parent corporation.
That Transfer to Parent appears twice in this statement can be confusing. It
appears in the cash flows from operating activities section to show that there was
$25,000 more cash available from operations than is shown in changes in net assets,
which is the beginning point for calculating cash flows from operating activities.
Since the inflow is included in the cash flows from operating activities, the cash
outflow is then shown as a cash flow from financing activities.
Summary
The financial viability of a health care organization is the result of numerous decisions
made by a variety of people, including caregivers, administrators, boards, lenders,
community members, and politicians. These decisions eventually result in the organization’s
acquiring and using resources to provide services, to incur obligations, and
to generate revenues. One of the major roles of accounting is to record these transac-
94 Financial Management of Health Care Organizations
Windmill Point Outpatient Center
Statement of Changes in Net Assests
For the Periods Ending December 31, 20X1 and 20X0
12/31/20X1 12/31/20X0
Unrestricted Net Assets
Excess of Revenues Over Expenses $845,000 $0
Contribution of Long-Lived Assets 0 0
Transfer to Parent (25,000) 0
Increase in Unrestricted Net Assets 820,000 0
Temporarily Restricted Net Assets
Restricted Contribution 0 0
Increase in Temporarily Restricted Net Assets 0 0
Permanently Restricted Net Assets
Increase in Permanently Restricted Net Assets 0 0
Increase in Net Assets 820,000 0
Net Assets, Beginning of Year 0 0
Net Assets, End of Year $820,000 $0
Exhibit 3–9 Statement of Changes in Net Assets for Windmill Point Outpatient Center
tions in a standardized format and to report the results to interested parties. This
chapter shows how a series of typical transactions of a health center are recorded on
the books, and how these records are used to produce the four major financial statements
of a not-for-profit, business-oriented health care organization.
Transactions are recorded using either the cash basis of accounting or the accrual
basis of accounting. In the cash basis of accounting, revenues are recognized when cash
is received, and expenses are recognized when cash is paid. In the accrual basis of
accounting, revenues are recognized when earned, and expenses are recognized when
resources are used. The accrual basis of accounting must be used by health care organizations.
Major rules for recording transactions using the accrual basis of accounting include:
1. At least two accounts must be used to record a transaction.
a. Increase (decrease) an asset account whenever assets are acquired (used).
b. Increase (decrease) a liability account whenever obligations are incurred
(paid for).
Principles and Practices of Health Care Accounting 95
Windmill Point Outpatient Center
Statement of Cash Flows
For the Periods Ending December 31, 20X1 and 20X0
12/31/20X1 12/31/20X0
Cash Flows from Operating Activities
Change in Net Assets $820,000 $0
Depreciation Expense 45,000 0
− Increase in Temporarily Restricted Net Assets 0 0
+ Transfers to Parent 25,000 0
− Increase in Net Accounts Receivable (95,000) 0
− Increase in Inventory (20,000) 0
+ Increase in Accounts Payable 10,000 0
+ Increase in Wages Payable 35,000 0
Net Cash Provided by Operating Activities 820,000 0
Cash Flows from Investing Activities
Purchase of assets limited as to use (60,000) 0
Purchase of Plant, Property, & Equipment (450,000) 0
Net Cash Flow Used in Investing Activities (510,000) 0
Cash Flows from Financing Activities
Transfers to Parent (25,000) 0
Increase in Long-Term Debt 480,000 0
Net Cash Provided by Financing Activities 455,000 0
Net Increase in Cash & Cash Equivalents 765,000 0
Cash and Cash Equivalents, Beginning of Year 0 0
Cash and Cash Equivalents, End of Year $765,000 $0
Exhibit 3–10 Statement of Cash Flows for Windmill Point Outpatient Center
c. Increase a revenue, gain, or other support account when revenues are
earned, a gain occurs, or other support is received.
d. Increase an expense account when an asset is used. Net Assets increase
when Unrestricted Revenues, Gains, and Other Support increase, and
Net Assets decrease when Expenses occur.
There are additional rules which must be followed for donations; however,
these rules can become quite complex and are beyond the scope of this text.
2. After each transaction, the fundamental accounting equation must
be in balance:
Assets = Liabilities + Net Assets
Questions and Problems
1. Definitions. Define the following terms:
a. Accrual basis of accounting
b. Cash basis of accounting
c. Contra-asset
2. Accrual versus Cash Basis of Accounting. Explain the difference
between the accrual basis of accounting and the cash basis of accounting.
What are the major reasons for using accrual accounting?
3. Accrual Accounting. How are revenues and expenses defined under
accrual accounting?
4. Journal versus Ledger. What are the purposes of a journal and a ledger?
5. Adjustment of Three Accounts. Give two examples of transactions which
involve the adjustment of three accounts, rather than the usual two accounts.
6. Contra-asset. Give an example of a contra-asset, and explain how it is
recorded on the ledger as a transaction.
7. Prepaid Expense. Explain what a “prepaid expense” is and how it is
recorded on the ledger as a transaction.
8. Timing of Transactions. How would transactions differ if Supplies were
completely paid for and consumed in one period, or paid for in one period
but not used until the next period?
9. Timing of Transactions. Are transactions recorded on a fiscal-year basis
or a calendar-year basis? Does it have to be one or the other, and if so, why?
10. For-profit versus Not-for-profit Transactions. What are the major
differences in recording transactions for a for-profit organization versus a
not-for-profit, or are there any?
11. Transactions + Multiple Statements. List and record each transaction
for S. Zee Outpatient Clinic under the accrual basis of accounting at
96 Financial Management of Health Care Organizations
Accrual Basis of Accounting Cash Basis of Accounting Contra-asset
Key Terms
December 31, 20X1. Then develop a balance sheet as of December 31, 20X1,
and a statement of operations for the year ended December 31, 20X1.
a. The clinic received a $3,000,000 unrestricted cash contribution from the
community. (Hint: this transaction increases the unrestricted net assets
account.)
b. The clinic purchased $2,000,000 of equipment. The clinic paid cash for
the equipment.
c. The clinic borrowed $1,000,000 from the bank on a long-term basis.
d. The clinic purchased $1,500,000 of supplies on credit.
e. The clinic provided $5,500,000 of services on credit.
f. In the provision of these services, the clinic used $1,000,000 of supplies.
g. The clinic received $500,000 in advance to care for capitated patients.
h. The clinic incurred $2,000,000 in labor expenses and paid cash for them.
i. The clinic incurred $1,500,000 in general expenses and paid cash for them.
j. The clinic received $4,500,000 from patients and their third parties in
payment of outstanding accounts.
k. The clinic met $300,000 of its obligation to capitated patients in
Transaction g.
l. The clinic made a $100,000 cash payment on the long-term loan.
m. The clinic also made a cash interest payment of $50,000.
n. A donor made a temporarily restricted donation of $100,000 to be used
for operations.
o. The clinic recognized $200,000 in depreciation for the year.
p. The clinic estimated that $500,000 of patient accounts would not be received.
12. Transactions + Multiple Statements. The following are the financial
transactions for Family Home Health Care Center, a not-for-profit,
business-oriented organization. Beginning balances at January 1, 20X1 for its
assets, liabilities, and net asset accounts were:
Cash $5,000
Accounts Receivable $55,000
Allowance for Uncollectibles $5,000
Supplies $20,000
Long-term Investments $5,000
Properties and Equipment $300,000
Accumulated Depreciation $10,000
Short-term Accounts Payable $20,000
Wages Payable $10,000
Long-term Debt $200,000
Unrestricted Net Assets $135,000
Permanently Restricted Net Assets $5,000
List and record each transaction under the accrual basis of accounting. Then
develop a balance sheet as of December 31, 20X1 and 20X0, and a statement of
operations for the year ended December 31, 20X1.
a. The center purchased $10,000 of supplies on credit.
Principles and Practices of Health Care Accounting 97
b. The center provided $150,000 of home health services on credit.
c. The center consumed $5,000 of supplies in the provision of its home
health services.
d. The center provided $100,000 of home health services and patients paid
for services in cash.
e. The center paid cash for $15,000 of supplies in the provision of its home
health services.
f. The center paid $15,000 in cash for supplies previously purchased on
credit.
g. A donor established a $10,000 permanent endowment fund (in the form
of long-term investments) for the center. (Hint: this transaction increases
the permanently restricted net assets account.)
h. The center collected $100,000 from patients for outstanding receivables.
i. The center recognized $50,000 in labor expense.
j. The center paid $50,000 in cash toward its long-term loan.
k. The center purchased $75,000 in small equipment on credit. Amount is
due within one year.
l. The center incurred $8,000 in general expenses. The center used cash to
pay for the general expenses.
m. The center incurred $2,000 in interest expense for the year. Cash
payment of $2,000 was made to the bank.
n. The center made a $1,000 cash transfer to its parent corporation.
o. The center owes its staff wages of $3,000.
p. The center recognized depreciation expenses of $10,000.
q. The center estimated it would not collect $25,000 of the patient accounts
receivable.
13. Statement of Operations. The following is a list of account balances for
Krakower Healthcare Services, Inc. on December 31, 20X1. Prepare a
Statement of Operations as of December 31, 20X1. (Hint: when net assets
are released from restriction, the restricted account is decreased, and the
unrestricted account is increased. It is recognized under revenues, gains
and other support).
Supply Expense $110,000
Transfer to Parent Corporation $25,000
Bad Debt Expense $30,000
Depreciation Expense $60,000
Labor Expense $350,000
Interest Expense $15,000
Administrative Expense $75,000
Net Patient Service Revenues $960,000
Net Assets Released from Restriction $180,000
14. Statement of Operations. The following is a list of account balances for
Northland Hospital on September 30, 20X1. Prepare a Statement of
98 Financial Management of Health Care Organizations
Operations as of September 30, 20X1. (Hint: unrestricted donations are
recognized under revenues, gains, and other support.)
Labor Expense $500,000
Provision for Bad Debt $50,000
Supplies Expense $200,000
Unrestricted Cash Donation for Operations $10,000
Net Patient Revenue $1,800,000
Professional Fees $300,000
Transfer to Parent Corporation $25,000
Other Revenues from Cafeteria and Gift Shop $30,000
Depreciation Expense $50,000
Income from Investments (Unrestricted Investments) $15,000
Administrative Expense $100,000
15. Statement of Cash Flows. The following is a list of account balances for
Dover Hospital on June 30, 20X1. Prepare a Statement of Cash Flows as of
June 30, 20X1.
Transfer to Parent Corporation $125,000
Proceeds from Sale of Fixed Equipment $400,000
Principal Payment on Bonds Payable $700,000
Beginning Cash Balance $500,000
Cash from Operating Activities $225,000
Principal Payment on Notes Payable $20,000
16. Multiple Statements. The following is a list of accounts for Bauer
Biomedical Supplies on December 31, 20X1. Prepare a Balance Sheet and
Statement of Operations as of December 31, 20X1. (Hint: unrestricted
contributions increase the unrestricted net assets account, and they are a part
of revenues, gains, and other support.)
Interest Expense $5,000
Cash $4,000
Gross Accounts Receivable $55,500
Accrued Expenses $9,000
Long-term Debt $145,000
Labor Expenses $236,000
Supplies $4,000
Accumulated Depreciation $147,000
Net Sales Revenues $484,500
Other Non-current Assets $5,000
Professional Expenses $42,000
Short-term Accounts Payable $35,000
Administrative Expenses $104,000
Prepaid Expenses $2,000
Depreciation Expense $37,000
Non-operating Gains $5,000
Principles and Practices of Health Care Accounting 99
Unrestricted Cash Contributions $20,000
Short-term Investments $18,000
Other Current Liabilities $8,000
Other Revenues $125,500
Gross Plant and Equipment $462,000
Deferred Revenue $3,000
Bad Debt Expense $12,000
Allowance for Bad Debt $4,500
17. Transactions + Multiple Statements. St. Catherine’s Diagnostic Center
had the following beginning balances at January 1, 20X0, for its assets,
liabilities, and net assets accounts.
Cash $30,000
Accounts receivable $250,000
Allowance for Bad Debts $50,000
Supplies $6,000
Plant and Equipment $500,000
Accumulated Depreciation $50,000
Accounts payable $8,000
Short-term Notes Payable $130,000
Bonds Payable $300,000
Unrestricted Net Assets $248,000
Restricted Net Assets $0
List and record each 20X1 transaction under the accrual basis of accounting.
Then develop a Balance Sheet for end-of-years 20X0 and 20X1, a Statement of
Operations, and a Statement of Changes in Net Assets for the year ended
December 31, 20X1.
a. The center collected $200,000 in cash from outstanding accounts receivable.
b. The center purchased $20,000 of supplies on credit.
c. The center provided $500,000 of patient services on credit.
d. The center incurred $200,000 of labor expenses, which it paid in cash.
e. The center consumed $15,000 of supplies in the provision of its
diagnostic services.
f. The center paid $15,000 in cash for outstanding short-term notes payable.
g. The center collected $150,000 in cash from outstanding accounts
receivable.
h. The center paid $18,000 in cash for outstanding accounts payable.
i. The center issued $2,000,000 in long-term bonds that they must pay back.
j. The center purchased $1,800,000 in equipment on credit.
k. The center recognized $40,000 in interest expense.
l. The center incurred $70,000 in general expenses, which it paid in cash.
m. The center paid in cash $200,000 principal payment toward its
outstanding bonds.
n. A local corporation gave an unrestricted $25,000 cash donation. (Hint:
this transaction increases the unrestricted net assets account.)
100 Financial Management of Health Care Organizations
o. The center earned but did not receive $1,000 in interest income from
unrestricted short-term investments.
p. The center transferred $7,000 in cash to its parent corporation.
q. The center incurred annual depreciation expense of $50,000.
r. The center estimated the ending balance of the Allowance of
Uncollectible Accounts is $60,000.
18. Transactions + Multiple Statements. Ambulatory Center Inc. had the
following beginning balances for its assets, liabilities, and net accounts as of
December 31, 20X0.
Cash $20,000
Accounts Receivable $55,000
Allowance for Uncollectibles $5,000
Supplies $15,000
Prepaid Insurance $2,000
Long-term Investments $50,000
Plant and Equipment $2,000,000
Accumulated Depreciation $150,000
Short-term Accounts Payable $20,000
Accrued Expenses $5,000
Long-term Debt $1,000,000
Unrestricted Net Assets $912,000
Permanently Restricted Net Assets $50,000
List and record each 20X1 transaction under the accrual basis of accounting.
Then develop a Balance Sheet for end-of-years 20X0 and 20X1, a Statement of
Operations, and a Statement of Changes in Net Assets for the year ended
December 31, 20X1.
a. The center made cash payment of $10,000 to pay off outstanding
accounts payable.
b. The center received $25,000 in cash from a donor who temporarily
restricted its use. (Hint: this transaction increases the temporarily
restricted net assets account.)
c. The center provided $750,000 of services on credit.
d. The center consumed $10,000 of supplies in the provision of its
ambulatory services.
e. The center paid off its accrued interest expense of $5,000 in cash.
f. The center collected $125,000 in cash from outstanding accounts
receivable.
g. The center incurred $50,000 in general expenses that it paid for in cash.
h. The center made a $25,000 cash principal payment toward its long-term
debt.
i. The center collected $600,000 in cash from outstanding accounts
receivable.
j. The center received $50,000 in cash from an HMO for future capitated
services.
Principles and Practices of Health Care Accounting 101
k. The center purchased $12,000 of supplies on credit.
l. The center earned, but did not receive, $5,000 in income from its
restricted net assets. The income can be used for general operations.
(Hint: this transaction increases interest receivable and is also recorded
under revenues, gains and other support.)
m. The center’s temporarily restricted asset account released $1,000 from its
restricted account to its unrestricted account for operations. (Hint: the
transfer gets recorded under revenues, gains, and other support.)
n. The center incurred $5,000 in interest expense. The interest expense was
recorded, but not yet paid in cash.
o. The center incurred $500,000 in labor expenses, which it paid for in cash.
p. The center paid $2,000 in advance for insurance expense.
q. The center transferred $10,000 in cash to its parent corporation.
r. The center incurred $150,000 in depreciation expense.
s. The center’s prepaid insurance of $2,000 expired for the year.
t. The center recognized $15,000 for bad debt for the year.
102 Financial Management of Health Care Organizations
C h a p t e r F o u r
FINANCIAL STATEMENT
ANALYSIS
Learning Objectives
After completing this chapter, you will be able to:
Analyze the financial statements of health care organizations using horizontal analysis, vertical (common-size)
analysis, and ratio analysis.
Calculate and interpret liquidity ratios, profitability ratios, activity ratios, and capital structure ratios.
Introduction
Horizontal Analysis
Trend Analysis
Vertical (Common-size) Analysis
Ratio Analysis
Categories of Ratios
Key Points to Consider When Using and
Interpreting Ratios
Liquidity Ratios
Current Ratio
Quick Ratio
Acid Test Ratio
Days in Accounts Receivable
Days Cash on Hand
Average Payment Period
Liquidity Summary
Profitability Ratios
Operating Margin
Non-operating Revenue Ratio
Return on Total Assets
Return on Net Assets
Profitability Summary
Activity Ratios
Total Asset Turnover
Fixed Asset Turnover
Age of Plant Ratio
Activity Summary
Capital Structure Ratios
Long-term Debt to Net Assets
Net Assets to Total Assets
Times Interest Earned
Debt Service Coverage
Capital Structure Summary
Summary of Newport Hospital’s Ratios
SUMMARY
Key Terms
Key Equations
Questions and Problems
Chapter Outline
Introduction
The financial performance of health care organizations is of interest to numerous individuals
and groups, including administrators, board members, creditors, bondholders,
community members, and government agencies (see Perspectives 4–1 and 4–2).
Chapters 2 and 3 examined the four main financial statements of health care organizations
and the accounting methods underlying the preparation of these statements.
This chapter shows how to analyze the financial statements of health care organizations
to help answer questions about the organization that produced them:
Is the organization profitable? Why or why not?
How effective is the organization in collecting its receivables?
Is the organization in a good position to pay its bills?
How efficiently is the organization using its assets?
Are the organization’s plant and equipment in need of replacement?
Is the organization in a good position to take on additional debt?
104 Financial Management of Health Care Organizations
Perspective 4–1
Using Clinical and Financial Ratios: Performance of the 100 Top Hospitals
In 1993, HCIA (now Solucient) created a model that identifies benchmark hospitals around the country, based solely
on empirical, publicly available performance data.The 100 Top Hospitals™ : Benchmarks for Success study rates hospitals
by nine measures of clinical, operational, and financial performance. Generally, 100 Top Hospitals:
have better outcomes.Their median Medicare case mix indices are 20 percent higher, but their quality of
care, as measured by mortality and complications, is as much as 17 percent better than the rest of the country’s
hospitals.
do more with less. With fewer staff, yet 23 percent higher occupancy rates, they are twice as profitable.
Moreover, the 100 Top hospitals have maintained this level of efficiency over the years, while their peers have
steadily increased staffing ratios.
manage their debt better. Debt service ratios are two times higher at 100 Top hospitals than at their
peers. A popular measure of creditworthiness, this ratio measures the amount of funds a hospital has available
to cover its debts.
have growing occupancy rates. In 1998, the 100 Top hospitals’ median occupancy rate was 62 percent,
compared with the peer hospitals’ 50 percent median. Benchmark hospitals grew their occupancy an average
of 4.2 percent a year between 1996 and 1998, compared with only 0.3 percent at peer hospitals.
invest more in plant modernization and patient services. Although higher capital costs (per adjusted
discharge) are often viewed as unfavorable, benchmark hospitals have been able to maintain these figures
without increasing overall operating expenses per discharge.
The 100 Top Hospitals exhibit high-quality care, operate efficiently, and produce superior financial results. These
benchmarks in turn provide the health care industry with some indications and directions for positive change. If all
US acute hospitals were to operate like the 100 Top Hospitals, expenses would decline by an aggregate $31.7 billion
yearly, resulting in lower costs and savings across the board.
(Continues)
Financial Statement Analysis 105
Perspective 4–1 (Contd)
National Performance Comparisons for 1999 Top 100
Performance Measure Median 1999 Median 1998 Peer Group of % Benchmark
Benchmark Benchmark US Hospitals Exceeds
Hospitals Hospitals Peer Group
Mortality index2 0.86 0.84 1.10 14.9%
Complications2 0.89 0.85 1.01 11.9%
Average length of stay 4.3 4.2 4.5 6.0%
Expenses per adjusted discharge $3,452 $3,509 $4,249 18.8%
Cash flow margin 16.9% 16.3% 10.5% 6.5%1
Proportion of outpatient revenue 37.0% 36.6% 41.6% –4.6%1
Occupancy rate 62.0% 60.4% 50.3% 11.7%1
Growth in occupancy rate 4.2% 2.0% 27.0%
Total asset turnover ratio 1.08 1.04 0.92 17.4%
HCIA 100 Top Hospital Performance
Mortality index2 # of actual deaths/# of expected deaths
Complications2 # of cases with complications/# of expected cases with complications
Average length of stay average length of stay adjusted for severity of illness
Expenses per adjusted discharge total operating expenses/discharges adjusted by casemix and wage index
Cash flow margin (net income + depreciation + interest)/(net patient revenues + other income)
Proportion of outpatient revenue proportion of outpatient revenue
Occupancy rate occupancy rate
Growth in occupancy rate % change in occupancy rate 1996–1998
Total asset turnover ratio net patient revenue/total assets
1Values are percentage point difference between current benchmark and peer group value.
2Clinical indexes used in these measures assign a value of one to the expected level of mortality and complications assigned to
pre-existing conditions. Less than one means deaths or complications were below expectations.
Source: 100 Top Hospitals ™ : Benchmarks for Success, 1999. © 1999 by HCIA, L.L.C. Reprinted with permission.
Perspective 4–2
Use of Financial Ratios to Benchmark Hospital Performance
The performance of the country’s hospital industry is not unidimensional. It can be appraised in a number of ways.
Performance measures have traditionally relied upon ratios calculated from a hospital’s income statement and balance
sheet.These chart a hospital’s historical financial performance and suggest its future. However, other measures,
such as a hospital’s occupancy rate and staffing ratios, are equally important because they illuminate the underlying
causes of favorable or unfavorable financial performance.
There are seven major categories of hospital performance measures.
Capacity and utilization – A hospital’s productive capacity and the utilization of that capacity are key
predictors of financial performance. Some of these measures are number of beds, total discharges, occupancy
rate, and average length of stay.
(Continues)
Three approaches are commonly used to analyze financial statements: horizontal
analysis, vertical analysis, and ratio analysis. Each of these approaches is examined
using the financial statements shown in Exhibit 4–1, Newport Hospital’s statement of
operations and balance sheet. For simplicity, the statement of operations only contains
operating items.
106 Financial Management of Health Care Organizations
Perspective 4–2 (Contd )
Patient and payer mix – Hospital financial performance is tied to the illness complexity of the patients
treated by the hospital and to the source and nature of third-party reimbursement for patient services.
Measures include percentage of Medicare and Medicaid acute care discharges, Medicare case mix index,
and percentage of outpatient revenue.
Capital structure – Measures of a hospital’s capital structure are key indicators of its ability to incur
additional long-term debt and gain access to similar sources of outside funding or financing for growth and
expansion. Similarly, these measures often predict a hospital’s long-term creditworthiness and solvency.
These measures include plant age; debt per bed; capital costs as a percentage of operating expense and
per adjusted discharge; long-term debt to total assets, to net fixed assets, and to capitalization; cash
flow to total debt; debt service coverage ratio; and capital acquisitions as a percentage of net patient
revenue.
Liquidity is a measure of a hospital’s ability to meet its short term obligations with the hospital’s cash on
hand plus its assets that are most easily convertible to cash.These include current ratio, acid test ratio,
days in accounts receivable, and average payment period.
Revenues, expenses, and profitability – Profitability refers to a hospital’s ability to generate an excess
of revenues over expenses. Some measures of profitability are gross patient revenue per adjusted discharge,
operating revenue per adjusted discharge, operating profit margin, total profit margin, cash flow
margin, return on assets, and cash flow per bed.
Productivity and efficiency – Measures of productivity and efficiency often display the underlying causes
of financial performance.These measures include full-time equivalent personnel (FTEs) per
adjusted average daily census, salary and benefits per FTE, overhead expense as a percentage of
operating expense, and total asset turnover ratio.
Pricing strategies – A hospital’s ability to generate profits is a function of its ability to operate
efficiently and of its pricing strategies. By examining some of the important markup ratios, such as
medical supplies sold, drugs sold, laboratory, diagnostic radiology, and ancillary services, a hospital can
examine their pricing strategies to meet the demands of a competitive marketplace.
When analyzing the performance of an individual hospital, it is crucial to evaluate the hospital against a comparison
group of similar hospitals. But even after controlling for the effects of structural, locational, and functional differences,
there can still be substantial variations in performance.These remaining performance differences should be
given special consideration because they are the ones most susceptible to scrutiny and modification by hospital management.
Source: The Comparative Performance of US Hospitals:The Sourcebook. © 2000 by HCIA, L.L.C. and Deloitte & Touche
LLP. Reprinted with permission.
The financial statements presented in this chapter have been simplified from those presented in Chapter 2 in
order to facilitate the application of the tools and techniques presented in this chapter.
Financial Statement Analysis 107
Newport Hospital Statement of Operations For Years Ended December 31, 20X1 and 20X0
12/31/20X1 12/31/20X0
Operating Revenues
Net Patient Revenues $10,778,272 $10,566,176
Other Operating Revenues 233,749 253,517
Total Operating Revenues 11,012,021 10,819,693
Operating Expenses
Salaries and Benefits 5,644,880 5,345,498
Supplies 1,660,000 1,529,680
Insurance 1,536,357 1,551,579
Depreciation 383,493 420,238
Interest 500,000 276,379
Bad debt 456,289 365,678
Other 500,093 276,455
Total Operating Expenses 10,681,112 9,765,507
Operating Income 330,909 1,054,186
Non-Operating Revenue 185,000 165,000
Excess of Revenues Over Expenses 515,909 1,219,186
Increase (Decrease) in Unrestricted Net Assets $515,909 $1,219,186
Newport Hospital Balance Sheet For Years Ended December 31, 20X1 and 20X0
12/31/20X1 12/31/20X0
ASSETS
Current Assets
Cash & Marketable Securities $363,181 $158,458
Patient Accounts Receivables
Net of Uncollectible Accounts 1,541,244 1,400,013
Inventories 346,176 316,875
Prepaid Expenses 163,734 78,788
Other Current Assets 100,000 0
Total Current Assets 2,514,335 1,954,134
Non-Current Assets
Gross Plant, Property, & Equipment 7,088,495 6,893,370
(less Accumulated Depreciation)(2,781,741) (2,398,248)
Net Plant, Property, and Equipment 4,306,754 4,495,122
Long-term Investments 3,414,732 4,525,476
Other Assets 640,915 340,853
Total Non-Current Assets 8,362,401 9,361,451
Total Assets $10,876,736 $11,315,585
LIABILITIES AND NET ASSETS
Current Liabilities
Accounts Payable $387,646 $166,600
Salaries Payable 135,512 529,298
Notes Payable 500,000 2,359,524
Current Portion of Long-term Debt 372,032 338,996
Total Current Liabilities 1,395,190 3,394,418
Long-term Liabilities
Bonds Payable 6,938,891 6,009,484
Total Long-term Liabilities 6,938,891 6,009,484
Total Liabilities 8,334,081 9,403,902
Net Assets
Unrestricted 1,901,739 1,570,830
Temporary Restricted 328,000 40,853
Permanently Restricted 312,916 300,000
Total Net Assets 2,542,655 1,911,683
Total Liabilities and Net Assets $10,876,736 $11,315,585
Exhibit 4–1 Statement of Operations and Balance Sheet for Newport Hospital
Horizontal Analysis
Horizontal and vertical analyses are two of the most commonly used techniques to
analyze financial statements; each is based on percentages. Horizontal analysis
looks at the percentage change in a line item from one year to the next. A horizontal
analysis of Newport Hospital’s statement of operations and balance sheet is presented
in Exhibit 4–2 and serves as the basis for the discussion in this section.
Horizontal analysis uses the formula:
The goal is to answer the question, “What is the percentage change in a line item from
one year to the next year?” For example, from Newport Hospital’s statement of operations
in Exhibit 4–2, the change in operating income from 20X0 (where 20X0 is the
base year) to 20X1 using horizontal analysis would be:
A problem with horizontal analysis is that percentage changes can hide major
dollar effects. For example, there is an 80.9 percent change in interest expense
from the statement of operations, which was the result of a $223,621 change from
20X0 to 20X1 ($500,000 − $276,379) (Exhibit 4–1); on the other hand, the 9.4 percent
change in total operating expenses was a $915,605 change (Exhibit 4–2).
Horizontal analysis is also often used to compare changes from one year to the next
over several years. The following example analyzes five consecutive years of Newport
Hospital’s operating income (not shown in the exhibits):
108 Financial Management of Health Care Organizations
subsequent year − previous year
previous year
100 = percentage change
$330,909 − $1,054,186
$1,054,186
100 = −68.6%
Three approaches to analyze financial statements: horizontal analysis, vertical analysis, and ratio analysis.
When using horizontal analysis: 1) small percentage changes can mask large dollar changes from one year to
the next; 2) large percentage changes from year to year may be relatively inconsequential in terms of dollar
amounts. This usually occurs when the base year is a small dollar amount.
20X0 20X1 20X2 20X3 20X4
Operating Income $1,054,186 $330,909 $500,098 $1,232,565 $1,453,567
Percentage Change from
Previous Year –68.6 51.1 146.5 17.9
Financial Statement Analysis 109
The change from 20X1 to 20X2 is calculated as follows:
This analysis shows how successful the organization was in increasing operating
income from one year to the next. A disadvantage of this approach is that it does not
answer the question, “How much overall change has there been since 20X0?” Trend
analysis supplies an answer to this question.
Trend Analysis
Instead of looking at single year changes, trend analysis compares changes over a longer
period of time by comparing each year to a base year. The formula for a trend analysis is:
$500,098 − $330,909
$330,909
100 = 51.1%
Newport Hospital Statement of Operations For the Years Ended December 31, 20X1 and 20X0
% Change
12/31/20X1 12/31/20X0 20X1–20X0
Operating Revenues
Net Patient Revenues $10,778,272 $10,566,176 2.0%
Other Operating Revenues 233,749 253,517 –7.8%
Total Operating Revenues 11,012,021 10,819,693 1.8%
Operating Expenses
Total Operating Expenses 10,681,112 9,765,507 9.4%
Operating Income 330,909 1,054,186 – 68.6%
Non-Operating Revenue 185,000 165,000 12.1%
Excess of Revenues Over Expenses 515,909 1,219,186 –57.7%
Increase (Decrease) in Unrestricted Net Assets $515,909 $1,219,186 –57.7%
Newport Hospital Balance Sheet December 31, 20X1 and 20X0
% Change
20X1 20X0 20X1–20X0
Assets
Current Assets $2,514,335 $1,954,134 28.7%
Non–current Assets 8,362,401 9,361,451 –10.7%
Total Assets $10,876,736 $11,315,585 –3.9%
Liabilities
Current Liabilities $1,395,190 $3,394,418 –58.9%
Long–term Liabilities 6,938,891 6,009,484 15.5%
Total Liabilities 8,334,081 9,403,902
Net Assets
Total Net Assets 2,542,655 1,911,683 33.0%
Total Liabilities and Net Assets $10,876,736 $11,315,585 –3.9%
Exhibit 4–2 Horizontal Analysis of the Statement of Operations and Balance Sheet for Newport Hospital
Horizontal
Analysis: A method
of analyzing financial
statements which
looks at the
percentage change in
a line item from one
year to the next. It is
computed by the
formula [(subsequent
year – previous year)/
previous year] × 100.
Applying this formula to operating income for the same five-year period used to illustrate
horizontal analysis yields the following results:
For instance, the change from 20X0 to 20X4 is calculated as follows:
Thus, from 20X0 (the base year) to 20X4, operating income rose 37.9 percent. Note
that the average annual increase of 9.5 percent (37.9 percent/4 years) is different from
that of simply averaging the increases or decreases each year.
Vertical (Common-size) Analysis
The purpose of vertical analysis is to answer the general question, “What percentage
of one line item is another line item?” The formula to use in this case is:
For instance, Newport Hospital might want to know if Net Patient Revenues has
increased as a percent of Total Operating Revenues or, similarly, what percentage of
its Operating Revenues are the Operating Expenses. The top of Exhibit 4–3 computes
all line items for Newport Hospital’s statement of operations as a percentage of Total
Operating Revenues. In 20X0, Total Operating Expenses were 90.3 percent of Total
Operating Revenues [($9,765,507/ $10,819,693) × 100], but by 20X1, they had
increased to 97 percent of total operating revenues [($10,681,112/$11,012,021) ×
100]. This information provides some insight as to why Newport Hospital experienced
the 68.6 percent decrease in operating income observed in the horizontal
analysis.
Though the focus up until now has been on the statement of operations, vertical
analysis is very useful for analyzing the balance sheet as well, as shown in the bottom
of Exhibit 4–3, which presents all line items as a percentage of total assets. By using
total assets as a base, the reader can ask such questions as: “Has the composition of the
balance sheet changed appreciably from 20X0 to 20X1?” In this example, total liabilities
decreased from 83.1 percent of total assets in 20X0 to 76.6 percent in 20X1.
110 Financial Management of Health Care Organizations
subsequent year − base year
base year
100
20X0 20X1 20X2 20X3 20X4
Operating Income $1,054,186 $330,909 $500,098 $1,232,565 $1,453,567
% Change from 20X0 −68.6% −52.6% 16.9% 37.9%
$1,453,567 − $1,054,186
$1,054,186
100 = 37.9%
Trend Analysis:
A type of horizontal
analysis that looks at
changes in line items
compared to a base
year. It is calculated:
[(any subsequent
year – base year)/
base year] × 100.
line item of interest
base line item
100
Vertical Analysis: A
method to analyze
financial statements
which answers the
general question:
What percentage of
one line item is
another line item?
Also called commonsize
analysis because
it converts every line
item to a percentage,
thus allowing
comparisons among
the financial
statements of
different
organizations. Since
all items are stated
as percentages, this
methodology can be
used to compare
several different
organizations to
determine, for
example, “Which
organization has the
highest percentage
of its assets as
current assets?”
Financial Statement Analysis 111
Two points can be noted from this information: 1) in 20X1, debt was used to
finance 76.6 percent of Newport Hospital’s assets, whereas in 20X0 it was used
to finance over 83 percent; and 2) the use of long-term debt to finance assets grew
from 53.1 percent of total assets in 20X0 to 63.8 percent in 20X1. In other words,
Newport is more highly leveraged in 20X1 than it was in 20X0.
Newport Hospital
Statement of Operations
For Years Ended December 31, 20X1 and 20X0
% of Total % of Total
12/3120X1 Revenues 12/3120X0 Revenues
Operating Revenues
Net Patient Revenues $10,778,272 97.9% $10,566,176 97.7%
Other Operating Revenues 233,749 2.1% 253,517 2.3%
Total Operating Revenues 11,012,021 100.0% 10,819,693 100.0%
Operating Expenses:
Total Operating Expenses 10,681,112 97.0% 9,765,507 90.3%
Operating Income 330,909 3.0% 1,054,186 9.7%
Non-Operating revenue 185,000 1.7% 165,000 1.5%
Excess of Revenues over Expenses 515,909 4.7% 1,219,186 11.3%
Increase (Decrease) in Unrestricted
Net Assets $515,909 4.7% $1,219,186 11.3%
Newport Hospital
Balance Sheet
For Years Ended December 31, 20X1 and 20X0
% of Total % of Total
20X1 Assets 20X0 Assets
Assets
Current Assets $2,514,335 23.1% $1,954,134 17.3%
Non-Current Assets 8,362,401 76.9% 9,361,451 82.7%
Total Assets $10,876,736 100.0% $11,315,585 100.0%
Liabilities
Current Liabilities $1,395,190 12.8% $3,394,418 30.0%
Long-Term Liabilities 6,938,891 63.8% 6,009,484 53.1%
Total Liabilities 8,334,081 76.6% 9,403,902 83.1%
Net Assets
Total Net Assets 2,542,655 23.4% 1,911,683 16.9%
Total Liabilities and Net Assets $10,876,736 100.0% $11,315,585 100.0%
Exhibit 4–3 Vertical (Common-Size) Analysis for the Statement of Operations and Balance Sheet for Newport
Hospital
112 Financial Management of Health Care Organizations
Exhibit 4–4 presents common-size financial statements for a small community hospital
and a large community hospital. The larger facility has a smaller percentage of
its assets in plant and equipment, 75 percent, compared to 88 percent for the smaller
facility. However, the smaller facility has a lower proportion of its capital structure in
total debt, 58 percent, compared to 70 percent for the larger facility. The larger facility
also has a higher percentage of its revenues from net patient revenues (97 percent)
than does the smaller facility (83 percent). While there are no standards to compare
these percentages to, they can elicit questions as to why the differences exist.
Ratio Analysis
Although horizontal and vertical analyses are easy to calculate and commonly used,
ratio analysis is the preferred approach to gain an in-depth understanding of financial
statements. A ratio expresses the relationship between two numbers as a single
number. For instance, the current ratio expresses the relationship between current
assets and current liabilities. This provides an indication of the organization’s ability
to cover current obligations with current assets (the ability to pay short-term debt).
Categories of Ratios
Ratios are generally grouped into four categories: liquidity, profitability, activity, and
capital structure.
Liquidity ratios answer the question: “How well is the organization
positioned to meet its short-term obligations?”
Profitability ratios answer the question: “How profitable is the
organization?”
Activity ratios answer the question: “How efficiently is the organization
using its assets to produce revenues?”
Capital structure ratios answer the questions: “How are the organization’s
assets financed?” and “How able is the organization to take on new debt?”
Financial Leverage:
The degree to which
an organization is
financed by debt.
Ratio: An expression
of the relationship
between two
numbers as a single
number.
Industry norms vary by hospital size. For the purposes of the example used throughout this chapter, Newport is
assumed to be a small hospital of fewer than 100 beds. Ratios for facilities of various sizes can be found at the
end of the chapter in Exhibit 4–16a.
Current Assets
Current Liabilities
Current Ratio =
Vertical analysis is also called common-size analysis because it converts every line item to a percentage, thus
allowing comparisons of the makeup of the financial statements of different-sized organizations.
Financial Statement Analysis 113
Exhibit 4–4 Common-Size Financial Statements for a Small and a Large Hospital
Small Community Hospital
Balance Sheet December 31, 20X0
% Total
Assets
Current Assets $1,000 10%
Net Plant and Equipment 9,000 88%
Other Assets 200 2%
Total Assets $10,200 100%
Current Liabilities $900 9%
Long-Term Debt 5,000 49%
Total Liabilities 5,900 58%
Net Assets 4,300 42%
Total Liabilities and Net Assets $10,200 100%
Small Community Hospital Statement of
Operations December 31, 20X0
% Total
Revenues
Net Patient Revenues $10,000 83%
Investment Income 2,000 17%
Total Operating Revenues 12,000 100%
Operating Expenses 10,000 83%
Income from Operations 2,000 17%
Excess of Revenues Over Expenses 2,000 17%
Increase in Net Assets $2,000 17%
Large Community Hospital
Balance Sheet December 31, 20X0
% Total
Assets
Current Assets $15,000 22%
Net Plant and Equipment 50,000 75%
Other Assets 2,000 3%
Total Assets $67,000 100%
Current Liabilities $12,000 18%
Long-Term Debt 35,000 52%
Total Liabilities 47,000 70%
Net Assets 20,000 30%
Total Liabilities and Net Assets $67,000 100%
Large Community Hospital Statement of
Operations December 31, 20X0
% Total
Revenues
Net Patient Revenues $68,000 97%
Investment Income 2,000 3%
Total Operating Revenues 70,000 100%
Operating Expenses 65,000 93%
Income from Operations 5,000 7%
Excess of Revenues Over Expenses 5,000 7%
Increase in Net Assets $5,000 7%
Exhibit 4–5 shows what the ratios would be for Newport Hospital and compares them
to industry norms. The remaining sections of this chapter will describe how these
results were derived.
Key Points to Consider When Using and Interpreting Ratios
1. No one ratio is necessarily better than any other ratio. It is often
useful to use more than one ratio to help answer a question.
2. Each ratio’s terms offer clues about how to fix a problem. For example,
if the current ratio (current assets/current liabilities) is too low, it can be
Note: All figures expressed in ’000.
114 Financial Management of Health Care Organizations
Exhibit 4–5 Newport Hospital Ratios for 20X0 and 20X1, and HCIA & HCFA Median Ratio Values
Standard
Small Hospitals’ Newport Current
HCIA & HCFA Desired Trend Analysis Year Trend Possible Explanation
Ratios Median Ratio1 Position 20X1 20X0 Position Position Current Year Relative to Standards
Liquidity Ratios
Current Ratio 2.18 Above 1.80 0.58 Below Increasing Liquidity improving, but many ratios are still
Quick Ratio2 1.76 Above 1.36 0.46 Below Increasing considerably below standard. Mixed picture on
Acid Test Ratio 0.35 Above 0.26 0.05 Below Increasing cash available:acid test ratio low while days in
Days in Accounts Receivable 67 Below 52 48 Below Increasing accounts receivable favorable. Its days cash on
Days Cash on Hand2 46 Above 13 6
Below Increasing hand is 70% below standard. Average payment
Average Payment Period 54 Below 49 133 Below Decreasing period is moving toward standard.
Profitability Ratios
Operating Margin 0.02 Above 0.03 0.10 Above Decreasing At or above the standard for two of the four
Non-Operating Revenue2 0.05 Varies 0.02 0.02 Below Increasing profitability ratios, but shows a precipitous
Return on Total Assets 0.03 Above 0.05 0.11 Above Decreasing drop in three of the four. This raises concerns
Return on Equity Net Assets2 0.06 Above 0.20 0.64 Above Decreasing about control of revenues and expenses.
Activity Ratios
Total Asset Turnover Ratio 1.02 Above 1.01 0.96 Below Increasing Near standard on its TAT, but ~ 25% below
std. on FAT. Though improving, still of
Net Fixed Assets Turnover Ratio 3.59 Above 2.56 2.41 Below Increasing concern. Avg. age of plant increase a
Age of Plant Ratio 9.86 Below 7.25 5.71 Below Increasing concern.
Capital Structure Ratios
Long-Term Debt to Net Assets Ratio 0.21 Below 2.73 3.14 Above Decreasing Though decreased its debt position, still well
Net Assets to Total Assets Ratio2 0.62 Above 0.23 0.17 Below Increasing above std. The proportion of debt to net assets
Times Interest Earned Ratio2 2.85 Above 2.03 5.41 Below Decreasing is still too high, but decreasing. Ability to
Debt Service Coverage Ratio 3.35 Above 2.00 4.02 Below Decreasing pay debt is of considerable concern.
1Since Newport Hospital was less than 100 beds, HCIA-Sachs Standard ratio values for Beds less than 100 were used
2These values were obtained from: the Health Care Financing Administration’s (
HCFA) Hospital Cost Report Information System Files for financial
statements ending in 1998 and HCIA-Sachs Standard’s 1998 median values, The Comparative Performance of US Hospitals: The Sourcebook 2000, HCIA
Publications, Baltimore, MD.
improved by increasing the numerator (current assets), decreasing the
denominator (current liabilities), or both. However, changing the conditions to
improve one ratio may affect other ratios as well.
3. Most ratios are interpreted as follows: “There are N dollars in the
numerator for every dollar in the denominator.” Thus, a current ratio
of 2 indicates that there is $2 in current assets for every $1 in current
liabilities.
4. A ratio can best be interpreted relative to a standard. The standard
may be the organization’s past performance, a goal set by the organization, a
comparison group (such as similar organizations), or some combination
thereof. For example, a current ratio of 2.00 probably would be interpreted
favorably if the industry standard were 1.75; however, it probably would be
interpreted unfavorably if the industry standard were 2.50.
5. There are several problems with using standards for comparison in
the health care industry. Two of the most prominent are the availability
and reliability of the data:
Finding appropriate data. Not all segments of the health care industry
have data available that can be used for standards. For example, there are no
complete, national-level ratio data on health departments or mental health
centers. On the other hand, certain segments of the industry have excellent
data. The Center for Healthcare Industry Performance Studies (CHIPS) and
HCIA-Sachs both provide excellent ratio information on hospitals on both a
national and regional basis. In addition, many cooperatives, such as Premier,
provide benchmarking standards to their members. Alternatively, individual
providers may join together to develop their own standards. Even if data are
available, it is important to compare an organization to similar organizations.
It might be highly inappropriate for a small rural hospital in North Dakota to
use the ratios of large academic medical centers in Boston for comparison.
Services such as CHIPS can provide data by size and location. The data are
presented by both median and percentile, which means that an organization
can set its own standards relative to what it considers an appropriate
comparison group.
The reliability of the data. The same ratio may be calculated differently
by different organizations and/or different sources of industry standards.
For example, in calculating the days in accounts receivable, one
organization may use the ending balance in accounts receivable, whereas
another organization may use the average daily balance. Therefore, when
comparing organizations to one another or to standards, it is necessary to make
sure the same formula is being used (see Perspective 4–3). There may be
differences in practices and procedures among organizations that may not
be immediately apparent to those using the information. For example,
hospitals may use different depreciation or inventory valuation methods.
This could have a profound effect on certain ratios.
6. In general, a ratio should be neither too high nor too low relative
to the standard. For example, the acid test ratio [(cash + marketable
securities)/current liabilities] looks at an organization’s ability to meet its
Financial Statement Analysis 115
116 Financial Management of Health Care Organizations
short-term debt. Though an organization would like to have this ratio
above the standard, a value too high may indicate too much cash on hand,
which likely could be better invested elsewhere.
7. Not only should a ratio be compared to a standard, but also the
trend of the ratio can help to interpret how well an organization is
doing. For example, an organization would feel differently if a ratio were at
the standard and declining versus being at the standard and rising over the
past five years.
8. Since ratios are usually relatively small, relatively small
differences may indicate large percentage deviations from the
standard. For example, if the organization’s current ratio were 1.5 and
the industry standard 2.0, while this is only a 0.5 difference, the
organization would be 25 percent below standard.
The remainder of this chapter uses ratio analysis to analyze the statement of operations
and balance sheet for Newport Hospital (see Exhibit 4–1) using industry standards
for small hospitals.
Perspective 4–3
Formulas Hospitals Report Using to Calculate Net Days in Accounts Receivable
Hospital Formula
Hospital 1 Gross Accounts Receivable – Uncollectibles ÷ [(Gross Charges – Deductions) ÷
Number of Days in Period]
Hospital 2 Net Patient Accounts Receivable ÷ (Net Patient Service Revenue ÷ 365)
Hospital 3 Net Accounts Receivable ÷ Net Charges per Day
Hospital 4 Net Accounts Receivable ÷ [(Gross Patient Service Revenue – Charity – Contractual
Allowances – Bad Debt) ÷ 365]
Hospital 5 Accounts Receivable + Reserve for Bad Debt + Contractual Adjustments ÷
(Net Patient Revenue ÷ Number of Days in the Period)
Hospital 6 Accounts Receivable ÷ (Revenue Available ÷ Days in Current Year)
Hospital 7 Net Patient Revenue ÷ Operating Margin
Hospital 8 Net Accounts Receivable ÷ (Net Revenue Past 3 months ÷ Days in Period)
Source: Contributed by Denise R. Smith, FHFMA, CMPA. DSS Data Analyst Columbia Cape Fear Memorial Hospital.
When comparing organizations to one another or to standards, it is necessary to make sure the same
formula is being used.
Liquidity Ratios
Liquidity ratios answer the question, “How well is the organization positioned to
meet its current obligations?” Six key ratios fall into this category: the current
ratio, quick ratio, acid test ratio, days in accounts receivable, days cash on hand,
and average payment period (Exhibit 4–6). Incidentally, by convention, the current
ratio, quick ratio and acid test ratio all have the word “ratio” in their title,
while the other three do not.
Each of these liquidity ratios provides a different insight into Newport Hospital’s
liquidity. Notice that the first three ratios focus only on the balance sheet, each giving
a little more stringent picture of the organization’s ability to pay off its current liabilities.
The last three ratios use information from both the statement of operations and
the balance sheet to look at different aspects of liquidity: the ability of the organization
to turn its receivables into cash, the actual amount of cash it has on hand to meet
its short-term obligations, and how long it takes the organization to pay its bills,
respectively.
Current Ratio
The current ratio (current assets/current liabilities) is one of the most commonly
used ratios. The current ratio is the proportion of all current assets to all current liabilities.
Values above the standard indicate either too many current assets, too few
current liabilities, or both. Values below the standard indicate either too few current
assets, too many current liabilities, or both. To calculate the current ratio (see Exhibit
4–6a):
Step 1. Identify the dollar amount of current assets on the balance sheet.
Step 2. Identify the dollar amount of current liabilities on the balance sheet.
Step 3. Divide the current assets by the current liabilities.
Newport Hospital’s current ratio increased from 0.58 in 20X0 to 1.80 in 20X1. The
standard used for comparison is 2.18. Although the 20X1 value is still below the
industry median, this dramatic increase in Newport’s current ratio reflects a major
improvement in liquidity according to this measure.
Quick Ratio
The quick ratio [(cash + marketable securities + net accounts receivable)/current liabilities]
is commonly used in industries in which net accounts receivable is relatively liquid.
Financial Statement Analysis 117
Liquidity ratios measure a facility’s ability to meet short-term obligations, collect receivables, and maintain a
cash position.
118 Financial Management of Health Care Organizations
Ratio Formula Standard1 Desired Position
Current Ratio Current Assets 2.18 Above
Current Liabilities
Quick Ratio Cash + Marketable Securities + Net Receivables 1.76 Above
Current Liabilities
Acid Test Ratio Cash + Marketable Securities 0.35 Above
Current Liabilities
Days in Accounts Receivable Net Patient Accounts Receivable 67 Below
Net Patient Revenues/365
Days Cash on Hand Cash + Marketable Securities 46 Above
(Operating Expenses − Depreciation Expense)/365
Average Payment Period (Days) Current Liabilities Organizationally
(Operating Expenses − Depreciation Expense)/365 54 Dependent
1Based upon HCIA-Sachs’ 1998 approximate hospital median values in mid-1990s
Exhibit 4–6 Selected Liquidity Ratios
Financial Statement Analysis 119
Traditionally, this has not been the case in health care organizations. To compute the
quick ratio (see Exhibit 4–6b):
Step 1. Identify the dollar amount of cash, marketable securities, and net
accounts receivable on the balance sheet.
Step 2. Identify the dollar amount of current liabilities on the balance sheet.
Step 3. Divide the sum of cash, marketable securities, and net accounts
receivable by current liabilities.
As with the current ratio, Newport Hospital’s quick ratio improved from 20X0 to 20X1,
but it is still approximately 25 percent below the industry standard of 1.76. In order to
improve this ratio, Newport Hospital must either increase its current assets or decrease
its current liabilities or both.
Acid Test Ratio
The acid test ratio [(cash + marketable securities)/current liabilities] provides the
most stringent test of liquidity. It looks at how much cash is on hand or readily available
from marketable securities to pay off all current liabilities. This ratio is particularly useful
if current liabilities contain a high percentage of accounts that must be paid off soon
(such as wages payable), and/or if collections of accounts receivable are slow. To compute
the acid test ratio (see Exhibit 4–6c):
Step 1. Identify the dollar amount of cash and marketable securities on the balance
sheet.
Step 2. Identify the dollar amount of current liabilities on the balance sheet.
Step 3. Divide the sum of cash and temporary investments by current
liabilities.
Year Current Ratio = Current Assets ÷ Current Liabilities
20X1 1.80 = $2,514,335 ÷ $1,395,190
20X0 0.58 = $1,954,134 ÷ $3,394,418
Standard = 2.18
Exhibit 4–6a Newport’s Current Ratio for 20X0 and 20X1
(Cash + Net Accounts Current
Year Quick Ratio = Marketable Securities + Receivable) ÷ Liabilities
20X1 1.36 = $363,181 + $1,541,244 ÷ $1,395,190
20X0 0.46 = $158,458 + $1,400,013 ÷ $3,394,418
Standard = 1.76
Exhibit 4–6b Newport’s Quick Ratio for 20X0 and 20X1
120 Financial Management of Health Care Organizations
Newport’s acid test ratio increased from 0.05 to 0.26 from 20X0 to 20X1. In this
case, there is a favorable trend, but a concern might be raised because Newport is still
about 25 percent below the industry standard of 0.35. This means that Newport needs
to increase its cash and marketable securities or decrease its current liabilities in order
to meet the target figure.
Days in Accounts Receivable
The days in accounts receivable ratio [net patient accounts receivable/(net patient
revenues/365)] provides an indication of how quickly a hospital is converting its
receivables into cash. By dividing net patient accounts receivable by an average day’s
revenue (net patient revenues/365), this ratio provides an estimate of how many days’
revenues have not yet been collected. Values above the standard indicate problems
relating to credit and/or collection policies. To calculate the days in accounts receivable
ratio (see Exhibit 4–6d):
The current ratio, quick ratio and acid test ratio all measure the relationship of various current assets to current
liabilities. The acid test ratio provides the most stringent test of liquidity of the three.
The term Average Collection Period can also be used interchangeably with Days in Accounts Receivable.
Acid Test (Cash + Current
Year Ratio = Marketable Securities) ÷ Liabilities
20X1 0.26 = $363,181 ÷ $1,395,190
20X0 0.05 = $158,458 ÷ $3,394,418
Standard = 0.35
Exhibit 4–6c Newport’s Acid Test Ratio for 20X0 and 20X1
Steps 1,2
Average Net Patient Net Patient
Year Revenues/Day = Revenues ÷ 365 days
20X1 $29,530 /day = $10,778,272 ÷ 365 days
20X0 $28,948 /day = $10,566,176 ÷ 365 days
Steps 3,4
Days in Net Patient Average Net Patient
Year Accounts Receivable = Accounts Receivable ÷ Revenues/Day
20X1 52 days = $1,541,244 ÷ $29,530 /day
20X0 48 days = $1,400,013 ÷ $28,948 /days
Standard = 67 days
Exhibit 4–6d Newport’s Days in Accounts Receivable Ratio of 20X0 and 20X1
Financial Statement Analysis 121
Step 1. Identify the dollar amount of net patient revenues on the statement of
operations.
Step 2. Divide net patient revenues by 365 to compute average net patient
revenues per day.
Step 3. Identify the dollar amount of net patient accounts receivable on the balance
sheet.
Step 4. Divide net patient accounts receivable by average net patient revenues
per day.
Though it took four days longer on average to collect receivables in 20X1 than it
did in 20X0, Newport Hospital is well below the standard (67 days) for both 20X0
(48 days) and 20X1 (52 days). This generally indicates excellent performance in this
area.
Days Cash on Hand
The days cash on hand ratio {(cash + marketable securities)/[(operating expenses −
depreciation expense)/365]} provides an indication of the number of days’ worth of
expenses an organization can cover with its most liquid assets: cash and marketable securities.
The denominator [(operating expenses − depreciation expense)/365] measures an
average day’s cash outflow. Depreciation is subtracted from operating expenses in the
denominator since it is an operating expense, but requires no cash outflow. To compute
the days cash on hand ratio (see Exhibit 4–6e):
Step 1. Identify the dollar amount of operating expenses and depreciation
expense on the statement of operations.
Step 2. Divide operating expenses minus depreciation expense by 365 days to
compute average cash operating expense per day.
Step 3. Identify the dollar amount of cash and marketable securities on the balance
sheet.
Step 4. Divide cash and marketable securities by the average cash operating
expense per day (from Step 2).
Operating (Operating Depreciation
Year Expense per Day = Expenses − Expense) ÷ 365 days
20X1 $28,213/day = $10,681,112 − $383,493 ÷ 365 days
20X0 $25,603/day = $9,765,507 − $420,238 ÷ 365 days
Year Days Cash = (Cash + ÷ Operating
On Hand Marketable Securities) Expense per Day
20X1 13 days = $363,181 ÷ $28,213/day
20X0 6 days = $158,458 ÷ $25,603/day
Standard = 46 days
Exhibit 4–6e Newport’s Days Cash on Hand Ratio for 20X0 and 20X1
122 Financial Management of Health Care Organizations
Newport Hospital has more than doubled its days cash on hand from six days (20X0)
to thirteen days (20X1). However, it is still 33 days below the standard, indicating that it
should consider either increasing its cash and marketable securities or decreasing its operating
expenses. When examining a hospital’s days cash on hand ratio, be aware that system-
affiliated hospitals may keep a very low balance of cash on hand, since they may
transfer a large portion of cash to their parent each day. If an unusual amount of cash is
needed, the parent will transfer back the needed amount. By doing this, the parent organization
has larger amounts of cash available for investment purposes, and in many cases
is in a better position to invest cash than are the subsidiaries. In such cases, a low days
cash on hand ratio of the subsidiary organization is not indicative of a problem.
Average Payment Period
The average payment period ratio {current liabilities/[(operating expenses −
depreciation expense)/365]} is the counterpart to the days in accounts receivable
ratio. It is a measure of how long, on average, it takes an organization to pay its bills.
Since the denominator is a measure of an average day’s payments for bills, dividing
current liabilities by an average day’s payment provides a measure of how many days’
bills have not been paid. In order to develop a creditworthy relationship and goodwill
with vendors and suppliers, health care organizations should attempt to pay their bills
on time. To calculate the average payment period ratio (see Exhibit 4–6f):
Step 1. Identify the dollar amount of total expenses and depreciation expense on
the statement of operations.
Step 2. Divide operating expenses minus depreciation expense by 365 days to
compute average cash expense per day.
Days in accounts receivable, cash on hand, and average payment period are all liquidity ratios which give an
insight into how quickly cash is flowing in and out of the organization.
Steps 1, 2
Year Average Cash (Operating Depreciation
Expense per Day = Expenses − Expense) ÷ 365 days
20X1 $28,213 /day = ($10,681,112 − $383,493)÷ 365 days
20X0 $25,603 /day = ($9,765,507 − $420,238)÷ 365 days
Steps 3, 4
Year Average Payment Current Average Cash
Period = Liabilities ÷ Expense per Day
20X1 49 days = $1,395,190 ÷ $28,213/day
20X0 133 days = $3,394,418 ÷ $25,603/day
Standard = 54 days
Exhibit 4–6f Newport’s Average Payment Period Ratio for 20X0 and 20X1
Financial Statement Analysis 123
Step 3. Identify the dollar amount of current liabilities on the balance sheet.
Step 4. Divide the current liabilities by average cash expense per day.
In the period of one year, Newport Hospital has decreased its average payment
period from 133 days to 49 days and is now below the industry standard of 54 days.
Liquidity Summary
From 20X0 to 20X1, Newport Hospital improved its ability to meet current obligations
with current assets as indicated by its current, quick, acid test and days cash on hand
ratios, though all are still considerably below their standards (Exhibit 4–7). In terms of
the relative amount of cash actually available, a mixed picture emerges. On the one hand,
the acid test ratio, which indicates the amount of cash and marketable securities available
to meet current liabilities, is below its desired position of being at the standard. On the
other hand, it is favorably positioned on its days in accounts receivable, which (see
Exhibit 4–8) indicates that the organization is performing well in turning its receivables
into cash. Its days cash on hand is over 70 per cent below standard.
In regard to collecting the money owed it and paying its bills, Newport’s days in
accounts receivable is increasing toward the standard (which means revenues will be
converted to cash more slowly), while it has greatly decreased its average payment
period (which will likely be well received by its suppliers). Unfortunately, days cash
on hand is still quite low, which should cause some concern to the organization.
Profitability Ratios
There are several profitability ratios, each providing a different insight into the ability
of a health care organization to produce a profit. The most commonly used ratios
include operating margin, non-patient service revenue, return on net assets, and
return on total assets (see Exhibit 4–9 and Perspective 4–4).
0.00
0.50
1.00
1.50
2.00
2.50
Current Ratio Quick Ratio Acid Test Ratio
20X0 20X1 Standard
Exhibit 4–7 Newport’s Hospital’s Current, Quick, and Acid Test Ratios for 20X0 and 20X1 as Compared to the
Standard
124 Financial Management of Health Care Organizations
Operating Margin
The operating margin ratio (operating income/total operating revenues) measures
profits earned from the organization’s main line of business. The margin indicates the
proportion of profit earned for each dollar of operating revenue; that is, the proportion
of profit remaining after subtracting total operating expenses from operating revenues.
To compute the operating margin (see Exhibit 4–9a):
Step 1. Identify operating income on the statement of operations.
Step 2. Identify total operating revenues on the statement of operations.
Step 3. Divide operating income by total operating revenues.
Ratio Formula Standard1 Desired Position
Operating Margin Operating Income 0.02 Above
Total Operating Revenues
Non-Operating Revenue Ratio Non-Operating Revenues 0.05 Organizationally
Total Operating Revenues Dependent
Return on Total Assets2 Excess of Revenues over Expenses 0.03 Above
Total Assets
Return on Net Assets3 Excess of Revenues over Expenses 0.06 Above
Net Assets
1 Based upon HCIA-Sachs’s 1998 approximate hospital median values in mid-1990s.
2 Called return on assets and calculated as net income/total assets in for-profit health care organizations.
3 Called return on equity in for-profit health care organizations (net income/owners’ equity).
Exhibit 4–9 Selected Profitability Ratios
0
20
40
60
80
100
120
140
Days in A/R Days Cash on Hand Avg. Payment Period
20X0 20X1 Standard
Exhibit 4–8 Newport Hospital’s Days in Accounts Receivable, Days Cash on Hand, and Average Payment Period
Ratios for 20X0 and 20X1 as Compared to the Standard
Financial Statement Analysis 125
In 20X0, Newport Hospital was considerably above the industry standard (0.10
versus 0.02). However, the operating margin ratio has decreased to 0.03 in 20X1,
reflecting the fact that total operating expenses have increased faster than have total
operating revenues.
Non-Operating Revenue Ratio
The purpose of the non-operating revenue ratio (non-operating revenues/total
operating revenues) is to find out how dependent the organization is on patientrelated
net income. The higher the ratio, the less the organization is dependent on
direct patient-related income and the more it is dependent on revenues from other
sources. This ratio is becoming increasingly difficult to use to compare health care
organizations, because under recent accounting rules, there is considerable discretion
as to what is classified as operating or non-operating revenues.
This results in two potential problems: 1) to the extent that the ratio for any one
organization is not calculated in exactly the same way as the standard, a comparison to
the standard may be inappropriate; and 2) when multiple organizations are being compared,
to the extent they did not classify various items (such as interest income) in
exactly the same way, the comparison may be invalid. Non-operating revenue may
include such accounts as interest income, parking lot revenues, sales to the general public
of such things as food and gift shop items, gains from investment activities, and
assets released from restricted investment accounts (see Exhibit 4–9b):
Year Operating Margin = Operating Income ÷ Total Operating Revenues
20X1 0.03 = $330,909 ÷ $11,012,021
20X0 0.10 = $1,054,186 ÷ $10,819,693
Standard = 0.02
Exhibit 4–9a Newport’s Operating Margin Ratio for 20X0 and 20X1
Perspective 4–4
Key Profitability Performance Measures
HCIA-Sachs considers four profitability measures in its analysis of hospital profitability. Operating profit margin, total
profit margin, and cash flow margin are expressed as a percentage of net revenues, while return on assets is
expressed as percentage of total assets. Operating profit margin measures a hospital’s operating income with respect
to the provision of patient care services.Total profit margin measures not only operating income but also non-operating
income earned from private philanthropy, interest income, and other income not generated from hospital operations.
Cash flow margin measures cash earnings before depreciation and is a critical measure in assessing a hospital’s
ability to borrow. Return on asset measures the income earned from assets.A downward trend in profitability can
impair a hospital’s liquidity position.
Source: HCIA, Comparative Performance of US Hospitals:The Sourcebook 2000. HCIA Publications, Baltimore, MD.
126 Financial Management of Health Care Organizations
Step 1. Identify non-operating revenues on the statement of operations.
Step 2. Identify total operating revenues on the statement of operations.
Step 3. Divide non-operating revenues by total operating revenues.
Newport’s non-operating revenue ratios in both years are 0.02, slightly below the
national standard of 0.05. An increase in contributions and greater investment portfolio
performance could raise its ratio value.
Return on Total Assets
In not-for-profit organizations, the return on total assets ratio is calculated as
(excess of revenues over expenses/total assets). In for-profit organizations it is called
return on assets and is calculated as (net income/total assets). It measures how much
profit is earned for each dollar invested in assets. To compute the return on total
assets ratio (see Exhibit 4–9c):
Step 1. Identify excess of revenues over expenses on the statement of operations.
Step 2. Identify total assets on the balance sheet.
Step 3. Divide excess of revenues over expenses by total assets.
Newport Hospital’s return on total assets ratio declined significantly over this time
period (0.11 to 0.05), and is currently only slightly above the standard of 0.03 in 20X1.
One reason for this decrease could be that Newport’s expenses have increased faster
than its revenues, thereby reducing the excess of revenues over expenses. To improve
this ratio, Newport could increase operating revenues, decrease expenses, and/or
decrease total assets.
Return on Net Assets
In not-for-profit organizations this ratio is called return on net assets (excess of revenues
over expenses/net assets). In for-profit organizations it is called return on equity
and is calculated using the formula (net income/owners’ equity). In for-profit organizations,
it measures the rate of return for each dollar in owners’ equity. In not-for-profit
health care organizations it measures the rate of return for each dollar in net assets. To calculate
the return on net assets ratio (see Exhibit 4–9d):
Year Non-Operating Revenue Ratio = Non-Operating Revenues ÷ Total Operating Revenues
20X1 0.02 = $185,000 ÷ $11,012,021
20X0 0.02 = $165,000 ÷ $10,819,693
Standard = 0.05
Exhibit 4–9b Newport’s Non-Operating Revenue Ratio for 20X0 and 20X1
Financial Statement Analysis 127
Step 1. Identify the excess of revenues over expenses on the statement of operations.
Step 2. Identify the net assets on the balance sheet.
Step 3. Divide excess of revenues over expenses by net assets.
As in the case for the return on total assets ratio, the return on net assets ratio also
decreased (from 0.64 in 20X0 to 0.20 in 20X1). Expenses growing faster than revenues
contributed to this decrease. However, the return on net assets in 20X1 is still considerably
above the industry standard of 0.06.
It is important to note that the return on net assets ratio is magnified by the amount of
debt financing. The higher the level of debt relative to net assets, the greater the return
on net assets is affected for a given level of profit or loss. Exhibit 4–10 provides an example
of this phenomenon.
In Case 1, the organization earns a profit (excess of revenues over expenses) of
$100,000. Since there is no debt, the return on net assets is 0.1 ($100,000/$1,000,000).
However, in Case 2, the assets are financed with 50 percent debt and 50 percent
equity. Thus, the return to the owners is doubled (0.2), because they only have half as
much invested ($500,000 instead of $1,000,000), the remainder of the assets being
financed by debt. Though debt financing results in higher returns when there is a
profit (as in both Cases 1 and 2), there is a greater loss in terms of return on net assets
when the organization is unprofitable (as illustrated in Cases 3 and 4). As previously
noted, financial leverage reflects the proportion of debt used within the organization’s
capital structure. Thus, these cases show that debt increases the financial risk to the
Year Return on Total Assets = Excess of Revenues over Expenses ÷ Total Assets
20X1 0.05 = $515,909 ÷ $10,876,736
20X0 0.11 = $1,219,186 ÷ $11,315,585
Standard = 0.03
Exhibit 4–9c Newport’s Return on Total Assets Ratio for 20X0 and 20X1
Year Return on Net Assets = Excess of Revenues over Expenses ÷ Net Assets
20X1 0.20 = $515,909 ÷ $2,542,655
20X0 0.64 = $1,219,186 ÷ $1,911,683
Standard = 0.06
Exhibit 4–9d Newport’s Return on Net Assets Ratio for 20X0 and 20X1
Higher debt increases financial risk by magnifying the returns on net assets or equity.
128 Financial Management of Health Care Organizations
In Case 1, the organization has no debt. In Case 2, the organization has 50 percent of its assets financed by debt.
In both cases, the organization makes a $100,000 profit, but the return on net assets is twice as high in Case 2.
Case 1: $100,000 Excess of Revenues over Expenses; no debt
Balance Sheet Statement of Operations
Assets $1,000,000 Debt $0 Excess of Revenues over Expenses $100,000
Net Assets $1,000,000
Return on Net Assets = $100,000/$1,000,000 = 0.10
Case 2: $100,000 Excess of Revenues over Expenses; 50% debt
Balance Sheet Statement of Operations
Assets $1,000,000 Debt $500,000 Excess of Revenues over Expenses $100,000
Net Assets $500,000
Return on Net Assets = $100,000/$500,000 = 0.20
In Case 3, the organization has no debt. In Case 4, the organization has 50 percent of its assets financed by
debt. In both cases, the organization incurs a $100,000 loss, but the negative return on net assets is twice as
much in Case 4.
Case 3: ($100,000) Excess of Revenues over Expenses; no debt
Balance Sheet Statement of Operations
Assets $1,000,000 Debt $0 Excess of Revenues over Expenses ($100,000)
Net Assets $1,000,000
Return on Net Assets = -100,000/$1,000,000 = −0.10
Case 4: ($100,000) Excess of Revenues over Expenses; 50% debt
Balance Sheet Statement of Operations
Assets $1,000,000 Debt $500,000 Excess of Revenues over Expenses ($100,000)
Net Assets $500,000
Return on Net Assets = -$100,000/$500,000 = –0.20
Point: Increased debt magnifies both gains and losses when computing Return on Net Assets
Exhibit 4–10 Example of How Increased Debt Magnifies Gains and Losses When Computing Return on Net Assets
owners of a health care organization. It magnifies positive returns when there is a
profit, but negative returns when there is a loss. It also carries the added burden of
fixed interest payments.
Profitability Summary
Though Newport Hospital is at or above the standard for two of the four profitability
ratios in 20X1, it has experienced a precipitous fall from 20X0 to 20X1 in three of
the four profitability ratios (see Exhibit 4–11). This raises concerns about control of
revenues and expenses.
Because many of the activity ratios ask the general question, “How many dollars in revenue (the numerator)
are being generated relative to [specific] assets (the denominator)”, activity ratios are also called efficiency
ratios. The higher the ratio, the more efficiently the assets are being used.
Financial Statement Analysis 129
Activity Ratios
In general, activity ratios (see Exhibit 4–12) ask the question, “For every dollar
invested in assets, how many dollars of revenue (not excess of revenues over expenses)
are being generated?” Most ratios in this category take the general form:
Thus, the more revenue generated, the higher the ratio.
Total Asset Turnover
The total asset turnover ratio (total operating revenues/total assets) measures the
overall efficiency of the organization’s assets to produce revenue. It answers the question,
“For every dollar in assets, how many dollars of operating revenue are being generated?”
To calculate the total asset turnover ratio:
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Operating Margin Non-Operating
Revenue
Return on Total
Assets
Return on Net
Assets
20X0 20X1 Standard
Exhibit 4–11 Newport Hospital’s Profitability Ratios for 20X0 and 20X1 as Compared to the Standard
Revenues
Assets
Ratio Formula Standard1 Desired Position
Total Asset Turnover Ratio Total Operating Revenues 1.02 Above
Total Assets
Fixed Asset Turnover Ratio Total Operating Revenues 3.59 Above
Net Plant and Equipment
Age of Plant Ratio Accumulated Depreciation 9.86 Below
Depreciation Expense
1 Based upon HCIA-Sachs’s 1998 median values.
Exhibit 4–12 Selected Activity Ratios
130 Financial Management of Health Care Organizations
Step 1. Identify total operating revenues on the statement of operations.
Step 2. Identify total assets on the balance sheet.
Step 3. Divide total operating revenues by total assets.
For Newport Hospital, the ratio increased slightly from 20X0 to 20X1 and has
remained very close to the standard. A value of 1.00 indicates that for every dollar of
total assets, one dollar of total revenues is generated, which is approximately the
standard (see Exhibit 4–12a).
Fixed Asset Turnover
The fixed assets turnover ratio (total operating revenues/net plant and equipment)
aids in the evaluation of the most productive assets, plant and equipment. To calculate
the fixed assets turnover ratio:
Step 1. Identify total operating revenues on the statement of operations.
Step 2. Identify net plant and equipment assets on the balance sheet.
Step 3. Divide total operating revenues by net plant and equipment (fixed) assets.
Newport’s fixed asset turnover ratio increased from 20X0 to 20X1 (2.41 to 2.56),
but is still below the standard of 3.59. The fixed asset turnover value of 2.56 indicates
that for every dollar of fixed assets, only $2.56 of operating revenues is being
generated (see Exhibit 4–12b).
Asset accounts reflect values at a specific point in time, which, in turn, can fail to account for
seasonal changes in asset accounts. To deal with this problem, some analysts use an average of the beginning
and ending year values for the fixed asset or current asset accounts. That convention, however, is not used in
this text.
Year Total Asset Turnover = Total Operating Revenues ÷ Total Assets
20X1 1.01 = $11,012,021 ÷ $10,876,736
20X0 0.96 = $10,819,693 ÷ $11,315,585
Standard = 1.02
Exhibit 4–12a Newport’s Total Asset Turnover Ratio for 20X0 and 20X1
The Fixed Asset Turnover Ratio is a measure of how productive the fixed assets of the organization are in
generating operating revenues.
Note that this text uses Excess of Revenues Over Expenses in the numerator for the Profitability Ratios Return
on Total Assets and Return on Net Assets, and it uses Total Operating Revenues in the numerator for the Activity
Ratios Total Asset Turnover Ratio and Net Asset Turnover Ratio.
Financial Statement Analysis 131
Age of Plant Ratio
The age of plant ratio (accumulated depreciation/depreciation expense) provides
an indication of the average age of a hospital’s plant and equipment. This ratio complements
the fixed asset turnover ratio. High fixed asset turnover ratios may be an
indication of a lack of investment in fixed assets. If the average age of plant is high, it
may indicate that the organization needs to replace its fixed assets shortly. If so, it
would be important to look at other ratios to see how well positioned the organization
is to finance the purchase of new assets. To compute the age of plant ratio (see Exhibit
4–12c):
Step 1. Identify accumulated depreciation on the balance sheet.
Step 2. Identify depreciation expense on the statement of operations.
Step 3. Divide accumulated depreciation by depreciation expense.
Newport Hospital’s average age of plant ratio has increased by over one and onehalf
years (5.71 to 7.25), but it is still more than two years under the industry standard
of 9.86.
Activity Summary
Though Newport Hospital has been near the standard on its total asset turnover ratio,
it is more than 25 percent below the standard on its fixed asset turnover ratios, but
Year Fixed Asset Turnover = Total Operating Revenues ÷ Net Plant and Equipment
20X1 2.56 = $11,012,021 ÷ $4,306,754
20X0 2.41 = $10,819,693 ÷ $4,495,122
Standard = 3.59
Exhibit 4–12b Newport’s Fixed Asset Turnover Ratio for 20X0 and 20X1
Year Age of Plant = Accumulated Depreciation ÷ Depreciation Expense
20X1 7.25 = $2,781,741 ÷ $383,493
20X0 5.71 = $2,398,248 ÷ $420,238
Standard = 9.86
Exhibit 4–12c Newport’s Age of Plant Ratio for 20X0 and 20X1
Asset turnover ratios have an interesting property because of accrual accounting. When revenues (the numerator)
stay the same, the ratio will continually increase from year to year because asset values (the denominator)
decrease each year due to depreciation. This will occur until the assets are fully depreciated. To check how old
the assets are, the age of plant ratio is used.
132 Financial Management of Health Care Organizations
shows improvement from 20X0 to 20X1 (see Exhibit 4–13). Its average age of plant is
below the standard of 9.86 years, which indicates that the hospital has newer assets
relative to the standard of small hospitals. Thus, because of the fixed asset ratio, a
question should be raised regarding how efficiently the fixed assets are being used to
generate revenue.
Capital Structure Ratios
Capital structure ratios answer two questions: 1) “How are an organization’s
assets financed?” and 2) “How able is this organization to take on new debt?” In
many cases, a greater understanding of these ratios (and answers to these
questions) can be gained by examining the statement of cash flows to see if
significant long-term debt has been acquired or paid off, or if there has been a sale
or purchase of fixed assets. Capital structure ratios include long-term debt to net
0.0
2.0
4.0
6.0
8.0
10.0
Total Asset Turnover Fixed Asset Turnover Average Age of Plant
20X0 20X1 Standard
Exhibit 4–13 Newport Hospital’s Activity Ratios for 20X0 and 20X1 as Compared to the Standard
Capital structure ratios measure how an organization’s assets are financed, and how able the organization is to
pay for the new debt.
One might also want to measure capital structure ratios by using the unrestricted net asset account rather than
the combined restricted and unrestricted net asset values. The unrestricted net asset account represents the
claim on assets that the provider could sell in order to meet debt payments.
Financial Statement Analysis 133
assets, net assets to total assets, times interest earned, and debt service coverage
(see Exhibit 4–14).
Long-term Debt to Net Assets
The long-term debt to net assets ratio (long-term debt/net assets) measures the
proportion of debt to net assets. In for-profit organizations, this ratio is called the longterm
debt to equity ratio and is calculated by the formula: (long-term debt/owners’
equity). Although most organizations certainly want to finance a portion of their assets
with debt, at a certain level an organization takes on too much debt and may find itself
in a precarious position where it has difficulty both paying back its existing debt and
borrowing additional funds. To calculate the long-term debt to net assets ratio (see
Exhibit 4–14a):
Long-term debt to net assets ratio measures the proportion of assets which are financed by debt relative to
those which are not.
Desired
Ratio Formula Standard Position
Long-Term Debt to Net Assets Ratio Long-Term Debt 0.21 Below
Net Assets
Net Assets to Total Assets Ratio Net Assets 0.62 Above
Total Assets
(Excess of Revenues over Expenses
Times Interest Earned Ratio + Interest Expense) 2.85 Above
Interest Expense
(Excess of Revenues over Expenses
Debt Service Coverage Ratio + Interest Expense + Depreciation Expense) 3.35 Above
(Interest Expense + Principal Payments)
Exhibit 4–14 Selected Capital Structure Ratios
Year Long-Term Debt to Net Assets = Long-Term Debt ÷ Net Assets
20X1 2.73 = $6,938,891 ÷ $2,542,655
20X0 3.14 = $6,009,484 ÷ $1,911,683
Standard = 0.21
Exhibit 4–14a Newport’s Long-Term Debt to Net Assets Ratio for 20X0 and 20X1
134 Financial Management of Health Care Organizations
Step 1. Identify non-current debt on the balance sheet.
Step 2. Identify net assets on the balance sheet.
Step 3. Divide non-current debt by net assets.
For Newport Hospital, despite an increase in non-current debt, the long-term debt
to net assets ratio actually decreased from 20X0 to 20X1 due to the increase in net
assets. Still, the 20X1 ending value (2.73) is over ten times the industry standard
(0.21).
Net Assets to Total Assets
The net assets to total assets ratio (net assets/total assets) reflects the proportion
of total assets financed by equity. In for-profit organizations, this ratio is
called the equity to total assets ratio and is calculated by the formula: (owners’
equity/total assets). Creditors desire a strong equity position with sufficient funds
to pay off debt obligations. A high net asset or equity position is enhanced either
through retention of earnings or through private contributions from the community.
In investor-owned facilities, retention of earnings and issuance of stock
increase the equity. To calculate the net assets to total assets ratio (see Exhibit
4–14b):
Step 1. Identify net assets on the balance sheet.
Step 2. Identify total assets on the balance sheet.
Step 3. Divide net assets by total assets.
In 20X1, this ratio was less than half of the industry standard (0.62), but it did
increase from 0.17 (20X0) to 0.23 (20X1). With this thin equity state, creditors
probably would be somewhat cautious about lending funds to this facility in the
future.
Times Interest Earned
The times interest earned ratio [(excess of revenues over expenses + interest
expense)/interest expense] enables creditors and lenders to evaluate a hospital’s
Year Net Assets to Total Assets = Net Assets ÷ Total Assets
20X1 0.23 = $2,542,655 ÷ $10,876,736
20X0 0.17 = $1,911,683 ÷ $11,315,585
Standard = 0.62
Exhibit 4–14b Newport’s Net Assets to Total Assets Ratio for 20X0 and 20X1
Financial Statement Analysis 135
ability to generate earnings necessary to meet interest expense requirements. In
for-profit organizations the ratio is calculated by the formula: [(net income + interest
expense)/interest expense]. The ratio answers the question: “For every dollar
in interest expense, how many dollars are there in profit?” Interest expense is
added back into the numerator so that the numerator reflects profit before taking
interest into account. To calculate the times interest earned ratio (see
Exhibit 4–14c):
Step 1. Identify excess of revenues over expenses on the statement of operations.
Step 2. Identify interest expense on the statement of operations.
Step 3. Add together excess of revenues over expenses and interest expense and
divide the total by interest expense.
Unfortunately, Newport’s times interest earned ratio decreased precipitously from
20X0 (5.41) to 20X1 (2.03), falling to below the standard of 2.85. A continued decline
in the times interest earned ratio may affect Newport’s ability to borrow in the future.
Debt Service Coverage
A more robust measure of ability to repay a loan is the debt service coverage ratio
[(excess of revenues over expenses + interest expense + depreciation expense)/(interest
expense + principal payments)]. In for-profit organizations it is calculated as: [(net
income + interest expense + depreciation expense)/(interest expense + principal payments)].
It answers the question, “For every dollar the organization has to pay on debt
service (principal + interest), what is its approximate cash inflow during the year?”
This ratio is used extensively by investment bankers and bond rating agencies to evaluate
a facility’s ability to meet its total loan requirements, principal payments plus interest.
Principal payments are usually presented in the statement of cash flows. Since it is
not provided, assume that Newport’s principal payments are $200,000 per year.
Times Interest (Excess of Revenues
Year Earned = over Expenses + Interest Expense) ÷ Interest Expense
20X1 2.03 = ($515,909 + $500,000) ÷ $500,000
20X0 5.41 = ($1,219,186 + $276,379) ÷ $276,379
Standard = 2.85
Exhibit 4–14c Newport’s Times Interest Earned Ratio for 20X0 and 20X1
Debt service coverage ratio is a critical ratio used by investment bankers, because it measures what proportion
of the cash flow payments is being used to pay off debt.
136 Financial Management of Health Care Organizations
Interest expense and depreciation expense are added to the excess of revenues over
expenses to develop an indication of cash flow before interest expense. To compute the
debt service coverage ratio (see Exhibit 4–14d):
Step 1. Identify excess of revenues over expenses on the statement of
operations.
Step 2. Identify interest expense on the statement of operations.
Step 3. Identify principal payments on the statement of cash flows.
Step 4. Add the excess of revenues over expenses, interest expense, and depreciation
expense from the statement of operations.
Step 5. Divide the sum from Step 4 by the sum of interest expense and principal
payments.
Reconfirming the outcome of the times interest earned ratio, Newport also has
placed itself in a precarious position in terms of meeting its interest and principal
payments. It is considerably below the standard of 3.35 and has dropped in half from
20X0 (4.02) to 20X1 (2.00). It currently has a cash flow before principal and interest
payments of only 2.00 times its debt service payments. If this condition were to
continue, Newport likely would find itself in technical default on its long-term
obligations.
Capital Structure Summary
Newport Hospital decreased its debt position from 20X0 to 20X1; however; this
amount of debt is still well above the industry standard. This is reflected in the capital
structure ratios, which show that its proportion of debt to net assets is still too
high, albeit decreasing. More troublesome for Newport is its ability to pay its debt:
Steps 1–4
Cash Flow (Excess of Revenues Interest Depreciation
Year Before Interest = over Expenses + Expense + Expense)
20X1 $1,399,402 = ($515,909 + $500,000 + $383,493)
20X0 $1,915,803 = ($1,219,186 + $276,379 + $420,238)
Step 5
Debt Service Cash Flow (Interest Principal
Year Coverage = Before Interest ÷ Expense + Payments)
20X1 2.00 = $1,399,402 ÷ ($500,000 + $200,000)
20X0 4.02 = $1,915,803 ÷ ($276,379 + $200,000)
Standard = 3.35
Exhibit 4–14d Newport’s Debt Service Coverage Ratio for 20X0 and 20X1
Financial Statement Analysis 137
both the times interest earned and debt service coverage ratios are considerably below
the standard (see Exhibit 4–15).
Summary of Newport Hospital’s Ratios
Newport Hospital’s ratios cause some concern. Most problematic are the capital
structure ratios, which indicate that Newport Hospital is above the standard in debt
and considerably below the standard in ability to pay it off. Though improving in liquidity
from 20X0 to 20X1, it is still below the standard in its ability to meet current
obligations with current assets, except with its ability to collect on its receivables.
The majority of Newport’s profitability ratios are above standard, but they are falling
precipitously, indicating potential problems in its ability to pay off its short-term
obligations. Though Newport Hospital seems to be using its assets more efficiently
as indicated by most of the activity ratios, this is likely due to increasing age of plant.
Newport’s capital structure ratios raise serious concerns about its ability to pay off
current debt, or to increase debt financing if needed to replace properties and equipment
in the near future.
While this chapter has introduced commonly used financial ratios, there are many
others. Perspective 4–5 presents some used by HMOs.
Summary
The financial performance of health care organizations is of interest to numerous
individuals and groups, including administrators, board members, creditors, bondholders,
community members, and government agencies. This chapter presented
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Long-term Debt
to Net Assets
Net Assets to
Total Assets
Times Interest
Earned
Debt Service
Coverage
20X0 20X1 Standard
Exhibit 4–15 Newport Hospital’s Capital Structure Ratios for 20X0 and 20X1 as Compared to the Standard
three ways to analyze the financial statements of health care organizations: horizontal
analysis, vertical analysis, and ratio analysis.
Horizontal analysis examines year-to-year changes in the line items of the financial
statements. It answers the question, “What is the percentage change from one year to
the next in a particular line item (such as cash, long-term debt, patient accounts
receivable)?” The formula for horizontal analysis is [(subsequent year − previous
year)/previous year] × 100 = percent increase (decrease) between years.
A variant of horizontal analysis is trend analysis. Instead of comparing one line
item with that of the previous year, trend analysis compares a line item from any
subsequent year to that of the base year. Trend analysis answers the question,
“What is the percentage change from a base year?” For example: “How much have
net patient service revenues increased between 20X4 and 20X0?” The formula for
trend analysis is [(any subsequent year − base year)/base year]. As the name suggests,
trend analysis is most useful when data for multiple periods are available.
Generally, there are no recognized national standards for either horizontal or trend
analysis.
Vertical analysis compares one line item to another line item for the same period. It
answers the question, “What percentage of one line item is another line item?” For
example: “What percentage of current assets is cash?” or “What percentage of operating
revenues are operating expenses?” Vertical analysis is also called common-size
analysis, because it allows comparison of different-sized organizations by converting
all items to percentages. As with horizontal analysis, there are no nationally recognized
standards.
138 Financial Management of Health Care Organizations
Perspective 4–5
How Health Plans in Phoenix, Arizona Benchmark against Local Market and National Market Ratios
According to Interstudy Data, the Phoenix-Mesa, AZ market has shown a steady rise in HMO enrollment from
564,000 in 1994 to 1,068,000 in 1999.This market is very competitive with no dominating health plan.The average
market has 15 HMOs with one HMO possessing over 30% of the market, while the Phoenix market has only 12
HMOs with no plan sharing more than 20% of the market. Listed below are the key financial ratios for benchmarking
of Pacificare of Arizona Health Plan against other local market and national market values for HMOs. Lower medical
and administrative expenses for Pacificare contributed to a higher profit margin. Higher premium revenues may
also have contributed to this profit position. Given the rising growth in enrollment, one might expect that Pacificare
will continue to expand its market share.
HMO 1998 ratios Pacificare Health Phoenix Mesa, Average Large
Plan AZ Market
Administrative Expenses 10.0% 14.5% 13.2%
Medical Loss 83.0% 84.7% 88.4%
Operating Margin 0.037 (0.001) (0.015)
Average PMPM Total Revenue $268 $171 $159
Source: Interstudy Financial Database 1998. Interstudy Quarterly Newsletter,Volume 1, Issue 1, 2000.
Financial Statement Analysis 139
HCIA & HCFA HCIA & HCFA HCIA & HCFA HCIA & HCFA HCIA & HCFA
Median Ratio1 Median Ratio1 Median Ratio1 Median Ratio1 Median Ratio1 Desired
Ratio Hospital Industry 1–99 beds 100–249 beds 250–399 beds 400+ beds Position2
Liquidity Ratios
Current Ratio 2.06 2.18 1.95 1.94 1.84 Above
Quick Ratio 1.69 1.76 1.57 1.54 1.48 Above
Acid Test Ratio 0.26 0.35 0.31 0.31 0.11 Above
Days in Accounts Receivable 66 67 65 64 68 Below
Days Cash on Hand 47 46 43 44 45 Above
Average Payment Period
(Days)58 54 66 69 67 Below
Profitability Ratios
Operating Margin 0.03 0.02 0.02 0.03 0.04 Above
Non-Operating Revenue 0.05 0.05 0.04 0.06 0.09 Varies
Return on Total Assets 0.04 0.03 0.04 0.05 0.04 Above
Return on Net Assets 0.08 0.06 0.09 0.10 0.10 Above
Activity Ratios
Total Asset Turnover Ratio 0.93 1.02 0.85 0.79 0.81 Above
Net Fixed Assets Turnover
Ratio 3.50 3.59 3.45 3.44 3.62 Above
Age of Plant Ratio 9.53 9.86 10.01 9.93 9.74 Below
Capital Structure Ratios
Long-Term Debt to Net
Assets Ratio 0.38 0.21 0.48 0.56 0.64 Below
Net Assets to Total Assets
Ratio 0.60 0.62 0.56 0.55 0.52 Above
Times Interest Earned Ratio 4.29 2.85 4.30 5.39 4.31 Above
Debt Service Coverage Ratio 4.06 3.35 3.73 4.61 5.59 Above
1 These values were obtained from: The Health Care Financing Administration’s (HCFA) Hospital Cost Report Information System Files for financial statements
ending in 1998; and HCIA-Sachs Standard’s 1998 median values, The Comparative Performance of US Hospitals: The Sourcebook 2000, HCIA
Publications, Baltimore, MD
2 These are true to a certain point. For example, for the acid test ratio, in general, the higher the better, but after a certain point, the organization might be better
off investing some of the excess cash.
Exhibit 4–16a Financial Ratios for All US Hospitals by Bed Size
Ratio analysis is the preferred approach for a detailed analysis of the financial statements
of health care organizations. Ratio analysis asks the question, “What is the ratio
of one line item to another?” For example: “How many dollars are there in current
assets compared to current liabilities?” Since ratios are not limited to just one financial
statement at a time, they may combine and compare items from several different
financial statements. The four categories of ratios are liquidity, profitability, activity,
and capital structure.
Liquidity ratios answer the question, “How well is an organization
positioned to meet its short-term obligations?”
Profitability ratios answer the question, “How profitable is an
organization?”
Activity ratios answer the question, “How efficiently is an organization
using its assets to produce revenues?”
Capital structure ratios answer two questions: 1) “How are an organization’s
assets financed?” and 2) “How able is this organization to take on new
debt?”
Once calculated, these ratios are generally compared to some meaningful standard
(historical, industry, etc.). Such comparisons yield clues as to how well an entity is
functioning and how it might improve its operational performance and financial
position. Exhibit 4–16a presents financial ratios for US hospitals overall and by
bed size categories. Exhibit 4–16b presents a summary of key financial ratios and their
formulas.
Key Equations
See Exhibit 4–16b
140 Financial Management of Health Care Organizations
Financial Leverage
Horizontal Analysis
Ratio
Trend Analysis
Vertical Analysis
Key Terms
Financial Statement Analysis 141
Exhibit 4–16b Formulas for Key Financial Ratios
Liquidity Ratios Formula
Current Ratio Current Assets/Current Liabilities
Quick Ratio (Cash + Marketable Securities + Net Receivables)/Current Liabilities
Acid Test Ratio (Cash + Marketable Securities)/Current Liabilities
Days in Accounts Receivable Net Patient Accounts Receivables/(Net Patient Revenues/365)
Days Cash on Hand (Cash + Marketable Securities)/((Operating Expenses − Depreciation Expense)/365)
Average Payment Period (Days)Current Liabilities/((Operating Expenses – Depreciation Expense)/365)
Profitability Ratios Formula
Operating Margin Operating Income/Total Operating Revenues
Non-Operating Revenue Ratio Non-Operating Revenues and Other Income/Total Operating Revenues
Return on Total Assets1 Excess of Revenues over Expenses/Total Assets
Return on Net Assets2 Excess of Revenues over Expenses/Net Assets
Activity Ratios Formula
Total Asset Turnover Ratio Total Operating Revenues/Total Assets
Net Fixed Assets Turnover Ratio Total Operating Revenues/Net Plant and Equipment
Age of Plant Ratio Accumulated Depreciation/Depreciation Expense
Capital Structure Ratios Formula
Long-term Debt to Net Assets Ratio3 Long-term Debt/Net Assets
Net Assets to Total Assets Ratio4 Net Assets/Total Assets
Times Interest Earned Ratio5 (Excess of Revenues over Expenses + Interest Expense)/Interest Expense
Debt Service Coverage Ratio6 (Excess of Revenues over Expenses + Interest Expense + Depreciation Expense)/(Interest Expense +
Principal Payments)
1 In for-profit health care organizations, caluclated as: Net Income/Total Assets.
2 Called the Return on Equity in for-profit health care organizations, and calculated as: Net Income/Owners’ Equity.
3 Called Long-term Debt to Equity in for-profit health care organizations, and calculated as: Long-term Debt/Owners’ Equity.
4 Called Equity to Total Assets in for-profit health care organizations, and calculated as: Owners’ Equity/Total Assets.
5 In for-profit health care organizations, calculated as: (Net Income + Interest Expense)/Interest Expense.
6 In for-profit health care organizations, calculated as: (Net Income + Interest Expense + Depreciation Expense)/(Interest Expense + Principal Payments).
142 Financial Management of Health Care Organizations
Questions and Problems
1. Definitions. Define the following terms:
a. Financial Leverage
b. Horizontal Analysis
c. Ratio
d. Trend Analysis
e. Vertical Analysis
2. Horizontal and Vertical Analyses. Compare horizontal and vertical
analyses, including trend analysis. How are they used?
3. Vertical Analysis. Explain common-sized analysis.
4. Ratio Analysis. What is the purpose of ratio analysis? What are the four
standard categories of ratios?
5. Medians. Explain why an industry median may not be an appropriate
benchmark to which a particular organization wants to compare itself.
6. Ratio Interpretation. How do the current, quick, and acid test ratios differ
from the average payment period ratio? To what categories do these ratios
belong?
7. Ratio Interpretation. How do capital structure ratios and liquidity ratios
differ in providing insight into an organization’s ability to pay debt
obligations? Identify two situations where an organization might have
increasing activity ratios but declining profitability.
8. Ratio Interpretation. What is the difference between the operating margin
ratio and a return on total assets ratio? To what categories of ratios do these
belong?
9. Ratio Interpretation. What capital structure ratio measures the ability to pay
debt service payments?
10. Ratio Interpretation. Discuss the plant and equipment status of a health
care provider with an increasing age of plant ratio.
11. Profitability Analysis. Compare the profitability ratios for Glen Hall
Hospital with its industry standards. Keep in mind that market conditions
reveal that 90 percent of Glen Hall’s market is under fixed contract payment
with HMOs, Medicare, and Medicaid (see Exhibit 4–17).
12. Ratio Analysis. Compare the profitability and capital structure ratios for
Buxton Hospital to its industry standards (see Exhibit 4–18).
13. Ratio Analysis. The balance sheet and statement of operations for Dogwood
Community Hospital for the years ended 20X0 and 20X1 are shown in Exhibits
Profitibility Ratios Industry Standard Glen Hall Hospital
Operating Margin 0.041 (0.031)
Return on Total Assets 0.075 0.024
Non-Operating Ratio 0.040 0.010
Exhibit 4–17 Selected Ratios for Glen Hall Hospital and the Industry Standards
Financial Statement Analysis 143
4–19a and 4–19b. Compute the following ratios for both years: current, acid
test, days in accounts receivable, average payment period, long-term debt to net
assets, net assets to total assets, total asset turnover, fixed asset turnover, return
on total assets, and operating margin. After calculating the ratios, comment on
Dogwood’s liquidity, efficient use of assets or activity ratios, profitability, and
capital structure relative to its standards for its respective bed size listed in
Exhibit 4–16a. Cite at least two meaningful ratios per category. Assume
Dogwood is a 125-bed facility for the analysis. How might the opinion of
Dogwood change if it were a 450-bed facility?
14. Ratio Analysis. Exhibits 4–20a and 4–20b show the statement of operations
and balance sheet for Maryville Community Hospital for the years ended
20X0 and 20X1. Compute the following ratios for both years: current, quick,
acid tests, days in accounts receivable, days cash on hand, average payment
period, operating margin, non-operating revenue, return on total assets and
net assets, total asset turnover, fixed asset turnover, age of plant, long-term
debt to net assets, and net assets to total assets. Comment on Maryville’s
Ratios Industry Standard Buxton Hospital
Return on Total Assets 0.044 0.044
Return on Net Assets 0.065 0.130
Net Assets to Total Assets 0.600 0.300
Long-Term Debt to Net Assets 0.380 0.615
Exhibit 4–18 Selected Ratios for Buxton Hospital and the Industry Standards
Dogwood Community Hospital Statement of Operations (in ’000)
For the Years Ended December 31, 20X1 and 20X0
20X1 20X0
Revenues:
Net Patient Service Revenue $1,400 $1,200
Other Revenue 200 200
Total Operating Revenues 1,600 1,400
Expenses:
Nursing Services 1,320 1,150
Administrative Services 110 100
Depreciation 20 15
General Services 50 35
Total Operating Expenses 1,500 1,300
Operating Income 100 100
Excess of Revenues over Expenses 100 100
Increase (Decrease) in Net Assets $100 $100
Exhibit 4–19a Statement of Operations for Dogwood Community Hospital
144 Financial Management of Health Care Organizations
liquidity, efficient use of assets, profitability, and capital structure, citing at
least one ratio per category. Use the national hospital industry standards
listed in Exhibit 4–16a for 250 beds, and then perform an analysis if hospital
size were unknown.
15. Ratio Analysis. Exhibit 4–21 lists the financial ratios for 227-bed
Hollywood Community Hospital. Assess the profitability, liquidity, activity,
and capital structure of Hollywood for 20X1. Explain why these financial
measures changed between 20X0 and 20X1.
16. Ratio Analysis. McGill Healthcare System, an 800-bed institution, is located in a
highly competitive, urban market area. Using the financial ratios from Exhibit
4–22 for the current and previous years, evaluate McGill’s financial condition,
focusing on profitability, liquidity, activity, and capital structure ratios.
17. Ratio Analysis, Unknown Bed Size. Compare Hope Community
Hospital’s liquidity, profitability, activity, and capital structure ratios to its
national industry standards using the data from Exhibits 4–16a and 4–23.
Dogwood Community Hospital Balance Sheet (in ’000)
For the Years Ended December 31, 20X1 and 20X0
20X1 20X0
Current Assets
Cash and Cash Equivalents $30 $50
Net Patient Receivables 295 235
Prepaid Expenses 80 80
Total Current Assets 405 365
Non-Current Assets
Plant, Property, & Equipment
Gross Plant, Property, & Equipment 350 300
(less Accumulated Depreciation)(70) (50)
Net Plant, Property, & Equipment 280 250
Construction in Progress 203 0
Total Assets $888 $615
Current Liabilities
Accounts Payable $220 $190
Salaries Payable 75 50
Total Current Liabilities 295 240
Long-Term Liabilities
Bonds Payable 100 20
Total Long-Term Liabilities 100 20
Net Assets 493 355
Total Liabilities and Net Assets $888 $615
Exhibit 4–19b Balance Sheet for Dogwood Community Hospital
Financial Statement Analysis 145
18. Ratio Analysis, Unknown Bed Size. In Exhibit 4–24 are the financial
ratios for St Jude’s Hospital, whose financial condition deteriorated from
20X0 to 20X1. Identify the problem areas relative to the standards, and
explain how this downfall came about.
19. Ratio Analysis. Swayze Community Hospital, a 265-bed facility, is a sole
provider hospital in small, rural New England serving a large area. Assess
Swayze’s profitability, liquidity, activity and capital structure ratios. Using
the financial ratios from Exhibit 4–25 for the current and previous years,
evaluate Swayze’s financial condition.
20. Ratio Analysis. Avon Community Hospital, a small 95-bed hospital, is
located in a large metropolitan area and competes with several large teaching
facilities as well as other community hospitals. During the past year, one of
the large teaching hospitals decided to sponsor a Medicaid and Medicare
HMO. As a result Avon has experienced a decline in its government payer
mix. Assess Avon’s profitability, liquidity, activity, and capital structure
ratios. Using the financial ratios from Exhibit 4–26 for the current and
previous years, evaluate Avon’s financial condition.
21. Horizontal, Vertical, and Ratio Analyses. Exhibits 4–27a and 4–27b
show the statement of operations and balance sheet for 190-bed Lake
Community Hospital for 20X0 and 20X1.
a. Perform a horizontal analysis on both statements.
b. Perform a vertical analysis on both statements relative to 20X0.
c. Compute all the selected ratios listed in Exhibit 4–16a, and compare them
to the standard.
Maryville Community Hospital Statement of Operations (in ’000)
For the Years Ended December 31, 20X1 and 20X0
20X1 20X0
Revenues
Net Patient Service Revenue $17,500 $18,000
Net Assets Released from Restriction 2,000 100
Other Revenue 500 450
Total Operating Revenues 20,000 18,550
Expenses
Nursing Services 13,000 15,000
Administrative Services 5,000 3,000
Depreciation 1,000 1,000
General Services 200 100
Total Operating Expenses 19,200 19,100
Operating Income 800 (550)
Excess of Revenues over Expenses 800 (550)
Transfer to Parent 500 0
Increase (Decrease) in Net Assets $300 ($550)
Exhibit 4–20a Statement of Operations for Maryville Community Hospital
146 Financial Management of Health Care Organizations
Exhibit 4–20b Balance Sheet for Maryville Community Hospital
Maryville Community Hospital Balance Sheet (in ’000)
For the Years Ended December 31, 20X1 and 20X0
20X1 20X0
Current Assets
Cash and Cash Equivalents $750 $650
Net Patient Receivables 2,500 3,800
Inventory 700 800
Total Current Assets 3,950 5,250
Non-current Assets
Plant, Property, & Equipment
Gross Plant, Property, & Equipment 20,000 19,000
(less Accumulated Depreciation)(6,000) (5,000)
Net Plant, Property, & Equipment 14,000 14,000
Board-designated Funds 7,000 4,500
Total Assets 24,950 23,750
Current Liabilities
Accounts Payable 1,500 1,800
Accrued Expenses 500 750
Total Current Liabilities 2,000 2,550
Long-term Liabilities
Bonds Payable 10,500 11,000
Total Long-term Liabilities 10,500 11,000
Net Assets 12,450 10,200
Total Liabilities and Net Assets $24,950 $23,750
Ratio 20X1 20X0
Current Ratio 4.05 2.30
Acid Test Ratio 0.95 0.20
Days in Accounts Receivable 75 days 65 days
Days Cash on Hand 25 days 5 days
Average Payment Period (Days)55 days 55 days
Fixed Asset Turnover Ratio 3.45 2.60
Total Asset Turnover Ratio 1.15 1.05
Operating Margin – 0.05 0.02
Return on Net Assets 0.01 0.06
Long-term Debt to Net Assets (Equity)2.95 1.18
Net Assets to Total Assets 0.34 0.46
Age of Plant 5.05 5.78
Exhibit 4–21 Selected Financial Ratios for Hollywood Community Hospital
Financial Statement Analysis 147
Ratio 12/31/20X1 12/31/20X0
Current Ratio 1.75 2.50
Quick Ratio 1.01 1.85
Acid Test Ratio 0.15 0.35
Days in Accounts Receivable 55 days 65 days
Average Payment Period 40 days 45 days
Days Cash on Hand 12 days 35 days
Fixed Asset Turnover Ratio 0.95 3.20
Total Asset Turnover Ratio 0.65 1.10
Operating Margin 0.03 0.02
Non-Operating Revenue 0.25 0.10
Return on Total Assets 0.06 0.04
Long-term Debt to Equity 0.22 0.25
Equity to Total Assets 0.65 0.35
Debt Service Coverage Ratio 5.55 4.55
Age of Plant 4.50 10.01
Exhibit 4–22 Selected Ratios for McGill Healthcare System
Ratio 20X1 20X0
Liquidity Ratios
Current Ratio 1.78 1.81
Quick Ratio 1.29 1.39
Acid Test Ratio 0.23 0.18
Average Collection Period 82 days 118 days
Days Cash on Hand 19 days 17 days
Average Payment Period (Days)81 days 95 days
Profitability Ratios
Return on Total Assets 0.14 0.14
Return on Net Assets 0.44 0.50
Operating Margin 0.12 0.06
Non-Operating Revenue 0.02 0.11
Activity Ratios
Total Asset Turnover Ratio 1.07 0.84
Fixed Asset Turnover Ratio 1.96 1.46
Age of Plant 13.00 11.00
Capital Structure Ratios
Net Assets to Total Assets 0.32 0.27
Long-term Debt to Net Assets 1.47 1.95
Debt Service Coverage Ratio 1.50 1.53
Times Interest Earned 4.00 4.10
Exhibit 4–23 Financial Ratios for Hope Community Hospital
148 Financial Management of Health Care Organizations
Ratio 20X1 20X0
Current Ratio 0.50 1.60
Acid Test Ratio 0.02 0.35
Days in Accounts Receivable 120 days 80 days
Average Payment Period 95 days 75 days
Days Cash on Hand 5 days 15 days
(Continues)
Exhibit 4–26 Financial Ratios for Avon Hospital
Ratio 20X1 20X0
Current Ratio 2.10 2.20
Acid Test Ratio 0.10 0.25
Days in Accounts Receivable 60 days 45 days
Days Cash on Hand 5 days 15 days
Average Payment Period (Days)45 days 43 days
Fixed Asset Turnover Ratio 2.54 3.58
Total Asset Turnover Ratio 1.04 1.10
Operating Margin 0.03 0.10
Return on Total Assets 0.12 0.20
Long-term Debt to Equity 2.18 1.10
Equity to Total Assets 0.42 0.55
Debt Service Coverage Ratio 2.10 3.20
Age of Plant 3.50 5.70
Exhibit 4–24 Financial Ratios for St Jude’s Hospital
Ratio 20X1 20X0
Current Ratio 2.25 1.95
Quick Ratio 1.65 1.45
Acid Test Ratio 0.10 0.25
Days in Accounts Receivable 80 50
Average Payment Period 65 75
Days Cash on Hand 15 35
Fixed Asset Turnover Ratio 3.50 3.20
Total Asset Turnover Ratio 1.12 1.10
Operating Margin 0.08 0.06
Return on Total Assets 0.10 0.07
Long-term Debt to Net Assets 0.55 0.68
Net Assets to Total Assets 0.45 0.35
Debt Service Coverage Ratio 3.55 2.25
Age of Plant 7.80 6.80
Exhibit 4–25 Financial Ratios for Swayze Community Hospital
Financial Statement Analysis 149
Exhibit 4–26 (Contd)
Fixed Asset Turnover 0.75 1.00
Total Asset Turnover 0.95 1.20
Operating Margin −0.08 −0.01
Return on Total Assets −0.01 0.02
Long-term Debt to Equity 3.11 2.10
Equity to Total Assets 0.10 0.35
Debt Service Coverage Ratio 1.25 2.01
Age of Plant 10.01 7.85
Lake Community Hospital
Statement of Operations (in ’000)
For the Years Ended 12/31/20X1 and 12/31/20X0
20X1 20X0
Revenues:
Net Patient Service Revenue $20,000 $17,000
Other Operating Revenue 2,500 2,000
Total Operating Revenues 22,500 19,000
Operating Expenses:
Nursing Services 12,000 10,000
Administrative Services (includes Bad Debt Expense of $100)4,000 3,500
Depreciation 1,000 1,200
General Services 2,500 2,500
Fiscal Services 400 400
Professional/Ancillary Services 3,500 3,000
Interest 1,000 1,000
Total Operating Expenses 24,400 21,600
Income from Operations (1,900)(2,600)
Non-Operating Income:
Investment Income/Contributions 3,000 3,000
Excess of Revenues over Expenses 1,100 400
Net Income $1,100 $400
(Continues)
Exhibit 4–27a Statement of Operations for Lake Community Hospital
Exhibit 4–27b Balance Sheet for Lake Community Hospital
Lake Community Hospital
Balance Sheet (in ’000)
For the Years Ended 12/31/20X1 and 12/31/20X0
20X1 20X0
Current Assets:
Cash and Cash Equivalents $1,300 $800
Net Patient Accounts Receivables 3,500 4,000
150 Financial Management of Health Care Organizations
Using these financial performance measures, evaluate the financial state of Lake
Community. The debt principal payments each year are $40,000.
22. Horizontal, Vertical, and Ratio Analyses. Exhibits 4–28a and 4–28b
show the statement of operations and balance sheet for 375-bed Pine Island
Regional Hospital for 20X0 and 20X1.
a. Perform a horizontal analysis on both statements.
b. Perform a vertical analysis on both statements relative to 20X0.
c. Compute all the selected ratios listed in Exhibit 4–16a, and compare them
to the standard.
Using these financial performance measures, evaluate the financial state of
Pine Island. The debt principal payments each year are $1,000,000.
23. Horizontal, Vertical, and Ratio Analyses. Exhibits 4–29a and 4–29b show
the statement of operations and balance sheet for Rocky Mountain Resort
Hospital for 20X1 and 20X0. The debt principal payments each year for Rocky
Mountain Resort are $500,000 for 20X1 and $1,300,000 for 20X0.
a. Perform horizontal and vertical analyses using the Statement of
Operations.
b. Perform horizontal and vertical analyses using the Balance Sheet.
c. Compute all the selected ratios listed in Exhibit 4–16.
Inventories 2,000 1,800
Other Current Assets 100 80
Total Current Assets 6,900 6,680
Plant, Property, & Equipment
Gross Plant, Property, & Equipment 21,000 22,000
(less Accumulated Depreciation)(6,500) (5,500)
Net Property, Plant and Equipment 14,500 16,500
Funded Depreciation/Board Designated Funds
Cash and Short-Term Investments 4,000 1,500
Total Assets $25,400 $24,680
Current Liabilities:
Accounts Payable $3,000 $3,200
Salaries Payable 30 25
Notes Payable 250 300
Total Current Liabilities 3,280 3,525
Long-term Liabilities:
Bonds Payable 15,000 18,000
Total Long-term Liabilities 15,000 18,000
Net Assets 7,120 3,155
Total Liabilities and Net Assets $25,400 $24,680
Exhibit 4-27b (Contd)
Financial Statement Analysis 151
Pine Island Regional Hospital
Statement of Operations (in ’000) For the Years Ended 12/31/20X1 and 12/31/20X0
12/31/20X1 12/31/20X0
Revenues:
Net Patient Service Revenue $55,000 $62,000
Net Assets Released from Restriction 5,000 4,000
Other Operating Revenue 3,000 7,000
Total Operating Revenues 63,000 73,000
Expenses:
Nursing Services 20,000 25,000
Administrative Services 18,000 22,000
Depreciation 5,000 5,000
Interest 4,000 4,000
General Services 8,000 3,000
Total Operating Expenses 55,000 59,000
Operating Income 8,000 14,000
Excess of Revenues over Expenses 8,000 14,000
Increase (Decrease) in Net Assets $8,000 $14,000
Exhibit 4–28a Statement of Operations for Pine Island Regional Hospital
Pine Island Regional Hospital
Balance Sheet (in ’000) For the Years Ended 12/31/20X1 and 12/31/20X0
12/31/20X1 12/31/20X0
Current Assets:
Cash and Cash Equivalents $4,200 $4,750
Net Patient Receivables 6,000 6,500
Inventory 300 250
Prepaid Expenses 750 800
Total Current Assets 11,250 12,300
Plant, Property, & Equipment
Gross Plant, Property, & Equipment 55,000 60,000
(less Accumulated Depreciation)(30,000) (25,000)
Net Property, Plant and Equipment 25,000 35,000
Long-Term Investments 2,000 1,500
Total Assets $38,250 $48,800
Current Liabilities:
Accounts Payable $5,500 $4,800
Salaries Payable 1,075 950
Total Current Liabilities 6,575 5,750
(Continues)
Exhibit 4–28b Balance Sheet for Pine Island Regional Hospital
152 Financial Management of Health Care Organizations
Long-term Liabilities:
Bonds Payable 20,000 25,000
Total Long-term Liabilities 20,000 25,000
Net Assets 11,675 18,050
Total Liabilities and Net Assets $38,250 $48,800
Exhibit 4-28b (Contd)
Rocky Mountain Resort Hospital
Statement of Operations (in ’000) For the Years Ended 12/31/20X1 and 12/31/20X0
12/31/20X1 12/31/20X0
Revenues:
Net Patient Service Revenue $45,000 $30,000
Net Assets Released from Restriction 12,000 9,000
Other Operating Revenue 10,000 7,000
Total Operating Revenues 67,000 46,000
Expenses:
Nursing Services 33,000 31,000
Administrative Services 13,000 12,500
Depreciation Expense 8,000 4,000
Interest Expense 4,000 500
General Services 5,000 4,000
Total Operating Expenses 63,000 52,000
Operating Income 4,000 (6,000)
Excess of Revenues over Expenses 4,000 (6,000)
Increase (Decrease) in Net Assets $4,000 ($6,000)
Exhibit 4–29a Statement of Operations for Rocky Mountain Resort Hospital
Exhibit 4–29b Balance Sheet for Rocky Mountain Resort Hospital
Rocky Mountain Resort Hospital
Balance Sheet (in ’000) For the Years Ended 12/31/20X1 and 12/31/20X0
12/31/20X1 12/31/20X0
Current Assets:
Cash and Cash Equivalents $3,800 $8,750
Net Patient Receivables 15,000 11,500
Inventory 2,300 1,250
Prepaid Expenses 5,500 4,500
Total Current Assets 26,600 26,000
(Continues)
Financial Statement Analysis 153
Evaluate the financial state of Rocky Mountain Resort, a 60-bed facility, using
all of the above measures. Make the basis for the vertical analyses the year 20X0.
24. Horizontal, Vertical, and Ratio Analyses. Exhibits 4–30a and 4–30b
show the Balance Sheet and Statement of Operations for 660-bed Williamson
Academic Medical Center for the years 20X0 and 20X1.
a. Perform full horizontal and vertical analyses on the Balance Sheet.
b. Perform full horizontal and vertical analyses on the Statement of
Operations.
c. Calculate every ratio described in the chapter for both years as compared
to the standard. (Note: assume that principal payments each year are for
$500,000.)
Discuss Williamson’s current financial position and future outlook based upon
these results. Make the basis for the vertical analyses the year 20X0.
Plant, Property, & Equipment
Gross Plant, Property, & Equipment 65,000 40,000
(less Accumulated Depreciation)(20,000) (15,000)
Net Property, Plant and Equipment 45,000 25,000
Long-Term Investments 2,000 10,500
Total Assets $73,600 $61,500
Current Liabilities:
Accounts Payable $8,500 $3,800
Salaries Payable 950 700
Total Current Liabilities 9,450 4,500
Long-term Liabilities:
Bonds Payable 40,000 5,000
Total Long-term Liabilities 40,000 5,000
Net Assets 24,150 52,000
Total Liabilities and Net Assets $73,600 $61,500
Williamson Academic Medical Center
Balance Sheet (in ’000) For the Years Ended December 31, 20X0 and 20X1
12/31/20X1 12/31/20X0
Current Assets:
Cash & Cash Equivalents $1,000 $800
Patient Accounts Receivables, Net 4,500 5,500
Inventories 2,000 1,800
Other Current Assets 100 80
Total Current Assets 7,600 8,180
(Continues)
Exhibit 4–30a Balance Sheet for Williamson Academic Medical Center
Exhibit 4–29b (Contd)
154 Financial Management of Health Care Organizations
Williamson Academic Medical Center
Statement of Operations (in ’000) For the Years Ended December 31, 20X0 and 20X1
12/31/20X1 12/31/20X0
Revenues:
Net Patient Revenues $20,000 $17,000
Other Operating Revenues 2,500 2,000
Total Operating Revenues 22,500 19,000
Expenses:
Nursing Services 8,000 7,000
Administrative Services 4,000 3,500
(includes bad debt expense of $100,000)
Depreciation 500 500
General Services 2,500 2,500
Fiscal Services 400 400
Professional/Ancillary Services 3,500 3,000
Interest 1,000 1,000
Total Operating Expenses 19,900 17,900
Income from Operations 2,600 1,100
Non-Operating Income:
Investment Income + Contributions 400 2,000
Excess of Revenues over Expenses 3,000 3,100
Increase (Decrease) in Net Assets $3,000 $3,100
Plant, Property, & Equipment Gross Plant, Property, & Equipment 18,000 18,500
(less Accumulated Depreciation)(6,500) (5,500)
Net Property, Plant and Equipment 11,500 13,000
Long-Term Investments 2,000 1,500
Total Assets $21,100 $22,680
Current Liabilities:
Accounts Payable $4,000 $4,200
Salaries Payable 30 25
Notes payable 250 300
Other Current Liabilities 0 0
Total Current Liabilities 4,280 4,525
Non-Current Liabilities:
Bonds Payable 10,000 12,000
Total Non-Current Liabilities 10,000 12,000
Net Assets 6,820 6,155
Total Liabilities and Net Assets $21,100 $22,68
Exhibit 4-30a (Contd)
Exhibit 4–30b Statement of Operations for Williamson Academic Medical Center
C h a p t e r F i v e
WORKING CAPITAL
MANAGEMENT
Learning Objectives
After completing this chapter you should be able to:
Define working capital.
Understand working capital management strategies.
Construct a cash budget.
Manage receivables and payables.
Introduction
The Working Capital Cycle
Working Capital Management Strategies
Asset Mix Strategy
Financing Mix Strategy
Cash Management
Sources of Temporary Cash
Bank Loans
Lines of Credit
Commitment Fees
Compensating Balances
Transaction Notes
Trade Credit/Payables
Billing, Collections, and Disbursement Policies,
and the Concept of Float
Billing Float
Collection Float
Transit Float
Disbursement Float
Investing Cash on a Short-term Basis
Treasury Bills (T-bills)
Negotiable Certificates of Deposit (CDs)
Commercial Paper
Money Market Mutual Funds
Forecasting Cash Surpluses and Deficits –
The Cash Budget
Cash Inflows
Cash Outflows
Ending Cash Balance
Accounts Receivable Management
Methods to Monitor Accounts Receivable
Methods to Finance Accounts Receivable
Factoring
Pledging Receivables as Collateral
Laws and Regulation for Billing Compliance
HIPAA
Summary
Key Terms
Key Equations
Questions and Problems
Chapter Outline
Introduction
Although non-current assets provide the capability to provide services, it is the
combination of current assets and current liabilities that turns that capability into
service. For example, an X-ray machine is useless without an adequate supply of film
on hand or cash to pay the radiation technologists. This chapter begins with a
discussion of working capital and then focuses on the management of two primary
components of working capital in the health care industry: cash and accounts
receivable.
The term “working capital” refers to both current assets and current liabilities. A
related term, “net working capital,” refers to the difference between current assets and
current liabilities. That is:
Net Working Capital = Current Assets − Current Liabilities
The Working Capital Cycle
In the day-to-day operations of an organization, an ongoing series of cash inflows and
outflows pays for day-to-day expenses (such as supplies and salaries). The organization
must have sufficient funds available to pay for these items on a timely basis. This
is particularly problematic in health care, where it is not unusual for payments to be
received more than two months after the patient or third party has been billed for the
provided services.
Ideally, a health care organization would earn and receive sufficient funds from
providing services to enable it to meet its current obligations with available cash. To
do this requires managing the four phases of the working capital cycle (see Exhibit
5–1): 1) obtaining cash; 2) turning cash into resources, such as supplies and labor, and
paying bills; 3) using these resources to provide services; and 4) billing patients for the
services, and collecting revenues so that the cycle can be continued.
With regard to cash, managing the working capital cycle involves not only ensuring
that total cash inflows cover cash outflows, but also managing the timing of these
flows. To the extent that payments are due before cash is available, the organization
will have to obtain cash from sources other than existing revenues, such as from
investments or through short-term borrowing. To illustrate, suppose an organization
starts the month of September with no working capital (see Exhibit 5–2). During the
month, it delivers $20,000 worth of services, but must pay $9,000 in staff salaries
every 15 days and $2,000 for supplies every 30 days. Situation 1 assumes that the full
amount owed is collected during the month, but isn’t received until the end of the
month. Situation 2 assumes that the organization also collects the full amount owed,
but in two equal payments of $10,000 each – the first payment arriving after 15 days,
and the second payment, after 30 days.
In both cases, cash inflows ($20,000) equal cash outflows ($20,000). However,
whereas in Situation 2 there is always sufficient cash on hand to meet the payments
156 Financial Management of Health Care Organizations
Working Capital:
Current assets and
current liabilities.
Net Working Capital:
The difference between
current assets and
current liabilities.
Working Capital
Strategy: The amount
of working capital that
an organization
determines it must
keep available as a
cushion to protect
against unforeseen
expenditures.
when due, in Situation 1 the organization would not be able to meet its first $9,000
payroll on Day 15. To meet this obligation, it either must take cash out of existing
reserves or borrow. However, even in Situation 2, there is little margin for error. The
amount of working capital that an organization determines it must keep available as a
cushion against unforeseen expenses is called its working capital strategy.
Working Capital Management Strategies
Working capital management strategy has two components: asset mix and financing
mix. Asset mix is the amount of working capital an organization keeps on hand
Working Capital Management 157
(Interest Expense on Amount Borrowed + Total Fees)
(Amount Borrowed − Compensating Balance)
Effective Interest Rate =
Exhibit 5–1 The Working Capital Cycle:The Importance of Timing in Managing Working Capital
Exhibit 5–2 Illustration of the Effects of Timing on Working Capital Needs
Situation #1 Situation #2
Cash Cash Cash Cash
Account Inflows Outflows Balance Account Inflows Outflows Balance
Day 1 $0 $0
Day 15 Revenues Revenues $10,000
Salaries $9,000 ($9,000) Salaries $9,000 $1,000
Day 30 Revenues $20,000 Revenues $10,000
Salaries $9,000 Salaries $9,000
Supplies $2,000 $0 Supplies $2,000 $0
relative to its potential working capital obligations. Financing mix refers to how an
organization chooses to finance its working capital needs.
Asset Mix Strategy
A health care provider’s asset mix strategy falls on a continuum between an aggressive
strategy and a conservative strategy (see Exhibit 5–3). Using the aggressive approach,
the health care organization attempts to maximize its returns by investing its funds in
potentially higher-earning non-liquid assets such as buildings and equipment; yet it
does so at the risk of lower liquidity with increased chances of inventory stock-outs,
dissatisfied customers from the stringent collections policies to earn revenues more
quickly, and lack of cash to pay employees and suppliers.
Conversely, using a conservative approach, a health care organization seeks to minimize
its risk of not having sufficient funds readily available by having higher liquidity.
However, it does so at the cost of receiving lower returns, since short-term investments
typically earn a lower return than do long-term investments (see Perspective 5–1).
Financing Mix Strategy
Financing mix refers to how the organization chooses to finance its working capital
needs. Temporary working capital needs result from short-term fluctuations, whereas
permanent working capital needs arise from more ongoing factors, such as a permanent
increase in patient volume. Borrowing short-term at lower interest costs for short-term
needs under normal conditions leads to a higher profit, because working capital is otherwise
being invested optimally (everything else being equal), but this places the facility
at risk because of possible higher debt payments if the need to borrow arises. If the
organization has long-term working capital financing needs, it is better off financing
those needs with long-term financing under normal conditions. Facilities borrowing
long-term at higher interest costs to support ongoing working capital needs face lower
158 Financial Management of Health Care Organizations
Aggressive Strategy Conservative Strategy
Goal Maximize Returns Minimize Risk
Liquidity Low High
Risk High Low
Return High Low
Exhibit 5–3 Working Capital Management Strategies
Financing Mix: How
an organization
chooses to finance its
working capital needs.
Liquidity: a measure
of how easily an asset
can be converted into
cash.
A health care organization that utilizes an aggressive asset mix strategy seeks to maximize its returns by investing
in non-liquid assets, but faces the risk of lower liquidity.
Asset Mix: The
amount of working
capital an organization
keeps on hand relative
to its potential working
capital obligations.
earnings, but reduce their risk with lower debt payments. Exhibit 5–4 compares the key
characteristics of short-term and long-term borrowing. Overall, an aggressive working
capital strategy involves maintaining a relatively low amount of working capital on hand
and financing working capital shortfalls with short-term debt. Though this results in a
greater return, it also results in lower liquidity and an increased chance of not having
the working capital available when needed.
Working Capital Management 159
Perspective 5–1
Changing Investment Philosophy of Health Care Providers in the 1990s and 2000
In the1990s, health care providers started to become more aggressive with their investment strategies. For example,
MedAmerica Health Systems Corp. of Dayton Ohio started investing more of its cash in stocks, and that’s been good
for the nonprofit hospital operator and its bondholders – so far. Currently, 50 percent of its investment portfolio is
in stocks, up from 20 percent three years ago. As a result, MedAmerica registered almost a 10 percent compounded
annual return. Its investment gains and interest income of $14.9 million in the first half of 2000 exceeded its slimmer
operating surplus of $ 4.4 million.
Overall, nonprofit hospitals on average more than tripled their stock holdings from 1995 to 1999, as reported by
a recent survey completed by the bond rating agency of Fitch, Inc. However, the rating agency has noted that some
hospitals have been utilizing stock investments to shore up for weak operating results, which could turn dangerous
with falling stocks prices during the year 2000. Anil Joseph, a Fitch analyst, notes that “they have so little room for
error, that it just magnifies the risk they have” if stock losses occur.
As a result, significant investment losses could cause further credit downgrades because they would reduce financial
cushions, especially at weaker hospitals with lower cash reserves. Rating analysts note that these returns masked
the effect of reduced reimbursement for health care.
Source: Dennis Walters, “Stocks are Risky Rx for Hospitals.” Chicago Sun-Times, October 29, 2000, Financial Section,
p. 48.
Short-term Long-term
Interest Rate1 Lower Higher
Interest Cost Lower Higher
Profit Higher Lower
Volatility Risks Variable Fixed
1 Short-term rates are typically lower than long-term rates
Exhibit 5–4 Comparison of Key Characteristics of Shortand
Long-term Borrowing under Normal Conditions
Three rules to follow under normal conditions to decide between short-term and long-term borrowing to finance
working capital needs: 1) finance short-term working capital needs with short-term debt; 2) finance long-term
working capital needs with long-term financing; and 3) when an organization has fluctuating needs for working
capital, employ a mixed strategy by financing a certain base amount with long-term financing, and as shortterm
situations arise, finance those with short-term debt.
In reality, most health care organizations follow neither an aggressive nor a conservative
approach, but fall somewhere in the middle. A health care provider located in a market
with little competition and a high degree of stability for services might consider a
more aggressive approach, since it is better able to forecast its working capital needs. On
the other hand, a provider in a competitive, unsettled market with fluctuating demand for
services should choose a more conservative approach to working capital management.
Cash Management
In general, the term cash refers not only to coin and currency, but also to cash
equivalents such as interest-bearing savings and checking accounts. There are three
major reasons for a health care provider to hold cash:
Daily operations.
Precautionary purposes.
Speculative purposes.
Daily operations refers to holding cash so that day-to-day bills may be paid.
Precautionary purposes refers to holding cash to meet unexpected demands, such
as unexpected maintenance of a facility or piece of equipment. Speculative
purposes refers to holding cash to take advantage of unexpected opportunities, such
as a group practice’s buying a competing practice that has decided to sell.
Sources of Temporary Cash
Though it would be favorable to always have excess short-term funds available to
invest, health care organizations often find that they need to borrow funds for short
periods of time to meet their maturing obligations. The three primary sources of
short-term funds include:
Extension of credit from suppliers (i.e. trade payables).
Bank loans.
Billings, collections, and disbursement policies that increase the speed with
which money is collected.
Bank Loans
There are two major types of unsecured (not backed by an asset) short-term
loans offered by banks: lines of credit, and transaction notes. The interest expense
160 Financial Management of Health Care Organizations
There are three major reasons to hold cash: daily operations, precautionary measures, and speculative needs.
associated with these alternatives is a function of economic conditions and the credit
background of the borrower.
Lines of Credit
There are two types of lines of credit: a normal line of credit, and a revolving line of
credit. A normal line of credit is an agreement established by the bank and the borrower
that establishes the maximum amount of funds that can be borrowed. Thus, the
bank is not legally obligated to fulfill the borrower’s credit request. On the other hand,
a revolving line of credit legally requires the bank to fulfill the borrower’s credit
request up to the pre-negotiated limit.
Commitment Fees
In addition to the interest rate on a line of credit, financial institutions are also compensated
through commitment fees and/or compensating balances. A commitment
fee is a percentage of the unused portion of the revolving credit line which is charged
to the potential borrower. The annual fee, often between 0.25 and 0.50 percent, is a
function of the credit risk of the borrower and the reason for the line of credit. For
example, assume a health care organization has a line of credit of $4,000,000 and borrows
on average $2,500,000 during the year. If the commitment fee rate were 0.25 percent,
then the borrower would pay an annual fee of $3,750 [($4,000,000 − $2,500,000)
× 0.0025] to have the right to borrow the full $4,000,000 essentially on demand.
Sometimes an organization can negotiate with a bank to reduce or eliminate a commitment
fee for a line of credit, especially if it has a favorable long-standing history
with the lending institution.
Compensating Balances
Under a compensating balance, the borrower is required to maintain a designated
dollar amount on deposit with the bank. The balance requirement generally is a
percentage (perhaps 10–20 percent) of the total credit line, or a percentage of the
unused portion of the credit line. The effect of the compensating balance is to increase
the true or effective interest rate that the borrower must pay. The effective interest
rate is calculated using the following formula:
Assume Community Healthcare Provider borrowed $600,000 during the year on a
credit line of $1,000,000 with an interest rate of 9 percent, with no fees. Using this
Working Capital Management 161
Normal Line of
Credit: an agreement
established by a bank
and a borrower which
establishes the
maximum amount of
funds that can be
borrowed, and the
bank may loan the
funds at its own
discretion.
Revolving Line of
Credit: an agreement
established by the
bank and the borrower
that legally requires
the bank to loan
money to the borrower
at any time requested
up to the prenegotiated
limit.
Commitment Fee: a
percentage of the
unused portion of a
credit line which is
charged to the
potential borrower.
Compensating
Balance: a designated
dollar amount on
deposit with a bank
which a borrower is
required to maintain.
(Interest Expense on Amount Borrowed + Total Fees)
(Amount Borrowed − Compensating Balance)
Effective Interest Rate = Effective Interest
Rate: The true interest
rate that a borrower
pays.
A revolving line of credit differs from a normal line of credit in that the revolving line of credit legally requires
a bank to fulfill the borrower’s credit request up to the pre-negotiated limit.
formula, the interest expense in the numerator is $54,000 (9% × $600,000). The
amount borrowed in the denominator is $600,000, and the compensating balance is 10
percent of the unused portion of the line of credit (10% × $400,000), or $40,000.
Thus, the effective interest rate is 9.64 percent [($54,000 + $0) / ($600,000 – $40,000)].
Transaction Notes
The second type of bank loan commonly used for short-term borrowing by health care
providers is a transaction note. A transaction note is a short-term, unsecured loan
made for some specific purpose, such as the financing of inventory purchases.
Transaction notes have compensating balance requirements. The borrower obtains
the loan by signing a promissory note or IOU. The terms of transaction (maturity and
cost) are similar to that for the line of credit.
Trade Credit/Payables
Instead of relying solely on the outside to obtain cash, an organization can generate
cash by controlling its outflow, but the health care organization must have strict cash
disbursement policies and procedures in effect. When a health care organization buys
on credit, it is in fact using the supplier’s money to pay for the purchase up until the
time it pays the supplier the amount owed. These credit obligations are called trade
payables (often referred to as accounts payable). Thus, one of the most important
areas to address in cash management is that of either accepting or rejecting discounts
offered by suppliers for early payment. These discounts are often stated as follows:
2/10 net 30
This example means that the full payment is due within 30 days (“net 30”), but a 2
percent discount is available if the payment is made within 10 days after the sale
(“2/10”) (see Exhibit 5–5). Although at first glance it may seem optimal to delay
162 Financial Management of Health Care Organizations
Transaction Note: a
short-term, unsecured
loan made for some
specific purpose.
Trade Credit: Short
term credit offered by
the supplier of a good
or service to the
purchaser.
Trade Payables: Shortterm
debt that results
from supplies
purchased on credit for
a given length time.
This allows an
organization to use the
supplier’s money to
pay for the purchase
up until the time it
pays the supplier the
amount owed.
If the payment isn’t made within 10 days,
the full payment is due within 30 days.
2/10 net 30
A 2% discount is available if
payment is made within 10 days.
Exhibit 5–5 Explanation of Commonly Used Discount Terms
($54,000+$0)
($600,000 − $40,000)
9.64% =
payment for 30 days to retain cash on hand, in fact, depending upon the credit terms, it
is usually in the best interests of an organization to pay early and take the discount.
To compare the financial implications of taking a discount versus not taking the
discount, assume an organization receives an invoice for $1,000 with terms of 2/10 net
30. If the organization pays within 10 days, it receives a 2 percent discount and only
has to pay $980 ($1,000 – $20). If the payment isn’t made until 30 days, the health care
organization has to pay the full $1,000. Although it should be clear that if the organization
takes the discount it is paying less as opposed to holding onto its cash longer,
the true cost of paying late may not be so apparent. To understand this involves
switching perspectives.
A common way to approach this situation would be to think that paying $1,000
after 30 days would be the “normal” management action, and to pay $980 early
would be the alternative action. From this perspective, the savings from taking the
discount is $20 (see Exhibit 5–6). A better way to approach this decision would be
to think of the discounted price ($980) as being the “real” price, and the full price
paid after 10 days ($1,000) as being a penalty price with a supplemental interest
charge for not paying within the discount period. In other words, the organization
would be paying $20 in interest ($1,000 – $980) to keep the $980 for an extra 20
days (the time between day 10 and day 30).
Working Capital Management 163
Situation: Community Healthcare Provider receives a bill for $1,000 for supplies purchased. The terms of
the bill are 2/10 net 30.
The bill: $ 980
Bill + interest $1,000
Interest to borrow $980 for 20 days $ 20
A common way to think about this situation….
The bill: $1,000
Discounted price $ 980
Discount $ 20
I only get a $20 discount
if I pay 20 days early?
A better way to approach this situation….
Interest % per 20 days = $20/$980 = 2.04%
CHP is paying 2.04% for 20 days. Since
there are 18.25 20-day periods per year
(365/20=18.25), the approximate annual
interest rate CHP will incur to pay its bill
20 days late is 2.04% 18.25 = 37.2%!!
Exhibit 5–6 Two Approaches to Conceptualize the Cost Associated with Not Taking a Discount
Depending upon a health care organization’s credit terms for its trade payables, it is usually in the best interest
of an organization to pay early and take the discount.
To determine the approximate interest rate the health care organization would pay
to keep $980 for an extra 20 days, use the formula in Exhibit 5–7.
The calculation shows that the approximate annual interest rate is 37.2 percent.
Thus, by not taking the discount within 10 days and waiting to pay until day 30, the
health care organization is paying the equivalent of 37.2 percent on an annual basis to
borrow $980. Thus, if the organization has the $980, it should take the discount unless
it can earn this much by investing the $980 elsewhere, or it should borrow the $980
on a short-term basis if it can do so at a rate less than 37.2 percent. Incidentally, the
higher the discount being offered, the higher the approximate interest rate for not taking
(or losing) the discount.
Exhibit 5–8 shows that the approximate interest rate decreases the longer the
period of time after the discount date increases until the bill is paid. Therefore, a prudent
approach is to pay as late as possible within the discount period or, if the discount isn’t
taken, to pay at the end of the “net” period. Although it is true that the effective interest
costs seem to decrease as the number of days the bill is not paid increases, at a certain
point after the “net” period, new costs are encountered. These costs include late
fees, loss of discounts in the future, loss of priority status with the supplier, etc.
Incidentally, in regard to the above example, organizations which do weekly processing
may find it virtually impossible to take advantage of a contract with terms such
as “2/10 net 30.” In such cases, an organization may try to negotiate terms such as
“2/15 net 35” in order to give itself enough time to process the invoice and still meet
the early payment deadline.
164 Financial Management of Health Care Organizations
365
0.02
1 − 0.020
365
30 − 10
=
Approximate Interest Rate =
Discount %
1 − Discount % # days until full payment is
due − last day for discount
1. Assume: $1,000 invoice is received for the purchase of medical supplies
with terms 2/10 net 30.
2. To calculate the approximate interest rate, the following formula is used:
= 0.0204 = 2.04%
This is the interest rate for one 20-day
period. The rate is somewhat higher than
2%, because $20 is being paid to borrow
$980, not $1,000.
18.25
This calculation is used to annualize the rate.
In this case, there are 18.25 periods during the
year. That is, if the facility kept paying 2.04%
to borrow for 20 days at a time all year long,
the process would be done 18.25 times.
Thus, to determine the approximate interest rate for one year, the interest rate for
one period is multiplied by the number of periods in a year.
3. Approximate Interest Rate = 0.0204 18.25 = 0.372 = 37.2%
Exhibit 5–7 Calculating the Approximate Interest Rate Associated with Not Taking a Discount
Approximate Interest
Rate: The annual
interest rate incurred
by not taking
advantage of a
supplier’s discount
offer to pay bills early.
The formula in this
chapter gives an
approximate annual
interest rate. A more
precise method of
calculation can be
found in more
advanced texts.
Billing, Collections, and Disbursement Policies, and the Concept of
Float
In addition to bank loans and trade credit, billing, collections, and disbursement
policies and procedures are also tools used to increase the amount of cash available to
the organization. The objective of billing, credit, and collection policies is to
accelerate cash receipts, while the objective of cash disbursement policies is to slow
down cash outflows. The concept of float is one of the most useful concepts to
implement good collections and disbursement policies. Float is the time delay during
the process that starts from the assembling of a bill and ends with the deposit of the
payment in the bank and subsequent payments to creditors. There are four main
categories of float: billing, collection, transit, and disbursement (see Exhibit 5–9).
Billing Float
Billing float is any delay in getting the bill to the patient or third party payor (such
as an insurance company). There are two aspects of billing float: assembling the bill
Working Capital Management 165
0%
50%
100%
150%
200%
250%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Approximate Annual Interest Rate
Note: The approximate interest rate increases dramatically
as the discount percent increases, holding the number
of days in the discount period constant.
Note: The approximate interest rate decreases dramatically
as the number of days between the last day for discount
and the day the bill is paid increases.
Number of Days Between the End
of the Discount Period and Payment
Interest Rates Associated with Selected Number
of Days Between the End of the
Discount Period and
Payment
0%
10%
20%
30%
40%
50%
60%
70%
80%
10
20
30
40
50
60
70
80
90
Approximate Interest Rate
Approximate Annual Interest Rates
Associated with Selected Discounts for
Payment within 10 Days
Percent Discount
Exhibit 5–8 Illustration of How Not Taking a Discount at Various Discount Rates and Extending Payments Affects
the Approximate Interest Rate Paid
Patient
receives
service
Bill
compiled &
delivered
Payment
sent
Payment
received
Payment
processed
Payment
deposited
Funds
available
for use
Funds
distributed
BILLING COLLECTION
MAIL PROCESSING
TRANSIT DISBURSEMENT
Exhibit 5–9 Types of Float
Float: The time delay
of the process of
assembling a bill until
depositing the
payment in the bank
and making
subsequent payments
to creditors.
and delivering the bill to the patient or his third-party payor. Ideally, a bill is made up
concurrently with service delivery, so that by discharge, or even at any point during
the service delivery process, the patient’s bill reflects all services received. However,
assembling the final bill is a problem for many health care organizations, which for
some can take weeks. Although delivering the bill may seem straightforward, a
number of problems can delay the billing process:
Medical records compliance issues and lack of trained coders.
Patients who use more than one name.
Name changes.
Address changes.
Lack of clarity as to who is responsible to pay the bill.
Specific requirements demanded by various third-party payors, such as
retrospective review.
In recent years, a number of techniques have been developed to help overcome
billing-related problems, including:
Improved Billing Policies and Procedures. An essential component of an
effective billing process is having up-to-date, well utilized billing policies and
procedures. The objective is to ensure that policies and procedures are in
place that will result in fair, timely, and accurate bills. Thus, billing policies
and procedures define the goals, roles and responsibilities, and appropriate
procedures to be used at various stages in the billing process (see Perspectives
5–2 and 5–3).
Improved Preadmissions and Admissions Screening. In preadmission
screening, information is gathered and verified before the patient enters the
providing organization. Preadmissions and admission screenings are
important because they help the health care organization determine a
patient’s ability to pay, including the verification of name, address,
employment status, and insurance coverage. Also in this process, the health
care organization can make financial arrangements for patients who are
unable to pay. It is important to note that under capitated payment systems,
much of the effort in this regard takes place at the time of enrollment and
assignment.
Management Information Systems. The health care provider’s
management information system is a key to gathering, compiling, analyzing,
and disseminating information concerning patient accounts. A key problem
facing many health care providers is difficulty assembling information about
a single patient from throughout the system. Ideally, the information system
should allow easy interface among admissions, patient accounts, and medical
records in a process that gathers and submits charge data in an accurate and
timely manner. The primary objective among these systems is the accurate
and timely transfer of data and information.
Internal Claims Processing. The purpose of internal claims processing is
to avoid the denial of claims. This involves the proper conduct of utilization
166 Financial Management of Health Care Organizations
Billing Float: Delay
getting a bill to the
patient or third-party
payor (such as an
insurance company).
This includes the time
to assemble the bill inhouse,
as well as the
time to send the bill to
the correct person or
place.
review: preadmission certification and second opinions, verification of patient
insurance, appropriate record keeping and patient classification, etc. An
important area to address is improper medical records coding, which can
result in delays and lost funds. For instance, failure of the medical staff to
Working Capital Management 167
Perspective 5–2
Getting One’s Due: The Latest Techniques in Collecting Receivables
Receivable collection is the critical element behind the financial viability of any health care organization. Monica
Lambert, who owns Netgain Medical Consulting in Fort Myers, Fla., advocates “revenue enhancement.” To stop the
bleeding in the health care payment process, you have to look where it starts, Lambert says.
And where revenue collection starts is at the registration and scheduling desk. But at most facilities, she notes,
this function is treated as the least important. The desk is usually staffed by the most recent hires or by part-time
staff, who are often the lowest paid.Yet these are the people who are responsible for collecting insurance information,
entering correct information on service dates, and usually collecting any co-pays as well. The cost to fix any
problem when the patient is not at the point of service is tremendous, Lambert points out. One of her first projects
when called in as a consultant is to convince management of the importance of having skilled and motivated
registration staff.This is accomplished by changing the job description, increasing the pay scale, and staffing the positions
with competent personnel.This alone cuts errors by 80% to 85% in a matter of months, she contends, and can
increase the revenue stream by 10% to 15%.
The accounts receivable department of a health care facility should be able to concentrate on collecting money
from patients who do not want to pay their bills, Lambert explains, not to deal with those whose insurance claims
were not filed or are being delayed because of errors in the first instance.These days, she says, many medical facilities
are writing off 35% to 40% of what they are billing. Much of this is due to faulty claims filing, which needs to be
identified and corrected rather than charged as an insurance discount.
Source: David Feldheim, Bond Buyer 2000, September 26, 2000.
Copyright © 2000 Thomson Financial Media.All Rights Reserved.
Perspective 5–3
Billing Scam Hits Hospitals
In their daily operations, hospitals sometime view more than a thousand invoices. However, sometimes these bills
are bogus. In the case of Bucyrus Community Hospital, an accounts payable coordinator found a heating repair bill
for $3,907. The employee noted, “There was something funny about it.” Further investigation on the part of the
employee found the invoice to be phony.The employee was able to uncover a scam, whereby a bogus company had
sent identical bills to dozens of Ohio hospitals as well as to medical centers in at least nine other states.The hospital
notified the Ohio Hospital Association, which alerted the American Hospital Association.They found that this
fake invoice was reported by hospitals in several Midwest States.The payables department was also able to find a
bogus invoice from a local supply company that indicated that the hospital was past due on a payment of $82.70,
but no such company existed.
Source: Mark D. Somerson and Mary Beth Lane, “Billing Scam Hits Hospitals.” The Columbus Dispatch, October 28,
2000, p. 1B.
assign final diagnosis to the chart as well as to sign the chart can delay the
timeliness of the payment. Similarly, miscoding the diagnosis can also impact
the funds the organization receives. The health care provider by-laws should
state the responsibility of physicians to fulfill these obligations.
Electronic Billing. Electronic billing is a process whereby bills are sent
electronically to third parties through electronic data interfacing (EDI). This
not only accelerates the transmission of bills, but also provides an editing
function that reduces the number of processing errors and subsequent audits,
ultimately decreasing turnaround time.
Of course, the best way to avoid having money owed to a health care organization
is to be paid ahead of time or at the point of service. This approach is taken by many
physicians’ offices, and it is a primary component of many capitation agreements that
pay providers a per member per month (PMPM) fee in advance.
Collection Float
Collection float is the time between the issuance of the bill and the time funds
are available for use by the health care organization. It has two components: mail
float and processing float. Mail float refers to the time from when the patient or
third-party payor sends in the payment to the time the health care provider
receives the payment. Note that mail float begins after the patient or the third party
has sent the bill. Improved clarity of who, where, by when and to whom to send
payments helps to ensure timely delivery of payments. Processing float is the
time it takes the facility to process the payment once received and to deposit it in
the bank. Incidentally, there is another aspect to processing float: the time it takes
the bank to process the transaction. Thus, processing float spans both collection
float and transit float.
Of course, in cases where patients or their third parties do not pay in full or in a
timely manner, collections policies and procedures should identify the steps in the
process to follow up, including which accounts will be sent to collections agencies and
when accounts will be written off as bad debt. For example, some facilities send out
follow-up letters 40 days after discharge, make follow-up phone calls 60 days after discharge,
employ a collection agency 150 days after discharge, and write off accounts
180 days after discharge.
168 Financial Management of Health Care Organizations
Collection Float: The
time between when a
bill is paid and the
time the payment is
deposited.
To achieve timely collection of billing, health care providers need to examine the areas of preadmission, billing,
claims processing, management information systems, and follow-up.
The government typically requires that fiscal intermediaries, the insurance companies that process Medicare
claims for the government, pay “clean” Medicare claims within 27 days of their receipt. Clean claims are those
that require no further response or modification by the provider.
Transit Float
Transit float is the time involved to clear the check through the provider’s bank until
the funds are available to the provider. Techniques developed to reduce collection and
transit float include:
Decentralized collection centers and concentration banking.
Lockboxes.
Wire transfers.
Decentralized Collection Centers and Concentration Banking
Decentralized collection centers and concentration banking allow the health
care provider to establish collection centers so that payors send their payment to a
location near them (thus reducing mail float). These collection centers deposit the
payments they have received in the provider’s local bank. Finally, the funds are transferred
to a concentration bank where the health care provider can draw on the cash for
payments. This procedure is designed to help a health care provider reduce its mail
and processing float, but there is a tradeoff between the number of collection centers
and the savings they provide and the costs incurred to maintain accounts at a number
of different financial institutions.
Lockboxes
Under the lockbox form of collection, a payor sends payments to a post office box
located near a Federal Reserve Bank or branch. The bank picks up the payments from
the box, and at various times during the day deposits these funds into the health care
provider’s account, processes the checks, and sends the facility a list of the payors and
payments. Having the bank perform these duties enables the facility to reduce its mail
and processing time. The decision to invest in the lockbox approach depends upon
whether the interest earned from the acceleration of funds exceeds the cost of having
a lockbox. Lockboxes usually have a fixed fee and a variable rate based on a per check
basis. To offset the costs to establish a lockbox, an organization may be able to save
money by freeing up internal staff who perform some of the functions that the bank
would be taking over.
Wire Transfers
Wire transfers eliminate mail and transit float. They are generally operated two
ways: 1) third parties electronically deposit payments in the health care organization’s
bank; and 2) banks of multi-provider systems electronically transfer cash from their
Working Capital Management 169
Transit Float: The time
between when a
payment is deposited
until the funds are
accessible for use.
Lockbox: A post office
box located near a
Federal Reserve Bank
or branch, from which
the bank will pick up
and process checks
quickly, but for a fee.
Decentralized Collection Center, Concentration Banking, Lockboxes, and Wire Transfers are methods to reduce
collection and transit float.
local branches to the corporate headquarters’ bank account, where all payments are
made from. This minimizes the “excess cash” kept at subsidiaries and maximizes the
amount at headquarters, which is responsible to invest all cash. However, this
approach is often quite expensive, as banks often charge $2 to $4 per transfer.
However, one large, central bank account may draw a better overall return than would
several smaller accounts, and there is an increased likelihood that the central account
would have adequate working capital funds available to meet all current expenses,
with reduced likelihood of needing to borrow. Related techniques are zero-balance
accounts and sweep accounts, whereby the bank automatically removes any excess
cash from subsidiaries and places it in the account of the parent corporation.
Disbursement Float
Unlike the other types of float that are oriented toward reducing the time it takes
to get money into the organization, disbursement float focuses on how long the
organization can keep its money before it pays its bills. The options available to
control cash going out of the organization are managing trade payables (also called
trade credit or accounts payable) and remote disbursement (see Perspective 5–4).
Trade payables refers to short-term debt that results from supplies purchased on
credit for a given length of time. This allows an organization to use the supplier’s
money to pay for the purchase up until the time it pays the supplier the amount
owed. Remote disbursement involves the use of a bank situated far from the
health care provider’s vendors or suppliers. By writing checks against this account,
the health care provider increases its transit float or check-clearing process through
the Federal Reserve System. Thus, the facility may earn an additional day in the
use of its funds. For example, a facility located in a metropolitan area in the South
may use a local bank for vendors located in the Midwest, but might use a bank in
another part of the country to pay local vendors. However, in doing so, a facility
may want to consider the importance of maintaining good relations with its
vendors, because the vendors are playing the same game and want to receive their
payments as quickly as possible.
Investing Cash on a Short-term Basis
After an organization has gone through the effort to reduce disbursement float, it
wants to ensure that the money that has not yet been disbursed is invested appropriately
to generate a favorable return. Myriad short-term investment instruments exist,
including treasury bills, certificates of deposit, commercial paper, and money market
mutual funds. Some of the key attributes of these short-term investments are summarized
in Exhibit 5–10.
170 Financial Management of Health Care Organizations
Remote
Disbursement: The
use of a bank situated
far from the health
care provider’s vendors
or suppliers to increase
float.
Disbursement Float:
The amount of time
between when funds
are available for
disbursement and
when they are actually
released.
Disbursement Float is the opposite of Collection Float. Disbursement Float focuses on how long an organization
keeps its cash before it pays its bills.
Working Capital Management 171
Investment Denominations Term Where Purchased Comments
T-bills $10,000; $15,000; $50,000; Usually 13/26/52 weeks Banks; Government 1
$100,000; $500,000;
$1,000,000
CDs Large: $100,000 to $1,000,000 + Usually 2 weeks to Banks 2
Small: $500 to $10,000 18 months
Commercial $100,000 or more 1–270 days Broker, Dealer, or
Paper Corporation 3
Money Market Varies; may be <$1,000 Varies (can be bought Mutual Fund, Broker,
Mutual Funds and sold on the or Bank4
market)
1 Most liquid and default free; purchased at a discount and redeemed at face value
2 Higher risk and higher yield than T-bills; smaller amounts have lower returns than larger amounts
3 Higher risk and higher yield than CDs
4 Highly liquid; higher risk and higher yield than commercial paper
Exhibit 5–10 Characteristics of Selected Short-term Investments
Perspective 5–4
Processing Claims via the Internet
Seven large managed-care companies:Aetna Inc.;Anthem Inc.; Cigna Corp.; Health Net Inc.; Oxford Health Plans Inc.;
PacifiCare Health Systems Inc.; and WellPoint Health Networks Inc. have implemented plans for an Internet-based
system to accelerate the processing of health-care transactions.The health plans have come together to fund a closely
held company called “MedUnite Inc.,” based in San Diego, to create an interactive network to execute transactions,
such as payment claims, patient referrals, and eligibility checks that are now handled mostly on paper or via
private electronic networks.The health plans expect electronic transactions will reduce the costs, inefficiencies, and
ill feeling that develop from the current paper-claims system.
MedUnite will concentrate on transactions, for example, by enabling the thousands of doctors who employ
Medical Manager practice-management software, now owned by WebMD, to link to MedUnite’s network. Presently,
the majority of doctors hire staff to perform the often time-consuming transactions – such as submitting claims for
payment, checking a patient’s eligibility for treatment, and requesting authorization to refer a patient to another doctor
– by paper or telephone, or via private electronic networks that don’t use the Internet. Developing an interactive,
Internet-based system can lower costs and speed handling, enabling doctors to receive payment faster, according
to Mr Cox.
Another reason to create the electronic system is the federal Health Insurance Portability and Accountability Act,
known as HIPAA, which requires the health-care industry to develop a standard format for electronic transactions
in the next few years. Plans call for doctors’ offices to pay a flat monthly subscription fee for unlimited transactions,
and for health plans to pay fees on a per-transaction basis. Some critics are unconvinced that health plans truly want
to accelerate payment of claims to doctors, since plans typically invest premiums that are paid to them up-front and
earn interest on that money, known as the “float.” But the company indicates that the savings available by eliminating
errors in claims submissions – so they don’t have to be resubmitted – far outweigh any benefit that the health
plans get by sitting on their money.
Source: Ann Carrns “Health Plans Create a Rival for WebMD.” Wall Street Journal, November 15, 2000, p. B8.
Copyright © 2000, Dow Jones & Company, Inc.
Treasury Bills (T-bills)
Treasury bills are financial instruments purchased for a short term. Normally, they
have maturities of 13, 26, or 52 weeks and are sold in units of $10,000, $15,000, $50,000,
$100,000, $500,000, and $1,000,000. Since they are issued by the government and are
part of an active secondary market to buy and sell these securities, they are considered
default-free and the most liquid short-term investment available. Instead of earning
interest directly, T-bills are purchased at a discount and redeemed at face value when
they mature. The discount represents the difference between the purchase price and the
face value at time of maturity. Typically, the face value is presented on a $100 maturity
value basis. If the discount price is $6.00, purchase price is $94.00.
Negotiable Certificates of Deposit (CDs)
CDs are issued by commercial banks as negotiable, interest-bearing, short-term certificates.
In other words, when the deposit matures, the investor receives the interest
earned plus the amount deposited. The maturities of CDs usually range from 14 days
to 18 months. Small-value CDs are normally issued in $500 to $10,000 denominations.
Large-value CDs are normally issued in $100,000 to $1,000,000 denominations.
Because of their size, large-value CDs earn a higher return than do small-value CDs.
“Negotiable” means the investor may sell the certificate to someone else before maturity.
Non-negotiable CDs are offered in smaller denominations. CDs are not as liquid
as T-bills and have a higher risk because they are issued by banks rather than the federal
government. Because of their risk and illiquidity, investors demand a higher yield
or return on CDs than they do on T-bills.
Commercial Paper
Commercial paper is a negotiable promissory note issued at a discount by large corporations
(usually publicly traded) that need to raise internal capital. This instrument
is issued for maturities of 1 to 270 days through a bank or a dealer that specializes in
selling short-term securities. Commercial paper is sold in denominations of $100,000
or more. Because of the possibility of default from a major corporation, this security
has a higher credit risk than do T-bills or CDs and, therefore, requires a higher yield.
Money Market Mutual Funds
These funds, which have a minimum investment of $1,000, represent a pooling of
investors’ funds for the purchase of a diversified portfolio of short-term financial
instruments, such as CDs, T-bills, and commercial paper. This pooling of funds
allows small investors, such as small health care facilities, to earn short-term money
172 Financial Management of Health Care Organizations
market rates on their investments. Furthermore, most money market funds offer an
investor a high degree of liquidity by allowing withdrawals by check, telephone, and
wire transfer.
Forecasting Cash Surpluses and Deficits – The Cash Budget
In order to minimize costs and plan ahead to finance deficits and invest excess cash, a
health care organization needs to clearly identify the timing of its cash inflows and
outflows. The main vehicle to project cash inflows and outflows is a cash budget.
Depending on the decision at hand, it may show inflows on a daily, weekly, monthly,
quarterly, semi-annual, annual, or multi-year basis. For instance, forecasts about
weekly inflows and outflows are not needed for long-range planning, but monthly
planning may require forecasting on a weekly or even daily basis. Much of the information
about preparing the cash budget comes from the operating and capital budgets
(see Chapter 10 on budgeting).
To illustrate cash inflows and outflows, a monthly cash budget for January through
March, 20X1 for Community Health Organization (CHO) is illustrated in Exhibit 5–11.
Cash Inflows
Cash inflow estimates are generally derived from patient revenues, other operating
revenues, proceeds from borrowing and/or stock issuances (for investor-owned
organizations), and non-operating contributions. To estimate cash receipts from
patient revenues for the month, CHO needs to estimate the amount of revenues and
when they will be received in cash. Assume CHO forecasts the following revenues for
20X1 based upon 20X0 data:
Actual Patient Revenues 20X0 Estimated Patient Revenues 20X1
October $400,000 January $500,000
November $500,000 February $600,000
December $300,000 March $700,000
From its historical records, CHO estimates that it will collect 50 percent of revenues
earned in the month of service, 40 percent the following month, and 10 percent
two months after service has been delivered. All other revenues, such as contributions,
appropriations, cash from sale of investments and used equipment, and interest
income, are expected to total $44,000, $55,000, and $52,000 in January, February, and
March, respectively.
Based on this information, CHO can calculate cash inflows. For instance,
February’s cash inflows of $585,000 are composed of 50 percent of February’s rev-
Working Capital Management 173
Some of the primary instruments for health care organizations to invest in on a short-term basis are: Treasury
Bills, Certificates of Deposit, Commercial Paper, and Money Market Funds.
174 Financial Management of Health Care Organizations
Givens:
1 Revenues:
Actual Patient Revenues, 20X0 Estimated Patient Revenues, 20X1
October $400,000 January $500,000
November $500,000 February $600,000
December $300,000 March $700,000
2 Funds are received as follows: 50% within the month of service, 40% one month after service, and 10% two
months after service.
3 “Other Revenues” includes interest earned and are forecasted to be $44,000 in January, $55,000 in February,
and $52,000 in March.
4 Cash outflows are forecasted to be $350,000, $450,000, $600,000, and $500,000 in January, February, March,
and April, respectively.
5 “Cash Outflows” are for the current month.
6 The ending cash balance for December was $50,000.
7 CHO desires a required cash balance of 40% of the following month’s forecasted cash outflows.
CHO Cash Budget For the Quarter Ending March 31, 20X1
Item Formula January February March Total
Cash Inflows
A From October [Givens 1,2] $0 $0 $0 $0
B From November [Givens 1,2] 50,000 0 0 50,000
C From December [Givens 1,2] 120,000 30,000 0 150,000
D From January [Givens 1,2] 250,000 200,000 50,000 500,000
E From February [Givens 1,2] 0 300,000 240,000 540,000
F From March [Givens 1,2] 0 0 350,000 350,000
G Other Revenues [Given 3] 44,000 55,000 52,000 151,000
H Net Cash Inflows [Sum A:G] 464,000 585,000 692,000 1,741,000
I Forecasted Cash Outflows [Givens 4,5] 350,000 450,000 600,000 1,400,000
J Monthly/Quarterly Net Cash Flow [H−I] 114,000 135,000 92,000 341,000
K Beginning Balance [1] 50,000 180,000 240,000 50,000
L Cash Before Borrowing or Investing [J+K] 164,000 315,000 332,000 391,000
M Required Cash Balance [2] 180,000 240,000 200,000 200,000
N Surplus (Deficit) [L−M] (16,000) 75,000 132,000 191,000
O Investment of Surplus in ST Investments [3] 0 (75,000) (132,000) (207,000)
P Short-term Borrowing [4] 16,000 0 0 16,000
Q Ending Cash Balance [M+N+O+P] $180,000 $240,000 $200,000 $200,000
1 January: [Given 6]; February/March: [Row Q], previous month.
2 [Given 7] × [Row I], next month.
3 [−Row N], but only if there is a surplus.
4 [−Row N], but only if there is a deficit.
Exhibit 5–11 A Cash Budget for Three Months, Beginning January 20X1
enue ($600,000 × 0.50 = $300,000), 40 percent of January’s revenue ($500,000 × 0.40
= $200,000), 10 percent of December’s revenue ($300,000 × 0.10 = $30,000), plus the
other revenues for February ($55,000) given above.
Cash Outflows
Cash outflows are estimated at $350,000, $450,000, $600,000, and $1,400,000 for
January, February, March, and Total, respectively (Exhibit 5–11, row I). These outflows
include such operating items as salaries and benefits, supplies, interest, capital
expenditure outflows for equipment and land, and debt payments.
Ending Cash Balance
By subtracting cash outflows from net cash inflows, CHO can derive its monthly net
cash flow. To this amount, it adds the beginning cash balance to calculate the cash
available before borrowing or investing. For instance, in January there were net cash
inflows of $464,000 and cash outflows of $350,000 that resulted in a $114,000 net cash
inflow for the month (row J). When this is added to the $50,000 available at the beginning
of the month (row K), CHO had $164,000 in cash before borrowing or investing
(row L).
Though this number represents how much cash is available at the end of the month
as a result of the normal cash flows during the month plus the beginning balance,
many health care organizations are required to end a month (actually, begin the next
month) with a certain minimum balance, called a required cash balance. If they are
below this amount they must borrow money, and if they are above they invest the
excess. In the case of CHO, the required cash balance is 40 percent of the next
month’s forecasted cash outflows (row M, January and row I, February:
$180,000/$450,000 = 0.40).
To illustrate this process, CHO had $164,000 in January’s cash before borrowing or
investing (row L), but the required cash balance is $180,000 (0.40 × $450,000,
February’s cash outflows). Therefore, it must borrow $16,000 to make up the difference
(row P). This results in an ending cash balance of $180,000 (row Q). If there had been a
surplus, as in February (row N), CHO would have invested the excess funds (row O).
Accounts Receivable Management
Accounts receivable, most of which comes through third-party payors, constitutes
approximately 75 percent of a health care provider’s current assets. Having a large dollar
amount in accounts receivable means lost returns in other investment opportunities.
Because third-party payors are volume purchasers of health care services, health care
Working Capital Management 175
Required Cash
Balance: The amount
of cash an organization
must have on hand at
the end of the current
period to ensure that it
has enough cash to
cover the expected
outflows during the
next forecasting
period.
The cash budget is the major budgetary tool to forecast an organization’s cash surplus and deficits over a given
period of time.
providers are confronted with the problem of trying to externally control the timely
payment of accounts. In order to expedite collections, health care provider management
does hold some degree of control with respect to processing payments internally.
The earlier discussion introduced several ways to reduce float, including: preadmission
and admission screenings, computerized information systems, electronic billing, and
billing and collection policies and procedures. These methods also reduce receivables,
since bringing cash in more quickly reduces the amount outstanding.
Methods to Monitor Accounts Receivable
Since not all money is collected in advance, it is important that an organization
closely monitor its outstanding balances. The tracking of outstanding accounts is
often carried out through an analysis similar to that presented in Exhibit 5–12.
Net accounts receivable (row A) presents the total amount of receivables outstanding,
both in total and by month. Thus, at the end of the first quarter, there are $6.4
million in receivables outstanding, of which $3.6 million are aged 1–30 days (row B),
$2.0 million are aged 31–60 days, and $0.8 million are aged 61–90 days. For simplicity,
assume that each month has 30 days and that all accounts are written off as bad
debt after 90 days.
176 Financial Management of Health Care Organizations
Exhibit 5–12 Key Measures to Monitor Accounts Receivable
QUARTER 1 (in ’000)
Formula Month 1 Month 2 Month 3 Total
A Net Accounts Receivable [Given] $800 $2,000 $3,600 $6,400
B Days Old [Given] 61–90 31–60 1–30 1–90
C Aging Schedule [1] 12.5% 31.3% 56.3%
D Net Patient Revenues [Given] $4,000 $5,000 $6,000 $15,000
E Average Daily Patient Revenue [D/B] $133 $167 $200 $167
F Days in Accounts Receivable [A/E] 38.4
G Receivables as a Percentage of Revenue [A/D] 20% 40% 60%
1 [Row A] (month)/[Row A] (quarter).
QUARTER 2 (in ’000)
Formula Month 1 Month 2 Month 3 Total
H Net Accounts Receivable [Given] $200 $1,000 $6,900 $8,100
I Days Old [Given] 61–90 31–60 1–30 1–90
J Aging Schedule [2] 2.5% 12.3% 85.2%
K Net Patient Revenues [Given] $1,000 $2,500 $11,500 $15,000
L Average Daily Patient Revenue [K/I] $33 $83 $383 $167
M Days in Accounts Receivable [H/L] 48.6
N Receivables as a Percentage of Revenue [H/K] 20% 40% 60%
2 [Row H] (month)/[Row H] (quarter).
Using this information, it is possible to prepare an aging schedule, shown in row
C. Thus, at the end of the first quarter, of the $6.4 million in receivables outstanding,
56.3 percent were generated in the third and most recent month ($3.6/$6.4), 31.3 percent
in the second month ($2.0/$6.4) and 12.5 percent in the first month ($0.8/$6.4).
Row D in each quarter shows the revenues recorded during each of the three months
of the quarter and for the quarter as a whole. Row E is the average daily patient revenue
(monthly revenue/30 days).
The information combined from rows A, B, and D yields two new measures: days
in accounts receivable for the quarter (row F) and monthly receivables as a percentage
of revenue (row G). Days in accounts receivable is calculated by dividing the net
accounts receivable (row A) by the average daily patient revenue for the quarter (row
E). For the first quarter, the average daily net revenue was $15.0 million/90 days =
$166,667 per day, whereas the net accounts receivable is $6.4 million; therefore, the
days in accounts receivable (row F) at the end of the quarter is $6,400,000/$166,667
= 38.4 days. This same procedure can be applied to each month to show the number
of days of outstanding receivables attributable to each month (using the quarter’s
average daily net revenue as the denominator).
The final item, receivables as a percentage of revenue (row G), is computed by
dividing net accounts receivable (row A) for each 30-day period by its corresponding
net patient revenue (row D). For example, at the end of the first quarter, 60 percent
of the third month’s revenues ($3.6/$6.0), 40 percent of the second month’s revenues
($2.0/$5.0), and 20 percent of the first month’s revenues ($0.8/$4.0) are all receivables
outstanding (dollar figures expressed in millions). A similar analysis follows
throughout for Quarter 2 (rows H–N).
Receivables as a percentage of revenues is probably a better measure than days in
accounts receivable to judge management’s success in collecting revenues, though
many health care organizations continue to rely upon the latter as a key ratio to
measure performance. In the example, it may appear as if collections are worsening,
since days in accounts receivable rose from 38.4 days for the first quarter to 48.6
days for the second quarter. However, receivables as a percentage of revenue shows
that collections as a percentage of revenue for each 30-day period remain the same
for both quarters: 60 percent, 40 percent, and 20 percent. The reason for the discrepancy
is that during the first quarter, a higher percentage of revenues came in the
early months than did revenues in the second quarter, when most of the patient revenues
occurred in the last month of the quarter. Thus, the reason that the days in
accounts receivable went up is not because collection efforts have changed, but
rather because the timing of the revenues varied (total revenues are $15,000,000 in
each quarter). Because patient revenues are higher in the earlier months of the first
quarter, more revenues have been collected by the end of the quarter. In turn, this
outcome reduces the days in accounts receivable to 38.4 days as well as the percentage
of receivables outstanding.
Working Capital Management 177
Aging Schedule: A
table which shows the
percentage of
receivables outstanding
by the month they
were incurred.
A common mistake is to infer that because days in accounts receivable is decreasing, collections are improving.
This is not necessarily the case.
Methods to Finance Accounts Receivable
In addition to trying to improve its cash and receivables collections, an organization
has two other options to bring funds in to meet cash needs: selling its accounts receivable,
called “factoring,” and using receivables as collateral.
Factoring
Factoring is the selling of accounts receivable, usually to a bank, at a discount.
There are two main reasons why a health care organization would decide to factor
its accounts: 1) it needs the cash currently tied up in receivables before it can
collect that money from patients and third parties; and 2) it predicts that the
benefits of selling the receivables at a discount would outweigh the possible returns
it would receive by holding on to the accounts and trying to manage the collections
process.
Typical discounts involved in factoring transactions range from 5 to 10 percent.
In addition, the financing institution may impose a factoring fee equal to 15–20
percent of the value of the receivables. Under this arrangement, the financing institution
purchasing the receivables assumes the risk and control over the collection of
the receivables from the health care provider. The more risky the collection of the
accounts receivable, the higher the discount demanded by the bank and the higher
the fees.
It is important to recognize that when a health care organization resorts to selling
its receivables to acquire cash as quickly as possible (perhaps out of desperation),
another institution is then involved in the collections process. The potential ill will
which may be generated to collect these funds by this other organization which
purchased the receivables should receive serious consideration before factoring is
undertaken. Of note, it is illegal to factor Medicaid accounts receivable.
Pledging Receivables as Collateral
As noted earlier, health care organizations can negotiate a line of credit with a financial
institution in order to cover temporary cash shortfalls. In such instances, the
amount of receivables outstanding can be used as collateral. The cost of a line of credit
is typically one to two percentage points above the prime rate, unless an organization
has an excellent credit history, in which case it can negotiate for the prime rate or
even slightly below it.
178 Financial Management of Health Care Organizations
Collateral: A tangible
asset which is pledged
as a promise to repay a
loan. If the loan is not
paid, the lending
institution as legal
recourse may seize the
pledged asset.
Factoring: Selling
accounts receivable at
a discount, usually to a
financial institution.
The latter then
assumes the role of
trying to collect upon
the outstanding
payment obligations.
Factoring and using receivables as collateral are two ways to receive cash advances from outstanding accounts
receivable.
Laws and Regulation for Billing Compliance
Hospitals and other health care organizations must comply with a multitude of laws
and regulation restrictions that include areas such as patient billing, cost reporting,
physician transactions, and occupational health and safety. Given the rise in health
care fraud and abuse, Federal and State governments have a strong incentive to reduce
any abusive practices in the area of patient billing. Likely, the most stringent restrictions
are those passed down by the Centers for Medicare and Medicaid Services
(CMS – called the Health Care Financing Administration, or HCFA, prior to June 1,
2001) for the billing of Medicare patients. An example of a billing practice likely to be
considered fraud by Medicare is unbundling: where a hospital charges for multiple
laboratory tests, when in reality a single battery of tests was done. Another example of
Medicare fraud is when a health care provider submits claims for medical supplies
that were never provided to the patient.
To ensure compliance with laws and regulations, health care providers need to implement
and maintain an effective corporate compliance plan. The plan should ensure that
corporate policies, practices, and culture promote the understanding and adherence to
appropriate legal requirements. This means that health care providers must develop
effective programs to detect and prevent violations of the law, which includes “whistleblower”
protections and hot-lines. Listed below are questions that will help health care
providers to assess their billing compliance:
Is there consistency in charging patients the same dollar amount for the same
service, regardless of patient’s payor and where the service was rendered?
Are controls implemented to assure proper recording and billing of services?
Do the medical records document that services billed were provided and
record the results of the tests?
Is there a practice in place that ensures that adjustments to patient accounts (bad
debt, discounts, etc.) are allowed and performed only by designated and
responsible individuals?
Are overpayments received by Medicare and other federal government
programs refunded in a timely manner?
Are policies and procedures developed to collect copayments and deductibles
from patients?
Are the changes in billing codes completed in a timely manner?
Are charges listed and bundled properly?
HIPAA
One of the major compliance regulations that hospitals face is the Health Insurance
Portability and Accountability Act (HIPAA). HIPAA provides reform in several areas
ranging from portability of health insurance, preventing fraud and abuse, information
security, and administrative simplification. HIPAA regulations covering fraudulent
activities are enforced under codes of criminal conduct. For example, individuals who
Working Capital Management 179
Corporate
Compliance Officer:
The individual (or
department)
responsible for
knowing the corporate
compliance rules and
regulations, and for
ensuring that the
organization strictly
abides by them.
Corporate
Compliance:
Mandated legislation
and regulations
bestowed upon health
care institutions to
ensure fairness,
accuracy, honesty, and
quality in the provision
of and billing for
health care services.
knowingly defraud a health care benefit program by giving false statements or embezzling
money can face personal fines, imprisonment, or both. Additionally, organizations
must take important measures to ensure that patient-specific information is kept
confidential, especially in the electronic age, and organizations can be held accountable
if reasonably appropriate measures have not been put into place.
HIPAA also requires the adoption of industry standards for the electronic transmission
of health information. According to the Department of Health and Human Services
(DHHS), at the start of the new millennium there were about 400 formats for electronic
health care claims processing in use nationwide. As a result, health care providers and
health plans are unable to standardize their claims processing, which increases the
expense to develop and maintain software and reduces their overall efficiency and savings
in administrative transactions (see Perspective 5–5). Health care providers and
health plans will need to achieve this standardization in the following administrative and
financial health care transactions: health claims and equivalent encounter information,
enrollment and disenrollment in a health plan, eligibility for a health plan, health care
payment and remittance advice, health plan premium payments, health claim status,
referral certification and authorization, and coordination of benefits. By meeting the
HIPAA standards in the areas of content and format, health care providers and plans
could save over $3–5 billion annually. However, there is a significant investment cost
beforehand to become compliant.
To meet these standards, health care providers will need to do the following:
Train personnel on the standards.
Develop a management team that assesses the impact of these standards
across the organization.
Identify and select vendors that support complying software.
Budget for the information system costs to adhere to these standards.
180 Financial Management of Health Care Organizations
Perspective 5–5
Report Predicts Huge HIPAA Price Tag
A rating analyst from the Fitch rating agency expects that healthcare providers will incur four times the costs of
what they incurred on Y2K in following the HIPAA regulations.The rating analyst estimates that healthcare providers
will spend about $25 billion nationwide, in contrast to the $8.2 billion cost of Y2K.As the analyst noted:“HIPAA is
going to be all that, plus it will require ongoing monitoring, which will elevate costs. . . . Plus there will be changes in
process, in security, in privacy, and in the culture of privacy within hospitals and healthcare.”
Conversely, another analyst from a consulting firm that’s monitoring HIPAA’s effects on providers provides a lower
estimation.This analyst predicts that “HIPAA will cost providers a little more than Y2K did, likely from $10 billion to $15
billion.” The analyst also found from a recent survey that 20% of integrated delivery systems had done preliminary
research on what HIPAA would cost them and found an estimated average compliance cost of $5 million per system.
Source: Barbara Kirchheimer,“Report Predicts Huge HIPAA Price Tag.” Modern Healthcare, October 2, 2000, p. 48.
HIPAA: Health
Insurance Portability
and Accountability Act.
A public law designed
to improve efficiency in
health care delivery by
standardizing
electronic data
interchange, and
protecting the
confidentiality and
security of health data
through setting and
enforcing standards.
Health care providers face the obstacles of state variation in billing codes for government
programs, health plans, and other commercial insurers, as well as local variation
in clinical codes.
Summary
Working capital refers to the current assets and current liabilities of a health care
organization. Working capital is important because it turns the capacity of an organization
(its long-term assets) into services and revenues. All health care organizations
must ensure that it has sufficient working capital available at appropriate times to
meet its day-to-day needs.
The management of working capital involves managing the working capital cycle:
1) obtaining cash; 2) purchasing resources and paying bills; 3) delivering services; and
4) billing and collecting for services rendered. There are two components to a working
capital management strategy: determining asset mix and financing mix. Asset mix is the
amount of working capital the organization keeps on hand relative to its potential working
capital obligations. Financing mix is how the organization chooses to finance its
working capital needs. To determine its level of working capital, a health care facility
must evaluate the risk/return tradeoff between over-investment or under-investment in
working capital. A conservative approach with a higher investment in working capital
increases an organization’s liquidity, but does so at the expense of lower returns. An
aggressive approach with less investment in working capital decreases liquidity but frees
funds to invest in higher returning fixed assets. The decision to select either option or
some comfortable medium depends upon the health care provider’s environment and
financial condition.
A major component of current assets is cash and cash equivalents. There are three
reasons to hold cash: daily operations, precautionary reasons, and speculative
purposes. The sources of temporary cash are bank loans, trade credit and billing,
collections, and disbursement policies and procedures. Types of bank loans include
normal and revolving lines of credit and transaction notes. Lines of credit are usually
pre-established and allow a health care organization to borrow money in a reasonably
expeditious manner. Transaction notes are short-term, unsecured loans made for
specific purposes, such as the purchase of supplies. Both of these borrowing methods
may involve either a commitment fee or compensating balance.
A second important source of temporary cash is trade credit, which does not actually
bring in cash, but instead slows its outflow. Although not commonly thought of
in this way, it is a loan by a vendor to the health care organization, and vendors often
provide discounts for early payment. It is normally beneficial for a health care
organization to take the discount. To determine the approximate interest rate, the following
formula is used:
Approximate Interest Rate = Discount%/(1 − Discount%) × (365/Net Period)
Another formula is the effective interest rate:
Working Capital Management 181
Because the approximate interest rate declines the longer the payment is delayed, a
prudent policy is to make the payment as close to the last day of the discount period
as is operationally feasible or, if the discount is not taken, on the last day of the “net”
period. Although interest costs decrease as the number of days increases after the last
day for the discount in which the bill is not paid, at a certain point new costs are
encountered. These costs include late fees, loss of discounts in the future, loss of
priority status with this supplier, etc.
A third source of temporary cash is good billing, collections, and disbursement
policies and procedures, all of which decrease the amount of float (time delays) existing
in the working capital cycle. The principal types of float are: billing, collection,
transit, and disbursement. Billing float is the delay in getting a bill to the patient or
the third-party payor. Techniques to reduce billing float include preadmissions and
admissions screening, accurate claims processing, utilization review, and effective
billing policies and procedures.
There are several well used techniques to reduce collection float (the time between
the issuance of a bill and the time the monies are available for use) and transit float
(the time it takes for a check to clear the banking system). These techniques include
using decentralized collection centers, lockboxes, and electronic deposit of funds. The
tools to reduce disbursement float include taking suppliers’ discounts and using
remote disbursement accounts.
A major function of cash management is to ensure that any excess cash is earning a
reasonable return at an acceptable level of risk. There are four primary vehicles for
short-term investment of cash: treasury bills, certificates of deposit, commercial
paper, and money market mutual funds. These financial vehicles may differ on
degrees of risk, return, and initial outlay.
A well managed cash strategy is based on accurate forecasting of cash flow. The
principal tool for this is the cash budget. A cash budget should forecast not only cash
inflows and outflows, but also when excess cash will become available or when cash
deficiencies that necessitate borrowing will occur.
In addition to managing cash, good working capital management involves managing
accounts receivable. Most of the methods used to decrease accounts receivable are
the same methods discussed under ways to speed up the inflows of cash. Managing
receivables is based on good record keeping and periodic review. There are three main
tools used to monitor receivables: creating an aging schedule, monitoring days in
accounts receivable, and monitoring receivables as a percentage of revenues. Though
days in accounts receivable is probably the most used ratio to monitor receivables, it
may be overly sensitive to the timing of revenues. Therefore, receivables as a
percentage of revenues is used to overcome this problem. Organizations can also do
much for their bottom line simply by keeping a well trained staff, implementing good
information systems, and maintaining good relations with payors. Finally, health care
organizations need to develop a compliance program to ensure that their payroll,
billing, and other financial transactions comply with governmental regulations.
182 Financial Management of Health Care Organizations
(Interest Expense on Amount Borrowed + Total Fees)
(Amount Borrowed − Compensating Balance)
Effective Interest Rate =
Key Equations
Approximate Interest Rate = Discount%/(1 − Discount%) × (365/Net Period)
Effective Interest Rate = (Interest Expense on Amount Borrowed + Total Fees)/
(Amount Borrowed − Compensating Balance)
Questions and Problems
1. Definitions. Define the following terms:
a. Aging Schedule.
b. Approximate Interest Rate.
c. Asset Mix.
d. Billing Float.
e. Collateral.
f. Collection Float.
g. Commitment Fee.
h. Compensating Balance.
i. Corporate Compliance.
j. Corporate Compliance Officer.
k. Disbursement Float.
l. Effective Interest Rate.
m. Factoring.
n. Financing Mix.
o. Float.
p. HIPAA.
q. Liquidity.
r. Lockbox.
s. Net Working Capital.
t. Normal Line of Credit.
Working Capital Management 183
Aging Schedule
Approximate Interest Rate
Asset Mix
Billing Float
Collateral
Collection Float
Commitment Fee
Compensating Balance
Corporate Compliance
Corporate Compliance Officer
Disbursement Float
Effective Interest Rate
Factoring
Financing Mix
Float
HIPAA
Liquidity
Lockbox
Net Working Capital
Normal Line of Credit
Required Cash Balance
Revolving Line of Credit
Trade Credit
Trade Payables
Transaction Note
Transit Float
Working Capital
Working Capital Strategy
Key Terms
u. Required Cash Balance.
v. Revolving Line of Credit.
w. Trade Credit.
x. Trade Payables.
y. Transaction Note.
z. Transit Float.
aa. Working Capital.
bb. Working Capital Strategy.
2. Working Capital. What is the function of working capital?
3. Working Capital Cycle. In terms of cash flow, what are the stages of the
working capital cycle?
4. Working Capital Management Strategy. Describe the two components
of a working capital management strategy.
5. Asset Mix Strategies. Compare aggressive and conservative asset mix
strategies. The comparison should address goals, liquidity, and risk.
6. Borrowing. What is the difference between temporary and permanent
working capital needs? What is the general rule about when to borrow longterm
or short-term?
7. Borrowing. In terms of risk and return (profit), compare the advantages and
disadvantages of short- and long-term borrowing to meet working capital needs.
8. Cash. State the three reasons why a health care facility holds cash.
9. Cash. What are the main sources of temporary cash?
10. Loans. What is an unsecured loan?
11. Loans. What are the two types of unsecured bank loans? Describe each.
12. Compensating Balance. Describe how compensating balances impact the
“true” rate the borrower pays.
13. Discounts. What does “1.5/15 net 25” mean?
14. Discounts. What is the formula to determine the approximate annual
interest cost for not taking a discount? When should discounts be taken?
15. Collections. What are the objectives of billing, credit, and collections policies?
16. Float. What is the purpose of cash disbursement policies?
17. Float. Define float. What are the major types of float?
18. Float. What is a hospital’s objective regarding collection and disbursement float?
19. Billings. In the hospital’s billing process, why is medical records a critical
department?
20. Float. Describe the remote disbursement technique of disbursement float.
21. Lockboxes. Describe the lockbox technique of collection float.
22. Float. What is the purpose of preadmissions screening?
23. Investments. Identify the alternatives for investing cash on a short-term
basis, and discuss the general characteristics of each.
24. Accounts Receivable. List three ways to measure accounts receivable
performance.
25. Accounts Receivable. Two methods to monitor accounts receivable are as a
percentage of net patient revenues, and as days in accounts receivable. What
factor can cause the former to be a better measure than the latter with regard
to collections activities?
184 Financial Management of Health Care Organizations
26. Accounts Receivable. Identify and define two methods to finance accounts
receivable.
27. Trade Credit Discount. Compute the annual approximate interest cost of
not taking a discount using the following scenarios. What conclusion can be
drawn from the calculations?
a. 1/10 net 20
b. 1/10 net 30
c. 1/10 net 40
d. 1/10 net 50
e. 1/10 net 60
28. Trade Credit Discount. Compute the annual approximate interest cost of
not taking a discount using the following scenarios. What conclusion can be
drawn from the calculations?
a. 2/10 net 20
b. 2/10 net 30
c. 2/10 net 40
d. 2/10 net 50
e. 2/10 net 60
29. Trade Credit Discount. Compute the annual approximate interest cost of
not taking a discount using the following scenarios. What conclusion can be
drawn from the calculations?
a. 1/10 net 30
b. 1/15 net 30
c. 1/20 net 30
d. 1/25 net 30
30. Trade Credit Discount. Compute the annual approximate interest cost of
not taking a discount using the following scenarios. What conclusion can be
drawn from the calculations?
a. 2/10 net 30
b. 2/15 net 30
c. 2/20 net 30
d. 2/25 net 30
31. Trade Credit Discount. Compute the annual approximate interest cost of
not taking a discount using the following scenarios. What conclusion can be
drawn from the calculations?
a. 1/5 net 30
b. 2/5 net 30
c. 3/5 net 30
d. 4/5 net 30
32. Trade Credit Discount. Compute the annual interest cost of not taking a
discount using the following scenarios. What conclusion can be drawn from
the calculations?
a. 1/10 net 30
b. 2/10 net 30
c. 3/10 net 30
d. 4/10 net 30
Working Capital Management 185
33. Accounts Receivable Management. Given the information below,
compute the days in accounts receivable, aging schedule, and accounts
receivable as a percentage of net patient revenues for Quarter 1 and Quarter
2, 20X1. Compare the two quarters to determine if the organization’s
collection procedure is improving.
Quarter 1, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $2,500 $200 $500 $1,800
Net Patient Revenue $7,500 $500 $2,500 $4,500
Quarter 2, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $2,500 $800 $500 $1,200
Net Patient Revenue $7,500 $2,000 $2,500 $3,000
34. Accounts Receivable Management. Given the information below,
compute the days in accounts receivable, aging schedule, and accounts
receivable as a percentage of net patient revenues for Quarter 1 and Quarter
2, 20X1. Compare the two quarters to determine if the organization’s
collection procedure is improving.
Quarter 1, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $5,000 $1,500 $500 $3,000
Net Patient Revenue $15,000 $3,000 $2,500 $9,500
Quarter 2, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $5,000 $3,000 $500 $1,500
Net Patient Revenue $15,000 $9,500 $2,500 $3,000
35. Accounts Receivable Management. Given the information below,
compute the days in accounts receivable, aging schedule, and accounts
receivable as a percentage of net patient revenues for Quarter 1 and Quarter
2, 20X1. Compare the two quarters to determine if the organization’s
collection procedure is improving.
Quarter 1, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $2,500 $200 $500 $1,800
Net Patient Revenue $7,500 $500 $2,500 $4,500
Quarter 2, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $2,500 $1,800 $500 $200
Net Patient Revenue $7,500 $2,000 $2,500 $3,000
186 Financial Management of Health Care Organizations
36. Accounts Receivable Management. Given the information below,
compute the days in accounts receivable, aging schedule, and accounts
receivable as a percentage of net patient revenues for Quarter 1 and Quarter
2, 20X1. Compare the two quarters to determine if the organization’s
collection procedure is improving.
Quarter 1, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $9,990 $799 $1,998 $7,193
Net Patient Revenue $30,000 $2,000 $10,000 $18,000
Quarter 2, 20X1 (in ’000)
Days Outstanding Total 1–30 31–60 61–90
Net Accounts Receivable $9,990 $7,193 $1,998 $799
Net Patient Revenue $30,000 $8,000 $10,000 $12,000
37. Compensating Balance. On January 2, 20X1, City Hospital established a
line of credit with First Union National Bank. The terms of the line of credit
called for a $200,000 maximum loan with an interest of 11 percent. The compensating
balance requirement is 15 percent of the total line of credit (with
no additional fees charged).
a. What is the effective interest rate for City Hospital if 50 percent of the total
amount were used during the year?
b. What is the effective interest rate if only 25 percent of the total loan
were used during the year?
c. How would the answer to part a change if the additional fees were $500?
d. How would the answer to part b change if the additional fees were $1,000?
38. Compensating Balance. Lawrence Hospital wishes to establish a line of credit
with a bank. The first bank’s terms call for a $300,000 maximum loan with an
interest rate of 11 percent and a $1,000 fee. The second bank for the same line of
credit charges an interest rate of 12 percent, but no fee. The compensating balance
requirement is 15 percent of the total line of credit for either bank.
a. What is the effective interest rate for Lawrence Hospital from the first
bank if 50 percent of the total amount were used during the year?
b. What is the effective interest rate for Lawrence Hospital from the first
bank if 25 percent of the total amount were used during the year?
c. What is the effective interest rate for Lawrence Hospital from the second
bank if 50 percent of the total amount were used during the year?
d. What is the effective interest rate for Lawrence Hospital from the second
bank if 25 percent of the total amount were used during the year?
Which bank would be the better choice for Lawrence Hospital?
39. Cash Budget. Jay Zeeman Clinic provided the following financial information
in Exhibit 5–13. Prepare a cash budget for the quarter ending March, 20X1.
40. Cash Budget. Iowa Diagnostic Center provided the following financial information
in Exhibit 5–14. Prepare a cash budget for the quarter ending March, 20X1.
41. Cash Budget. Stacie Zeeman Clinic provided the following financial information
in Exhibit 5–15. Prepare a cash budget for the quarter ending March, 20X1.
Working Capital Management 187
188 Financial Management of Health Care Organizations
Revenues/Expenses:
Patient Estimated Patient
Revenues, 20X1 Revenues, 20X1
October $1,500,000 January $1,700,000
November $1,600,000 February $1,300,000
December $1,700,000 March $1,200,000
Other Estimated Cash
Revenues, 20X1 Outflows, 20X11
January $44,000 January $1,199,000
February $55,000 February $1,263,800
March $52,000 March $1,390,600
April $855,000
Receipt of Payment Ending
for Patient Services Cash Balances
Month earned 60% December, 20X0 $200,000
2nd month 30%
3rd month 10% [2] 40%
4th+ months 0%
1 “Cash Outflows” within the given month.
2 The ending balance for each month as a percentage of the estimated cash outflows for the next month.
Exhibit 5–13 Jay Zeeman Clinic
Revenues/Expenses:
Patient Estimated Patient
Revenues, 20X1 Revenues, 20X1
October $1,000,000 January $1,300,000
November $1,200,000 February $1,350,000
December $1,300,000 March $1,400,000
Other Estimated Cash
Revenues, 20X1 Outflows, 20X11
January $40,000 January $1,250,000
February $50,000 February $1,300,000
March $60,000 March $1,350,000
April $1,400,000
Receipt of Payment Ending
for Patient Services Cash Balances
Month earned 60% December, 20X0 $150,000
2nd month 30%
3rd month 10%
4th+ months 0% [2] 40%
1 “Cash Outflows” within the given month.
2 The ending balance for each month as a percentage of the estimated cash outflows for the next month.
Exhibit 5–14 Iowa Clinic
42. Cash Budget. Happy Valley Rehab Facility provided the following financial
information in Exhibit 5–16. Prepare a cash budget for the quarter ending
March, 20X1.
43. Cash Budget. How would the cash budget in Problem 41 change if new credit
and collection policies were implemented such that collections resulted as follows:
40% month earned
30% + 1 month
10% + 2 months
5% + 3–6 months
44. Cash Budget. How would the cash budget in Problem 42 change if new
credit and collection policies were implemented such that collections resulted
as follows:
40% month earned
30% + 1 month
Working Capital Management 189
Revenues:
Patient Patient Estimated Patient
Revenues, 20X0 Revenues, 20X0 Revenues, 20X1
July $1,500,000 October $1,420,000 January $1,600,000
August $1,350,000 November $1,210,000 February $1,350,000
September $1,530,000 December $1,800,000 March $1,220,000
Other Receipt of Payment
Revenues, 20X1 for Patient Services
January $44,000 Month earned 45%
February $55,000 2nd month 25%
March $52,000 3rd month 10%
4–7 months 5%
Expenses1:
Supplies Purchases Estimated Supply Other Estimated
20X0 Purchases, 20X1 Expenses, 20X11
Nursing Admin. Other
October $400,000 January $500,000 January $500,000 $50,000 $145,000
November $500,000 February $600,000 February $550,000 $50,000 $235,000
December $300,000 March $700,000 March $600,000 $50,000 $175,000
April $100,000 April $350,000 $50,000 $105,000
Timing of Cash Payment for Ending
Supplies Purchases Cash Balances
0% Month purchased December, 20X0 $400,000
60% +1 Month [2] 50%
30% +2 Months
10% +3 Months
1 All estimated expenses are cash outflows for the given month.
2 The ending balance for each month as a percentage of the estimated cash outflows for the next month.
Exhibit 5–15 Stacy Zeeman Clinic
10% + 2 months
5% + 3–6 months
45. Discounts. Stacie Zeeman Clinic in Exhibit 5–15 is going to take better
advantage of credit terms offered by suppliers. The clinic has negotiated a 3
percent discount for all supplies purchases
beginning in 20X1, if paid in full during the month of service. How does this
change the answer to Problem 41?
46. Discounts. Happy Valley Clinic in Exhibit 5–16 is going to take better
advantage of credit terms offered by suppliers. The clinic has negotiated a 3
percent discount for all supplies purchases
beginning in 20X1, if paid in full during the month of service. How does this
change the answer to Problem 42?
190 Financial Management of Health Care Organizations
Revenues:
Patient Patient Estimated Patient
Revenues, 20X0 Revenues, 20X0 Revenues, 20X1
July $2,200,000 October $2,500,000 January $2,600,000
August $2,400,000 November $2,550,000 February $2,500,000
September $2,500,000 December $2,600,000 March $2,500,000
Other Receipt of Payment
Revenues, 20X1 for Patient Services
January $100,000 Month earned 45%
February $110,000 2nd month 25%
March $115,000 3rd month 10%
4–7 months 5%
Expenses1:
Supplies Purchases Estimated Supply Other Estimated
20X0 Purchases, 20X1 Expenses, 20X11
Nursing Admin. Other
October $800,000 January $900,000 January $1,000,000 $100,000 $700,000
November $850,000 February $925,000 February $1,100,000 $100,000 $675,000
December $900,000 March $950,000 March $1,200,000 $100,000 $650,000
April $975,000 April $1,300,000 $100,000 $525,000
Timing of Cash Payment for Ending
Supplies Purchases Cash Balances
0% Month purchased December, 20X0 $500,000
60% +1 Month [2] 50%
30% +2 Months
10% +3 Months
1 All estimated expenses are cash outflows for the given month.
2 The ending balance for each month as a percentage of the estimated cash outflows for the next month.
Exhibit 5–16 Happy Valley Rehab Facility
C h a p t e r S i x
THE TIME VALUE OF MONEY
Learning Objectives
After completing the material in this chapter, you will be able to:
Explain why a dollar today is worth more than a dollar in the future.
Define the terms future value and present value.
Calculate the future value of an amount and annuity.
Introduction
The Future Value of a Dollar Invested Today
Using a Formula to Calculate Future Value
Using Tables to Compute Future Value
Using a Spreadsheet to Calculate Future
Value
The Present Value of an Amount to Be
Received in the Future
Using a Formula to Calculate Present
Value
Using Tables to Compute Present Value
Using a Spreadsheet to Calculate Present
Value
Annuities
The Future Value of an Ordinary Annuity
Using Tables to Calculate the Future Value of an
Ordinary Annuity
Using a Spreadsheet to Calculate the Future
Value of an Ordinary Annuity
The Future Value of an Annuity Due
The Present Value of an Ordinary Annuity
Using Tables to Calculate the Present Value of
an Ordinary Annuity
Using a Spreadsheet to Calculate the Present
Value of an Ordinary Annuity
The Present Value of an Annuity Due
Special Situations to Calculate Future or
Present Value and Other EXCEL Functions
1.What if the interest rate is not expressed
as an annual rate?
2. How to compute periodic loan payments
using Excel
3. How to calculate the compounded
growth rate
Chapter Outline
(Continues)
Introduction
Is it better to receive $10,000 today or at the end of the year? The clear answer is
today, for a variety of reasons:
1. Certainty. A dollar in hand today is certain, whereas a dollar to be received
sometime in the future is not.
2. Inflation. During inflationary periods, a dollar will purchase less in the
future than it would today. Thus, because of inflation, the value of the dollar
in the future is worth less than it is today.
3. Opportunity Cost. A dollar today can be used or invested elsewhere. The
interest forgone by not having the dollar to invest now is an opportunity cost.
The concept of interest determines how much an amount of money invested today
will be worth in the future (its future value). It can also be used to determine how much
a dollar received at some point in the future would be worth today (its present value)
(see Exhibit 6–1). This chapter focuses on both future and present value, the basics of the time
value of money, which is essential to making long-term decisions – the focus of Chapter 7.
The Future Value of a Dollar Invested Today
What a dollar invested today will be worth in the future depends on the length of the
investment period, the method used to calculate interest, and the interest rate. There are
two types of methods to calculate interest: the simple method, and compounding. When
the simple interest method is used, the interest is calculated only on the original principal
each year. When the compound interest method is used, interest is calculated
on both the original principal and on any accumulated interest earned up to that point.
Perspective 6–1 presents a review of how stock prices are affected by the time value of
money.
Exhibit 6–2 part A uses the simple interest method to calculate how much $10,000
invested today at 10 percent interest would be worth in five years. Since the simple
interest method calculates interest on the principal only, each year of investment
would earn $1,000 interest (0.10 × $10,000). After five years, the net worth of the
investment would be $15,000 ($10,000 plus $5,000 in interest).
192 Financial Management of Health Care Organizations
4. How to calculate the present value of
perpetual annuities
5. How to solve for the interest rate of a
loan with fixed loan payments
Summary
Key Terms
Key Equations
Questions and Problems
Appendix B: Future and Present Value Tables
Chapter Outline (Contd)
Opportunity Cost:
Proceeds lost by
forgoing other
opportunities.
Time Value of
Money: The concept
that a dollar received
today is worth more
than a dollar
received in the
future.
Simple Interest
Method: A method
which calculates
interest only on the
original principal. The
principal is the
amount invested.
The Time Value of Money 193
Exhibit 6–2 part B uses the same scenario to illustrate the difference of
compounded interest. In the first year, there is no difference between using the simple
and compound interest methods, since no interest has yet been earned. However, in
the second and all subsequent years, more interest is earned using the compound
interest method, because 10 percent is earned on the original $10,000, plus 10 percent
on the total amount of interest previously accumulated. Thus, the future value of $10,000
invested at 10 percent interest after five years is $16,105 using compound interest,
compared to $15,000 using simple interest.
Future Value
Present Value Grows to its Future Value
Present Value
Present Value
An amount to be received
in the future
Is discounted to its
Present Value (PV) – The worth today of a future payment,
or the worth today of a series of payments made over time.
Future Value (FV) — The worth in the future of an amount invested today,
or the worth in the future of a series of payments made over time.
Exhibit 6–1 Comparison of Future Value and Present Value Concepts
Compound Interest
Method: A method
which calculates
interest on both the
original principal and
on all interest
accumulated since
the beginning of the
investment time
period.
Perspective 6–1
The Time Value of Money in Stock Valuation
Understanding the time value of money is crucial to prudent investing in stocks and bonds.The price of a stock is
the sum of its anticipated future earnings or cash flow, taking into account the time value of money.
The “cost of capital”; could be thought of as the investment hurdle or opportunity cost for similar risk investments;
in other words, it is the minimum return an investor will accept to invest in a stock of similar risk.Typically,
this rate is greater than the return on US Treasury Bonds. In January of 2000,Treasury bond rates were around 6.5%,
which are guaranteed by the federal government. If an investor did not expect to achieve a return of at least 6.5%
on a stock investment, then there would be no reason to take on the risk. However, over the past 70 years, most
investors have received a premium of 7% above the bond rate to compensate for this risk. In other words, stocks
have outpaced government bonds by 7%.Thus, the value of stock hinges upon two factors: the cost of capital, and
the expected future earnings or cash flow streams.
Source: Shawn Tully,“Has the Market Gone Mad?” Fortune, January 24, 2000, pp. 81–2
194 Financial Management of Health Care Organizations
The difference between the two methods is considerable and increases with time. After
10 years, $10,000 invested at 10 percent simple interest would grow to $20,000, after 20
years it would be worth $30,000, and after 50 years it would grow to $60,000. The comparable
numbers for compound interest are $25,937, $67,275 and $1,173,909, respectively.
These differences are illustrated in Exhibit 6–3, which compares the constant rate of
growth using simple interest to the increasing growth rate using compound interest.
Using a Formula to Calculate Future Value
One approach to calculating future value is to use the formula:
FV = PV × (1 + i)n
A. The future value of investing $10,000 over five years at 10 percent simple interest:
A B C D
Year Total at Beginning of Year Interest earned Amount at End of Year1
[Given] [D, Previous Year) [$10,000 × 10%] [B + C]
1 $10,000 $1,000 $11,000
2 $11,000 $1,000 $12,000
3 $12,000 $1,000 $13,000
4 $13,000 $1,000 $14,000
5 $14,000 $1,000 $15,000
Summary:
Beginning Balance $10,000
Interest Earned $5,000
Ending Balance $15,000
B. The future value of investing $10,000 over five years at 10 percent compound interest:
E F G H
Year Total at Beginning of Year Interest earned Amount at End of Year1
[Given] [H, Previous Year] [F × 10%] [F + G]
1 $10,000 $1,000 $11,000
2 $11,000 $1,100 $12,100
3 $12,100 $1,210 $13,310
4 $13,310 $1,331 $14,641
5 $14,641 $1,464 $16,105
Summary:
Beginning Balance $10,000
Interest Earned $6,105
Ending Balance $16,105
1Also called future value.
Exhibit 6–2 Comparison of Investing $10,000 Over Five Years at 10 Percent Using Simple and Compound
Future Value (FV):
What an amount
invested today (or a
series of payments
made over time) will
be worth at a given
time in the future
using the compound
interest method,
which accounts for
the time value of
money. See also
Present Value.
The Time Value of Money 195
where: PV is the present value (initial investment amount), i is the interest rate, and
n is the number of time periods of the investment. This formula says that an investment’s
worth in the future, FV, is equal to the investment’s present worth today, PV,
multiplied by a factor, (1 + i)n, which takes into account the compounded growth in
interest over the lifetime of the investment.
As an example, to calculate the future value of $10,000 in four years at 10 percent
interest, the formula is set up as follows:
FV = PV × (1 + i)n
FV = $10,000 × (1 + 0.10)4
FV = $10,000 × (1.4641)
FV = $14,641
$1,200,000
$0
$200,000
$400,000
$600,000
$800,000
$1,000,000
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50
Years
Future Value
Simple Interest Compound Interest
Future value using
compound interest = $1,173,909
Future value using
simple interest = $60,000
Exhibit 6–3 The Future Value of $10,000 Earning 10 Percent Using Simple and Compound Interest
Simple interest only calculates interest on the original principal, whereas compound interest calculates interest
on both the principal and any accumulated interest. Thus, the value in the future using compound interest will
always be higher than that using simple interest, except in the first period.
As commonly used, the term future value implies using the compound interest method. It is used in this way
throughout this text unless noted otherwise.
196 Financial Management of Health Care Organizations
Similarly, to calculate the future value of $10,000 earning 10 percent interest over five
years, the formula is set up as follows:
FV = PV × (1 + i)n
FV = $10,000 × (1 + 0.10)5
FV = $10,000 × (1.6105)
FV = $16,105
Notice that these are the same numbers derived in Exhibit 6–2 part B for four and five
years, respectively.
Using Tables to Compute Future Value
An alternative to calculating the future value using the formula is to use a future value
table. Table B–1, at the end of this chapter, contains a pre-calculated range of
future value factors (FVF) using the future value formula, (1 + i)n. Across the top
of the table, the column headings list various interest rates. The leftmost column in the
table, or the row headings, provides the number of compounding periods (annual,
semi-annual, quarterly, etc.). The intersecting cell for a row/column combination contains
the corresponding future value factor. For example, as shown in Exhibit 6–4, the
FVF to invest $10,000 at 10 percent for five years (abbreviated as FVF10,5), is found by
following the 10 percent column down to the fifth row (five years), to the number
1.6105. This number is then used in the following formula to derive the future value
FV = PV × FVFi,n
Period 2% 4% 6% 8% 10% 12%
12345
1.6105
Interest Rate
Exhibit 6–4 Example of How to Find the Future Value Factor at 10 Percent Interest for Five Years Using Table B–1
The future value factor (FVF): (1 + i)n, where i is the interest rate and n is the number of periods.
The formula to find the future value: Future value = Present value × Future value factor. It is abbreviated as
FV = PV × FVFi,n or FV = PV(1 + i)n.
The Time Value of Money 197
in a manner similar to the last two steps in using the formula approach:
FV = $10,000 × (1.6105)
FV = $16,105
This is the same result calculated earlier by using the formula, FV = PV × (1 + i)n. Table
B–1 can be used to find the FVF for numbers up to 50 percent interest and 50 years.
Using a Spreadsheet to Calculate Future Value
Most spreadsheets have easy-to-use financial functions that can calculate future value.
For example, to calculate the future value of $10,000 at 10 percent interest over five
years using Excel, simply call up the future value function by clicking on “Insert,” then
“Function,” then “Financial.” On the right-hand side of the screen double-click on
“FV.” Enter the rate (10%), the number of periods (5), and the present value as a negative
number (−10000), to represent the cash outflow of the investment. The future
value, $16,105, is automatically calculated at the bottom (see Exhibit 6–5). Note that
the future value is a positive number, because it represents a cash inflow of the principal
and interest at a later point in time.
The Present Value of an Amount to Be Received in
the Future
The focus until now has been on the future value of money that is invested today. The
example showed that $10,000 invested by a clinic today will be worth $16,105 in five
years at 10 percent interest each year. In this section, the question is turned around,
Exhibit 6–5 Using Excel to Calculate the Future Value for a Single Payment
Present Value (PV):
The value today of a
payment (or series of
payments) to be
received in the
future, taking into
account the cost of
capital (sometimes
called “discount
rate”). It is
calculated using the
formula: Present
Value = Future Value
× Present Value
Factor (PV = FV ×
PVF or PV = FV ×
1/(1 + i)n).
198 Financial Management of Health Care Organizations
“How much is $16,105 to be received five years from now worth today?” The value
today of a payment (or series of payments) to be received in the future taking into
account the cost of capital is the present value. Taking future values back to the present
is also called “discounting.”
Using a Formula to Calculate Present Value
Just as the present value is multiplied by a future value factor to determine the future
value, the future value is multiplied by a present value factor to calculate present value.
The present value factor, 1/(1 + i)n, is the inverse of the future value factor, (1 + i)n.
Thus, using the formula, the present value of $16,105 at 10 percent interest for five
years can be calculated as follows:
PV = FV × 1/(1 + i)n
PV = $16,105 × 1/(1 + 0.10)5
PV = $16,105 × 1/(1.6105)
PV = $16,105 × (0.6209)
PV = $10,000
The 1/(1.6105), which equals 0.6209, is the present value factor. It can be
interpreted to mean that at 10 percent interest, a dollar received five years from now
is worth only about 62 percent of its value in today’s dollars. In the example, $16,105
received five years from now is only worth $10,000 in today’s dollars.
Exhibit 6–6 illustrates the relationship between present value and future value. Just
as $10,000 today grows to $16,105 over five years at 10 percent compound interest,
$16,105 received five years from now is worth $10,000 today, assuming a 10 percent
(discount) rate.
Compounding:
Converting a present
value into its future
value taking into
account the time
value of money. See
Compound Interest
Method. It is the
opposite of
discounting.
Discounting:
Converting future
cash flows into their
present value taking
into account the time
value of money. It is
the opposite of
compounding.
The present value factor is the reciprocal of the future value factor and is calculated using the formula
1/(1 + i)n.
The formula to find the present value: Present Value = Future Value × Present Value Factor. It is abbreviated as:
PV = FV × PVFi,n or PV = FV × 1/(1 + i)n.
To find future value, compound. To find present value, discount. Discounting is the opposite of compounding.
Compound toward the future. Discount to the present.
The Time Value of Money 199
Using Tables to Compute Present Value
Just as Table B–1 contains a list of pre-calculated future value factors (FVF) based on
the formula (1 + i)n, Table B–3 contains a list of present value factors (PVF) based
on the formula 1/(1 + i)n. (Tables B–2 and B–4 will be discussed shortly.) Finding a
present value factor in Table B–3 is analogous to finding a future value factor in Table
B–1. The process to locate the present value factor for five years at 10 percent interest
is illustrated in Exhibit 6–7.
This present value factor can be used in the formula PV = FV × PVFi,n to derive
the present value of $16,105 at 10 percent interest for five years.
PV = FV × PVF10,5
PV = $16,105 × 0.6209
PV = $10,000
This is the same result derived by using the formula. Table B–3 can also be used to
find the PVF for a wide range of numbers up to 50 percent interest and 50 years.
Times the future value factor:
1.6105
The Present Value:
$10,000
The Future Value:
$16,105
Times the present value factor:
1/1.6105 or 0.6209
becomes
becomes
Exhibit 6–6 The Relationship between Present Value and Future Value, 10 Percent, Five Periods
Period
Note: The present value factor for 10 percent, 5 periods is abbreviated as: PVF10,5
2% 4% 6% 8% 10% 12%
1
2
3
4
5 0.6209
Interest Rate
Exhibit 6–7 Example of How to Find the Present Value Factor at 10 Percent Interest for Five Years Using Table B–3
200 Financial Management of Health Care Organizations
Using a Spreadsheet to Calculate Present Value
As with future value, most spreadsheets have basic financial functions that can calculate
present value. For example, to calculate the present value of $16,105 at 10 percent
interest for five years in Excel 7.0a, simply call up the present value function by clicking
on “Insert,” then “Function,” then “Financial.” On the right-hand side of the
screen, double-click on “PV”. Enter the rate, 10%, the number of periods, 5, and the
future value as a negative number, −16,105. The present value, 9999.937908
($10,000), is automatically calculated at the bottom (see Exhibit 6–8).
Annuities
The earlier discussion of present and future value shows how a single amount
invested today grows over time, and how a single amount to be received in the future
is discounted to today’s dollars. But sometimes, instead of a single amount, there is a
series of payments. This section deals with a particular kind of series of payments
called an annuity. An annuity is a series of equal payments made or received at equally
spaced (regular) time intervals.
The Future Value of an Ordinary Annuity
This section shows how to determine what an annuity to be received or invested
will be worth at some future date. Suppose a donor were going to give $10,000 per
year at the end of each year for the next three years. What would it be worth at the
end of three years if it earned 10 percent interest each period? Based upon the
Exhibit 6–8 Using Excel to Calculate the Present Value for a Single Payment
Future Value of an
Annuity: What an
equal series of
payments will be
worth at some future
date using compound
interest. See also
Future Value Factor
of an Annuity and
Present Value of an
Annuity.
Annuity: A series of
equal payments
made or received at
regular time
intervals.
The Time Value of Money 201
information previously discussed, at the end of three years there would be
$33,100, computed as shown in Exhibit 6–9.
Using Tables to Calculate the Future Value of an Ordinary Annuity
Rather than making three separate calculations (one for each year, as shown), a
shortcut is to add the future value factors, which total 3.3100 (1.2100 + 1.1000 +
1.000), then multiply the sum by $10,000. In this case, 3.3100 × $10,000 = $33,100,
the same value as seen in Exhibit 6–9. Rather than adding the factors for each of
the three years, an alternative approach is to use a future value factor of an
annuity (FVFA) table, such as Table B–2. Such tables contain the same figures as
achieved by adding together the separate future value factors for each year. For
example, in Table B–2, the future value factor of an annuity at 10 percent interest
for three years, FVFA10,3, is 3.3100. This is the same number derived by adding
the future value factors for each of the three years in Exhibit 6–9. Thus, whenever
a series of equal payments is to be made or received at the end of each period, the
future value of an annuity table can be used rather than computing the future value
of each year’s cash flow and adding the results.
Using a Spreadsheet to Calculate the Future Value of an Ordinary
Annuity
Most spreadsheets can easily calculate the future value of an ordinary annuity. For
example, in Excel 7.0a, to calculate the future value of a series of $10,000 payments to
be received at the end of each of three years, assuming a 10 percent interest rate, click
on “Insert,” then “Function,” then “Financial.” On the right-hand side of the screen,
double-click on “FV.” Enter the rate, 10%, the number of periods, 3, and the annu-
Future Value Factor
of an Annuity
(FVFA): A factor that
when multiplied by a
stream of equal
payments equals the
future value of that
stream. See also
Present Value Factor
of an Annuity.
Ordinary Annuity: A
series of equal annuity
payments made or
received at the end of
each period.
FV = Annuity ×
FVFA10,3
FV = $10,000 ×
3.3100
FV = $33,100
Incidentally, a series
of payments made or
received at the end
of each period is
called an ordinary
annuity, while a
series of payments
made or received at
the beginning of
each period is called
an annuity due
(discussed shortly).
A B C D
Amount to Be Received Future Value Future Value Future Value
Year at the End of the Year Formula Factor at End of Year 3
[Given] [Given] [Given] [Table B−1] [A × C]
1 $10,000 (1 + i)2 1.2100 $12,100
2 $10,000 (1 + i)1 1.1000 $11,000
3 $10,000 (1 + i)0 1.0000 $10,000
Total 3.3100 $33,100
Exhibit 6–9 Calculating the Future Value of $10,000 to Be Received at the End of Each of the Next Three Years,
Assuming 10 Percent Interest
Whenever a series of payments is to be invested or received at the end of the year, an ordinary annuity table
can be used to determine future value, rather than computing the future value of each year’s cash flow.
202 Financial Management of Health Care Organizations
ity or “pmt” input value as a negative number, −10,000. The future value is automatically
calculated and appears at the bottom (see Exhibit 6–10).
The Future Value of an Annuity Due
The future value of an annuity table, such as Table B–2, is developed for ordinary
annuities: cash flows which occur at the end of each period. Sometimes, however, a
series of cash flows occurs at the beginning of each period, instead of at the end. Such
an annuity is called an annuity due. The future value factor for an annuity due is
equal to the factor from the future value of an ordinary annuity table for n + 1 years,
less 1.
Suppose a lessee has agreed to pay an organization $10,000 today and at the
beginning of each of the next four years, for a total of five $10,000 payments over
five years. The organization thinks it can invest this money at 10 percent. To
determine the future value of the investment after five years, the organization: 1)
takes the future value factor for an ordinary annuity in Table B–2 at 10 percent
interest for 5 + 1 = 6 years (7.7156); 2) subtracts 1 from this future value factor
(7.7156 – 1 = 6.7156); and 3) multiplies this value by $10,000.
FV annuity due = (FVFAi, n + 1 − 1) × Annuity
FV annuity due = (FVFA10, 5 + 1 − 1) × $10,000
FV annuity due = (7.7156 − 1) × $10,000
FV annuity due = 6.7156 × $10,000
FV annuity due = $67,156
Exhibit 6–10 Using Excel to Calculate the Future Value for an Ordinary Annuity Payment
Annuity Due: A
series of equal
annuity payments
made or received at
the beginning of
each period.
The Time Value of Money 203
This procedure can also be performed on a spreadsheet using the future value function.
In Excel, the function to find an ordinary annuity is used, but a “1” is entered in
the space for “type” to indicate that this is an annuity due (see Exhibit 6–10).
The Present Value of an Ordinary Annuity
As with future value, it is possible to calculate the present value of an annuity, whether
an ordinary annuity or an annuity due. Suppose a donor wants to give $10,000 per
year at the end of each of the next three years. What is it worth today if the donations
can earn 10 percent interest each period? One way to approach this problem is to calculate
the present value of each year’s cash flows and then add them, which equals
$24,869 (see Exhibit 6–11).
Using Tables to Calculate the Present Value of an
Ordinary Annuity
The same result can be derived by first adding the three present value factors (0.9091
+ 0.8264 + 0.7513 = 2.4869), and then multiplying the result times $10,000 (2.4869
× $10,000 = $24,869), as shown in Exhibit 6–11. A shortcut is to use a present value
of an annuity table, such as Table B–4. Such tables contain the same numbers as
would be derived by adding the separate present value factors for each year (differences
due to rounding). For example, in Table B–4, the present value of an annuity
factor for 10 percent interest for three years, PVFA10,3, is 2.4869.
Present Value of an
Annuity: What a
series of equal
payments in the
future is worth today
taking into account
the time value of
money.
A B C D
Amount to Be Received Present Value Present Value Present Value
Year at the End of the Year Formula Factor at End of Year 3
[Given] [Given] [Given] [Table B−3] [A × C]
1 $10,000 1 / (1 + i)1 0.9091 $9,091
2 $10,000 1 / (1 + i)2 0.8264 $8,264
3 $10,000 1 / (1 + i)3 0.7513 $7,513
Total 2.4869 $24,869
Exhibit 6–11 Calculating the Present Value of $10,000 to Be Received at the End of Each of the Next Three
Years,Assuming 10 Percent Interest
Whenever a series of payments is to be received at the end of the year, an ordinary annuity table can be used
to determine its present value rather than computing the present value of each year’s cash flow. Each factor in
the present value of an annuity table is the sum of each of the present value factors for each year of the annuity.
Present value annuity tables are set up as ordinary annuities.
204 Financial Management of Health Care Organizations
PV = Annuity × PVFA10,3
PV = $10,000 × 2.4869
PV = $24,869
Using a Spreadsheet to Calculate the Present Value of an
Ordinary Annuity
Most spreadsheets easily calculate the present value of an ordinary annuity (in Excel,
the function is called “PV”). Exhibit 6–12 shows the result of entering the numbers
in the appropriate category to calculate the present value of a $10,000 annuity to be
received at the end of each of the next three years, assuming 10 percent interest.
The Present Value of an Annuity Due
Table B–4, which shows the present value factors for an ordinary annuity, can be used
to calculate the present value factor for an annuity due. This is done by finding the
present value factor for n – 1 years, and then adding 1 to this factor.
Suppose a lessee has agreed to pay an organization $10,000 today and at the beginning
of each of the next four years, for a total of five $10,000 payments over five years.
To find the present value of this series of payments, assuming an interest rate of 10
percent, the organization: 1) determines the present value factor for an ordinary annuity
from Table B–4 at 10 percent interest and 5 − 1 = 4 years (3.1699); 2) adds 1 to
this factor to get the factor for an annuity due (3.1699 + 1 = 4.1699); and 3) multiplies
this new factor by $10,000.
PV annuity due = (PVFAi, n – 1 + 1) × Annuity
PV annuity due = (PVFA10, 5 – 1 + 1) × $10,000
Exhibit 6–12 Using Excel to Calculate the Present Value for an Ordinary Annuity Payment
PV annuity due = (3.1699 + 1) × $10,000
PV annuity due = 4.1699 × $10,000
PV annuity due = $41,699
This procedure can also be performed on a spreadsheet using the present value function.
In Excel, the function to find an ordinary annuity is used, but a “1” is entered in
the space for “type” to indicate that this is an annuity due (see Exhibit 6–12).
Special Situations to Calculate Future or Present Value and
Other EXCEL Functions
1.What if the interest rate is not expressed as an
annual rate?
In the examples presented thus far, the interest rate has been expressed as an annual interest
rate, and periods have been expressed in years. However, periods can also refer to other
periods of time, such as months or days. If periods of time other than a year are being used,
then the interest rate must be expressed for an equivalent period of time. For example, 12
percent annually is 1 percent a month.
Suppose an investment of $10,000 is invested at an interest rate of 12 percent and
compounded semi-annually for ten years. Since interest rates are always annual unless
stated otherwise, the formula must be adjusted to account for periods other than annual.
The future value formula to compound at intervals more frequent than annual is:
FV = PV × (1 + i/m)n × m
where i = annual interest rate, m = number of times during a year that compounding
occurs (e.g. m = 4 for quarterly, m = 12 for monthly), and n = number of years.
Using the figures in the example:
FV = PV × (1 + i/m)n × m
FV = $10,000 × (1 + 0.12/2)10 × 2
FV = $10,000 × (1 + 0.06)20
FV = $10,000 × 3.2071
FV = $32,071
Note that the final value, $32,071, is higher than it would have been had the same amount
been invested and compounded annually rather than semi-annually. For example, had it
been compounded annually using the standard formula FV = PV × FVF12,10, the future
value factor would have been 3.1058, yielding a future value of $31,058 ($10,000 ×
3.1058). This discrepancy is not a mistake (see Exhibit 6–13). It happens because compounding
in the first instance is occurring twice during a year rather than once per year,
The Time Value of Money 205
206 Financial Management of Health Care Organizations
so interest is growing upon interest more frequently. With quarterly compounding over
the same 10-year time period (i.e. 3 percent per quarter for 40 quarters), the answer
would be still higher, and with monthly compounding (i.e. 1 percent per month for 120
months), still higher yet. While the equation to calculate future value with continuous
compounding is beyond the scope of this text, the key point is that the more frequent the
compounding for any given interest level and time period, the higher the future value.
2. How to compute periodic loan payments using Excel
Excel can also calculate periodic loan payments with the PMT (payment) function.
This function can only be used for loans which involve equal periodic payments over
the length of the loan. Exhibit 6–14 provides an example of how to compute annual
loan payments for a 10-year, $1,000,000 loan, which has an interest rate of 10 percent.
Note that the present value, $1,000,000, is entered as a negative number to make the
final result positive. This final result, $162,745, is interpreted to mean that by paying
this annual amount under these conditions, the loan will be completely paid off at the
end. This type of analysis is also called a loan amortization, which will be discussed
in more detail in Chapter 8.
3. How to calculate the compounded growth rate
When examining data, researchers often like to present the compounded growth rate
for numerical data, such as revenues, expenses, and earnings. Suppose Memorial
Hospital would like to determine the compounded growth rate for patient revenues
between 20X0 and 20X7, shown in Exhibit 6–15.
Givens:
Initial Amount $10,000
Annualized Interest Rate 12%
Time Horizon (Years) 10
Compounding Period Future Value
Annual $31,058
Semi-annual $32,071
Quarterly $32,620
Monthly $33,004
Daily $33,195
Continuously $33,201
Exhibit 6–13 Effect of Compounding Using Various
Compounding Periods
The more frequent the compounding for any given interest level and time period, the higher the future value.
The Time Value of Money 207
Solving this problem requires finding the compound growth rate (which is similar
to compound interest) that causes 20X0 revenues to have a future value equal to 20X7
revenues (seven time periods into the future). To do this analysis:
Step 1: Solve for FVF in the equation, FV = PV × FVFi,n, where: FV =
20X7 amount ($3,650,000); PV = 20X0 amount ($2,123,000).
FV = PV × FVFi,n
$3,650,000 = $2,123,000 × FVFi,7
$3,650,000/$2,123,000 = FVFi,7
1.7192 = FVFi,7
Step 2: Using Table B–1, Memorial then compares the calculated FVF,
1.7192, against all FVF factors in the row for seven time periods to find the
factor closest to 1.7192. The appropriate interest rate is the rate given at the
Year Patient Revenues
20X0 $2,123,000
20X1 $2,245,000
20X2 $2,555,000
20X3 $2,700,000
20X4 $2,889,000
20X5 $3,145,000
20X6 $3,496,000
20X7 $3,650,000
Exhibit 6–15 Patient Revenues for Memorial Hospital
Exhibit 6–14 Using the Excel Payment Function to Compute Loan Payments
top of that column. In this case, 1.7138 is the closest number to 1.7192.
Therefore the appropriate interest rate is approximately 8 percent, which
also represents the average compound growth rate per year in sales from 20X0
to 20X7; however, year-to-year changes may be more or less than 8 percent.
4. How to calculate the present value of perpetual annuities
All the annuities in the earlier sections of this chapter were calculated using a finite
number of time periods, such as 10 years. In some instances, however, an organization
needs to make an investment to generate an annuity (cash flow) for an infinite period
of time. Such an annuity is called a perpetual annuity, or a perpetuity. For example,
a donor may bequeath a large sum of money to a hospital under the condition
that it generates a specified income every year for Alzheimer’s research. Because there
is no stipulation as to when this research funding should cease by allowing the funds
to become depleted, the hospital would treat the donation as a perpetuity.
The concept of perpetuities and the calculations involved are actually quite simple.
If $1,000,000 were reinvested each year forever at an annual 10 percent interest rate,
$100,000 in interest income could be extracted every year ($1,000,000 × 10%) without
ever depleting the principal. Every year after withdrawal of the interest income, the
investment would still be worth $1,000,000 in real terms. Looked at another way, how
much principal would need to be invested at 10 percent to earn $100,000 per year forever?
The answer is obviously $1,000,000. This leads to the formula for a perpetuity:
Amount of Perpetuity = Initial Investment × Interest Rate
Thus, using this formula, in order to generate a $100,000 perpetuity at a 10 percent
interest rate, $100,000/0.10, or $1,000,000, would be needed.
Suppose that in her will, a wealthy donor leaves a $2,500,000 donation upon her
death to her alma mater’s university hospital. The funds are to be used solely to buy
gifts for pediatric cancer patients and to subsidize hotel costs for visiting parents. The
donor’s only son died at age eight from leukemia, and she wished to give other children
hope and happiness. She stipulates in her will that no less than $150,000 in gift
monies be available every year from the donation. It is at the hospital’s discretion to
decide how to invest the money prudently. What rate of return must the investment
generate after the donor’s death in order to ensure that her wishes be granted?
The formula for a perpetuity can be rearranged to solve for rate of return, given the
other two factors:
Interest rate = Amount of Perpetuity/Initial Investment
Interest rate = $150,000/$2,500,000
Interest rate = 0.06 = 6%
Therefore, as long as the hospital can invest the $2,500,000 at a minimum 6 percent
rate of return, the donor’s wishes will be granted indefinitely.
208 Financial Management of Health Care Organizations
Perpetuity: An
annuity for an
infinite period of
time. Also called a
perpetual annuity.
5. How to solve for the interest rate of a loan with fixed
loan payments
Assuming equal loan payments over the life of the loan, it is also possible to solve
for the interest rate. If the present value of the loan, the annuity payments over
time, and the length of the loan are given, the unknown interest rate of the loan, i,
can be determined.
For example, suppose Mt Moriah Hospital needs to borrow $10,000 for a new computer
system. The annual loan payments are $3,019 per year at the end of each year
for the next four years. What is the interest rate of this loan? Using the present value
formula for an ordinary annuity, solve for the interest rate, i:1
PV = Annuity × PVFAi,4
$10,000 = $3,019 × PVFAi,4
$10,000/$3,019 = PVFAi,4
3.3124 = PVFAi,4
3.3124 = PVFA8,4
i = 8%
This could also be done in a spreadsheet, such as by using the “Rate” function in
Excel, as shown in Exhibit 6–16. This is a four-year, $10,000 loan with equal annual
payments of $3,019. This “Rate” function can only be used for loan payments that are
equal over the life of the loan. The loan payment value must be a negative value (cash
outflow); otherwise, the rate function will give an incorrect value if both PMT and PV
values are positive.
Summary
Future value is used to determine the value of dollar payments in the future, whereas
present value indicates the current value of future dollars. Either simple interest,
where interest is only calculated on the principal, or compound interest, where the
The Time Value of Money 209
In the Excel “Rate” function, the PMT box or loan payment box must be a negative value.
1 From Table B–4, the PVFA equal or closest to 3.3124 is found in the row for 4 time periods. At this
PVFA, the interest rate of this column heading is 8%.
Future Value Table:
Table of factors which
shows the future value
of a single investment
at a given interest rate.
210 Financial Management of Health Care Organizations
interest is calculated on the principal and the interest, can be used to determine the
future value of money. The compound interest method produces a larger sum of
money in the future and is the standard method used.
The future value factor (FVF), or (1 + i)n, where i is the interest rate and n is the
number of periods of the investment, is part of the formula to determine how much
an investment will be worth in the future. This entire formula to find future value is:
Future Value = Present Value × Future Value Factor, abbreviated as FV = PV
× FVFi,n or FV = PV(1 + i)n. The opposite formula calculates the present value:
Present Value = Future Value × Present Value Factor, abbreviated as PV = FV
× PVFi,n or PV = FV/(1 + i)n. Similar formulas are used to calculate the present value
or future value of an annuity; all that changes is the factor. All these factors can be
found in pre-calculated tables, which are known as future value tables and present
value tables.
If a series of payments is to be paid or received at the end of each period, it is called
an ordinary annuity. If the series of payments is to be paid or received at the beginning
of each period, it is called an annuity due. The steps used to calculate each of these two
types of annuities are somewhat different. An understanding of present and future
values and annuities can be used to answer a number of key questions, such as, “How
much will an investment today be worth in the future?” or “What is the rate of return
for a loan?” Special situations and applications are described in the Appendices, and
all calculations can be made either through the use of the accompanying tables, or with
the aid of a spreadsheet.
Exhibit 6–16 Using the Excel Rate Function to Compute a Loan Rate
Future Value of an
Annuity Table: Table
of factors which shows
the future value of
equal flows at the end
of each period, given a
particular interest rate.
Present Value Table:
Table of factors which
shows what a single
amount to be received
in the future is worth
today at a given
interest rate.
Present Value of an
Annuity Table: Table
of factors which shows
the value today of
equal flows at the end
of each future period,
given a particular
interest rate.
Key Equations
Future Value Equation: FV = PV × (1 + i)n
Future Value Formula: FV = PV × FVFi,n
Future Value Formula, Annuity Due: FV = Annuity × (FVFAi,n + 1 − 1)
Future Value Formula, Ordinary Annuity: FV = Annuity × FVFAi,n
Future Value Formula, Period < 1 Year: FV = PV × (1 + i/m) n × m
Perpetuity Formula: Amount of Perpetuity = Initial Investment × Interest Rate
Present Value Equation: PV = FV × 1/(1 + i)n
Present Value Formula: PV = FV × PVFi,n
Present Value Formula, Annuity Due: PV = Annuity × (PVFAi,n − 1 + 1)
Present Value Formula, Ordinary Annuity: PV = Annuity × PVFAi,n
Questions and Problems
1. Definitions. Define the following terms:
a. Annuity.
b. Annuity Due.
c. Compound Interest Method.
d. Compounding.
e. Discounting.
f. Future Value.
The Time Value of Money 211
Annuity
Annuity Due
Compound Interest Method
Compounding
Discounting
Future Value
Future Value Factor
Future Value Factor of an
Annuity
Future Value of an Annuity
Future Value of an Annuity
Table
Future Value Table
Opportunity Cost
Ordinary Annuity
Perpetuity
Present Value
Present Value Factor
Present Value Factor of an
Annuity
Present Value of an Annuity
Present Value of an Annuity
Table
Present Value Table
Simple Interest Method
Time Value of Money
Key Terms
g. Future Value Factor.
h. Future Value Factor of an Annuity.
i. Future Value of an Annuity.
j. Future Value of an Annuity Table.
k. Future Value Table.
l. Opportunity Cost.
m. Ordinary Annuity.
n. Perpetuity.
o. Present Value.
p. Present Value Factor.
q. Present Value Factor of an Annuity.
r. Present Value of an Annuity.
s. Present Value of an Annuity Table.
t. Present Value Table.
u. Simple Interest Method.
v. Time Value of Money.
2. Simple and Compound Interest. What is the difference between simple
interest and compound interest?
3. Defining Future Value Equation Terms. Write out the future value of
an amount equation, and define each of the terms in it.
4. Defining the exponent. Does the n in the formula (1 + i)n always mean
compounding on an annual basis?
5. Multiple compounding periods in a year. How should the future
value equation be modified if compounding occurs more frequently than
annually?
6. Multiple compounding periods in a year (continued). What is the
future value of $10,000 with an interest rate of 16 percent and one annual
period of compounding? With an annual interest rate of 16 percent and two
semiannual periods of compounding? With an annual interest rate of 16
percent and four quarterly periods of compounding?
7. Multiple compounding periods in a year (continued). Based on the
answer to Question 6, explain why the investment increases in value when
the number of compounding periods increases.
8. Present and Future Value Factors. What is the relationship between the
present value factor and the future value factor?
9. Present Value Factor and Discount Rate. What happens to the present
value factor as the discount rate or interest rate increases for a given time
period? If the discount rate or interest rate decreases?
10. Relationship between Ordinary Annuity and Annuity Due. Compare
the results of the present value of a $6,000 ordinary annuity at 10 percent
interest for 10 years with the present value of a $6,000 annuity due at 10
percent interest for 11 years. Explain the difference.
11. Perpetuities. How many years in a typical perpetuity?
12. Factors. What is the relationship between the future value factor for
five years at 5 percent and the present value factor for five years at
5 percent.
212 Financial Management of Health Care Organizations
13. Future Value of an Annuity Table. In the future value annuity table at
any interest rate for one year, why is the future value interest factor of this
annuity equal to 1.00?
14. Present Value of an Amount and Present Value of an Annuity.
What is the relationship between the present value of a single dollar
payment formula and the present value of an ordinary annuity formula
for the same number of years and the same discount rate? Assume a
discount rate of 10 percent and an n value of five periods. Explain with
an example.
15. If a nurse deposits $1,000 today in a bank account and the interest is
compounded annually at 12 percent, what will be the value of this
investment:
a. five years from now?
b. ten years from now?
c. fifteen years from now?
d. twenty years from now?
16. If a nurse deposits $10,000 today in a bank account and the interest is
compounded annually at 12 percent, what will be the value of this
investment:
a. three years from now?
b. six years from now?
c. nine years from now?
d. twelve years from now?
17. If a business manager deposits $200 in a savings account at the end of each
year for twenty years, what will be the value of her investment:
a. at a compounded rate of 10 percent?
b. at a compounded rate of 20 percent?
What would the outcome be in both cases if the deposits were made at the
beginning of each year?
18. If a business manager deposits $2,000 in a savings account at the end of each
year for twenty years, what will be the value of her investment:
a. at a compounded rate of 15 percent?
b. at a compounded rate of 25 percent?
What would the outcome be in both cases if the deposits were made at the
beginning of each year?
19. The CFO of a home health agency needs to determine the present value of a
$5,000 investment received at the end of year 10. What is the present value if
the discount rate is:
a. 5 percent?
b. 10 percent?
c. 15 percent?
d. 20 percent?
20. The CFO of a home health agency needs to determine the present value of a
$50,000 investment received at the end of year 15. What is the present value
if the discount rate is:
a. 4 percent?
The Time Value of Money 213
b. 8 percent?
c. 12 percent?
d. 16 percent?
21. If a hospital were to receive $4,000 in payments per year at the end of each
year for the next 12 years from an uninsured patient who underwent an
expensive operation, what would be the current value of these collection
payments:
a. at a 4 percent rate of return?
b. at a 14 percent rate of return?
If the funds were received at the beginning of the year, what would be the
current value of these collection payments for each of the two rates of
return?
22. If a hospital were to receive $14,000 in payments per year at the end of each
year for the next 6 years from an uninsured patient who underwent an
expensive operation, what would be the current value of these collection
payments:
a. at a 4 percent rate of return?
b. at a 14 percent rate of return?
If the funds were received at the beginning of the year, what would be the
current value of these collection payments for each of the two rates of
return?
23. After completing her residency, an obstetrician plans to invest $10,000 per
year at the end of each year in a low-risk retirement account. She expects to
earn five percent for 35 years. What will her retirement account be worth at
the end of these 35 years?
24. After completing her residency, an oncologist plans to invest $15,000 per
year at the end of each year in a high-risk retirement account. She expects to
earn ten percent for 35 years. What will her retirement account be worth at
the end of these 35 years?
25. Lincoln Memorial Hospital has just been informed that a private donor is
willing to contribute $1,000 per year at the beginning of each year for 15
years. What is the current dollar value of this contribution if the discount
rate is 8 percent?
26. Boulder City Hospital has just been informed that a private donor is willing to
contribute $20,000 per year at the beginning of each year for 15 years.
What is the current dollar value of this contribution if the discount rate is 16
percent?
27. If a community clinic invested $4,000 in excess cash today, what would be
the value of its investment at the end of three years:
a. at a 16 percent rate compounded semiannually?
b. at a 16 percent rate compounded quarterly?
28. If a community hospital invested $8,000 in excess cash today, what would be
the value of its investment at the end of three years:
a. at a 32 percent rate compounded semiannually?
b. at a 32 percent rate compounded quarterly?
214 Financial Management of Health Care Organizations
29. Love Canal General Hospital wants to purchase a new blood analyzing
device today. Its local bank is willing to lend it the money to buy the analyzer
at a 2 percent monthly rate. The loan payments will start at the end of the
month and will be $1,700 per month for the next 18 months. What is the
purchase price of the device?
30. General Hospital wants to purchase a new MRI today. Its local bank is
willing to lend it the money to buy the MRI at a 3 percent monthly rate.
The loan payments will start at the end of the month and will be $5,000
per month for the next 30 months. What is the purchase price of the
MRI?
31. Midstate Medical Center is starting an endowment fund to pay for the
expenses of a medical research program. The expenses are $2,000,000 per
year and the program is expected to last for ten years. Assuming payments
are made at the end of each year and the interest rate is 9 percent per year,
what should be the initial size of the endowment?
32. Seaside Medical Center is starting an endowment fund to pay for the
expenses of a community outreach pediatric program. The expenses are
$500,000 per year and the program is expected to last for five years.
Assuming payments are made at the end of each year and the interest rate is
7 percent per year, what should be the size of the initial endowment?
33. In 2000, Lilliputian County Hospital’s total patient revenues were $20
million. In 2008, patient revenues are expected to be $40 million. What is the
compound growth rate in patient revenues over this time period?
34. In 2001, Wythe County Hospital’s total patient revenues were $5 million. In
2010, patient revenues were expected to be $27.75 million. What was the
compound growth rate in patient revenues over this time period?
35. Shawnee Valley Family Practice Center plans to invest $30,000 in a money
market account at the beginning of each year for the next five years. The
investment pays 12 percent annual interest. How much would this
investment be worth after five years of investing?
36. Starting today, and every six months thereafter for the next ten years, St
Luke’s Hospital plans to invest $50,000 at 10 percent annual interest in an
account. How much would this investment be worth after ten years of
investing?
37. Dr Thomas plans to retire today and would like an income of $200,000 per
year for the next 15 years with the income payments starting one year from
today. He will be able to earn interest of 9 percent per year compounded
annually from his investment account. What must he deposit today in his
investment account to achieve this income of $200,000 per year?
38. Today, Williamson Hospital lends its Home Health Care Center $938,510.
The center expects to repay them in quarterly installments for three years of
$100,000 with the first payment starting one quarter from now. What annual
interest rate is the hospital charging for this loan?
39. Goldfarb Cancer Research Institute just received a $1.2 million gift to cover
the salary for a permanent scientific research position to study Hodgkin’s
The Time Value of Money 215
216 Financial Management of Health Care Organizations
Disease. What would be the required rate of return on the investment if the
position paid an annual salary of:
a. $60,000 per year?
b. $75,000 per year?
c. $100,000 per year?
40. Upon the untimely and tragic death of their wealthy aunt, the heirs wanted
to memorialize her with a named donation to the local hospital. They offered
the hospital a choice of $30,000 annual payments forever or a lump sum
payment of $400,000 today.
a. What should be the decision if the hospital thinks it could earn an average
of 4 percent annually on this donation?
b. What should be the decision if the hospital thinks it could earn an average
of 8 percent annually on this donation?
c. What should be the decision if the hospital thinks it could earn an average
of 12 percent annually on this donation?
41. Stillwater Hospital is borrowing $2,000,000 for its medical office building.
The annual interest rate is 6 percent. What will be the equal annual
payments on the loan if the length of the loan is 4 years and payments occur
at the end of each year?
42. Williamsburg Nursing Home is investing in a restricted fund for a new
assisted-living home. How much do they need to invest each year in order to
earn $5,000,000 after 15 years:
a. If the expected rate of return on the investment is 10 percent, and the
hospital invests at the end of each year?
b. If the expected rate of return on the investment is 10 percent, and the
hospital invests at the beginning of each year?
43. Carondelet Hospital is evaluating a lease arrangement for its ambulance fleet.
The total value of the lease is $405,000. The hospital will be making equal
monthly payments starting today.
a. What is the monthly interest rate if the lease payments are $21,000 per
month for 24 months?
b. What is the monthly interest rate if the lease payments are $21,000 per
month for 36 months?
c. What is the monthly interest rate if the lease payments are $26,000 per
month for 36 months?
44. A wealthy philanthropist has established the following endowment for a
hospital. The details of the endowment include the following:
a. A cash deposit of $10 million one year from now.
b. An annual cash deposit of $3 million per year for the next 15 years. The
first $3 million deposit will start today.
c. At the end of year 15, the hospital will also receive a lump sum payment
of $15 million.
Assuming the cost of money is 5 percent, what is the value of this
endowment in today’s dollars?
The Time Value of Money 217
Appendix B
Future and Present Value Tables
Appendix B presents pre-calculated tables to assist in determining future and present values,
(FV) and (PV). Future value is used to determine the future value of dollar payments made
earlier; present value indicates the current value of future dollars. Although the formulas to
compute these values appear in Chapter 6, pre-calculated tables provide a quick and flexible reference
for this information.
Appendix B presents this information in four ways. Table B–1 presents the future value of
$1 (FV): what the future value of a single investment today will be worth at a future time at a
given interest rate. Table B–2 reflects the future value of an annuity (FVFA): what the future
value an annuity received or invested today will be worth at a future time, given the interest rate
and number of periods involved. Table B–3 presents the present value of $1: how much a single,
one time amount to be received in the future at a specified interest rate is worth today.
Table B–4 reflects the present value of an annuity: the amount an annuity at a specified rate to
be received at equal flows at the end of a specified number of periods, is worth today.
Table B–1 Future Value of $1
FVFi,n = PV(1 + i)n; FV = PV(FVFi,n)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000 1.1100 1.1200 1.1300 1.1400 1.1500
2 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100 1.2321 1.2544 1.2769 1.2996 1.3225
3 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310 1.3676 1.4049 1.4429 1.4815 1.5209
4 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641 1.5181 1.5735 1.6305 1.6890 1.7490
5 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105 1.6851 1.7623 1.8424 1.9254 2.0114
6 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716 1.8704 1.9738 2.0820 2.1950 2.3131
7 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487 2.0762 2.2107 2.3526 2.5023 2.6600
8 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436 2.3045 2.4760 2.6584 2.8526 3.0590
9 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579 2.5580 2.7731 3.0040 3.2519 3.5179
10 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937 2.8394 3.1058 3.3946 3.7072 4.0456
11 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531 3.1518 3.4785 3.8359 4.2262 4.6524
12 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384 3.4985 3.8960 4.3345 4.8179 5.3503
13 1.1381 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523 3.8833 4.3635 4.8980 5.4924 6.1528
14 1.1495 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975 4.3104 4.8871 5.5348 6.2613 7.0757
15 1.1610 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772 4.7846 5.4736 6.2543 7.1379 8.1371
16 1.1726 1.3728 1.6047 1.8730 2.1829 2.5404 2.9522 3.4259 3.9703 4.5950 5.3109 6.1304 7.0673 8.1372 9.3576
17 1.1843 1.4002 1.6528 1.9479 2.2920 2.6928 3.1588 3.7000 4.3276 5.0545 5.8951 6.8660 7.9861 9.2765 10.761
18 1.1961 1.4282 1.7024 2.0258 2.4066 2.8543 3.3799 3.9960 4.7171 5.5599 6.5436 7.6900 9.0243 10.575 12.375
19 1.2081 1.4568 1.7535 2.1068 2.5270 3.0256 3.6165 4.3157 5.1417 6.1159 7.2633 8.6128 10.197 12.056 14.232
20 1.2202 1.4859 1.8061 2.1911 2.6533 3.2071 3.8697 4.6610 5.6044 6.7275 8.0623 9.6463 11.523 13.743 16.367
21 1.2324 1.5157 1.8603 2.2788 2.7860 3.3996 4.1406 5.0338 6.1088 7.4002 8.9492 10.804 13.021 15.668 18.822
22 1.2447 1.5460 1.9161 2.3699 2.9253 3.6035 4.4304 5.4365 6.6586 8.1403 9.9336 12.100 14.714 17.861 21.645
23 1.2572 1.5769 1.9736 2.4647 3.0715 3.8197 4.7405 5.8715 7.2579 8.9543 11.026 13.552 16.627 20.362 24.891
24 1.2697 1.6084 2.0328 2.5633 3.2251 4.0489 5.0724 6.3412 7.9111 9.8497 12.239 15.179 18.788 23.212 28.625
25 1.2824 1.6406 2.0938 2.6658 3.3864 4.2919 5.4274 6.8485 8.6231 10.835 13.585 17.000 21.231 26.462 32.919
26 1.2953 1.6734 2.1566 2.7725 3.5557 4.5494 5.8074 7.3964 9.3992 11.918 15.080 19.040 23.991 30.167 37.857
27 1.3082 1.7069 2.2213 2.8834 3.7335 4.8223 6.2139 7.9881 10.245 13.110 16.739 21.325 27.109 34.390 43.535
28 1.3213 1.7410 2.2879 2.9987 3.9201 5.1117 6.6488 8.6271 11.167 14.421 18.580 23.884 30.633 39.204 50.066
29 1.3345 1.7758 2.3566 3.1187 4.1161 5.4184 7.1143 9.3173 12.172 15.863 20.624 26.750 34.616 44.693 57.575
30 1.3478 1.8114 2.4273 3.2434 4.3219 5.7435 7.6123 10.063 13.268 17.449 22.892 29.960 39.116 50.950 66.212
35 1.4166 1.9999 2.8139 3.9461 5.5160 7.6861 10.677 14.785 20.414 28.102 38.575 52.800 72.069 98.100 133.18
40 1.4889 2.2080 3.2620 4.8010 7.0400 10.286 14.974 21.725 31.409 45.259 65.001 93.051 132.78 188.88 267.86
45 1.5648 2.4379 3.7816 5.8412 8.9850 13.765 21.002 31.920 48.327 72.890 109.53 163.99 244.64 363.68 538.77
50 1.6446 2.6916 4.3839 7.1067 11.467 18.420 29.457 46.902 74.358 117.39 184.56 289.00 450.74 700.23 1,083.7
(Continues)
Table B–1 (
Contd)
FVFi,n = PV(1 + i)n; FV = PV(FVFi,n)
Period 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 30% 35% 40% 45% 50%
1 1.1600 1.1700 1.1800 1.1900 1.2000 1.2100 1.2200 1.2300 1.2400 1.2500 1.3000 1.3500 1.4000 1.4500 1.5000
2 1.3456 1.3689 1.3924 1.4161 1.4400 1.4641 1.4884 1.5129 1.5376 1.5625 1.6900 1.8225 1.9600 2.1025 2.2500
3 1.5609 1.6016 1.6430 1.6852 1.7280 1.7716 1.8158 1.8609 1.9066 1.9531 2.1970 2.4604 2.7440 3.0486 3.3750
4 1.8106 1.8739 1.9388 2.0053 2.0736 2.1436 2.2153 2.2889 2.3642 2.4414 2.8561 3.3215 3.8416 4.4205 5.0625
5 2.1003 2.1924 2.2878 2.3864 2.4883 2.5937 2.7027 2.8153 2.9316 3.0518 3.7129 4.4840 5.3782 6.4097 7.5938
6 2.4364 2.5652 2.6996 2.8398 2.9860 3.1384 3.2973 3.4628 3.6352 3.8147 4.8268 6.0534 7.5295 9.2941 11.391
7 2.8262 3.0012 3.1855 3.3793 3.5832 3.7975 4.0227 4.2593 4.5077 4.7684 6.2749 8.1722 10.541 13.476 17.086
8 3.2784 3.5115 3.7589 4.0214 4.2998 4.5950 4.9077 5.2389 5.5895 5.9605 8.1573 11.032 14.758 19.541 25.629
9 3.8030 4.1084 4.4355 4.7854 5.1598 5.5599 5.9874 6.4439 6.9310 7.4506 10.604 14.894 20.661 28.334 38.443
10 4.4114 4.8068 5.2338 5.6947 6.1917 6.7275 7.3046 7.9259 8.5944 9.3132 13.786 20.107 28.925 41.085 57.665
11 5.1173 5.6240 6.1759 6.7767 7.4301 8.1403 8.9117 9.7489 10.657 11.642 17.922 27.144 40.496 59.573 86.498
12 5.9360 6.5801 7.2876 8.0642 8.9161 9.8497 10.872 11.991 13.215 14.552 23.298 36.644 56.694 86.381 129.75
13 6.8858 7.6987 8.5994 9.5964 10.699 11.918 13.264 14.749 16.386 18.190 30.288 49.470 79.371 125.25 194.62
14 7.9875 9.0075 10.147 11.420 12.839 14.421 16.182 18.141 20.319 22.737 39.374 66.784 111.12 181.62 291.93
15 9.2655 10.539 11.974 13.590 15.407 17.449 19.742 22.314 25.196 28.422 51.186 90.158 155.57 263.34 437.89
16 10.748 12.330 14.129 16.172 18.488 21.114 24.086 27.446 31.243 35.527 66.542 121.71 217.80 381.85 656.84
17 12.468 14.426 16.672 19.244 22.186 25.548 29.384 33.759 38.741 44.409 86.504 164.31 304.91 553.68 985.26
18 14.463 16.879 19.673 22.901 26.623 30.913 35.849 41.523 48.039 55.511 112.46 221.82 426.88 802.83 1,477.9
19 16.777 19.748 23.214 27.252 31.948 37.404 43.736 51.074 59.568 69.389 146.19 299.46 597.63 1,164.1 2,216.8
20 19.461 23.106 27.393 32.429 38.338 45.259 53.358 62.821 73.864 86.736 190.05 404.27 836.68 1,688.0 3,325.3
21 22.574 27.034 32.324 38.591 46.005 54.764 65.096 77.269 91.592 108.42 247.06 545.77 1,171.4 2,447.5 4,987.9
22 26.186 31.629 38.142 45.923 55.206 66.264 79.418 95.041 113.57 135.53 321.18 736.79 1,639.9 3,548.9 7,481.8
23 30.376 37.006 45.008 54.649 66.247 80.180 96.889 116.90 140.83 169.41 417.54 994.66 2,295.9 5,145.9 11,223
24 35.236 43.297 53.109 65.032 79.497 97.017 118.21 143.79 174.63 211.76 542.80 1,342.8 3,214.2 7,461.6 16,834
25 40.874 50.658 62.669 77.388 95.396 117.39 144.21 176.86 216.54 264.70 705.64 1,812.8 4,499.9 10,819 25,251
26 47.414 59.270 73.949 92.092 114.48 142.04 175.94 217.54 268.51 330.87 917.33 2,447.2 6,299.8 15,688 37,877
27 55.000 69.345 87.260 109.59 137.37 171.87 214.64 267.57 332.95 413.59 1,192.5 3,303.8 8,819.8 22,748 56,815
28 63.800 81.134 102.97 130.41 164.84 207.97 261.86 329.11 412.86 516.99 1,550.3 4,460.1 12,348 32,984 85,223
29 74.009 94.927 121.50 155.19 197.81 251.64 319.47 404.81 511.95 646.23 2,015.4 6,021.1 17,287 47,827 127,834
30 85.850 111.06 143.37 184.68 237.38 304.48 389.76 497.91 634.82 807.79 2,620.0 8,128.5 24,201 69,349 191,751
35 180.31 243.50 328.00 440.70 590.67 789.75 1,053.4 1,401.8 1,861.1 2,465.2 9,727.9 36,449 130,161 444,509 1,456,110
40 378.72 533.87 750.38 1,051.7 1,469.8 2,048.4 2,847.0 3,946.4 5,455.9 7,523.2 36,119 163,437 700,038 2,849,181 11,057,332
45 795.44 1,170.5 1,716.7 2,509.7 3,657.3 5,313.0 7,694.7 11,110 15,995 22,959 134,107 732,858 3,764,971 18,262,495 83,966,617
50 1,670.7 2,566.2 3,927.4 5,988.9 9,100.4 13,781 20,797 31,279 46,890 70,065 497,929 3,286,158 20,248,916 117,057,734 637,621,500
Table B–2 Future Value of an Annuity (FVFA)
Future Value of an Annuity of $1: FVIFAi, n = [(1 + i)n − 1] / i
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.0100 2.0200 2.0300 2.0400 2.0500 2.0600 2.0700 2.0800 2.0900 2.1000 2.1100 2.1200 2.1300 2.1400 2.1500
3 3.0301 3.0604 3.0909 3.1216 3.1525 3.1836 3.2149 3.2464 3.2781 3.3100 3.3421 3.3744 3.4069 3.4396 3.4725
4 4.0604 4.1216 4.1836 4.2465 4.3101 4.3746 4.4399 4.5061 4.5731 4.6410 4.7097 4.7793 4.8498 4.9211 4.9934
5 5.1010 5.2040 5.3091 5.4163 5.5256 5.6371 5.7507 5.8666 5.9847 6.1051 6.2278 6.3528 6.4803 6.6101 6.7424
6 6.1520 6.3081 6.4684 6.6330 6.8019 6.9753 7.1533 7.3359 7.5233 7.7156 7.9129 8.1152 8.3227 8.5355 8.7537
7 7.2135 7.4343 7.6625 7.8983 8.1420 8.3938 8.6540 8.9228 9.2004 9.4872 9.7833 10.089 10.405 10.730 11.067
8 8.2857 8.5830 8.8923 9.2142 9.5491 9.8975 10.260 10.637 11.028 11.436 11.859 12.300 12.757 13.233 13.727
9 9.3685 9.7546 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.164 14.776 15.416 16.085 16.786
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722 17.549 18.420 19.337 20.304
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 19.561 20.655 21.814 23.045 24.349
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 22.713 24.133 25.650 27.271 29.002
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212 28.029 29.985 32.089 34.352
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 30.095 32.393 34.883 37.581 40.505
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405 37.280 40.417 43.842 47.580
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 39.190 42.753 46.672 50.980 55.717
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545 44.501 48.884 53.739 59.118 65.075
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 50.396 55.750 61.725 68.394 75.836
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159 56.939 63.440 70.749 78.969 88.212
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203 72.052 80.947 91.025 102.44
21 23.239 25.783 28.676 31.969 35.719 39.993 44.865 50.423 56.765 64.002 72.265 81.699 92.470 104.77 118.81
22 24.472 27.299 30.537 34.248 38.505 43.392 49.006 55.457 62.873 71.403 81.214 92.503 105.49 120.44 137.63
23 25.716 28.845 32.453 36.618 41.430 46.996 53.436 60.893 69.532 79.543 91.148 104.60 120.20 138.30 159.28
24 26.973 30.422 34.426 39.083 44.502 50.816 58.177 66.765 76.790 88.497 102.17 118.16 136.83 158.66 184.17
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.41 133.33 155.62 181.87 212.79
26 29.526 33.671 38.553 44.312 51.113 59.156 68.676 79.954 93.324 109.18 128.00 150.33 176.85 208.33 245.71
27 30.821 35.344 40.710 47.084 54.669 63.706 74.484 87.351 102.72 121.10 143.08 169.37 200.84 238.50 283.57
28 32.129 37.051 42.931 49.968 58.403 68.528 80.698 95.339 112.97 134.21 159.82 190.70 227.95 272.89 327.10
29 33.450 38.792 45.219 52.966 62.323 73.640 87.347 103.97 124.14 148.63 178.40 214.58 258.58 312.09 377.17
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.28 136.31 164.49 199.02 241.33 293.20 356.79 434.75
35 41.660 49.994 60.462 73.652 90.320 111.43 138.24 172.32 215.71 271.02 341.59 431.66 546.68 693.57 881.17
40 48.886 60.402 75.401 95.026 120.80 154.76 199.64 259.06 337.88 442.59 581.83 767.09 1,013.7 1,342.0 1,779.1
45 56.481 71.893 92.720 121.03 159.70 212.74 285.75 386.51 525.86 718.90 986.64 1,358.2 1,874.2 2,590.6 3,585.1
50 64.463 84.579 112.80 152.67 209.35 290.34 406.53 573.77 815.08 1,163.9 1,668.8 2,400.0 3,459.5 4,994.5 7,217.7
(Continues)
Table B–2 (
Contd)
Future Value of an Annuity of $1: FVIFAi,n = [(1 + i)n – 1]/i
Period 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 30% 35% 40% 45% 50%
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.1600 2.1700 2.1800 2.1900 2.2000 2.2100 2.2200 2.2300 2.2400 2.2500 2.3000 2.3500 2.4000 2.4500 2.5000
3 3.5056 3.5389 3.5724 3.6061 3.6400 3.6741 3.7084 3.7429 3.7776 3.8125 3.9900 4.1725 4.3600 4.5525 4.7500
4 5.0665 5.1405 5.2154 5.2913 5.3680 5.4457 5.5242 5.6038 5.6842 5.7656 6.1870 6.6329 7.1040 7.6011 8.1250
5 6.8771 7.0144 7.1542 7.2966 7.4416 7.5892 7.7396 7.8926 8.0484 8.2070 9.0431 9.9544 10.946 12.022 13.188
6 8.9775 9.2068 9.4420 9.6830 9.9299 10.183 10.442 10.708 10.980 11.259 12.756 14.438 16.324 18.431 20.781
7 11.414 11.772 12.142 12.523 12.916 13.321 13.740 14.171 14.615 15.073 17.583 20.492 23.853 27.725 32.172
8 14.240 14.773 15.327 15.902 16.499 17.119 17.762 18.430 19.123 19.842 23.858 28.664 34.395 41.202 49.258
9 17.519 18.285 19.086 19.923 20.799 21.714 22.670 23.669 24.712 25.802 32.015 39.696 49.153 60.743 74.887
10 21.321 22.393 23.521 24.709 25.959 27.274 28.657 30.113 31.643 33.253 42.619 54.590 69.814 89.077 113.33
11 25.733 27.200 28.755 30.404 32.150 34.001 35.962 38.039 40.238 42.566 56.405 74.697 98.739 130.16 171.00
12 30.850 32.824 34.931 37.180 39.581 42.142 44.874 47.788 50.895 54.208 74.327 101.84 139.23 189.73 257.49
13 36.786 39.404 42.219 45.244 48.497 51.991 55.746 59.779 64.110 68.760 97.625 138.48 195.93 276.12 387.24
14 43.672 47.103 50.818 54.841 59.196 63.909 69.010 74.528 80.496 86.949 127.91 187.95 275.30 401.37 581.86
15 51.660 56.110 60.965 66.261 72.035 78.330 85.192 92.669 100.82 109.69 167.29 254.74 386.42 582.98 873.79
16 60.925 66.649 72.939 79.850 87.442 95.780 104.93 114.98 126.01 138.11 218.47 344.90 541.99 846.32 1,311.7
17 71.673 78.979 87.068 96.022 105.93 116.89 129.02 142.43 157.25 173.64 285.01 466.61 759.78 1,228.2 1,968.5
18 84.141 93.406 103.74 115.27 128.12 142.44 158.40 176.19 195.99 218.04 371.52 630.92 1,064.7 1,781.8 2,953.8
19 98.603 110.28 123.41 138.17 154.74 173.35 194.25 217.71 244.03 273.56 483.97 852.75 1,491.6 2,584.7 4,431.7
20 115.38 130.03 146.63 165.42 186.69 210.76 237.99 268.79 303.60 342.94 630.17 1,152.2 2,089.2 3,748.8 6,648.5
21 134.84 153.14 174.02 197.85 225.03 256.02 291.35 331.61 377.46 429.68 820.22 1,556.5 2,925.9 5,436.7 9,973.8
22 157.41 180.17 206.34 236.44 271.03 310.78 356.44 408.88 469.06 538.10 1,067.3 2,102.3 4,097.2 7,884.3 14,962
23 183.60 211.80 244.49 282.36 326.24 377.05 435.86 503.92 582.63 673.63 1,388.5 2,839.0 5,737.1 11,433 22,443
24 213.98 248.81 289.49 337.01 392.48 457.22 532.75 620.82 723.46 843.03 1,806.0 3,833.7 8,033.0 16,579 33,666
25 249.21 292.10 342.60 402.04 471.98 554.24 650.96 764.61 898.09 1,054.8 2,348.8 5,176.5 11,247 24,041 50,500
26 290.09 342.76 405.27 479.43 567.38 671.63 795.17 941.46 1,114.6 1,319.5 3,054.4 6,989.3 15,747 34,860 75,752
27 337.50 402.03 479.22 571.52 681.85 813.68 971.10 1,159.0 1,383.1 1,650.4 3,971.8 9,436.5 22,047 50,548 113,628
28 392.50 471.38 566.48 681.11 819.22 985.55 1,185.7 1,426.6 1,716.1 2,064.0 5,164.3 12,740 30,867 73,296 170,443
29 456.30 552.51 669.45 811.52 984.07 1,193.5 1,447.6 1,755.7 2,129.0 2,580.9 6,714.6 17,200 43,214 106,280 255,666
30 530.31 647.44 790.95 966.71 1,181.9 1,445.2 1,767.1 2,160.5 2,640.9 3,227.2 8,730.0 23,222 60,501 154,107 383,500
35 1,120.7 1,426.5 1,816.7 2,314.2 2,948.3 3,755.9 4,783.6 6,090.3 7,750.2 9,856.8 32,423 104,136 325,400 987,794 2,912,217
40 2,360.8 3,134.5 4,163.2 5,529.8 7,343.9 9,749.5 12,937 17,154 22,729 30,089 120,393 466,960 1,750,092 6,331,512 22,114,663
45 4,965.3 6,879.3 9,531.6 13,203 18,281 25,295 34,971 48,302 66,640 91,831 447,019 2,093,876 9,412,424 40,583,319 167,933,233
50 10,436 15,090 21,813 31,515 45,497 65,617 94,525 135,992 195,373 280,256 1,659,761 9,389,020 50,622,288 260,128,295 1,275,242,998
Table B–3 Present Value of $1
PVFi,n = 1/(1 + i)n; PV = FV(PVFi,n)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696
2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.7831 0.7695 0.7561
3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.6931 0.6750 0.6575
4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 0.6587 0.6355 0.6133 0.5921 0.5718
5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 0.5935 0.5674 0.5428 0.5194 0.4972
6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.4803 0.4556 0.4323
7 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132 0.4817 0.4523 0.4251 0.3996 0.3759
8 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665 0.4339 0.4039 0.3762 0.3506 0.3269
9 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.3329 0.3075 0.2843
10 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522 0.3220 0.2946 0.2697 0.2472
11 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.2607 0.2366 0.2149
12 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186 0.2858 0.2567 0.2307 0.2076 0.1869
13 0.8787 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897 0.2575 0.2292 0.2042 0.1821 0.1625
14 0.8700 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.1807 0.1597 0.1413
15 0.8613 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.1599 0.1401 0.1229
16 0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.1415 0.1229 0.1069
17 0.8444 0.7142 0.6050 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.1252 0.1078 0.0929
18 0.8360 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502 0.2120 0.1799 0.1528 0.1300 0.1108 0.0946 0.0808
19 0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.0981 0.0829 0.0703
20 0.8195 0.6730 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.0868 0.0728 0.0611
21 0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351 0.1117 0.0926 0.0768 0.0638 0.0531
22 0.8034 0.6468 0.5219 0.4220 0.3418 0.2775 0.2257 0.1839 0.1502 0.1228 0.1007 0.0826 0.0680 0.0560 0.0462
23 0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.2109 0.1703 0.1378 0.1117 0.0907 0.0738 0.0601 0.0491 0.0402
24 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1971 0.1577 0.1264 0.1015 0.0817 0.0659 0.0532 0.0431 0.0349
25 0.7798 0.6095 0.4776 0.3751 0.2953 0.2330 0.1842 0.1460 0.1160 0.0923 0.0736 0.0588 0.0471 0.0378 0.0304
26 0.7720 0.5976 0.4637 0.3607 0.2812 0.2198 0.1722 0.1352 0.1064 0.0839 0.0663 0.0525 0.0417 0.0331 0.0264
27 0.7644 0.5859 0.4502 0.3468 0.2678 0.2074 0.1609 0.1252 0.0976 0.0763 0.0597 0.0469 0.0369 0.0291 0.0230
28 0.7568 0.5744 0.4371 0.3335 0.2551 0.1956 0.1504 0.1159 0.0895 0.0693 0.0538 0.0419 0.0326 0.0255 0.0200
29 0.7493 0.5631 0.4243 0.3207 0.2429 0.1846 0.1406 0.1073 0.0822 0.0630 0.0485 0.0374 0.0289 0.0224 0.0174
30 0.7419 0.5521 0.4120 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.0256 0.0196 0.0151
35 0.7059 0.5000 0.3554 0.2534 0.1813 0.1301 0.0937 0.0676 0.0490 0.0356 0.0259 0.0189 0.0139 0.0102 0.0075
40 0.6717 0.4529 0.3066 0.2083 0.1420 0.0972 0.0668 0.0460 0.0318 0.0221 0.0154 0.0107 0.0075 0.0053 0.0037
45 0.6391 0.4102 0.2644 0.1712 0.1113 0.0727 0.0476 0.0313 0.0207 0.0137 0.0091 0.0061 0.0041 0.0027 0.0019
50 0.6080 0.3715 0.2281 0.1407 0.0872 0.0543 0.0339 0.0213 0.0134 0.0085 0.0054 0.0035 0.0022 0.0014 0.0009
(Continues)
Table B-3 (
Contd)
PVFi,n = 1/(1 + i)n; PV = FV(PVFi,n)
Period 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 30% 35% 40% 45% 50%
1 0.8621 0.8547 0.8475 0.8403 0.8333 0.8264 0.8197 0.8130 0.8065 0.8000 0.7692 0.7407 0.7143 0.6897 0.6667
2 0.7432 0.7305 0.7182 0.7062 0.6944 0.6830 0.6719 0.6610 0.6504 0.6400 0.5917 0.5487 0.5102 0.4756 0.4444
3 0.6407 0.6244 0.6086 0.5934 0.5787 0.5645 0.5507 0.5374 0.5245 0.5120 0.4552 0.4064 0.3644 0.3280 0.2963
4 0.5523 0.5337 0.5158 0.4987 0.4823 0.4665 0.4514 0.4369 0.4230 0.4096 0.3501 0.3011 0.2603 0.2262 0.1975
5 0.4761 0.4561 0.4371 0.4190 0.4019 0.3855 0.3700 0.3552 0.3411 0.3277 0.2693 0.2230 0.1859 0.1560 0.1317
6 0.4104 0.3898 0.3704 0.3521 0.3349 0.3186 0.3033 0.2888 0.2751 0.2621 0.2072 0.1652 0.1328 0.1076 0.0878
7 0.3538 0.3332 0.3139 0.2959 0.2791 0.2633 0.2486 0.2348 0.2218 0.2097 0.1594 0.1224 0.0949 0.0742 0.0585
8 0.3050 0.2848 0.2660 0.2487 0.2326 0.2176 0.2038 0.1909 0.1789 0.1678 0.1226 0.0906 0.0678 0.0512 0.0390
9 0.2630 0.2434 0.2255 0.2090 0.1938 0.1799 0.1670 0.1552 0.1443 0.1342 0.0943 0.0671 0.0484 0.0353 0.0260
10 0.2267 0.2080 0.1911 0.1756 0.1615 0.1486 0.1369 0.1262 0.1164 0.1074 0.0725 0.0497 0.0346 0.0243 0.0173
11 0.1954 0.1778 0.1619 0.1476 0.1346 0.1228 0.1122 0.1026 0.0938 0.0859 0.0558 0.0368 0.0247 0.0168 0.0116
12 0.1685 0.1520 0.1372 0.1240 0.1122 0.1015 0.0920 0.0834 0.0757 0.0687 0.0429 0.0273 0.0176 0.0116 0.0077
13 0.1452 0.1299 0.1163 0.1042 0.0935 0.0839 0.0754 0.0678 0.0610 0.0550 0.0330 0.0202 0.0126 0.0080 0.0051
14 0.1252 0.1110 0.0985 0.0876 0.0779 0.0693 0.0618 0.0551 0.0492 0.0440 0.0254 0.0150 0.0090 0.0055 0.0034
15 0.1079 0.0949 0.0835 0.0736 0.0649 0.0573 0.0507 0.0448 0.0397 0.0352 0.0195 0.0111 0.0064 0.0038 0.0023
16 0.0930 0.0811 0.0708 0.0618 0.0541 0.0474 0.0415 0.0364 0.0320 0.0281 0.0150 0.0082 0.0046 0.0026 0.0015
17 0.0802 0.0693 0.0600 0.0520 0.0451 0.0391 0.0340 0.0296 0.0258 0.0225 0.0116 0.0061 0.0033 0.0018 0.0010
18 0.0691 0.0592 0.0508 0.0437 0.0376 0.0323 0.0279 0.0241 0.0208 0.0180 0.0089 0.0045 0.0023 0.0012 0.0007
19 0.0596 0.0506 0.0431 0.0367 0.0313 0.0267 0.0229 0.0196 0.0168 0.0144 0.0068 0.0033 0.0017 0.0009 0.0005
20 0.0514 0.0433 0.0365 0.0308 0.0261 0.0221 0.0187 0.0159 0.0135 0.0115 0.0053 0.0025 0.0012 0.0006 0.0003
21 0.0443 0.0370 0.0309 0.0259 0.0217 0.0183 0.0154 0.0129 0.0109 0.0092 0.0040 0.0018 0.0009 0.0004 0.0002
22 0.0382 0.0316 0.0262 0.0218 0.0181 0.0151 0.0126 0.0105 0.0088 0.0074 0.0031 0.0014 0.0006 0.0003 0.0001
23 0.0329 0.0270 0.0222 0.0183 0.0151 0.0125 0.0103 0.0086 0.0071 0.0059 0.0024 0.0010 0.0004 0.0002 0.0001
24 0.0284 0.0231 0.0188 0.0154 0.0126 0.0103 0.0085 0.0070 0.0057 0.0047 0.0018 0.0007 0.0003 0.0001 0.0001
25 0.0245 0.0197 0.0160 0.0129 0.0105 0.0085 0.0069 0.0057 0.0046 0.0038 0.0014 0.0006 0.0002 0.0001 0.0000
26 0.0211 0.0169 0.0135 0.0109 0.0087 0.0070 0.0057 0.0046 0.0037 0.0030 0.0011 0.0004 0.0002 0.0001 0.0000
27 0.0182 0.0144 0.0115 0.0091 0.0073 0.0058 0.0047 0.0037 0.0030 0.0024 0.0008 0.0003 0.0001 0.0000 0.0000
28 0.0157 0.0123 0.0097 0.0077 0.0061 0.0048 0.0038 0.0030 0.0024 0.0019 0.0006 0.0002 0.0001 0.0000 0.0000
29 0.0135 0.0105 0.0082 0.0064 0.0051 0.0040 0.0031 0.0025 0.0020 0.0015 0.0005 0.0002 0.0001 0.0000 0.0000
30 0.0116 0.0090 0.0070 0.0054 0.0042 0.0033 0.0026 0.0020 0.0016 0.0012 0.0004 0.0001 0.0000 0.0000 0.0000
35 0.0055 0.0041 0.0030 0.0023 0.0017 0.0013 0.0009 0.0007 0.0005 0.0004 0.0001 0.0000 0.0000 0.0000 0.0000
40 0.0026 0.0019 0.0013 0.0010 0.0007 0.0005 0.0004 0.0003 0.0002 0.0001 0.0000 0.0000 0.0000 0.0000 0.0000
45 0.0013 0.0009 0.0006 0.0004 0.0003 0.0002 0.0001 0.0001 0.0001 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
50 0.0006 0.0004 0.0003 0.0002 0.0001 0.0001 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Table B–4 Present Value of an Annuity
PVAi,n = [1 − 1/(1 + i)n]/i; PVA = PMT or Annuity × (PVAi,n)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8850 0.8772 0.8696
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7591 1.7355 1.7125 1.6901 1.6681 1.6467 1.6257
3 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.5313 2.4869 2.4437 2.4018 2.3612 2.3216 2.2832
4 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.2397 3.1699 3.1024 3.0373 2.9745 2.9137 2.8550
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.8897 3.7908 3.6959 3.6048 3.5172 3.4331 3.3522
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.4859 4.3553 4.2305 4.1114 3.9975 3.8887 3.7845
7 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 5.0330 4.8684 4.7122 4.5638 4.4226 4.2883 4.1604
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.5348 5.3349 5.1461 4.9676 4.7988 4.6389 4.4873
9 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.9952 5.7590 5.5370 5.3282 5.1317 4.9464 4.7716
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.4177 6.1446 5.8892 5.6502 5.4262 5.2161 5.0188
11 10.368 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.8052 6.4951 6.2065 5.9377 5.6869 5.4527 5.2337
12 11.255 10.575 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 7.1607 6.8137 6.4924 6.1944 5.9176 5.6603 5.4206
13 12.134 11.348 10.635 9.9856 9.3936 8.8527 8.3577 7.9038 7.4869 7.1034 6.7499 6.4235 6.1218 5.8424 5.5831
14 13.004 12.106 11.296 10.563 9.8986 9.2950 8.7455 8.2442 7.7862 7.3667 6.9819 6.6282 6.3025 6.0021 5.7245
15 13.865 12.849 11.938 11.118 10.380 9.7122 9.1079 8.5595 8.0607 7.6061 7.1909 6.8109 6.4624 6.1422 5.8474
16 14.718 13.578 12.561 11.652 10.838 10.106 9.4466 8.8514 8.3126 7.8237 7.3792 6.9740 6.6039 6.2651 5.9542
17 15.562 14.292 13.166 12.166 11.274 10.477 9.7632 9.1216 8.5436 8.0216 7.5488 7.1196 6.7291 6.3729 6.0472
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.3719 8.7556 8.2014 7.7016 7.2497 6.8399 6.4674 6.1280
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.6036 8.9501 8.3649 7.8393 7.3658 6.9380 6.5504 6.1982
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.8181 9.1285 8.5136 7.9633 7.4694 7.0248 6.6231 6.2593
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.2922 8.6487 8.0751 7.5620 7.1016 6.6870 6.3125
22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.4424 8.7715 8.1757 7.6446 7.1695 6.7429 6.3587
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.5802 8.8832 8.2664 7.7184 7.2297 6.7921 6.3988
24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.7066 8.9847 8.3481 7.7843 7.2829 6.8351 6.4338
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.8226 9.0770 8.4217 7.8431 7.3300 6.8729 6.4641
26 22.795 20.121 17.877 15.983 14.375 13.003 11.826 10.810 9.9290 9.1609 8.4881 7.8957 7.3717 6.9061 6.4906
27 23.560 20.707 18.327 16.330 14.643 13.211 11.987 10.935 10.027 9.2372 8.5478 7.9426 7.4086 6.9352 6.5135
28 24.316 21.281 18.764 16.663 14.898 13.406 12.137 11.051 10.116 9.3066 8.6016 7.9844 7.4412 6.9607 6.5335
29 25.066 21.844 19.188 16.984 15.141 13.591 12.278 11.158 10.198 9.3696 8.6501 8.0218 7.4701 6.9830 6.5509
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.4269 8.6938 8.0552 7.4957 7.0027 6.5660
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.6442 8.8552 8.1755 7.5856 7.0700 6.6166
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.7791 8.9511 8.2438 7.6344 7.1050 6.6418
45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9.8628 9.0079 8.2825 7.6609 7.1232 6.6543
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.9148 9.0417 8.3045 7.6752 7.1327 6.6605
(Continues)
Table B–4 (
Contd)
PVAi,n = [1 − 1/(1 + i)n]/i; PVA = PMT or Annuity × (PVAi,n)
Period 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 30% 35% 40% 45% 50%
1 0.8621 0.8547 0.8475 0.8403 0.8333 0.8264 0.8197 0.8130 0.8065 0.8000 0.7692 0.7407 0.7143 0.6897 0.6667
2 1.6052 1.5852 1.5656 1.5465 1.5278 1.5095 1.4915 1.4740 1.4568 1.4400 1.3609 1.2894 1.2245 1.1653 1.1111
3 2.2459 2.2096 2.1743 2.1399 2.1065 2.0739 2.0422 2.0114 1.9813 1.9520 1.8161 1.6959 1.5889 1.4933 1.4074
4 2.7982 2.7432 2.6901 2.6386 2.5887 2.5404 2.4936 2.4483 2.4043 2.3616 2.1662 1.9969 1.8492 1.7195 1.6049
5 3.2743 3.1993 3.1272 3.0576 2.9906 2.9260 2.8636 2.8035 2.7454 2.6893 2.4356 2.2200 2.0352 1.8755 1.7366
6 3.6847 3.5892 3.4976 3.4098 3.3255 3.2446 3.1669 3.0923 3.0205 2.9514 2.6427 2.3852 2.1680 1.9831 1.8244
7 4.0386 3.9224 3.8115 3.7057 3.6046 3.5079 3.4155 3.3270 3.2423 3.1611 2.8021 2.5075 2.2628 2.0573 1.8829
8 4.3436 4.2072 4.0776 3.9544 3.8372 3.7256 3.6193 3.5179 3.4212 3.3289 2.9247 2.5982 2.3306 2.1085 1.9220
9 4.6065 4.4506 4.3030 4.1633 4.0310 3.9054 3.7863 3.6731 3.5655 3.4631 3.0190 2.6653 2.3790 2.1438 1.9480
10 4.8332 4.6586 4.4941 4.3389 4.1925 4.0541 3.9232 3.7993 3.6819 3.5705 3.0915 2.7150 2.4136 2.1681 1.9653
11 5.0286 4.8364 4.6560 4.4865 4.3271 4.1769 4.0354 3.9018 3.7757 3.6564 3.1473 2.7519 2.4383 2.1849 1.9769
12 5.1971 4.9884 4.7932 4.6105 4.4392 4.2784 4.1274 3.9852 3.8514 3.7251 3.1903 2.7792 2.4559 2.1965 1.9846
13 5.3423 5.1183 4.9095 4.7147 4.5327 4.3624 4.2028 4.0530 3.9124 3.7801 3.2233 2.7994 2.4685 2.2045 1.9897
14 5.4675 5.2293 5.0081 4.8023 4.6106 4.4317 4.2646 4.1082 3.9616 3.8241 3.2487 2.8144 2.4775 2.2100 1.9931
15 5.5755 5.3242 5.0916 4.8759 4.6755 4.4890 4.3152 4.1530 4.0013 3.8593 3.2682 2.8255 2.4839 2.2138 1.9954
16 5.6685 5.4053 5.1624 4.9377 4.7296 4.5364 4.3567 4.1894 4.0333 3.8874 3.2832 2.8337 2.4885 2.2164 1.9970
17 5.7487 5.4746 5.2223 4.9896 4.7746 4.5755 4.3908 4.2190 4.0591 3.9099 3.2948 2.8398 2.4918 2.2182 1.9980
18 5.8178 5.5339 5.2732 5.0333 4.8122 4.6079 4.4187 4.2431 4.0799 3.9279 3.3037 2.8443 2.4941 2.2195 1.9986
19 5.8775 5.5845 5.3162 5.0700 4.8435 4.6346 4.4415 4.2627 4.0967 3.9424 3.3105 2.8476 2.4958 2.2203 1.9991
20 5.9288 5.6278 5.3527 5.1009 4.8696 4.6567 4.4603 4.2786 4.1103 3.9539 3.3158 2.8501 2.4970 2.2209 1.9994
21 5.9731 5.6648 5.3837 5.1268 4.8913 4.6750 4.4756 4.2916 4.1212 3.9631 3.3198 2.8519 2.4979 2.2213 1.9996
22 6.0113 5.6964 5.4099 5.1486 4.9094 4.6900 4.4882 4.3021 4.1300 3.9705 3.3230 2.8533 2.4985 2.2216 1.9997
23 6.0442 5.7234 5.4321 5.1668 4.9245 4.7025 4.4985 4.3106 4.1371 3.9764 3.3254 2.8543 2.4989 2.2218 1.9998
24 6.0726 5.7465 5.4509 5.1822 4.9371 4.7128 4.5070 4.3176 4.1428 3.9811 3.3272 2.8550 2.4992 2.2219 1.9999
25 6.0971 5.7662 5.4669 5.1951 4.9476 4.7213 4.5139 4.3232 4.1474 3.9849 3.3286 2.8556 2.4994 2.2220 1.9999
26 6.1182 5.7831 5.4804 5.2060 4.9563 4.7284 4.5196 4.3278 4.1511 3.9869 3.3297 2.8560 2.4996 2.2221 1.9999
27 6.1364 5.7975 5.4919 5.2151 4.9636 4.7342 4.5243 4.3316 4.1542 3.9903 3.3305 2.8563 2.4997 2.2221 2.0000
28 6.1520 5.8099 5.5016 5.2228 4.9697 4.7390 4.5281 4.3346 4.1566 3.9923 3.3312 2.8565 2.4998 2.2222 2.0000
29 6.1656 5.8204 5.5098 5.2292 4.9747 4.7430 4.5312 4.3371 4.1585 3.9938 3.3317 2.8567 2.4999 2.2222 2.0000
30 6.1772 5.8294 5.5168 5.2347 4.9789 4.7463 4.5338 4.3391 4.1601 3.9950 3.3321 2.8568 2.4999 2.2222 2,0000
35 6.2153 5.8582 5.5386 5.2512 4.9915 4.7559 4.5411 4.3447 4.1644 3.9984 3.3330 2.8571 2.5000 2.2222 2.0000
40 6.2335 5.8713 5.5482 5.2582 4.9966 4.7596 4.5439 4.3467 4.1659 3.9995 3.3332 2.8571 2.5000 2.2222 2.0000
45 6.2421 5.8773 5.5523 5.2611 4.9986 4.7610 4.5449 4.3474 4.1664 3.9998 3.3333 2.8571 2.5000 2.2222 2.0000
50 6.2463 5.8801 5.5541 5.2623 4.9995 4.7616 4.5452 4.3477 4.1666 3.9999 3.3333 2.8571 2.5000 2.2222 2.0000
C h a p t e r S e v e n
THE INVESTMENT DECISION
Introduction
The Objectives of Capital Investment
Analysis
Non-financial Benefits
Financial Returns
Ability to Attract Funds in the Future
Analytic Methods
The Payback Method
Analysis
Strengths and Weaknesses of the Payback
Method
Net Present Value
NPV – Using the Small Hospital as an Example
of NPV Analysis
Decision Rules Regarding NPV
Using Spreadsheets to Calculate NPV
Strengths and Weaknesses of the NPV Method
Internal Rate of Return (IRR)
Equal Cash Flows
Unequal Cash Flows
Decision Rules with IRR
Strengths and Weaknesses of IRR Analysis
Using an NPV Analysis for a Replacement
Decision
Illustrative Example
Solution
Summary
Key Terms
Key Equation
Questions and Problems
Appendix C:Technical Concerns Regarding
Net Present Value
Determining the Amount of the Initial
Investment
Included Costs
Excluded Costs
Chapter Outline
Learning Objectives
After completing the material in this chapter, you will be able to:
Explain the financial objectives of health care providers.
Evaluate various capital investment alternatives.
Calculate and interpret net present value (NPV).
Calculate and interpret internal rate of return (IRR).
(Continues)
Introduction
Capital investment decisions involve major dollar investments that are expected to
achieve long-term benefits for an organization. Such investments, quite common in
health care, fall into three categories:
Strategic decisions: Capital investment decisions designed to increase a health
care organization’s strategic (long-term) position (e.g. purchasing physician
practices to increase horizontal integration).
Expansion decisions: Capital investment decisions designed to increase the
operational capability of a health care organization (e.g. increasing examination
space in a group practice to accommodate increased volume).
Replacement decisions: Capital investment decisions designed to replace older
assets with newer, cost saving, ones (e.g. replacing a hospital’s existing costaccounting
system with a newer, cost saving one).
A capital investment decision has two components: 1) determining if the investment is
worthwhile; and 2) determining how to finance the investment. Although these two decisions
are interrelated, they should be separated. This chapter focuses on the first component
– determining whether a capital investment should be undertaken. It is organized
around three factors related to analyzing capital investment decisions: 1) the objectives of
capital investment analysis; 2) three techniques to analyze capital investment decisions;
and 3) technical concerns related to capital budgeting. Chapter 8 focuses on capital financing
alternatives. Perspectives 7–1 and 7–2 offer some examples of capital investments.
The Investment Decision 227
Determining the Annual Cash Flows
Operating Cash Flows
Spillover Cash Flows
Non-regular Cash Flows and Terminal
Value Cash Flows
Accuracy of Cash Flow Estimates
Determining a Discount Rate
Appendix D:Adjustments for Net Working
Capital
Appendix E:Tax Implications for
For-profits in a Capital Budgeting
Decision
Appendix F: Comprehensive Capital
Budgeting Replacement Cost Example
Comparative Approach – Not-for-profit
Analysis
Existing Equipment
Replacement Equipment
Comparative Approach – For-profit
Analysis
Incremental Approach – Not-for-profit
Analysis
Incremental Approach – For-profit Analysis
Appendix Summary
Capital Investment
Decision: Decisions
involving major dollar
investments that are
expected to achieve
long-term benefits for
an organization.
Expansion Decision:
Capital investment
decision designed to
increase the
operational capability
of a health care
organization.
Strategic Decision:
Capital investment
decision designed to
increase a health care
organization’s strategic
(long-term) position.
Although determining if an investment is worthwhile and how to finance the investment are interrelated, they
should be considered separately.
Chapter Outline (Contd)
228 Financial Management of Health Care Organizations
Perspective 7–1
Investment in Cancer Treatment Equipment
St Joseph Healthcare and Radiation Oncology Associates of Albuquerque, New Mexico, have collaborated for 11
years to provide radiation treatment for cancer. Their latest joint effort resulted in $2.2 million in state-of-the-art
cancer treatment equipment. The investment in a new linear accelerator, a high-energy X-ray machine, was made
possible by $1 million from Radiation Oncology Associates and a year of fund-raising by the nonprofit St Joseph
Healthcare Foundation.
The nine-physician Radiation Oncology Associates, which built the $2.3 million cancer center in 1989, leases the
building and equipment to St Joseph.“We needed a place to practice our trade,” said Paul Anthony, who is a group
member and St Joseph radiation oncology medical director. Physician groups in other cities often set up their own
radiation treatment centers, but Radiation Oncology Associates wanted the stability of a hospital affiliation,Anthony
said. The new equipment enhances the group’s cancer treatment abilities as well as services available through St
Joseph.That health-care organization reported $5 million in operating losses earlier this year and has since hired the
Florida-based Hunter Group to find a way to reverse the decline in its financial fortunes.
The cancer center expansion “is financially viable whether the hospital does it or we do,” Anthony said. Medicare
still provides adequate reimbursement for radiation treatment, he added.“For the hospital to be in radiation therapy
is good for the hospital.” This is the center’s second linear accelerator for radiation treatment of cancer.The new
machine can handle about 30 percent more patients per day with more effective treatment and fewer side effects.
A third accelerator, at St. Joseph’s Downtown hospital, will be used for inpatient treatment.The Heights center will
be able to treat 80 patients a day.
Source: Winthrop Quigley,“Doctors, St Joseph Gets New Tool.” Albuquerque Journal, September 7, 2000, p. 1.
Perspective 7–2
McKessonHBOC Announces Next-Generation, Integrated Clinical Solution to Improve Patient Safety
and Reduce Cost of Care
The Information Technology Business of McKesson HBOC, Inc. (NYSE:MCK) recently announced a strategic relationship
with Vanderbilt University Medical Center (Vanderbilt) in Nashville,Tenn., to offer a world-class solution for
advanced clinical decision support and expert physician order entry.The solution, which has been in use at Vanderbilt
for the past six years, will be known as Horizon Expert Orders.
Horizon Expert Orders assists physicians in decision-making by presenting clinically relevant information about a
patient’s condition along with treatment protocols and evidence-based guidelines agreed upon by the organization’s
physicians. Armed with this information, physicians and other clinicians can quickly enter orders with a few keystrokes
or mouse clicks. Horizon Expert Orders also has financial implications. At Vanderbilt, system-driven results
include a $5 million annual reduction in pharmacy costs – excluding the value of adverse drug event prevention.
Vanderbilt also reduced its X-ray costs by more than $1.1 million.
Source: Jean Hodges, McKessonHBOC,Alpharetta (Information Technology Business), Atlanta, July 16, 2001.
The Objectives of Capital Investment Analysis
A capital investment is expected to achieve long-term benefits for the organization.
Such benefits generally fall into three categories: non-financial benefits, financial
returns, and the ability to attract more funds in the future (see Exhibit 7–1). Clearly,
these three objectives are highly interrelated. In the following discussion, it is important
to keep in mind that “investors” are not limited to those outside the organization.
When an organization purchases new assets or starts a new program, it is also an
investor – it is investing in itself.
Non-financial Benefits
A primary concern with many capital investment decisions is how well an investment
enhances the survival of the organization and supports its mission, patients, employees,
and the community. A particularly interesting movement in health care is the
increasing number of governmental agencies with taxing authority asking for proof of
community benefit. Community benefits include increased access to different types of
care, higher quality of care, lower charges, the provision of charity care, and the
employment of community members. Perspective 7–3 illustrates such an instance.
Financial Returns
Direct financial benefits are a primary concern not only to health care organizations,
but also to many – if not all – investors who invest in health care organizations and their
projects. Direct financial benefits to investors can take two forms. The first is periodic
payments in the form of dividends to stockholders and/or interest to bondholders.
The Investment Decision 229
Replacement
Decision: Capital
investment decision
designed to replace
older assets with
newer, cost saving,
ones.
Financial
Return
Future
Funding
Non-financial
Benefit
Exhibit 7–1 The Objectives of the Capital Investment Decision
(Bonds are discussed in Chapter 8.) Dividends represent the portion of profit that an
organization distributes to equity investors, whereas interest is a payment to creditors
– those who have loaned the organization funds or otherwise extended credit.
The second type of benefit to an investor is in the form of retained earnings,
the portion of the profits the organization keeps in-house to use in growth and support
of its mission. This describes the plowing back or investing of funds (including
retained earnings) into capital projects that appreciate in value. Capital
appreciation takes place whenever an investment is worth more when it is sold
than when it was purchased. For investor-owned organizations, this appreciation
in value increases the value of their stock.
Though almost all organizations can make periodic payments to their investors in
the form of interest, by law, only investor-owned health care organizations can distribute
dividends outside the organization.
Ability to Attract Funds in the Future
Without new capital funds, many health care organizations would be unable to offer
new services, support medical research, or subsidize unprofitable services. Therefore,
another objective of capital investment is to invest in profitable projects or services
that will attract debt (borrowing) and equity financing in the future. (Capital financing
is discussed at length in Chapter 8. Capital financing includes funds from a variety
of sources including government entities, foundations, and community-based
organizations.)
230 Financial Management of Health Care Organizations
Perspective 7–3
New Beckley Clinic to Help Thousands
Residents of Southern West Virginia who don’t have health insurance will soon have a medical clinic dedicated to
their care. Beckley Appalachian Regional Healthcare donated a building and will soon hire a nurse practitioner to see
patients, said Joe Zager, community CEO for Beckley Appalachian Regional Hospital. The clinic is patterned after
Helping Hands Health Right, a Charleston facility that offers medical care to the poor.“We have about 500 patients
from Raleigh and Fayette counties who drive or hitchhike to get to our medical services in Charleston,” said clinic
administrator Pat White. “This facility in Beckley will make a tremendous difference for them, as well as for many
other residents who are without access to health care.” The Beckley clinic is supported by a team of ministers,
health-care workers, and community leaders led by Jackie Snead, president of the board of directors of Helping
Hands Health Right Inc.
House Speaker Bob Kiss, D-Raleigh, presented Snead with a $25,000 check to help with initial operating costs.An
additional $5,000 was donated by Stanaford Missionary Baptist Church.Tom Williams, former director of Raleigh
County Hospice Care, will serve as administrator of the clinic, which is expected to serve 6,000 to 9,000 patients
during its first year.
Source: The Sunday Gazette Mail, Charleston, May 6, 2001, p. P7B.
Retained Earnings:
The portion of profits
that an organization
keeps in-house for
itself to use in growth
and support of its
mission.
Capital
Appreciation: Occurs
whenever an asset is
worth more when it is
sold than when it was
purchased. Common
examples would be
land, property, or
stocks.
Analytic Methods
An investment decision involves many factors (see Perspectives 7–4 and 7–5). Three
commonly used financial techniques to analyze capital investment decisions for health
care organizations are:
Payback.
Net Present Value.
Internal Rate of Return.
The Investment Decision 231
Perspective 7–4
Carolinas HealthCare System (CHS) Gains $326,000 Profit for First Quarter
CHS is one of the Southeast’s largest health-care systems, with dozens of hospitals, outpatient care centers, doctors’
offices, and other medical services in the Carolinas. It’s governed by a public hospital authority created by the
General Assembly in1943. Like other hospitals, CHS has been hit by tightened reimbursements from government
health insurance programs. CHS recently has been renegotiating its contracts with private insurers to try to increase
revenues.“It’s hard to say at this point” what effect those new contracts will have on CHS’s bottom line, said Steven
Graybill, a Charlotte-based health care consultant with William M. Mercer Inc.
In the meantime, CHS is working on other ways to raise revenues and cut expenses. On the revenue side, CHS
opened Carolinas Integrative Health, a cash-only alternative medicine clinic in Dilworth that is expected to prove
popular with people who seek massage, acupuncture, and nutritional supplements.
On the expense side, CHS continues to streamline its food services, contracting with a company that last month
opened a $5.6 million central kitchen facility that now cooks the food for all the hospitals. The relationship with
Morrison Healthcare Food Services is expected to save CHS $20 million over 10 years, a spokesman said.
Source: Mike Stobbe, The Charlotte Observer, June 20, 2001. Copyright 2001.
Perspective 7–5
CEO of Nashville, Tenn.-Based Healthcare Company Defends Integrity
Dr Frist, HCA’s chairman and CEO from 1987 to 1994, returned to that post in 1997. In his absence, the company
then known as Columbia/HCA underwent explosive growth and ran afoul of the federal government. “I found it a
far different company (in 1997) than the one I left,” he said.“We had 67 hospitals when I left and 367 when I came
back.We had to refocus the company, ask ourselves what markets we really wanted to be in.” Dr Frist said HCA’s
roster now includes 200 hospitals, on which the company spends about $1.5 billion per year.The $36 million project
at Parkridge includes expanded parking, renovation of patient rooms, and the hospital’s emergency facility and
construction of a cancer center. Frank Morgan, managing director and health care services analyst at the Nashville
office of Jefferies and Co., said the Parkridge project is consistent with the track HCA has taken since Dr Frist’s
return.“They’ve downsized, paid down debt, and made major reinvestments in core markets,” Mr Morgan said.“Why
buy a hospital in a new market? Renovating and building replacement hospitals in markets you already know is
viewed as less risky, and Chattanooga’s been a very good market for them.”
Source: Bob Gary Jr,“CEO of Nashville,Tenn.-Based Healthcare Company Defends Integrity.” Chattanooga Times/Free
Press, April 26, 2001. Copyright 2001.
Suppose Marquee Valley Hospital has $1,000,000 available to invest in a new business
(Exhibit 7–2, rows 1, 3). After examining the marketplace, it has narrowed the
possibilities to two promising options, each of which would require the full amount of
money available: it could either buy a small existing physician practice, or it could
build its own small satellite clinic. If it buys the physician practice, it would expect to
generate new net cash inflows of $333,333 each year for six years (Exhibit 7–2, row 2).
By investing in its own satellite clinic, Marquee Valley could expect to generate net
cash flows of $200,000, $250,000, $300,000, $350,000, $450,000, and $650,000 over the
next six years (Exhibit 7–2, row 4).
The Payback Method
One way to analyze these investments is to calculate the time it would take to recoup
the investment. This is called the payback method and is illustrated in Exhibit 7–3,
which builds on Exhibit 7–2.
Analysis
Exhibit 7–3 shows four rows for each investment: row A is the initial investment, row
B is the beginning balance for each year, row C is the cash flow for each year, and row
D is the cumulative cash flow for each year. Although the satellite clinic began the
fourth year with a $250,000 deficit (row B), it had a cash flow of $350,000 during the
year (row C); thus, its cumulative cash flow by the end of the fourth year was
$100,000. From row D, it is apparent that during the fourth year, the hospital would
have recouped its investment. Under either scenario, the hospital would be tying up
its money for at least three years.
The actual month in which breakeven occurs can be obtained by dividing the
amount of the deficit at the end of the year prior to breaking even by the average
232 Financial Management of Health Care Organizations
Until now, this book has stressed the accrual method of accounting. However, the techniques introduced in this
chapter – payback, net present value (NPV), and the internal rate of return (IRR) – use only cash flows. Therefore,
when only accrual information is available (such as information from financial statements), accrual items must
be converted into cash flows. An example is shown in the discussion of net present value.
Payback Method: A
method to evaluate
the feasibility of an
investment by
determining how long
it would take until the
initial investment is
recovered,
disregarding the time
value of money.
Givens:
Physician Practice Years 0 1
1 Initial Investment ($1,000,000)
2 Project’s Cash Flows Each Year $333,333 $333,333 $333,333 $333,333 $333,333 $333,333
Satellite Clinic Years 0 1
2
2
3
3
4
4
5
5
6
6
3 Initial Investment ($1,000,000)
4 Project’s Cash Flows Each Year $200,000 $250,000 $300,000 $350,000 $450,000 $650,000
Exhibit 7–2 Cash Flows for Two Alternative Project Investments
monthly inflow in the breakeven year. For example, the deficit at the end of the third
year for the satellite clinic is $250,000, and the average monthly inflow during the
fourth year is $29,167 ($350,000/12). Solving the equation, $250,000/$29,167 = 8.6
months. Thus, Marquee Valley would break even 6/10 of the way into month 9
(September) of the fourth year. If it bought the physician practice, it would break even
at the end of year 3, since it ends year 3 with no deficit.
If net cash inflows are equal each year (as they are with the physician practice), then
the number of years it takes to break even is simply the initial investment divided by the
annual net cash inflows resulting from the investment, and use of a table such as in
Exhibit 7–3 is unnecessary. Thus, the payback time for the physician practice would be
$1,000,000/$333,333, which equals 3 years, the same answer derived in Exhibit 7–3.
Strengths and Weaknesses of the Payback Method
The strengths of the payback method are that it is: 1) simple to calculate; and 2) easy to
understand (see Exhibit 7–4). There are three major weaknesses to the payback method,
however: 1) it gives an answer in years, not dollars; 2) it disregards cash flows after the
The Investment Decision 233
Physician Practice Years 0 1 2 3 4 5 6
A Initial Investment [1] ($1,000,000)
B Beginning of Year Balance [2] ($1,000,000) ($666,667) ($333,333) ($0) $333,333 $666,667
C Project’s Cash Flows Each Year [3] $333,333 $333,333 $333,333 $333,333 $333,333 $333,333
D Cumulative Cash Flow [A+B+C] ($1,000,000) ($666,667) ($333,333) ($0) $333,333 $666,667 $1,000,000
1 Exhibit 7−2, Row 1
2 Balance from End of Previous Year, Row D
3 Exhibit 7−2, Row 2
Breakeven year = Year 3
Satellite Clinic Years 0 1 2 3 4 5 6
A Initial Investment [4] ($1,000,000)
B Beginning of Year Balance [5] ($1,000,000) ($800,000) ($550,000) ($250,000) $100,000 $550,000
C Project’s Cash Flows Each Year [6] $200,000 $250,000 $300,000 $350,000 $450,000 $650,000
D Cumulative Cash Flow [A+B+C] ($1,000,000) ($800,000) ($550,000) ($250,000) $100,000 $550,000 $1,200,000
4 Exhibit 7−2, Row 3
5 Balance from End of Previous Year, Row D
6 Exhibit 7−2, Row 4
Breakeven year = Year 4
Exhibit 7–3 Calculation of Payback Year for Two Alternative Investments
Strengths Weaknesses
Simple to calculate Answers in years, not dollars
Easy to understand Disregards cash flows after payback
Does not account for the time value of money
Exhibit 7–4 Strengths and Weaknesses of the Payback Method
Formula to calculate the breakeven point in years if cash flows are equal each year:
Initial Investment/Annual Cash Flows
payback time; and 3) it does not account for the time value of money. Each of these is discussed
briefly in the next section.
1. The payback is in years, not dollars. Knowing that a project has a
payback of three years does not provide key financial information such as the
size of the dollar impact on the organization in future years.
2. The payback method disregards cash flows after the payback
time. For example, the physician practice has equal annual cash inflows
and a payback of three years, whereas the satellite clinic has unequal
annual cash inflows and doesn’t reach payback until year 4. Thus, the
physician practice, with its shorter payback, would appear to be the
better investment. However, the satellite clinic has better cash flows in later
years, and by the end of year 6, it brings in $200,000 more than does the
physician practice. Hence, in addition to time until payback, it is important
to consider the cash flows after the payback date when making an
investment.
3. The payback method does not account for the time value of money.
Chapter 6 demonstrated that a dollar received sometime in the future is not
worth the same as a dollar received today. The two evaluation methods
discussed in the remainder of this chapter, net present value and internal rate
of return, do take the time value of money into account, whereas the payback
method does not.
Net Present Value
Because of the deficiencies in using the payback method to analyze capital investments,
a preferred alternative is a net present value analysis. Net Present Value
(NPV) is the difference between the initial amount paid for an investment and the
future cash flows the investment brings in over time after they have been adjusted
(discounted) by the cost of capital. The cost of capital accounts for two costs: first,
investors (bondholders and stockholders) are being asked to delay the consumption of
their funds by investing in the project (time value of money); second, these investors
face a risk that the investment may not generate the revenues and net cash flows anticipated,
leaving them with an inadequate rate of return, or the project may fail altogether,
leaving the investors with perhaps nothing other than a tax loss.
If the sum of the discounted cash flows resulting from the investment is greater
than the initial investment itself, then the NPV is positive. Thus, from a purely financial
standpoint, the project is acceptable, all else being equal. On the other hand, if the
sum of the discounted cash flows resulting from the investment is less than the
234 Financial Management of Health Care Organizations
Net Present Value:
The difference
between the initial
amount paid for an
investment and the
future cash flows that
the investment brings
in, adjusted for the
cost of capital.
Discounted Cash
Flows: Cash flows
that have been
adjusted to account
for the cost of capital.
Cost of Capital: The
rate of return required
to undertake a project.
The cost of capital
accounts for both the
time value of money
and risk. Also called
the hurdle rate or
discount rate.
The following terms are used interchangeably: Cost of Capital, Discount Rate, and Hurdle Rate.
investment itself, then the investment brings in less than was initially paid out, the
NPV is negative, and the investment should be rejected.
NPV – Using the Satellite Clinic as an Example of an NPV Analysis
In the example used earlier (Exhibit 7–3), the annual cash flows were given, but in realworld
situations, organizations may not always have such information readily available.
Therefore, in the following example (see Exhibit 7–5), the same annual cash flows are used
as in the previous example ($200,000, $250,000, $300,000, $350,000, $450,000, and
$650,000), but these numbers are derived using additional information commonly found
in a budget forecast (revenues, expenses, depreciation, etc.). With this in mind, the net
present value of the satellite clinic alternative will be recalculated using the following steps:
Steps to Calculate Net Present Value of the Satellite Clinic Alternative
Step 1. Identify the initial cash outflow.
Step 2. Determine revenues and expenses (net income):
a. Identify annual net revenues.
b. Identify annual cash operating expenses and depreciation expense.
c. Compute annual net income.
Step 3. Add back in depreciation expense to get net operating cash flows.
Step 4. Add (subtract) any non-annual cash flows.
Step 5. Adjust for working capital.
Step 6. Determine the present value of each year’s cash flow.
Step 7. Sum the present values of all cash flows.
Step 8. Determine the net present value of the project.
1. Identify the initial cash outflow (row A). The initial investment in the
satellite clinic is $1,000,000.
2. Determine net income (rows B, C, D, E).
a. Identify annual cash inflows (revenues). Use net revenues rather
than gross revenues to account for the fact that discounts and allowances
will not be collected.
b. Identify annual cash operating expenses and depreciation expense.
c. Compute annual net income.
3. Add back depreciation (rows F, G). The annual expenses (Step 2b)
include depreciation expenses. However, depreciation is an expense that
does not require any cash outflow. Therefore, to calculate actual cash flows,
an amount equal to depreciation expense is added back to net income.
Depreciation is estimated at $145,000 annually. The end result is a higher
cash flow.
4. Add (subtract) any non-annual cash flows (rows H, I). Some projects
may have various non-annual cash flows that occur during the project. In
this example, the only non-annual cash flow is a cash inflow in year 6
resulting from selling some assets of the investment project. The salvage
value is estimated to be $130,000.
The Investment Decision 235
Salvage Value: The
amount of cash to be
received when an
asset is sold, usually
at the end of its useful
life. Also called
terminal value,
residual value, and
scrap value.
Exhibit 7–5 Computation of Net Present Value for the Satellite Clinic
Givens: Years 0
1
2
3
4
5
6
1 Initial investment ($1,000,000)
2 Net Revenue $
400,000 $
550,000 $
800,000 $
900,000 $
1,100,000 $
1,370,000
3 Cash Operating Expense $
200,000 $
300,000 $
500,000 $
550,000 $
650,000 $
850,000
4 Annual Depreciation $
145,000 $
145,000 $
145,000 $
145,000 $
145,000 $
145,000
5 Salvage value (
end of year 6) $
130,000
6 Cost of Capital 10%
Years 0
1
2
3
4
5
6
A Initial Investment [Given 1] ($1,000,000)
B Net Revenue [Given 2] $400,000 $550,000 $800,000 $900,000 $1,100,000 $1,370,000
C Less: Cash Operating Expenses [Given 3] $200,000 $300,000 $500,000 $550,000 $650,000 $850,000
D Less: Depreciation Expense [Given 4] $145,000 $145,000 $145,000 $145,000 $145,000 $145,000
E Net Operating Income [B − C − D] 55,000 105,000 155,000 205,000 305,000 375,000
F Add: Depreciation Expense [Given 4] 145,000 145,000 145,000 145,000 145,000 145,000
G Net Operating Cash Flows [E + F] 200,000 250,000 300,000 350,000 450,000 520,000
H Add: Sale of Salvage Value [Given 5] 130,000
I Project Cash Flows [G +
H] $200,000 $
250,000 $
300,000 $
350,000 $
450,000 $
650,000
J Cost of Capital [
Given 6] 10% 10% 10% 10% 10% 10%
K Present Value Interest Factors 1/(1 + i)n 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
L Annual PV of Cash Flows1 [l × K] $181,818 $206,612 $225,394 $239,055 $279,415 $366,908
M PV of Cash Flows [Sum L] $1,499,202
N Net Present Value [A + M] $499,202
1Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference between the
number displayed and that calculated manually.
5. Adjust for working capital. Some projects affect working capital, and to
the extent that this effect is material, it must be considered. In this example,
assume that there are no material working capital effects. Adjusting for
working capital is discussed in Appendix D.
6. Determine the present value of each year’s cash flow (rows I, J, K, L).
Steps 1–5 estimate cash flows that will occur each year. Step 6 discounts
these cash flows using the methods discussed in Chapter 6. A discount rate
of 10 percent is assumed for the satellite clinic project.
The $200,000 received at the end of year 1 (row I) is worth $181,818 in
today’s dollars (row L). The $250,000 received two years from now (row I)
is worth only $206,612 today (row L). The cash flows received in years 3
through 6 are discounted similarly.
7. Sum the present values of all cash flows (row M).
8. Determine the net present value of the project (rows A, M, N). The
net present value of the project is the difference between the discounted
annual cash flows and the initial investment. The net present value,
$499,202, is computed by adding the initial investment, −$1,000,000, a cash
outflow, to the present value of the annual cash flows, $1,499,202. If this
were the only investment alternative, since the net present value is positive,
this investment would be accepted based only on financial criteria.
It is also possible to calculate the NPV of the physician practice introduced in
Exhibit 7–2. Since the cash flows from this investment are equal in both amount and
timing, they can be treated as an ordinary annuity of $333,333 for six years at 10 percent.
The present value factor for this ordinary annuity is 4.3553. Thus, the present
value of the cash flows is $1,451,765 (4.3553 × $333,333) and the net present value of
the physician practice is $451,765 ($1,451,765 − $1,000,000).
The Investment Decision 237
In deriving the annual cash flows using pro forma operating statements that include depreciation expense,
depreciation expense or any other non-cash expense (amortization of goodwill) is added back to the bottom
line (operating income).
Interest expense should not be included as a cash flow, since it is part of financing flows and is included in the
discount rate. Therefore, if interest expense is included in the operating expenses, then for the non-taxpaying
entity, it should be added back into revenue in excess of expenses or earnings.
The terms present value and net present value should not be confused. Whereas present value is the sum
of discounted future cash flows, net present value is equal to the present value net (less) the cost of the initial
investment. Hence, in Exhibit 7–5, whereas the present value of the cash flows is $1,499,202 (the sum of the
cash flows for years 1–6), the net present value is only $499,202 (the cash flows from years 1–6 less the cost
of the initial $1,000,000 investment).
Goodwill: An amount
paid above and
beyond the book value
of an asset (typically a
business) when it is
sold, representing the
value of intangible
factors such as brand
reputation, customer
or supplier
relationships,
employee
competencies, etc.
Decision Rules Regarding NPV
As noted in Exhibit 7–5, the net present value of the satellite clinic investment, after
adjusting for depreciation and salvage value, is $499,202.
The general decision rule regarding NPV is: If NPV > 0, accept the
project; If NPV < 0, reject the project; If NPV = 0, then accept or
reject. Based on this rule, the satellite clinic should be purchased since it has
a positive NPV of $499,202. This rule applies in most cases; however, the rule
is modified for two other possible situations.
If more than one mutually exclusive project is being considered, the
one with the higher/highest positive NPV should be chosen. Thus, if a
second project were being considered, such as the purchase of the physician
practice, the satellite clinic alternative would be taken only if the physician
practice’s NPV were less than $499,202.
If more than one mutually exclusive project is being considered and
one must be selected regardless of NPV, then the one with the
higher/highest NPV should be chosen, even if its NPV is negative.
Suppose the organization was considering developing either a burn unit or a
school-based education program. Upon analysis, it is determined that one
project has a net present value of
−$4,000,000, and the other has a net present value of −$1,500,000. If it has
been decided in advance that one of the two projects will be undertaken, then
the one with the higher NPV should be chosen. In this case,
−$1,500,000 is the better choice.
Using Spreadsheets to Calculate NPV
Any popular spreadsheet is an ideal platform to calculate net present value, as most,
if not all, have built-in functions that make determination of NPV simple. Exhibit 7–6
shows how the NPV function in Excel can be used to compute the present value,
$1,499,202, of the annual cash flows in Exhibit 7–5. Note that all six years’ cash flows
are actually entered, although only the cash flows for the first four years are shown,
Excel’s NPV function is similar to its PV function, but allows for the use of unequal
cash flows. Finally, it is necessary to add the initial investment, −$1,000,000, to the
outside of the NPV function formula, which computes the present value of the annual
project cash flows, $1,499,202, to obtain the NPV of $499,202. (A common mistake
among users of the NPV function is to include the initial investment as a value in the
NPV function formula. The initial investment must be added outside the function
and needs to represent the negative outflow for the initial investment.)
238 Financial Management of Health Care Organizations
When using the Excel NPV function, the initial investment outlay must be added to the NPV function result, and
not entered as a value within the function itself.
Strengths and Weaknesses of the NPV Method
The NPV method has a number of strengths and weaknesses (see Exhibit 7–7). Its
strengths are: 1) it provides an answer in dollars, not years; 2) it accounts for all cash
flows in the project, including those beyond the payback period; and 3) it discounts
the cash flows at the cost of capital. Its main difficulties are developing estimates of
cash flows and the discount rate.
Conceptually, NPV is very strong because it accounts for all cash flows in a project
and discounts at the cost of capital. However, the cost of capital can be difficult to
determine, as discussed in Appendix C.
Internal Rate of Return (IRR)
The internal rate of return (IRR) on an investment can be defined and interpreted
several ways. It is: 1) the discount rate at which the discounted cash flows over the life of
the project exactly equal the initial investment; 2) the discount rate that results in a net
The Investment Decision 239
Exhibit 7–6 Using Excel to Calculate the Net Present Value of Unequal Annual Cash Flows,Assuming a 10
Percent Discount Rate
Strengths
Answers in dollars, not years
Accounts for all the cash flows in the project
Discounts at the cost of capital
Weaknesses
Estimates may be difficult to develop
Discount rate may be difficult to determine
Exhibit 7–7 Strengths and Weaknesses of the NPV Analysis
present value equal to zero; and 3) the percentage return on the investment. In contrast,
NPV is the dollar return on the investment. The method to use to solve for the IRR
depends on whether the cash flows are equal or unequal.
Equal Cash Flows
If the cash flows are equal each period, the IRR can be determined by first finding the
present value factor for an annuity, and then converting the answer to a discount rate
depending on the number of years. Since the physician practice example used earlier
has equal cash flows each period, its IRR can be found by:
1. Computing the present value factor for an annuity (PVFA) (see Chapter 6):
PV = Annuity × PVFAi,n
$1,000,000 = $333,333 × PVFAi,6
PVFAi,6 = 3.0
2. Finding the interest rate that yields this PVFA factor. In the present value
of an annuity table (Table B–4), in the row for 6 time periods (since the
investment is over 6 years), the column heading for the number closest to
3.0 (the PVFA factor) is the IRR. In this case, the PVFA factor of 3.0 lies
somewhere between the 24 percent and 25 percent columns; thus, the IRR
is approximately 24.5 percent.
Unequal Cash Flows
Business calculators and computer programs make finding the IRR for unequal cash
flows relatively easy. Excel’s function is called “IRR” (see Exhibit 7–8). All the operating
cash flow values of the project, including the initial investment, are entered individually,
or an array of cells is referenced (the initial investment must be a negative
value in either case, because it is a cash outflow). As shown in Exhibit 7–8, the IRR
appears at the bottom of the box.
240 Financial Management of Health Care Organizations
Internal Rate of Return: That rate of return on an investment which makes the net present value equal to $0,
after all cash flows have been discounted at the same rate. It is also the discount rate at which the discounted
cash flows over the life of the project exactly equal the initial investment
In contrast to Excel’s NPV function, the IRR function includes the initial investment as one of the entries in the
function.
Decision Rules with IRR
When an organization chooses a project according to the IRR method, its financial
decision depends upon the value of the IRR relative to the required rate of return
on the investment (which is also called the cost of capital or hurdle rate).
If the IRR is greater than the required rate of return, the project should be
accepted.
If the IRR is less than the required rate of return, the project should be
rejected.
If the IRR is equal to the required rate of return, the facility should be
indifferent about accepting or rejecting the project.
Strengths and Weaknesses of IRR Analysis
There are three major strengths to using IRR as a decision criterion: 1) it considers all the
relevant cash flows related to the investment project; 2) it is a time value of money-based
approach; and 3) managers are accustomed to evaluating projects by their respective rates
of return. Similarly, there are three weaknesses to using internal rate of return as a decision
criterion: 1) it assumes that proceeds are reinvested at the internal rate of return,
which may or may not be equal to the cost of capital; 2) developing estimates of cash flows
is difficult; and 3) internal rate of return sometimes generates multiple rates of return, if
future cash flows are estimates. Still, this method is widely used in industry as the preferred
way to make responsible investment decisions (see Exhibit 7–9).
Using an NPV Analysis for a Replacement Decision
The previous analyses have focused on situations in which an organization was interested
in either expanding its existing services or offering a new service altogether.
The Investment Decision 241
Required Rate of
Return: An
organization’s
minimally acceptable
internal rate of return
on any investment to
justify an initial
investment. Also called
Cost of Capital or
Hurdle Rate.
Exhibit 7–8 Using Excel to Calculate the Internal Rate of Return of a $1,000,000 Investment which Yields
Unequal Operating Cash Flows to Be Received at the End of Each of Six Successive Years
Note :The values in the array A1 :A7 = – 1000000; 200000; 250000; 300000; 350000; 450000; 650000
However, a common and more complicated analysis is the replacement decision,
which must be made by an organization when it contemplates replacing an older,
existing asset with a newer, more cost-efficient one. There are two ways to undertake
this problem, both using a net present value approach and both yielding the same
result. The first approach is to compare the net present value of continuing as is to
that of the replacement alternative, with the preferred investment alternative being
the one yielding the higher net present value. The second approach is to perform a
single net present value analysis using the incremental differences brought about by
replacing an asset. If the single NPV is positive, then the replacement alternative is
preferred.
Illustrative Example
Assume that a radiology laboratory in a not-for-profit organization is considering
renovating its X-ray processing area with new equipment that is faster and produces
better, more reliable images. The existing equipment was purchased five years ago for
$1,150,000 and is being depreciated on a straight-line basis over a ten-year life to a
$150,000 salvage value. The old equipment can be sold now for its current book value
of $650,000 ($1,150,000 original cost less $500,000 in accumulated depreciation).
The new equipment can be purchased for $1,500,000 and is estimated to have a
five-year life. It would be depreciated on a straight-line basis to a $750,000 salvage
value. The radiology department is a revenue-producing center. Presently, 45 patients
per day, 260 days/year, can be screened by one radiology technologist at an average
reimbursement of $75 per test, but a significant portion of these patients must be
given a second test at no additional charge because the first image is inconclusive. The
new equipment, because it is not only faster but produces images of better quality, can
process 60 patients per day. (In this example, the hospital believes that sufficient
demand exists to fully utilize the higher capacity of the new equipment.) An in-depth
discussion of how to estimate future cash flows is found in Appendix C.
242 Financial Management of Health Care Organizations
Replacement
Decision: Capital
investment decision
designed to replace
older assets with
newer, cost saving
ones.
Straight-line
Depreciation: A
method which
depreciates an asset
an equal amount each
year until it reaches its
salvage value at the
end of its useful life.
Strengths
Considers all relevant cash flows of the investment project
Time value of money-based approach
Widely used by practitioners and easily understood
Weaknesses
Assumes reinvestment of proceeds at the internal rate of return
Estimates may be difficult to develop
Can generate multiple rates of return
Exhibit 7–9 Strengths and Weaknesses of the IRR Analysis
The old equipment costs $60,000 per year in utilities and maintenance. The new
equipment would cost $30,000 per year in utilities and maintenance. The annual
labor expenses will not change because one radiology technologist is needed
to operate either piece of equipment. Cost of capital for this organization is
9 percent.
Solution
Exhibits 7–10a and 7–10b present the comparative approach to solve this problem.
This approach employs the same eight steps outlined in Exhibit 7–5. An NPV is calculated
for each alternative, and then the NPVs are compared to determine which is
higher. As an alternative method, Exhibit 7–11 uses the incremental approach to solve
the same problem, whereby instead of calculating two NPVs and comparing them, it
calculates a single NPV based upon marginal differences for each cash flow. The
results are exactly the same.
Using the comparative approach, the net present value over the next five years for the
new equipment, $4,071,651 (Exhibit 7–10b, row N), is higher than that of the old equipment,
$3,277,280 (Exhibit 7–10a, row N). Therefore, the decision in this case would be
to renovate the area with the new equipment. Similarly, using the incremental approach,
the net present value is $794,371 (Exhibit 7–11, row N). Thus, since the NPV is positive,
the replacement decision should be made. Incidentally, note that the $794,371 NPV using
the incremental method is exactly the difference between the two alternatives ($4,071,651
− $3,277,280) using the comparative approach. Thus, the results are the same using either
method; just the method of calculation differs.
Before a final decision is made, however, several issues must be considered: 1) the
purchase of a new asset typically requires a large up-front expenditure, which may not
always be feasible; 2) future cash flows are difficult to determine and may not always
be accurate, especially the salvage value; 3) the exact cost of capital is difficult to determine;
and 4) though not the case here, replacement of an old asset with a new asset
may not make sense financially (i.e. NPVNew < NPVOld), but replacement may be
necessary for other reasons, such as to remain competitive by being able to offer the
latest technology to consumers.
Summary
This chapter introduces three methods to evaluate large dollar, multi-year investment
decisions: payback, net present value, and internal rate of return. The payback
method measures how long it takes to recover the initial investment. The
strengths of the payback method are that it is simple to calculate and is easy to
understand. Its major weaknesses are that it does not account for the time value of
money, it provides an answer in years, not dollars, and it disregards cash flows after
the payback.
The net present value (NPV) method overcomes the weaknesses of the payback
method by accounting for cash flows after payback and discounting these cash flows
The Investment Decision 243
Exhibit 7–10a NPV Comparative Analysis of a Replacement Decision – Old Equipment
Cash flows with the Old Equipment
Givens:
1 Initial Investment $0
2 Annual Revenues1 $
877,500
3 Annual Cash Operating Expenses $
60,000
4 Annual Depreciation2 $
100,000
5 Salvage Value at 10 Years (5
years hence) $
150,000
6 Cost of Capital 9%
1 $75/Exam × 45 Exams/Day × 260 Operating Days/Year
2 ($1,150,000 Initial Cost – $
150,000 Salvage Value)/10 years
Years 0
1
2
3
4
5
A Initial Investment [Given 1] $0
B Net Revenues [Given 2] $877,500 $877,500 $877,500 $877,500 $877,500
C Less: Cash Operating Expenses [Given 3] 60,000 60,000 60,000 60,000 60,000
D Less: Depreciation Expense [Given 4] 100,000 100,000 100,000 100,000 100,000
E Operating Income [B − C − D] 717,500 717,500 717,500 717,500 717,500
F Add: Depreciation Expense [Given 4] 100,000 100,000 100,000 100,000 100,000
G Net Operating Cash Flows [E + F] 817,500 817,500 817,500 817,500 817,500
H Add: Sale of Salvage [Given 5] 150,000
I Project Cash Flows [G +
H] $
817,500 $
817,500 $
817,500 $
817,500 $
967,500
J Cost of Capital [
Given 6] 9% 9% 9% 9% 9%
K Present Value Interest Factors 1/(1 + i)n 0.9174 0.8417 0.7722 0.7084 0.6499
L Annual PV of Cash Flows3 [I × K] $750,000 $688,073 $631,260 $579,138 $628,809
M PV of Cash Flows [Sum L] $3,277,280
N Net Present Value [A + M] $3,277,280
3 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the
number displayed and that calculated manually.
Exhibit 7–10b NPV Comparative Analysis of a Replacement Decision – New Equipment
Cash flows with the New Equipment
Givens:
1 Initial Investment Amount1 $
850,000
2 Annual Revenues2 $
1,170,000
3 Annual Cash Operating Expenses $
30,000
4 Annual Depreciation3 $
150,000
5 Salvage Value (5
years hence) $
750,000
6 Cost of Capital 9%
1 $1,500,000 Initial Cost − $650,000 Sale of Old Equipment
2 $75/Exam × 60 Exams/Day × 260 Operating Days/Year
3 ($1,500,000 Initial Cost – $750,000 Salvage Value)/5 Years
Years 0
1
2
3
4
5
A Initial Investment [Given 1
($850,000)
B Net revenues [Given 2] $1,170,000 $1,170,000 $1,170,000 $1,170,000 $1,170,000
C Less: Cash Operating Expenses [Given 3] 30,000 30,000 30,000 30,000 30,000
D Less: Depreciation Expense [Given 4] 150,000 150,000 150,000 150,000 150,000
E Operating Income [B − C − D] 990,000 990,000 990,000 990,000 990,000
F Add: Depreciation Expense [Given 4] 150,000 150,000 150,000 150,000 150,000
G Net Operating Cash Flows [E + F] 1,140,000 1,140,000 1,140,000 1,140,000 1,140,000
H Add: Sale of Salvage Value [Given 5] 750,000
I Project Cash Flows [G +
H] $
1,140,000 $
1,140,000 $
1,140,000 $
1,140,000 $
1,890,000
J Cost of Capital [
Given 6] 9% 9% 9% 9% 9%
K Present Value Interest Factors 1/(1 + i)n 0.9174 0.8417 0.7722 0.7084 0.6499
L Annual PV of Cash Flows4 [I × K] $1,045,872 $959,515 $880,289 $807,605 $1,228,370
M PV of Cash Flows [Sum L] $4,921,651
N Net Present Value [A + M] $4,071,651
4 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a difference between the
number displayed and that calculated manually.
Exhibit 7–11 NPV Comparative Analysis of a Replacement Decision – The Incremental Approach
Cash Flows
Incremental
Old New Difference
Givens: Equipment Equipment (New – Old) Incremental = New – Old
1 Initial Investment ($850,000) ($850,000)
2 Annual Revenues1 $
877,500 $
1,170,000 $
292,500 Incremental Net Revenues
3 Annual Cash Operating Expenses ($60,000) ($30,000) $
30,000 Incremental Operating Cash Savings
4 Annual Depreciation2 $
100,000 $
150,000 $
50,000 Incremental Depreciation Expenses
5 Salvage Value $
150,000 $
750,000 $
600,000 Incremental Salvage Value
6 Cost of Capital 9%
1 Old: $
75/Exam ×
45 Exams/Day ×
260 Operating Days/Year New: $
75/Exam ×
60 Exams/Day ×
260 Operating Days/Year
2 Old: ($1,150,000 Initial Cost − $
150,000 Salvage Value)/10 Years New: ($1,500,000 Initial Cost − $
750,000 Salvage Value)/5
Years
The income statement below subtracts the $50,000 depreciation expense in row E.
Years 0
1
2
3
4
5
A Initial Investment [Given 1] ($850,000)
B Incremental Net Revenues [Given 2] $292,500 $292,500 $292,500 $292,500 $292,500
C Incremental Operating Cash Savings [Given 3] 30,000 30,000 30,000 30,000 30,000
D Incremental Depreciation Expenses [Given 4] 50,000 50,000 50,000 50,000 50,000
E Incremental Net Operating Income [(B + C) − D] 272,500 272,500 272,500 272,500 272,500
F Add: Incremental Depreciation [Given 4] 50,000 50,000 50,000 50,000 50,000
G Incremental Net Operating Cash Flow [E + F] 322,500 322,500 322,500 322,500 322,500
H Add: Incremental Salvage Value [Given 5] 600,000
I Project Incremental Cash Flows [G +
H] $322,500 $
322,500 $
322,500 $
322,500 $
922,500
J Cost of Capital [
Given 6] 9% 9% 9% 9% 9%
K Present Value Interest Factors 1/(1 + i)n 0.9174 0.8417 0.7722 0.7084 0.6499
L Annual PV of Incremental Cash Flows3 [I × K] $295,872 $271,442 $249,029 $228,467 $599,562
M PV of Incremental Cash Flows [Sum L] $1,644,371
N Net Present Value [A + M] $794,371
3 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference between the
number displayed and that calculated manually.
by the project’s cost of capital. The project’s cost of capital is the rate of return that
compensates investors for the time value of money and for the risk of the investment.
The net present value measures the difference between the present value of the operating cash
flows generated by the investment and the initial cost of that investment. The NPV technique
measures the dollar return on the investment.
The general decision rule regarding NPV is: if NPV > 0, accept the project;
if NPV < 0, reject the project; if NPV = 0, then accept or reject. If more than
one mutually exclusive project is being considered, then the one with the higher/
highest positive NPV should be chosen. If more than one mutually exclusive
project is being considered, and one must be undertaken regardless of NPV, then
the one with the higher/highest NPV should be chosen, even if the NPV is
negative.
The strengths of the NPV method of capital investment analysis are that it
provides an answer in dollars, not years; it accounts for all cash flows from the
project, including those beyond the payback period; and it discounts these cash
flows at the cost of capital. The major weakness to the NPV method is that the
discount rate is often difficult to determine and may be hard to justify. The
calculation of an NPV can be accomplished in the eight steps presented in
the chapter.
Step 1. Identify the initial cash outflow.
Step 2. Determine revenues and expenses (net income):
a. Identify annual net revenues.
b. Identify annual cash operating expenses and depreciation
expense.
c. Compute annual net income.
Step 3. Add back in depreciation expense to get net operating cash
flows.
Step 4. Add (subtract) any non-annual cash flows.
Step 5. Adjust for working capital.
Step 6. Determine the present value of each year’s cash flow.
Step 7. Sum the present values of all cash flows.
Step 8. Determine the net present value of the project.
The internal rate of return (IRR) method determines the actual percentage
return on the investment. When an organization chooses a project according to
the IRR method, its decision depends on the value of the IRR relative to the
required rate of return on the investment (also called the cost of capital or hurdle
rate).
If the IRR is greater than the required rate of return, the project should be
accepted.
If the IRR is less than the required rate of return, the project should be
rejected.
If the IRR is equal to the required rate of return, the facility should be
indifferent about accepting or rejecting the project.
The Investment Decision 247
Key Equation
Payback in Years if Cash Flows are Equal Each Year:
Initial Investment/Annual Cash Flows
Questions and Problems
Note that questions and problems include materials from the Appendices following this
chapter.
1. Define the following terms:
a. Cannibalization.
b. Capital Appreciation.
c. Cost of Capital.
d. Discount Rate.
e. Discounted Cash Flows.
f. Dividends.
g. Expansion Decisions.
h. Goodwill.
i. Hurdle Rate.
j. Incremental Cash Flows.
k. Interest.
l. Internal Rate of Return.
m. Internal Rate of Return Method.
n. Net Present Value.
o. Net Present Value Method.
p. Non-regular Cash Flows.
q. Operating Cash Flows.
r. Opportunity Costs.
s. Payback Method.
248 Financial Management of Health Care Organizations
Cannibalization
Capital investments
Capital Investment Decisions
Capital Appreciation
Cost of Capital
Discount Rate
Discounted Cash Flows
Dividends
Expansion Decision
Goodwill
Hurdle Rate
Incremental Cash Flows
Interest
Internal Rate of Return
Internal Rate of Return
Method
Net Present Value
Net Present Value Method
Non-regular Cash Flows
Operating Cash Flows
Opportunity Costs
Payback Method
Regular Cash Flows
Replacement Decision
Required Rate of Return
Residual Value
Retained Earnings
Salvage Value
Scrap Value
Straight-line Depreciation
Strategic Decision
Sunk Costs
Terminal Value
Key Terms
t. Regular Cash Flows.
u. Replacement Decisions.
v. Required Rate of Return.
w. Residual Value.
x. Retained Earnings.
y. Salvage Value.
z. Scrap Value.
aa. Straight-line Depreciation.
bb. Strategic Decisions.
cc. Sunk Costs.
dd. Terminal Value.
2. Comment on the following statement. “When a not-for-profit facility receives a
contribution from a member of the community, the cost of capital is inconsequential
when deciding how to use this contribution, because it is, in effect, free
money.”
3. From a capital investment point of view, what are the goals of a health care
facility?
4. What are the primary drawbacks of the payback method as a capital budgeting
technique?
5. When using the IRR approach, when can the internal rate of return be
determined simply by dividing the initial outlay by the cash flows?
6. Explain why pro forma income statements adjust for depreciation expense when
developing projected cash flows for a project.
7. If a hospital were considering a new Women’s Health Initiative, what spillover
cash flows might result?
8. When performing a capital budgeting analysis, what costs should be included,
and what costs should be excluded as part of the initial investment?
9. Why are financing flows such as interest expense and dividend payments
excluded from the computation of cash flows?
10. Will a decision that is based upon NPV ever change if it were based upon IRR
instead? Why or why not?
11. Marleboro Memorial Hospital is expecting its new cancer center to generate the
following cash flows:
Year 0 1 23 4 5
Initial ($1,000,000)
investment
Net operating $200,000 $300,000 $500,000 $300,000 $250,000
cash flows
a. Determine the payback for the new cancer center.
b. Determine the net present value using a cost of capital of 12 percent.
c. Determine the net present value at 16 percent and the internal rate of return.
d. Based on net present value, should the project be accepted on a financial
basis?
The Investment Decision 249
12. Buxton Community is expecting its new dialysis unit to generate the following
cash flows:
Year 0 1 23 4 5
Initial ($5,000,000)
investment
Net operating ($150,000) $800,000 $1,000,000 $4,000,000 $5,000,000
cash flows
a. Determine the payback for the new dialysis unit.
b. Determine the net present value using a cost of capital of 11 percent.
c. Determine the net present value at 20 percent and the internal rate of
return.
d. Based on net present value, should the project be accepted on a financial
basis?
13. Letterman Hospital expects Projects A and B to generate the following cash flows:
Project A
Year 0 1 23 4 5
Initial ($500)
investment
Net operating $900 $800 $300 $200 $100
cash flows
Project B
Year 0 1 2 3 4 5
Initial ($500)
investment
Net operating $100 $200 $300 $800 $900
cash flows
a. Determine the net present value for both projects using a cost of capital of
15 percent.
b. Determine the net present value for both projects using a cost of capital of
5 percent.
c. At a 5 percent discount rate, which project should be accepted? At a 15
percent discount rate, which project should be accepted? Explain.
14. Castle Rock Medical Center expects Projects X and Y to generate the following
cash flows:
Project X
Year 0 1 23 4 5
Initial ($2,500)
investment
Net operating $2,300 $1,500 $1,000 $800 $500
cash flows
250 Financial Management of Health Care Organizations
Project Y
Year 0 1 23 4 5
Initial investment ($2,500)
Net operating $500 $800 $1,000 $1,500 $2,300
cash flows
a. Determine the net present value for both projects using a cost of capital of
13 percent.
b. Determine the net present value for both projects using a cost of capital of
8 percent.
c. At an 8 percent discount rate, which project should be accepted? At a 13
percent discount rate, which project should be accepted? Explain.
15. Goodbar Practice expects Projects 1 and 2 to generate the following cash flows:
Project 1
Year 0 1 23 4 5
Initial ($3,755)
investment
Net operating $900 $1,200 $1,300 $1,400 $1,450
cash flows
Project 2
Year 0 1 23 4 5
Initial ($1,880)
investment
Net operating $500 $500 $500 $500 $500
cash flows
a. Determine the payback for both projects.
b. Determine the internal rate of return.
c. Determine the net present value at a cost of capital of 12 percent.
16. Martin Medical expects Alpha Project and Beta Project to generate the following
cash flows:
Alpha Project
Year 0 1 23 4 5
Initial ($8,000)
investment
Net operating ($4,000) $2,500 $5,000 $7,000 $12,000
cash flows
Beta Project
Year 0 1 23 4 5
Initial ($12,000)
investment
Net operating $3,000 $3,000 $3,000 $3,000 $3,000
cash flows
The Investment Decision 251
a. Determine the payback for both projects.
b. Determine the internal rate of return.
c. Determine the net present value at a cost of capital of 14 percent.
17. Tin Man Memorial Hospital, a non-taxpaying entity, is starting a new heart
center. The expected patient volume demands will generate $8,000,000 per year
in revenues for the next five years. The expected operating expenses, excluding
depreciation, will increase expenses by $3,000,000 per year for the next five
years. The initial cost of building and equipment is $16,000,000. Straight-line
depreciation is used to estimate depreciation expense and the building and
equipment will be depreciated over a five-year life to their salvage value. The
expected salvage value of the building and equipment at year five is $1,000,000.
The cost of capital for this project is 8 percent.
a. Compute the net present value and internal rate of return to determine the
financial feasibility of this project.
b. Compute the net present value and internal rate of return to determine the
financial feasibility of this project if this were a taxpaying entity with a tax
rate of 40 percent. (Hint: see Appendix E. Since the hospital is depreciating
to the salvage value, there is no tax effect on the sale of the asset.)
18. Fall City Healthcare System, a non-taxpaying entity, is going to build a satellite
ancillary facility. The tests will generate $15,000,000 per year in revenues for
the next five years. The expected operating expenses, excluding depreciation,
will increase expenses by $8,000,000 per year for the next five years. The initial
cost for the building is $25,000,000, which will be depreciated on a straight-line
basis to its salvage value. The salvage value at year 5 is $5,000,000. The cost of
capital for this project is 9 percent.
a. Compute the net present value and internal rate of return to determine the
financial feasibility of this project.
b. Compute the net present value and internal rate of return to determine the
financial feasibility of this project if this were a taxpaying entity with a tax
rate of 35 percent. (Hint: see Appendix E. Since the organization is depreciating
to the salvage value, there is no tax effect on the sale of the asset.)
19. Due to rising fuel prices, Eastern Community Hospital wants to replace its
existing fleet of ambulances with a more fuel-efficient fleet. The existing fleet
was purchased three years ago for $150,000 and is being depreciated on a
straight-line basis over an eight-year life to zero salvage value. Though the current
book value for the existing fleet is $93,750, this fleet could only be sold for
$80,000 today. The new fleet would cost $250,000 and would be depreciated on
a straight-line basis over a five-year life to a zero salvage value. The new fleet
would reduce fuel costs by $80,000 per year for five years and would not affect
the level of net working capital. The economic life of the new fleet is five years
and the required rate of return on the project is 5 percent.
a. Should the existing fleet of ambulances be replaced? Use the incremental
NPV approach to evaluate the decision under a non-profit assumption.
b. If the facility were a taxpaying entity with a tax rate of 40 percent, should
the existing fleet be replaced? Use the incremental NPV approach to evaluate
the decision. (Hint: see Appendix F.)
252 Financial Management of Health Care Organizations
20. Because of a rise in chart requests complicated by constant turnover within the
Medical Records Department, Valley Regional wants to replace its existing
medical records system with a labor saving optical disk version. The existing
system, which has a current book value of $75,000, was purchased three years
ago for $120,000 and is being depreciated on a straight-line basis over an eightyear
life to zero salvage value. This system could be sold for $65,000 today. The
new optical system would reduce the need for staff by three people per year for
five years at a savings of $25,000 per person per year; however, it would require
additional part-time programming costs to maintain the system at $15,000 per
year. The project would not affect the level of net working capital. The new
optical system would cost $300,000 and would be depreciated on a straight-line
basis over a five-year life to a zero salvage value. The economic life of the new
system is five years and the required rate of return on the project is 6 percent.
a. Should the existing medical records system be replaced? Use the incremental
NPV approach to evaluate the decision under a non-profit assumption.
b. If the facility were a taxpaying entity with a tax rate of 40 percent, should
the existing system be replaced? Use the incremental NPV approach to
evaluate the decision. (Hint: see Appendix F.)
21. Washington Federal Hospital plans to invest in a new X-ray machine. The cost
of the machine is $800,000. The machine has an economic life of seven years,
and it will be depreciated over a seven-year life to a $100,000 salvage value.
Additional revenues attributed to the new machine will amount to $600,000 per
year for seven years. Additional operating costs, excluding depreciation expense,
will amount to $400,000 per year for seven years. Over the life of the machine,
net working capital will increase by $50,000 per year for seven years.
a. Assuming Washington Federal is a non-taxpaying entity, what is the project’s
NPV at a discount rate of 7 percent, and what is the project’s IRR?
b. Assuming Washington Federal is a taxpaying entity and its tax rate is 40
percent, what is the project’s NPV at a discount rate of 7 percent, and
what is the project’s IRR? (Hint: see Appendices C, D, and E.)
22. Lima Radiological Services has seen a growth in patient volume since its primary
competitor decided to relocate to a different area of the city. To accommodate
this growth, a consultant has advised that Lima invest in a new SPECT imaging
system. The cost to implement the system would be $1,000,000. The useful life
of this equipment is typically about seven years, and it will be depreciated over a
seven-year life to a $160,000 salvage value. Additional patient volume will yield
$1,200,000 in new revenues the first year, and revenues will increase by $50,000
each year thereafter, but the system is expensive to operate. Additional staff and
variable costs, excluding depreciation expense, will come to $950,000 annually,
but these expenses will rise by $60,000 every year. Over the life of the machine,
net working capital will increase by $15,000 per year for seven years.
a. Assuming Lima Radiological Services is a non-taxpaying entity, what is the
project’s NPV at a discount rate of 8 percent, and what is the project’s IRR?
b. Assuming Lima Radiological Services is a taxpaying entity and its tax rate
is 35 percent, what is the project’s NPV at a discount rate of 8 percent, and
what is the project’s IRR? (Hint: see Appendices C, D and E.)
The Investment Decision 253
23. Nimble Nursing Homes, Inc. owns an abandoned schoolhouse. The after tax
value of the land is $600,000. The furniture and fixtures of the school have been
fully depreciated to an after tax market value of $50,000. The two options
Nimble faces are either to sell the land and furniture/fixtures, or to convert the
building into a nursing home. To refurbish and renovate the facility would cost
$30 million. The new building and equipment would be depreciated on a
straight-line basis over a ten-year life to a $5 million salvage value. At the end of
ten years, the land could be sold for an after tax value of $3 million. The new
long-term care facility will have the pro forma income statement listed below for
the next ten years. Net working capital will increase at a rate of $200,000 per year
over the life of the project. Nimble Nursing Homes, Inc. has a 30 percent tax rate
and has a required rate of return of 7 percent. Use both the NPV technique and
IRR method to evaluate this project. (Hint: see Appendices C, D and E.)
Pro Forma Income Statement Years 1–3 Years 4–10
Patient revenues $5.0 million/year $7.0 million/year
Operating expenses (includes $4.0 million/year $5.0 million/year
depreciation expense)
Earnings before taxes $1.0 million/year $2.0 million/year
Less taxes (30%) $0.3 million/year $0.6 million/year
Earnings after taxes $0.7 million/year $1.4 million/year
24. Ridgewood Healthcare Enterprises is in possession of a non-operational 70-bed
hospital. The after tax value of the land is $500,000. The equipment and the
building are fully depreciated and have an after tax market value of $1,250,000.
Ridgewood could either sell off its property or convert it into a fully functional
nursing home for private-paying residents. An analysis of the market reveals that
the facility could easily draw 100 patients per year, which is maximum capacity,
at an initial reimbursement of $3,500 per resident per month for the first year,
and increasing annually by $100 per month thereafter. Renovation costs to create
a plush facility would be $20 million. The new facility would be depreciated on a
straight-line basis over a ten-year life to a $2 million salvage value. At the end of
ten years, the land is expected to be sold for an after tax value of $1.5 million.
Net working capital will increase at a rate of $175,000 per year over the life of the
project. Ridgewood has a 35 percent tax rate and has a required rate of return of
9 percent. The pro forma earnings before tax, which includes the deduction for
depreciation expense, is projected to be $1,500,000 the first year and increase by
$70,000 every year thereafter. Use the NPV technique and IRR method to
evaluate this project. (Hint: see Appendices C, D and E.)
25. Faith Hospital, a tax-paying entity, wants to replace its current telemedicine
system with a new version, which would cost $6 million. This new system
has a five-year life and would be depreciated over a straight-line basis to a
salvage of $900,000. The current telemedicine system was purchased five
years ago for $8 million, has five years remaining on its useful life, and would
be depreciated similarly to a salvage of $400,000. This current system could
254 Financial Management of Health Care Organizations
be sold in the market place right now for $2 million. The new telemedicine
system has annual labor operating costs of $25,000, while the current system
has annual labor operating costs of $300,000. Neither system will change
patient revenues. The hospital has a 40 percent tax rate and required rate of
return of 6 percent. The financial analysis will be projected over a five-year
period. Use the Net Present Value approach to determine if the new
telemedicine system should be selected. (Hint: see Appendix F.)
26. Queen Victoria Hospital, a for-profit institution, wants to replace its CT scanner
with a new model. The cost of the new CT scanner is $5 million. The current
CT scanner was purchased three years ago for $3 million. The new scanner has a
five-year life and will be depreciated over a straight-line basis to a salvage of $2
million. The current CT scanner has five years remaining on its life and will be
depreciated over a straight-line basis to a salvage value of $1 million. The current
scanner could be sold in the marketplace for $2.5 million. The new scanner is
expected to generate annual cash labor savings of $500,000 per year relative to
the current scanner. Neither system will change patient revenues. The hospital
has a 40 percent tax rate and required rate of return of 5 percent. The financial
analysis will project over a five-year period. Use the Net Present Value approach
to determine if the new CT scanner should be selected. (Hint: see Appendix F.)
27. Alvin Hospital, a taxpaying entity, is considering a new pediatrics emergency
room (ER). The building and equipment for the new pediatric ER will cost $10
million. The equipment and building will be depreciated on a straight-line basis
over the project’s five-year life to a $1 million salvage value. The pediatric ER
projected net revenue and expenses are as follows. Net revenues are expected to
be $4 million the first year and will grow by 12 percent each year thereafter.
The operating expenses, which exclude interest and depreciation expenses, will
be $2 million the first year and are expected to grow annually by 3 percent for
every year after that. Interest expense will be $1 million per year, while principal
payments on the loan will be $2.7 million a year. The new pediatric ER is
expected to generate additional after tax cash flows of $0.5 million from radiology
and other ancillary services, which will grow at an annual rate of 5 percent
per year for every year after that. Starting in year 1, net working capital will
increase by $1.5 million per year for the first four years, but during the last year
of the project, net working capital will decrease by $1.5 million. The tax rate for
the hospital is 40 percent and its cost of capital is 15 percent. Use the Net
Present Value and IRR approach to determine if this project should be undertaken.
(Hint, see Appendix C and E.)
28. Blackmoore Radiology, a taxpaying entity, is considering a new outpatientimaging
center. The building and equipment for the new center will cost $40
million. The equipment and building will be depreciated on a straight-line basis
over its five-year life to a $10 million salvage value. The new imaging center’s
projected net revenue and expenses are listed below. The project will be
financed partially by debt capital. Interest expense is expected to be $2 million
per year while principal payments on the bank loan are expected to be $1.5
million per year for the first five years of the loan. The new outpatient-imaging
center is expected to take after tax cash profits of $1million per year away from
The Investment Decision 255
the inpatient imaging. The tax rate for the institution is 40 percent and its cost
of capital is 10 percent. Two years ago, a $100,000 financial feasibility study was
conducted and paid for. Pro forma working capital projections are listed below.
These are the permanent account balances for inventory, accounts receivable
and accounts payable. Use the net present value and internal rate of return
approaches to determine if this project should be undertaken? (Hint: see
Appendices C and E.)
Pro forma income statement before tax projections for outpatient-imaging center (in
thousands):
Year 1 23 4 5
Net revenues $12,000 $14,000 $19,000 $30,000 $40,000
Operating expenses $5,000 $6,000 $7,000 $7,500 $8,000
Depreciation expense $6,000 $6,000 $6,000 $6,000 $6,000
Interest expense $2,000 $2,000 $2,000 $2,000 $2,000
Pro forma working capital for outpatient-imaging center (in thousands):
Year 1 23 4 5
Inventory/accounts $4,500 $9,000 $13,500 $11,500 $9,500
receivable
Accounts payable $500 $1,000 $1,500 $2,000 $2,500
Appendix C
Technical Concerns Regarding Net Present Value
This appendix addresses three commonly asked questions about performing a net present value
analysis: 1) determining the amount of the initial investment; 2) determining the annual cash
flows; and 3) determining a discount rate.
Determining the Amount of the Initial Investment
Included Costs
Expenditures for plant, property, and equipment are usually the primary initial investment
items in a capital project. The amount recorded for these items is the purchase price plus all
costs related to making the investment “ready to go,” including labor, renovation of space,
rewiring, transportation, and any investment in working capital (cash, inventory).
Along with these relatively tangible costs, the initial investment should include any additional
planning costs incurred specifically for the project after it has been selected. General
planning costs to decide which capital project to undertake are not included, for they are sunk
costs (those costs incurred before a specific project has been selected).
The final category of costs to include in the initial cost estimate is the opportunity cost, which
are proceeds lost by forgoing other opportunities. For example, suppose a health care facility has
a plot of land it is holding for investment purposes. It can either sell the land for $150,000 or use
it to build a long-term care facility. If it builds on the land, it will be losing $150,000 from the new
256 Financial Management of Health Care Organizations
Opportunity Costs: Lost
proceeds by forgoing or
delaying other
opportunities.
facility: even though no cash is changing hands yet, losing the chance to collect $150,000 is a real
cost to the organization. Thus, $150,000 would be included as part of the initial outlay as an
opportunity cost or a cash outflow if the organization chose to build.
Excluded Costs
In an NPV analysis, several categories of costs should explicitly not be included as part of the
initial investment costs. For example, though the purchase price of assets should be included in
the initial cost, interest paid from borrowing money to finance those assets should not be
included because interest costs are financing flows and are reflected in the cost of capital.
Costs that have already occurred in the past are sunk costs and should not be included in the
analysis. For example, $50,000 already spent by the health care organization to renovate a building
should not be included as part of the cost for a new project. The initial investment should
only include the cost of plant, property, and equipment; investment in working capital; additional
planning costs; and opportunity costs (see Exhibit C–1).
Determining the Annual Cash Flows
An NPV analysis is designed to analyze the relationship between an initial investment and the
incremental cash flows resulting from that investment in the future. There are three types
of incremental cash flows: operating, spillover, and non-regular.
Operating Cash Flows
Incremental operating cash flows are the new, ongoing cash flows that occur solely as a result of
undertaking a project. They include payments received for services rendered, and expenditures for
such things as labor, materials, marketing, utilities, and taxes. Excluded from NPV analyses are
principal and interest payments made on loans to finance the project, as well as any dividends that
may result from the project. The purpose of maintaining this separation is to assess whether a project
can generate enough positive cash flows from operations on its own merits to pay off its financing
costs (interest, principal payments, and dividends) or costs of capital.
The Investment Decision 257
Sunk Costs: Costs
incurred in the past. They
should not be included in
NPV-type analyses.
Incremental Cash
Flows: Cash flows that
occur solely as a result of
a particular action such
as undertaking a project.
Included Costs
Plant, property, and equipment, and related preparation costs
Additional planning costs
Opportunity costs
Excluded Costs
Interest costs
Sunk costs
Exhibit C–1 Initial Costs of an investment
Operating flows are kept separate from financing flows. Operating cash flows include: Revenues, Labor Expenses, Supply
Expenses. Financing cash flows include: interest expenses, principal payments, dividends.
If a facility is a for-profit organization, a project’s positive net cash flows also entail tax payments according to the
organization’s tax rate. Therefore, operating cash flows are calculated after tax. Appendix E provides a detailed example of
how to generate appropriate cash flows for taxable entities.
To realize these flows under the cash basis of accounting, the revenue and expense accounts
are converted to a cash basis by changes in net working capital. These adjustments are discussed
under the example for computing cash flows in Appendix D.
Spillover Cash Flows
Spillover cash flows, which can be classified into two types, are increases or decreases in cash
flows that occur elsewhere in an organization if a project is undertaken. The first type occurs
when a new service produces additional cash flows to other departments. For example, if a facility
were expanding its emergency room department, additional revenues could be generated by
ancillary support services, such as radiology or laboratory. The second type occurs when a new
service diminishes cash flows elsewhere, sometimes called cannibalization. For example, if a
facility were evaluating the development of an outpatient diagnostic center, it would have to
consider the expected loss in cash flows for the existing inpatient diagnostic center. This loss in
cash profits for inpatient services is a cash outflow.
Non-regular Cash Flows and Terminal Value Cash Flows
As opposed to operating cash flows, which by definition occur on a regular basis, nonregular
cash flows are incremental cash flows that typically occur on an irregular basis, typically
at the end of the life of a project. One of the most common non-regular cash flows is
salvage value, the money received from selling an asset at the termination of a project. Another
typical cash flow at the end of project life is recovery of working capital, which is typically a cash
inflow. Cash flows to be included or excluded are described in Exhibit C–2. The recovery of
working capital is discussed in detail in Appendix D.
Accuracy of Cash Flow Estimates
Because cash flows occur at some point in the future, they cannot be measured precisely.
Expected revenues or projected cost savings can only be estimated based upon a market analysis
and the current operations of the organization. Unforeseeable events, such as new competition
258 Financial Management of Health Care Organizations
Operating Cash Flows:
Cash flows that occur on
a regular basis,
oftentimes following
implementation of a
project. Also called
regular cash flows.
Included Items
Operating Cash Flows
Revenues in the form of payments (inflows)
Cash payments for labor, supplies, utilities,
marketing, and taxes (outflows)
Spillover Cash Flows
Effects of a new service on other departments, such
as ancillary services (inflows)
Effects of a new service’s cannibalizing similar
existing services (outflows)
Non-regular Cash Flows (terminal value cash flows)
Salvage value of equipment that will be sold at the
end of a project (inflow)
Recovery of working capital (inflow)
Excluded Items
Existing Cash Flows Not Affected by the Project
Being Considered
Revenues already being generated by an existing
service
Financing-related Items
Interest
Principal payments
Dividends
Adjusted Items
Accrual-based Items
Revenues earned but not received in cash
Expenses recognized but no cash expended (i.e.
depreciation, accrued expenses)
Other
Changes in net working capital
Exhibit C–2 The Components of Incremental Cash Flow
Cannibalization: When a
new service decreases the
revenues from other
services or service lines.
These are considered cash
outflows.
or an unexpected rise in energy prices, could significantly cut back on positive cash inflows. On
the other hand, an investment such as a convenient new visitor parking deck may be so popular
that it draws in unexpected patient volume, which would increase revenues. Given that the
future cash flows must be present in order to offset the cost of the initial investment, marked
variation in these could alter the final net present value decision.
Determining a Discount Rate
Although commonly thought of as an adjustment for the time value of money, the discount rate
also accounts for the effect of project risk. The discount rate or cost of capital is the required
rate of return for investors who fund the project to compensate them for the risk of the investment
opportunity and the temporary loss of funds to be used elsewhere. To estimate the
required rate of return for investment projects with risk similar to the current risk of the health
care organization, a facility can use its current cost of capital. This is the rate an organization
currently pays for its use of debt and equity financing. However, it should adjust the cost of
capital to a higher (lower) value if the risk of the project is higher (lower) than the overall risk
of the health care organization. The determination of precise models to estimate cost of capital
is technical and beyond the scope of this text.
Appendix D
Adjustments for Net Working Capital
To the extent that new projects impact working capital, adjustments in cash flows must be
made. If working capital increases, then the organization has invested additional resources in
working capital; that is, the project requires the organization to increase both current asset
accounts, which result in cash outflows, and current liability accounts, which are cash inflows,
since they delay the use of cash (example below). The difference between current assets and
current liabilities is called net working capital, as discussed in Chapter 5. The effects of
changes in net working capital, it must be accounted for each year. If there is an increase in net
working capital, it is subtracted from net operating cash flows. Likewise, if there is a decrease,
it is added to net operating cash flows.
An illustration of how to adjust for changes in net working capital is shown by continuing
with the example of building a satellite hospital. Assume the organization had balance sheet
results as shown in rows 7–9 of Exhibit D–1. As shown in row 9, its net working capital (current
assets − current liabilities) is $1,000, $1,300, $1,800, $600, $400, and $300 in years 1–6,
respectively.
The change in net working capital is the difference between the current year’s net working
capital and that from the previous year (row 10). For example, the change in net working capital
the first year was $1,000 ($1,000 in Year 1 − $0 in Year 0). The second year’s change in net
working capital was $300 ($1,300 in Year 2 − $1,000 in Year 1). The same procedure is followed
for Years 3–6. As noted earlier, if net working capital increased, then cash decreased, which
The Investment Decision 259
Non-regular Cash
Flows: Cash flows that
occur sporadically or on
an irregular basis. A
common non-regular cash
flow is salvage value,
receipt of funds following
a one-time sale of an
asset at the end of its
useful life.
The discount rate is also called the opportunity cost of capital to the company undertaking the capital investment
project. It is the cost of the next best alternative, those returns the company is forgoing by making this investment as
opposed to another. From the lenders’ or investors’ points of view, it is the returns they forgo by investing their money in this
project rather than alternative projects of similar risk. For example, if an investor-owned hospital chain were issuing stock to
purchase a health insurance business, investors considering buying this stock would expect at least the return on the stocks
of other publicly held health insurance companies, such as Cigna or Aetna.
Exhibit D–1 Computation of Net Present Value for a Satellite Hospital, Including Working Capital Adjustments
Givens: Years 0
1
2
3
4
5
6
1 Initial Investment ($1,000,000)
2 Net Revenues $
400,000 $
550,000 $
800,000 $
900,000 $
1,100,000 $
1,370,000
3 Cash Operating Expenses 200,000 300,000 500,000 550,000 650,000 850,000
4 Depreciation Expense 145,000 145,000 145,000 145,000 145,000 145,000
5 Sale of Assets 130,000
6 Cost of Capital 10%
7 Current Assets $
2,200 $
4,800 $
7,400 $
1,400 $
1,300 $
1,200
8 Current Liabilities $
1,200 $
3,500 $
5,600 $
800 $
900 $
900
9 Net Working Capital [
Given 7 −
Given 8] $0 $
1,000 $
1,300 $
1,800 $
600 $
400 $
300
10 Change in Net Working Capital [1] $1,000 $300 $500 ($1,200) ($200) ($100)
1 Net Working Capital (
Current Year) −
Net Working Capital (
Previous Year)
Net Present Value for Satellite Hospital, Adjusting for Depreciation, Working Capital and Salvage Value
Years 0
1
2
3
4
5
6
A Initial Investment [Given 1] ($1,000,000)
B Net Revenues [Given 2] $400,000 $550,000 $800,000 $900,000 $1,100,000 $1,370,000
C Less: Cash Operating Expenses
Before Depreciation [Given 3] 200,000 300,000 500,000 550,000 650,000 850,000
D Less: Depreciation Expense [Given 4] 145,000 145,000 145,000 145,000 145,000 145,000
E Operating Income [B − C − D] 55,000 105,000 155,000 205,000 305,000 375,000
F Add: Depreciation Expense [Given 4] 145,000 145,000 145,000 145,000 145,000 145,000
G Net Operating Cash Flows [E + F] 200,000 250,000 300,000 350,000 450,000 520,000
H Add: Sale of Assets [Given 5] 130,000
I Adjustments for changes in working capital [− Given 10] (1,000) (
300) (
500) 1,200 200 100
J Recapture of net working capital [− Sum] — — — — — 300
K Project Cash Flows [G + H + I + J] $199,000 $249,700 $299,500 $351,200 $450,200 $650,400
L Cost of Capital [Given 6] 10% 10% 10% 10% 10% 10%
M Present Value Interest Factors 1/(1 + I)n 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
N Annual PV of Cash Flows2 [K × M] $180,909 $206,364 $225,019 $239,874 $279,539 $367,134
O PV of Cash Flows [Sum N] $1,498,838
P Net Present Value [A + O] $498,838
2 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference between the number displayed and that
calculated manually.
must be subtracted from the cash flows. If net working capital decreased, then cash increased,
and that amount must be added to cash flows. Since net working capital increased by $1,000 in
year 1 (row 10), $1,000 (row I) is subtracted from the net operating cash flows (row G). This
process is continued for the remaining years.
In the first three years, cash outflows occurred and net working capital for the project
increased (row 10). But in Year 4 and thereafter, the decreases in net working capital constitute
cash inflows for the years. The facility is no longer investing cash in its current assets and liabilities.
It is decreasing its investment in cash, collecting at a higher rate on its receivables,
and/or reducing its outstanding payables.
Once the changes in net working capital are calculated, they are entered into the NPV calculation
to adjust for changes in cash flows due to changes in net working capital (rows I, J).
When a project ends, it is assumed that: 1) the total amount of net working capital investment
is recaptured and is accounted for as a cash inflow; and 2) plant and equipment will be
sold or disposed of. In regard to the recapture of net working capital, typically all project receivables
are collected, all project inventory is sold, and all project payables are paid. The recapture
of changes in net working capital is the sum of all the changes in net working capital during the
life of the project, which, in the case of the satellite hospital, is −$300 [($1,000)+ ($300)+
($500)+ $1,200+ $200+ $100]. The negative $300 indicates that there is an ending excess balance
of $300 in net working capital to sell off; therefore, $300 in net working capital is a cash
inflow that can be recaptured or recovered (see Exhibit D–1, row J).
Appendix E
Tax Implications for For-profits in a Capital Budgeting
Decision, and the Adjustment for Interest Expense
This appendix introduces an NPV analysis for a for-profit entity. The total number of forprofit
hospitals in the United States at the turn of the century represented less than 15 percent
of the total number of short-term community hospitals. In contrast, there were more than 7,000
skilled and intermediate-care nursing homes nationwide, of which more than two-thirds were
for-profit entities. Also, more than two-thirds of the managed-care insurers were taxpaying
entities. Therefore, it is imperative to consider the tax effects that can take place in a for-profit
investment analysis. Appendix C discussed the separation of financing flows from the operating
cash flow analysis for an NPV analysis. When computing a cash flow analysis from a projected
income statement, interest expense needs to be taken out to be able to adjust for the tax
effect if the entity is for-profit. The following analysis shows the calculations had the satellite
hospital project been a for-profit endeavor.
The Investment Decision 261
Interest-bearing, short-term debt (notes payable) should be excluded from calculations of changes in net working capital
because it represents financing flows and is accounted for in the cost of capital.
Increases in net working capital are cash outflows. Decreases in net working capital are cash inflows.
The two most important tax adjustments that must be made for for-profit entities are: 1)
accounting for the effect of taxes on operating income; and 2) accounting for the tax effect from
the gains/losses resulting from the sale of assets at the expected end of the project’s life. This
example focuses only on the first, since gains and losses, like most other tax effects, are complicated
and only introduced in this text.
As evidenced in Exhibit E–1, the analysis is nearly identical to that for not-for-profit
entities (Exhibit D–1), except for the tax expense and interest expense accounts, and the
inclusion of a new line for payment of taxes (Exhibit E–1, row G, which assumes that the
organization has a 40 percent tax rate on its net income). In Year 1, the organization
had earnings before taxes of $30,000 (row F). Since the tax rate is 40 percent, it must pay
an additional $12,000 in taxes ($30,000 × 0.40). In Year 2, it pays $32,000 in taxes on
earnings before tax of $ 80,000 (rows F and G). A similar analysis is conducted for Years
3–6.
At this point, an adjustment must be made for interest, because interest expense affected
net income (and thus the amount of taxes paid), but interest expense is not itself an operating
cash flow. Thus, interest expense must be added back at the amount of (1 − tax rate)
to determine true cash outflows. This is done in row J, where $15,000 is added back
($25,000 × (1 − 0.40)). In effect, the interest expense provided a tax deduction of $10,000
($25,000 × 0.40 saved), which represents a cash inflow. Thus, the true cash outflow is only
$15,000 ($25,000 − $10,000), which matches the value in row J. For non-profit entities with
interest expense in the projected income statement, the full amount of the interest expense
is added back in because the tax rate is zero. The remainder of the analysis remains the
same. Overall, the net present value for the hospital as a taxpaying entity equals $181,116
(row T) versus $498,838 as a not-for-profit hospital (Exhibit D–1, row P), which is much
less.
Appendix F
Comprehensive Capital Budgeting Replacement Cost
Example
Assume that a cardiology laboratory is considering replacing its manual EKG (electrocardiogram)
management information system with a new, more efficient one. The new system
automatically stores EKG and stress records online. The existing system was purchased
five years ago for $70,000 and is being depreciated over a ten-year life to a salvage value of
$10,000. The old system can be sold now at a market price of $20,000 and has a book value
of $40,000 ($70,000 original cost − $30,000 accumulated depreciation). The new system can
be purchased for $100,000 and is estimated to have a five-year life. It can be depreciated to
a salvage value of $20,000. Since the organization is paid on a capitated basis, there are no
revenues directly associated with the EKG. Thus, the focus is on the cash savings in
operational expenses. Labor expenses will drop from $50,000 for the old system to $15,000
with the new system, resulting in a labor cash savings of $35,000. Purchasing the new system
will increase net working capital by $1,000 each year, compared to a $300 annual
increase for the old system, starting in Year 1. The remainder of this appendix provides
comparative and incremental NPV analyses of this situation, first assuming that the lab is
not-for-profit, and then assuming that it is investor-owned. In both cases, the cost of
capital is 5 percent.
262 Financial Management of Health Care Organizations
Exhibit E–1 NPV Decision Assuming Satellite Hospital Is For-profit
Givens: Years 0
1
2
3
4
5
6
1 Initial Investment ($1,000,000)
2 Net Revenues $
400,000 $
550,000 $
800,000 $
900,000 $
1,100,000 $
1,370,000
3 Cash Operating Expenses $
200,000 $
300,000 $
500,000 $
550,000 $
650,000 $
850,000
4 Depreciation Expense $
145,000 $
145,000 $
145,000 $
145,000 $
145,000 $
145,000
5 Interest Expense $
25,000 $
25,000 $
25,000 $
25,000 $
25,000 $
25,000
6 Sale of Assets $
130,000
7 Cost of Capital 10%
8 Tax Rate 40%
9 Current Assets $
2,200 $
4,800 $
7,400 $
1,400 $
1,300 $
1,200
10 Current Liabilities $1,200 $3,500 $5,600 $800 $900 $900
11 Net Working Capital [Given 9 – Given 10] $0 $1,000 $1,300 $1,800 $600 $400 $300
12 Change in Net Working Capital [1] $1,000 $300 $500 ($1,200) ($200) ($100)
1Net Working Capital (
Current Year) –
Net Working Capital (
Previous Year) (Continues)
Net Present Value for Satellite Hospital, Adjusting for Depreciation, Interest, Working Capital and Salvage Value
Years 0
1
2
3
4
5
6
A Initial Investment [Given 1] ($1,000,000)
B Net Revenues [Given 2] $400,000 $550,000 $800,000 $900,000 $1,100,000 $1,370,000
C Less: Cash Operating Expenses Before
Dep. & Int. [Given 3] $200,000 $300,000 $500,000 $550,000 $650,000 $850,000
D Less: Depreciation Expense [Given 4] $145,000 $145,000 $145,000 $145,000 $145,000 $145,000
E Less: Interest Expense [Given 5] $25,000 $25,000 $25,000 $25,000 $25,000 $25,000
F Earnings Before Taxes [B – C – D – E] 30,000 80,000 130,000 180,000 280,000 350,000
G Less: Tax Expense (40% Tax Rate) [Given 8 × F] 12,000 32,000 52,000 72,000 112,000 140,000
H Earnings After Tax [F – G] 18,000 48,000 78,000 108,000 168,000 210,000
I Add Depreciation Expense [
Given 4] 145,000 145,000 145,000 145,000 145,000 145,000
J Add Back Interest Expense at (
1-Tax Rate) [(1 –
Given 8) ×
E] 15,000 15,000 15,000 15,000 15,000 15,000
K Net Operating Cash Flow [H + I + J] 178,000 208,000 238,000 268,000 328,000 370,000
L Add: Sale Of Assets2 [Given 6] 130,000
M Adjustments For Changes In Working
Capital [− Given 12] (1,000) (300) (500) 1,200 200 100
N Recapture Of Net Working Capital [− Sum M] — — — — — 300
O Project Cash Flows [K + L + M + N] $177,000 $207,700 $237,500 $269,200 $328,200 $500,400
P Cost Of Capital [Given 7] 10% 10% 10% 10% 10% 10%
Q Present Value Interest Factors 1/(1 + i)n 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645
R Annual PV Of Cash Flows3 [O × Q] $160,909 $171,653 $178,437 $183,867 $203,786 $282,463
S PV Of Cash Flows [Sum R] $1,181,116
T Net Present Value [A + SS] $
181,116
2 There is no tax effect from selling the asset, because it was depreciated to the salvage value; therefore, salvage value equals book value.
3 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference between the number displayed and that
calculated manually.
Exhibit E–1 (
Contd)
Comparative Approach – Not-for-profit Analysis
As its name implies, the comparative approach compares the cash flows resulting from continuing
with the existing alternative to those that would result if the equipment were
replaced. It does this by separately calculating each of these cash flows and then comparing
them (Exhibit F–1).
If the organization were to continue with the existing system, there would be no investment at
Year 0 (it has already been made), and the operating loss would be $56,000 a year (row D), which
includes operating expenses (row B) and depreciation (row C). However, since operating loss contains
depreciation, and depreciation is an expense that does not require a cash outlay, depreciation
must be added back in order to derive cash flows from operations. This is done in row F by adding
$6,000 (row E) to the $56,000 operating loss (row D). Though the same result, $50,000 (row F),
can be derived without first subtracting out and then adding back in depreciation expense, this
approach is used to make it easier to compare the not-for-profit and for-profit analyses. In regard
to the change in net working capital, since it increases by $300 each year, the resultant cash outflow
must be accounted for (row G). However, as explained in Appendix D, assume that this is recovered
at the end of the project (row I). The only other cash flow to account for would be the $10,000
salvage value that results in a cash inflow in Year 5 (row H). Finally, the cash flows are computed
for each of the five years (row J), and then discounted using the cost of capital (rows K, L). This
information forms the basis to calculate net present value of the cash flows attributable to the existing
machine: −$208,762 (row O).
The initial outlay, expenses, depreciation, salvage value, and working capital effects differ for
the purchase of the replacement system (Exhibit F–1, lower half). The initial outlay is computed
in row A. Though the new equipment costs $100,000, the organization only has to pay $80,000
from its existing funds, since it can allocate $20,000 from the sale of the existing equipment.
Since net working capital increases by $1,000 each year, the resulting cash outflow must be
accounted for (rows G, I). The remaining steps in the replacement analysis are the same as those
in the previous analysis, and only the amounts differ. Using the comparative approach, the net
present value of the replacement alternative is −$129,683 (row O). Thus, since the replacement
alternative has a higher NPV (−$129,683 versus −$208,762), the replacement alternative should
be undertaken.
Comparative Approach – For-profit Analysis
The for-profit analysis is exactly the same as that for the not-for-profit analysis with two
exceptions (Exhibit F–2, rows E and F), which arise as a result of the effects of taxes on cash
flows, and ultimately NPV. As in the not-for-profit analysis, earnings (loss) before tax is calculated
in row D. Since earnings before tax is taxed at 40 percent, the resulting tax savings
would be $22,400 for the existing alternative as compared to $12,400 for the replacement
alternative, respectively (rows E, top and bottom). Because earnings before tax is negative,
the organization is losing money but will not be incurring negative taxes. However, the tax
expense becomes a positive value because this tax loss either can be carried forward to offset
future income, or else carried back to offset prior income to result in a tax refund. This
has the same effect as a cash inflow: for each additional $1.00 in expenses, the organization
pays $0.40 less in taxes. Therefore, these tax savings get added back to the loss in
row D. Taking into account the tax effects, the NPV of the existing alternative is -$111,782,
and the NPV of the replacement alternative is −$67,998. Again, showing a smaller loss, or a
saving of $43,784 (row R, bottom table), the replacement alternative should be undertaken,
all other things being equal.
The Investment Decision 265
Exhibit F–1 Comparative Approach to Analyzing a Capital Budgeting Decision – Not-for-profit Entity
Existing Equipment
Givens: Years 0
1
2
3
4
5
1 Initial Outlay $0
2 Operating Expenses ($50,000) ($50,000) ($50,000) ($50,000) ($50,000)
3 Depreciation Expense ($6,000) ($6,000) ($6,000) ($6,000) ($6,000)
4 Change in Net Working Capital 300 300 300 300 300
5 Salvage Value $
10,000
6 Cost of Capital 5%
Years 0
1
2
3
4
5
A Initial Outlay [Given 1] $0
B Operating Expenses Before Depreciation [Given 2] ($50,000) ($50,000) ($50,000) ($50,000) ($50,000)
C Depreciation Expense [Given 3] ($6,000) ($6,000) ($6,000) ($6,000) ($6,000)
D Operating Income (loss) [B + C] (56,000) (56,000) (56,000) (56,000) (56,000)
E Add: Depreciation Expense [− Given 3] 6,000 6,000 6,000 6,000 6,000
F Net Operating Cash Flow [D + E] (50,000) (50,000) (50,000) (50,000) (50,000)
G Change in Net Working Capital [− Given 4] (300) (300) (300) (300) (300)
Terminal Value Changes:
H Salvage Value [Given 5] 10,000
I Recovery of Net Working Capital [− Sum G] 1,500
J Change in Net Cash Flow [F + G + H +
I] ($50,300) ($50,300) ($50,300) ($50,300) ($38,800)
K Cost of Capital [Given 6] 5% 5% 5% 5% 5%
L Present Value Interest Factor 1/(1 + i)n 0.9524 0.9070 0.8638 0.8227 0.7835
M Annual PV Of Cash Flows1 [J × L] ($47,905) ($45,624) ($43,451) ($41,382) ($30,401)
N Sum of PV of Cash Flows [Sum M] ($208,762)
O Net Present Value [A + N] ($208,762)
(Continues)
Replacement Equipment
Givens: Years 0
1
2
3
4
5
1 Initial Outlay2 [
2] ($80,000)
2 Operating Expenses ($15,000) ($15,000) ($15,000) ($15,000) ($15,000)
3 Depreciation Expense ($16,000) ($16,000) ($16,000) ($16,000) ($16,000)
4 Change in Net Working Capital 1,000 1,000 1,000 1,000 1,000
5 Salvage Value $
20,000
6 Cost of Capital 5%
Years 0
1
2
3
4
5
A Initial Outlay2 [Given 1] ($80,000)
B Operating Expenses Before Depreciation [Given 2] ($15,000) ($15,000) ($15,000) ($15,000) ($15,000)
C Depreciation Expense [Given 3] ($16,000) ($16,000) ($16,000) ($16,000) ($16,000)
D Operating Income (loss) [B + C] (31,000) (31,000) (31,000) (31,000) (31,000)
E Add: Depreciation Expense [− Given 3] 16,000 16,000 16,000 16,000 16,000
F Net Operating Cash Flow [D + E] (15,000) (15,000) (15,000) (15,000) (15,000)
G Change in Net Working Capital [− Given 4] (1,000) (1,000) (1,000) (1,000) (1,000)
Terminal Value Changes:
H Salvage Value [Given 5] 20,000
I Recovery of Net Working Capital [− Sum G] 5,000
J Change in Net Cash Flow [F + G + H +
I] ($16,000) ($16,000) ($16,000) ($16,000) $
9,000
K Cost of Capital [Given 6] 5% 5% 5% 5% 5%
L Present Value Interest Factor 1/(1+i)n 0.9524 0.9070 0.8638 0.8227 0.7835
M Annual PV Of Cash Flows1 [J × L] ($15,238) ($14,512) ($13,821) ($13,163) $7,052
N Sum of PV of Cash Flows [Sum M] ($49,683)
O Net Present Value [A + N] ($129,683)
P NPV Difference3 [3] $79,079
1 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference
between the number displayed and that calculated manually.
2 − $
100,000 purchase of new equipment + $
20,000 sale of old equipment
3 ($129,683) −
($208,762) = $
79,079
Exhibit F–1 (
Contd)
Exhibit F–2 Comparative Approach to Analyzing a Capital Budgeting Decision – For-profit Entity
Existing Equipment
Givens: Years 0
1
2
3
4
5
1 Initial Outlay $0
2 Operating Expenses ($50,000) ($50,000) ($50,000) ($50,000) ($50,000)
3 Depreciation Expense ($6,000) ($6,000) ($6,000) ($6,000) ($6,000)
4 Change in Not Working Capital 300 300 300 300 300
5 Salvage Value $
10,000
6 Cost of Capital 5%
7 Tax Rate 40%
Existing Equipment
Years 0
1
2
3
4
5
A Initial Outlay [Given 1] $0
B Operating Expenses Before Depreciation [Given 2] ($50,000) ($50,000) ($50,000) ($50,000) ($50,000)
C Depreciation Expense [Given 3] ($6,000) ($6,000) ($6,000) ($6,000) ($6,000)
D Earnings (Loss) Before Tax [B + C] ($56,000) ($56,000) ($56,000) ($56,000) ($56,000)
E Taxes at 40% [Given 7 × D] 22,400 22,400 22,400 22,400 22,400
F Earnings after Tax [D + E] (33,600) (33,600) (33,600) (33,600) (33,600)
G Add: Depreciation Expense [− Given 3] 6,000 6,000 6,000 6,000 6,000
H Net Operating Cash Flow [F + G] (27,600) (27,600) (27,600) (27,600) (27,600)
I Change in Net Working Capital [− Given 4] (
300) (
300) (
300) (
300) (
300)
Terminal Value Changes:
J Salvage Value [
Given 5] 10,000
K Recovery of Net Working Capital [−Sum I] 1,500
L Change in Net Cash Flow [H + I + J + K] ($27,900) ($27,900) ($27,900) ($27,900) ($16,400)
M Cost of Capital [Given 6] 5% 5% 5% 5% 5%
N Present Value Interest Factor 1/(1 + i)n 0.9524 0.9070 0.8638 0.8227 0.7835
O Annual PV Of Cash Flows1 [L × N] ($26,571) ($25,306) ($24,101) ($22,953) ($12,850)
P Sum of PV of Cash Flows [Sum O] ($111,782)
Q Net Present Value [A + P] ($111,782)
(Continues)
Replacement Equipment
Givens: Years 0
1
2
3
4
5
1 Initial Outlay2 [
2] ($72,000)
2 Operating Expenses ($15,000) ($15,000) ($15,000) ($15,000) ($15,000)
3 Depreciation Expense ($16,000) ($16,000) ($16,000) ($16,000) ($16,000)
4 Change in Net Working Capital $
1,000 $
1,000 $
1,000 $
1,000 $
1,000
5 Salvage Value $
20,000
6 Cost of Capital 5%
7 Tax Rate 40%
Replacement Equipment
Years 0
1
2
3
4
5
A Initial Outlay2 [Given 1] ($72,000)
B Operating Expenses Before Depreciation [Given 2] ($15,000) ($15,000) ($15,000) ($15,000) ($15,000)
C Depreciation Expense [Given 3] ($16,000) ($16,000) ($16,000) ($16,000) ($16,000)
D Earnings Before Tax (Loss Before Tax) [B + C] (31,000) (31,000) (31,000) (31,000) (31,000)
E Taxes at 40% [Given 7 × D] 12,400 12,400 12,400 12,400 12,400
F Net Income or Earnings after Tax [D + E] (18,600) (18,600) (18,600) (18,600) (18,600)
G Add: Depreciation Expense [− Given 3] 16,000 16,000 16,000 16,000 16,000
H Net Operating Cash Flow [F + G] (2,600) (2,600) (2,600) (2,600) (2,600)
I Change in Net Working Capital [− Given 4] (
1,000) (
1,000) (
1,000) (
1,000) (
1,000)
Terminal Value Changes:
J Salvage Value [
Given 5] 20,000
K Recovery of Net Working Capital [− Sum I] 5,000
L Change in Net Cash Flow [H + I + J + K] ($3,600) ($3,600) ($3,600) ($3,600) $21,400
M Cost of Capital [Given 6] 5% 5% 5% 5% 5%
N Present Value Interest Factor 1/(1 + i)n 0.9524 0.9070 0.8638 0.8227 0.7835
O Annual PV Of Cash Flows1 [L × N] ($3,429) ($3,265) ($3,110) ($2,962) $16,767
P Sum of PV of Cash Flows [Sum O] $4,002
Q Net Present Value [A + P] ($67,998)
R NPV Difference3 [3] 43,784
1 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference
between the number displayed and that calculated manually.
2 − $
100,000 purchase of new equipment + $
20,000 sale of old equipment + $
8,000 in tax savings from loss on sale of existing equipment (
0.40 Tax Rate × $
20,000 loss)
3 ($67,998) −
($111,782) = $
43,784
Exhibit F–2 (
Contd)
Incremental Approach – Not-for-profit Analysis
Exhibit F–3 analyzes a replacement decision using the incremental approach. It looks at the savings
for each item (or lack thereof) that would result if the decision were made to replace the
old EKG with a new one. To make this decision, several aspects of cash flows must be taken
into account.
To compute the initial outlay, though the new system cost $100,000, the facility received
$20,000 for the old system. Thus, the initial outlay is -$80,000 (row A). The change in operating
cash flows produced a net operating cash flow savings of $35,000 per year (row B: $15,000
replacement equipment versus $50,000 existing equipment).
As with the comparative analysis, in this non-taxpaying example, depreciation expense could
be disregarded altogether, for it has no effect on cash flow. However, to compare the not-forprofit
and for-profit examples, operating income is first computed (which is needed to compute
taxes in the for-profit example) by subtracting the $10,000 in depreciation expense (row C) and
then adding it back in, to show that net operating cash flows do not change as a result of depreciation
(row E).
The effects of changes in working capital and the salvage value must be added to the analysis
as well. Since net working capital increases by $700 annually, cash flows decrease by $700
each year (row G). In Year 5, the year in which the investment is assumed to end, there is an
increase of $10,000 from the salvage value (row H, sale of assets), which equals the incremental
difference between the salvage value of the new system, $20,000, and the salvage value of the
old system, $10,000. Since the project is assumed to end at this time, it is also necessary to
recapture $3,500 in net working capital (row I: 5 years × $700 per year).
To determine the net present value, the cash flows each year are discounted at 5 percent and
summed (rows J through O), and then the initial outlay (row A) is added. Since the net present
value is $79,079, which represents a positive return due to replacement, from a financial perspective,
the new EKG system should be purchased.
Incremental Approach – For-profit Analysis
Exhibit F–4 presents a similar incremental analysis, but for a for-profit, taxpaying organization.
In this case, the new initial outlay is still reduced from $100,000 to $80,000 by the additional
$20,000 from the sale of the old system, but it is also reduced another $8,000 (to $72,000) by
the tax effect of that sale (row 1). This tax benefit arises because the organization is selling a
machine with a book value of $40,000 for $20,000, incurring a $20,000 loss. Assuming the tax
rate is 40 percent, it will pay $8,000 less in taxes (0.40 × $20,000) than had it not sold the
machine.
Taxes also affect operating income and represent a real cash outflow. Since the change in
change in earnings before tax is $25,000 (row D), assuming a 40 percent tax rate, taxes will
increase by $10,000 (row E), thereby reducing the change in net income to $15,000 (row F).
However, reflected in this $15,000 net income is the $10,000 in depreciation expense that
does not require a cash outflow. Therefore, it must be added back in, and cash flow
becomes $25,000 (rows G, H). The remainder of the analysis remains the same as the
not-for-profit analysis, adjusting for the change in net working capital and the terminal
value.
After accounting for the sale of the new system at its termination date and discounting at the
cost of capital, the decision to make this investment results in a positive net present value of
$43,784. Since the NPV is positive, the investment should be made.
270 Financial Management of Health Care Organizations
Exhibit F–3 Incremental Approach to Analyzing a Capital Budgeting Decision – Not-for-profit Entity
Givens:
1 Initial Outlay1 ($80,000)
2 Cost of Capital 5%
Change in Annual Operating Expenses & Depreciation Expense:
Change
Old MIS New MIS (New-Old)
3 Operating Expenses (
labor) ($50,000) ($15,000) $
35,000
4 Depreciation Expense2 ($6,000) ($16,000) ($10,000)
5 Net Working Capital ($300) ($1,000) ($700)
6 Salvage Value $
10,000 $
20,000 $
10,000
1 $
100,000 Purchase of New Equipment + $
20,000 Sale of Old Equipment
2 Old MIS: ($70,000 − $
10,000)/10 years = $
6,000/year
New MIS: ($100,000 − $20,000)/5 years = $16,000/year
Years 0
1
2
3
4
5
A Initial Outlay [Given 1] ($80,000)
B Cash Savings Due to Decreased
Operating Expenses [Given 3] $35,000 $35,000 $35,000 $35,000 $35,000
C Increase in Depreciation Expense [Given 4] (10,000) (10,000) (10,000) (10,000) (10,000)
D Change in Operating Income [B + C] 25,000 25,000 25,000 25,000 25,000
E Add: Increase in Depreciation Expense [− Given 4] 10,000 10,000 10,000 10,000 10,000
F Change in Net Operating Cash Flow [D + E] 35,000 35,000 35,000 35,000 35,000
G Change in Net Working Capital [Given 5] (700) (700) (700) (700) (700)
Terminal Value Changes:
H Salvage Value [Given 6] 10,000
I Recovery of Net Working Capital [− Sum G] 3,500
J Change in Net Cash Flow [F + G + H +
I] $34,300 $
34,300 $
34,300 $
34,300 $
47,800
K Cost of Capital 5% 5% 5% 5% 5%
L Present Value Interest Factor 1/(1+i)n 0.9524 0.9070 0.8638 0.8227 0.7835
M Annual PV of Cash Flows3 [J×L] $32,667 $31,111 $29,630 $28,219 $37,453
N Sum of PV Cash Flows [Sum M] $159,079
O Net Present Value [A+N] $79,079
3 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference
between the number displayed and that calculated manually.
Exhibit F–4 Incremental Approach to Analyzing a Capital Budgeting Decision – For-profit Entity
Givens:
1 Initial Outlay1 ($72,000)
2 Cost of Capital 5%
3 Tax Rate 40%
Change in Annual Operating Expenses & Depreciation Expense:
Change
Old MIS New MIS (New-Old)
4 Operating Expenses (
labor) ($50,000) ($15,000) $
35,000
5 Depreciation Expense2 ($6,000) ($16,000) ($10,000)
6 Net Working Capital ($300) ($1,000) ($700)
7 Salvage Value $
10,000 $
20,000 $
10,000
1 ($100,000) purchase of new equipment + $
20,000 sale of old equipment + $
8,000 (
0.40 × $
20,000) tax savings due to sale at a
loss
2 Old MIS: ($70,000 − $10,000)/10 years = $
6,000/year
New MIS: ($100,000 − $20,000)/5 years = $16,000/year
Years 0
1
2
3
4
5
A Initial Outlay [Given 1] ($72,000)
B Cash Savings Due to Decreased Operating Expenses [Given 4] $35,000 $35,000 $35,000 $35,000 $35,000
C Increase in Depreciation Expense3 [Given 5] (10,000) (10,000) (10,000) (10,000) (10,000)
D Change in Earnings Before Tax [B + C] 25,000 25,000 25,000 25,000 25,000
E Less: Increased Tax Expense [Given 3 × D] 10,000 10,000 10,000 10,000 10,000
F Increase in Net Income or Earnings after Tax [D − E] 15,000 15,000 15,000 15,000 15,000
G Add: Increase in Depreciation Expense [− Given 5] 10,000 10,000 10,000 10,000 10,000
H Change in Net Operating Cash Flow [F + G] 25,000 25,000 25,000 25,000 25,000
I Change in Net Working Capital [
Given 6] (
700) (
700) (
700) (
700) (
700)
Terminal Value Changes:
J Change in Salvage Value [
Given 7] 10,000
K Recovery of Net Working Capital [− Sum I] 3,500
L Change in Net Cash Flow [H + I + J + K] $24,300 $24,300 $24,300 $24,300 $37,800
M Cost of Capital [Given 2] 5% 5% 5% 5% 5%
N Present Value Interest Factor 1/(1 + i)n 0.9524 0.9070 0.8638 0.8227 0.7835
O Annual PV of Cash Flows4 [L × N] $23,143 $22,041 $20,991 $19,992 $29,617
P Sum of PV Cash Flows [Sum O] $115,784
Q Net Present Value [A + P] $43,784
3 For Row C, Depreciation expense increased. However, it is an expense and must be deducted from cash savings.
4 Present Value Interest Factors in the exhibit have been calculated by formula, but are necessarily rounded for presentation. Therefore, there may be a
difference between the number displayed and that
calculated manually.
Appendix Summary
This appendix provided both a comparative and an incremental NPV analysis of purchasing a
new EKG system. The analysis was conducted for both a not-for-profit and a for-profit entity.
The summary results are presented in Exhibit F–5, which show that the comparative and incremental
approaches provide exactly the same answer. Thus, the method used depends only on
preference, but has no effect upon the final result. It is also important to note that in this case,
though tax effects are considerable, they do not change the decision.
The Investment Decision 273
Exhibit F–5 Results of the Comparative and Incremental NPV Analyses of Replacing an Existing EKG System
Not-for-profit Institution For-profit Institution
Replace Equipment ($129,683)1 ($67,998)2
Keep Existing Equipment ($208,762)1 ($111,782)2
Difference (Replace − Keep) $79,079 $43,784
Incremental Approach $79,0793 $43,7844
1 Exhibit F-1, Comparative Approach
2 Exhibit F-2, Comparative Approach
3 Exhibit F-3, Incremental Approach
4 Exhibit F-4, Incremental Approach
C h a p t e r E i g h t
CAPITAL FINANCING FOR HEALTH
CARE PROVIDERS
Learning Objectives
After completing this chapter, you will be able to:
Describe the types of equity and debt financing.
Define various bond terminology.
Compare tax-exempt with taxable financing.
Explain lease financing.
INTRODUCTION
EQUITY FINANCING
DEBT FINANCING
Sources of Debt Financing by Maturity
Sources of Debt Financing by Type of
Interest Rate: Fixed and Variable Interest
Selected Types of Health Care Debt Financing
Bank Term Loans
Conventional Mortgages
Pooled Equipment Financing
FHA Program Loans
Bonds
BOND ISSUANCE PROCESS
Public versus Private Placement
The Steps in the Bond Issuance Process
Selected Roles of Underwriters and Trustees
LEASE FINANCING
Operating Lease
Capital Lease
Analysis of the Lease versus Purchase Decision
SUMMARY
KEY TERMS
KEY EQUATIONS
QUESTIONS AND PROBLEMS
Appendix G: Bond Valuation and Loan
Amortization
Chapter Outline
Capital Financing for Health Care Providers 275
Introduction
In Chapters 2 and 3, the basic accounting equation was defined as: Assets = Liabilities
+ Net Assets. Since liabilities are debts and net assets represent the community’s
equity in a not-for-profit health care organization, in terms of the sources of financing,
the basic accounting equation can also be thought of as:
Assets = Debt + Equity
The equation shows that any increase in assets must be balanced by a similar
increase in debt and/or equity. The structuring of debt relative to equity is called the
capital structure decision, and is becoming increasingly important to both forprofit
and not-for-profit providers. This has not always been the case. Until recently,
the cost of capital was never a major concern for health care providers.
Like other operational costs, the costs of debt and equity financing were simply
passed on to third-party payors. Hospitals had no trouble accessing capital markets
because they were virtually guaranteed any income they needed to cover all their
debts. Today’s environment, however, is characterized by prospective and capitated
payments, the increased use of managed care and outpatient services, and increasing
cutbacks being forced by competition and cost-control. As a result, obtaining debt and
equity financing has become more complicated and risky. Perspectives 8–1 and 8–2
offer additional opinions about equity financing issues and how too much debt can
result in bankruptcy.
The first section of this chapter briefly examines equity financing. The remaining
sections focus on the issuance of bonds, which is the main source of debt financing for
many health care organizations.
Bond: A form of longterm
financing
whereby an issuer
receives cash from a
lender (an investor),
and in return issues a
promissory note (a
“bond”) agreeing to
make principal and/or
interest payments on
specific dates.
Perspective 8–1
Ailing Stocks Land E-Health Companies in Sick Bay
In late 1990s, higher stock prices for growing internet companies enabled them to finance their purchase of other
companies by using their stocks as currency for the acquisition.The “e-health” companies were using the Internet
to reduce the paperwork among doctors, patients, hospitals, and insurers, and to acquire medical supplies and equipment.
However, when stock prices plunged as they did in the year 2000, the acquisition plans of several
“e-health” companies faced the possibility of being voted down by stockholders because of lower stock prices. From
October 1999 until April 2000, the “e-health” companies of Healtheon/WebMD,TriZetto Group, MedicaLogic, and
Neoforma.com saw their stock prices fall by 77%, 73%, 69%, and 82%, respectively.These companies all had several
acquisition deals in the works:TriZetto had agreed to buy IMS Health; MedicaLogic had agreed to buy Medscape;
Neoforma had agreed to buy Eclipsys; and Healtheon had agreed to buy several companies, including OnHealth
Network, Medical Manager, and CareInsite.The reason behind these company mergers was to develop economies
of scale and to enhance revenue growth.
Source: Robert McGough and Ann Carrns,Wall Street Journal, April 10, 2000, p. c1.
Equity Financing
The primary sources of equity financing for not-for-profit health care organizations
are internally generated funds, philanthropy, and government grants, whereas the primary
sources for for-profit organizations are internally generated funds and stock
issuances. Unfortunately, internally generated funds – those funds retained from
operations (retained earnings) – are shrinking. As discussed in Chapter 1, financial
pressures have lowered revenues and eroded earnings for health care organizations,
especially hospitals. However, these organizations still must be able to generate new
sources of capital to be able to survive.
Because the equity account on the balance sheet represents the claim on assets, as earnings
increase an organization builds its asset base. Typically, the health care organization
uses its most liquid assets on the balance sheet (i.e. cash and marketable securities) to
finance small capital purchases. But by doing so, an organization incurs an opportunity
cost, which represents the lost financial returns from not putting these funds into shortand
long-term investments. Assuming these funds are not invested in tax-exempt debt
funds, the financial returns from these short and long-term investments are higher than
the interest cost on tax-exempt debt. Since tax-exempt debt financing is a cheaper source
of capital than equity financing, health care organizations try to minimize their cost of capital
by utilizing more debt than equity in their financing decision.
276 Financial Management of Health Care Organizations
Perspective 8–2
The Fall of the House of AHERF: The Allegheny Bankruptcy
On July 21, 1998,Allegheny Health, Education, and Research Foundation (AHERF) filed for bankruptcy in Philadelphia,
PA.The Company listed total debt of $1.3 billion and outstanding claims from 65,000 creditors.The $1.3 billion was
composed of the following claims: $200 million in loans from Pittsburgh; $497 million owed to suppliers, of which a
bankruptcy court will determine how much if any the suppliers receive; and $605 million in bonds. 60 percent of these
bonds were insured and will be paid off, while non-insured bonds will be decided upon in bankruptcy court.
The bankruptcy stems from several factors ranging from a lack of fiscal responsibility, poor management decisions,
and overpayment of hospital and physician practices. In attempting to horizontally integrate,AHERF purchased hospitals
with high capital demands and low profit margins. In attempting to vertically integrate,AHERF overpaid for 310
primary care practices in the Philadelphia area due to competition from other health systems.
To finance the expansions,AHERF used debt financing, but several factors contributed to the decline in cash flow
to meet debt service requirements. Specifically: the competitive nature of the Philadelphia market from five major
academic medical centers; reimbursement reductions from the Balanced Budget Act of 1997; and lower premium
payments from managed care plans.
Source: L. R. Burns, J. Cacciamani, J. Clement, and W. Aquino, Health Affairs,Volume 19, number 1, January/ February
2000.
Equity financing for not-for-profits is derived from retained earnings, government grants, and contributions. Equity
financing for for-profits comes from issuing stock as well as retained earnings.
The Tax Reform Act of 1986 was seen as a major setback for health care providers,
because it lowered the tax deduction available to private individuals who wanted to
make philanthropic donations. Nevertheless, charitable giving remains a major source
of capital for certain health care providers. Although individuals who make contributions
do not receive a direct monetary return, they expect non-monetary benefits for
the community in terms of greater access to or increased quality of care. As health care
providers reach their debt limits, equity financing becomes their only source of new
funds. Besides externally generated equity, such as grants and appropriations, which
are available to all health care organizations, for-profit organizations (commonly
referred to as investor-owned) can also issue stock. Exhibit 8–1 lists selected advantages
and disadvantages of issuing stock versus debt financing.
The stock markets generally require a higher rate of return on equity financing (issuing
stock) relative to debt financing (issuing bonds). This is due to the greater uncertainty
associated with equity relative to debt: organizations are legally required to pay
back debt, but there is no legal obligation on the issuer’s part to pay back the equity.
Debt Financing
The major alternative to equity financing is debt financing: borrowing money from
others at a cost. The remainder of this chapter describes several types of debt financing,
and then describes the process to issue bonds. In the late 1980s hospitals were
highly dependent on debt. Perspective 8–3 provides insight on how some non-profit
hospital systems used debt financing in the year 2000. Recently, the uncertainty in the
health care industry has reduced its access to debt financing.
Sources of Debt Financing by Maturity
The general rule of thumb is to borrow short-term for short-term needs and longterm
for long-term needs. Short-term borrowing was discussed in the working cap-
Capital Financing for Health Care Providers 277
Stock Debt Financing
Ownership Gives up ownership to investors No ownership rights given up
Tax Implications Dividends are not tax deductible Interest on debt is deductible
Set Payments Dividends are not required to be paid Debt service payments are legally
required to be made
Amount of Payments Dividend payment at the organization’s Debt service payments are legally
discretion specified as to amount
Time Limit of Payments No limit Time limit is part of borrowing
agreement
Restrictions on Other Indirect through giving up of May place restrictions on operations
Actions ownership and capital acquisition
Exhibit 8–1 Comparison of Stock and Debt Financing
ital chapter. There are two important types of long-term financing: term loans,
which typically must be paid off within ten years, and bonds, which typically can
have a maturity of 20–35 years. Bonds are the primary source of long-term financing
for tax-exempt health care entities. Term loans, such as bank loans, conventional
mortgages, and FHA-issued mortgages, require the borrower to pay off or
amortize the principal value of the loan over its life. The amortization of a loan
requires equal periodic payments for principal and interest obligations. (Appendix
G provides a detailed analysis on the computation and development of a loan amortization
schedule.) In contrast, the payment of a bond can require the payment of the
principal at maturity, at which time the bondholder receives the face value of the
bond, and interest payments either can be paid periodically or else all at once at
maturity, along with the principal.
As opposed to a bank, which lends funds, the issuer of a bond receives funds from
the purchasers of the bond, typically the public. However, bond payments may be
structured so that the issuer can make early repayments of the principal or equal pay-
278 Financial Management of Health Care Organizations
Sinking Fund: A fund
into which monies are
set aside each year to
ensure that a bond
can be liquidated at
maturity.
Perspective 8–3
Buying on Credit: Hospital Systems Post Modest Increase in Their Long-term Liabilities
Hospital acquisitions, medical office buildings, transportation systems, and equipment purchases all helped to
increase the amount of long-term liabilities of the nation’s healthcare systems in 2000. Hospital systems overall
reported a 6% increase in long-term liabilities: $95 billion in the year 2000 as compared to $89.6 billion in 1999,
according to Modern Healthcare’s 25th annual Hospital Systems Survey. Not-for-profit systems reported a 3.3%
increase; for-profit systems recorded an increase of 7.2%; and public systems reported the largest increase in longterm
liabilities, 10.2%.
Long-term liabilities can include notes, mortgages, capital leases, bonds, and obligations under continuing-care contracts.
The numbers seem to indicate that healthcare organizations took advantage of a favorable borrowing market
in the year 2000 due to attractive long-term interest rates, a trend that has continued into 2001. Unlike for-profit
chains, which can raise capital in the equity market without increasing debt, the not-for-profits are limited to borrowing
in one way or another because they don’t have investors, says Brian McGough, managing director at Banc
One Capital Markets in Chicago. He says there were three main reasons why systems increased their long-term liabilities
last year: not-for-profits borrowing to finance acquisitions of other not-for-profit facilities; not-for-profit systems
buying hospitals divested by for-profit companies; and investments in technology, especially costs related to
addressing the anticipated Y2K computer problems. “Considering those three variables . . . it’s not surprising there
has been a modest increase in debt,” he says.
Source: Deanna Bellandi, Modern Healthcare, June 18, 2001, p. 94.
Short-term financing typically refers to a wide range of financing, from debt that must be paid back almost
immediately, to debt that may not have to be paid off for a year. Long-term financing typically refers to debt
that will be paid off in a period longer than one year.
ments over the life of the bond through a sinking fund. In the latter case, the issuer
makes payments to the bond trustee who then uses the funds to retire a portion of the
debt.
Sources of Debt Financing by Type of Interest Rate: Fixed
and Variable Interest
Fixed interest rate debt is a security whose rate does not change during the lifetime of
the bond; conversely, variable interest rate debt is a security whose rate changes based
on market conditions. Health care providers are attracted to fixed rate debt because of
the predictability of future payments, but the generally higher cost of fixed rate debt
may encourage a health care provider to borrow on a lower-cost, variable basis (see
Exhibit 8–2).
The primary concern about variable interest rates is that interest rates may increase,
which could cause an unanticipated demand for cash flow. However, health care
providers may use variable rate debt if they have sufficient cash/investment accounts
to hedge against changes in interest rates. The concept of hedging is that as variable
rates increase and debt payments increase, so too will the returns on the facility’s
investments, thereby offsetting increased debt payments.
Selected Types of Health Care Debt Financing
This section discusses further several specific types of debt financing: bank loans,
conventional mortgages, FHA program loans, and bonds.
Bank Term Loans
Loans traditionally issued by banks with maturities of one to ten years are defined as
term loans. These loans are usually paid off in equal or “level” amounts over the life
of the loan.
Capital Financing for Health Care Providers 279
Advantages Disadvantages
Fixed Rate Debt 1. Fixed debt service payments 1. Higher up front or issurance expenses
2. Fixed interest rate 2. Depending on market condition of variable debt,
may pay higher interest cost over life of loan
Variable Rate Debt 1. Lower up front issuance costs 1. Higher interest costs if interest rates increase
2. Lower initial interest rate 2. Unstable debt service payments (interest rate
risk)
3. Decline in cash flow if interest rates increase
Exhibit 8–2 Selected Advantages and Disadvantages of Fixed and Variable Rate Debt
Hedging: The art of
offsetting high
variable rate debt
payments with returns
from high-rate
investments.
Term Loan: A loan
typically issued by a
bank which has a
maturity of
1 to 10 years.
Conventional Mortgages
Under a conventional mortgage, the health care facility pledges its land or building(
s) as collateral for a loan. Typical lenders include commercial banks, insurance
companies, and savings and loan institutions. The term of a loan is normally 20
years. Unfortunately, the lender may allow the borrower to finance only a portion
of the purchase, requiring a down-payment on the rest.
Pooled Equipment Financing
To create greater access to tax-exempt debt financing for less expensive loans,
a program of pooled equipment financing was developed. Given the high
fixed issuance costs of borrowing, pooled financing spreads these costs over a
number of health care borrowers, who each receive a portion of the loan.
State or regional hospital associations typically sponsor pooled equipment financing
programs.
FHA Program Loans
To improve marketability and encourage lower interest rates, the governmentsponsored
Federal Housing Administration (FHA) provides mortgage insurance
for health care facilities’ loans. The insurance guarantees the principal and interest
on a loan. The disadvantages are the fees charged and the time it takes to have
a loan approved. Many FHA-insured loans can take a year or more to
implement.
Bonds
A bond is a long-term contract whereby on specific dates a borrower agrees to make
principal and/or interest payments to the holder of the bond who lent the funds. The
section below describes key terms used in the rest of this chapter as they relate to
bonds and the bond issuance process.
1. Indenture and Covenant. A legal document that states the conditions and
terms of a bond is called an indenture.It usually is lengthy – often 100 pages
or more – and covers the amount and timing of payments to be made to
bondholders.It also lists the numerous covenants of the bond.A loan
covenant is a legal provision stated in the bond that the issuer must follow,
such as the security backing the bond, the amount of future debt that can be
offered, and acceptable ranges for liquidity and debt service coverage ratios.
Covenants protect the claims of bondholders on the facility’s assets in case of
default.
280 Financial Management of Health Care Organizations
Collateral: An asset
with clear value (such
as land or buildings)
which is pledged
against a loan to
reduce risk to the
lender. If the loan is
not paid off
satisfactorily, the
lender has a legal
claim to seize the
pledged asset.
2. Debenture. A debenture is an unsecured bond; that is, it is not backed by
specific assets of the organization.
3. Subordinated Debenture. A subordinated debenture is an unsecured
bond that is junior to debenture bonds.In the case of default, debenture
bondholders are paid first.A subordinated debenture is more risky to the
investor and thus pays a higher interest rate.
4. Par Value. The par value of a bond is the security’s face value, such as
$1,000 or $5,000.This is the amount that a bondholder is paid at the time
of the bond’s maturity.
5. Coupon Rate and Coupon Payment. The coupon rate is the stated
interest rate on the bond, as promised by the issuer.The coupon payment
is the amount the holder of the coupon receives periodically, usually semiannually.
It equals the coupon rate times the face value of the bond
payment.For example, if the coupon rate is 10 percent for a bond with a
$1,000 par value, the coupon payment is $100 annually, or $50 semiannually.
6. Callable Bonds. Callable bonds may be redeemed by the issuer before they
mature.An issuer may call a bond if its coupon rate is higher than the
presently prevailing interest rates for bonds, or if the issuer wants to
eliminate restrictions caused by having the bond outstanding.In order to
attract investors, most callable bonds guarantee a certain coupon payment
for ten years (the call protection period), and contain a call price feature that
equals par value plus a call premium, usually equal to one to two percent of
the outstanding balance.
7. Zero Coupon Bonds. The term coupon refers to the amount of interest that
will be paid by the issuer to the bondholders.Bonds issued with no coupon
at all are called zero coupon bonds.The tradeoff to the issuer for not making
any coupon payments over the lifetime of a bond is that the bond must be
issued at a deep discount, i.e. less than face value, which means that the
issuer receives less initially in bond proceeds.Investors are attracted to
these bonds not only because of their bigger discount rates, but also because
they need not concern themselves with managing and reinvesting coupon
payments (although they still must pay annual taxes on portions of taxable
bonds).
8. Serial Bonds. Bonds issued at various maturities and coupon rates are
called serial bonds.Bonds of this nature allow the investor to purchase
bonds with shorter maturities in addition to investing in bonds with longer
maturities.
9. Basis Points. Security traders discuss the changes in a bond’s interest
rate by basis points.A basis point is 1/100th of 1 percent.Thus, 100
basis points is equal to 1 percent; one bond yielding 8.75 percent and one
bond yielding 8.65 percent have a spread of 10 basis points. Traders also
consider the basis point spread between different types of bonds.For
example, the spread between taxable and tax-exempt bonds may be 300
basis points, or there may be a spread of 30 basis points between AAA and
A-rated bonds (bond ratings are discussed more shortly).
Capital Financing for Health Care Providers 281
10. Sinking Fund. As part of the bond contract, a covenant may establish that
part of the principal be paid back each year, earmarked for the orderly
retirement or the redemption of bonds before maturity.These funds,
called sinking funds, are paid periodically to the trustee who maintains the
fund for the health care provider.They are analogous to the principal
repayment of a mortgage.
11. Secondary Market. Markets that deal in the buying and selling of bonds
that have already been issued.
Tax-exempt Bonds
Tax-exempt bonds are bonds in which the interest payments to the investor have
exempt status from the IRS; thus, the interest payments are typically lower than those
from bonds, which do not have tax-exempt status. The lower interest payments of taxexempt
financing have made it the primary choice of debt financing for not-for-profit
health care organizations. These bonds can only be issued by an organization which has
received tax exemption as designated by the IRS, and the funds must be used for projects
that qualify as “exempt uses.” Rather than having assets as collateral, these bonds
are usually backed by the organization’s revenues; such issues are called tax-exempt
revenue bonds.
An alternative to revenue bonds are mortgage bonds, which carry the health care
provider’s real property and equipment as security or collateral in the case of default.
In today’s market, health care providers with an A or higher bond rating normally are
not required to pledge their assets as collateral; in the unlikely case of default, creditors
are secured by the pledge of the health care provider’s revenues. However, creditors
can enhance their security indirectly by requiring a negative pledge on a health
care provider’s real estate. A negative pledge prohibits the health care provider from
giving a lien (claim) on its real estate to any other creditor.
Another advantage to the issuer of tax-exempt bonds other than the lower interest
rates is their long maturity to term, often 30–35 years, as compared to 20–25 years typical
of taxable bonds. One disadvantage is the higher issuance cost due to documentation
fees for the issuing authority, bond counsel fees, and other documentation required to
achieve tax-exempt status on the issue. Slower issuance is another drawback. Since the
facility must act through a governmental authority, the bureaucratic approval and
issuance process increases the time it takes to bring the security to market.
Taxable Bonds
Taxable bonds differ from tax-exempt bonds primarily in that the coupon payments
must be reported as taxable income by the investor. Taxable bonds typically have
282 Financial Management of Health Care Organizations
Tax-exempt bonds have lower interest rates than do taxable bonds because investors in tax-exempt bonds
do not have to pay taxes on the interest income they receive.
shorter maturity (20–25 years) and reduced marketability. To sell them, a health care
facility must compete in the marketplace against such corporate giants as IBM and
General Motors. Thus, to attract investors, the yields or coupon payments on these
bonds have to be higher than those of bonds issued by the large, well established firms,
because the investor faces greater risk buying bonds from a lesser-known organization.
The major advantages that taxable bonds have over tax-exempt bonds are lack of
restrictions as to use and quicker market turnaround time.
Bond Issuance Process
Before a bond can be issued, it must be sold under either public or private placement.
Health care providers, whether they are issuing a taxable or a tax-exempt bond, must
select between public or private placement. In a public offering, a bond is sold to the
investing public through an underwriter, sometimes called an investment banker.
Private placements are sold to a particular institution or group of institutions
(banks, pension funds, or insurance companies), also with the assistance of an underwriter.
Exhibit 8–3 introduces the key parties involved in the bond issuance process,
which is discussed in more detail below.
Public versus Private Placement
The advantage of private over public placement is that the issuer avoids marketing
and printing costs; moreover, depending on the requirements of the buyer, the seller
may be able to lower issuance costs even further by forgoing the project’s feasibility
study and not having the bonds rated. The primary disadvantage of private placement
Capital Financing for Health Care Providers 283
Industrial Development Authority
Bond Trustee
Underwriter/
Investment Banker
Bondholders
Indenture of Trust
$$$ Bonds
Loan Agreement
Interest &
Principal
Payments
Interest &
Principal
Payments
$$$
$$$
Hospital
Bonds
Bonds
Exhibit 8–3 Parties Involved in a Tax-exempt Bond Issuance Process
is that because of the bond’s reduced liquidity in a narrower market, buyers demand
higher interest rates. If the buyer desires to resell the bonds, there is no public secondary
market, only other institutions. Other disadvantages of private placement are
shorter maturity (leading to higher debt service payments) and increased bond restrictions.
Most health care facilities select public placement because the lower interest
cost differential over the lifetime of the bond offsets the front-end savings of a private
placement.
Public offering of a bond by a tax-exempt health care institution requires an offering
prospectus called an Official Statement (OS) and, due to a recent proposal by the
Securities and Exchange Commission (SEC), also requires annual updates of financial
statements to investors. In contrast, stock or bond issues by for-profit corporations
require stiffer disclosure requirements for investors, registration with the SEC, and
annual and quarterly reports to stockholders. The OS must fully disclose information
about the issue, which includes the financial state of the facility (audited financial
statements), operational background (medical and management staff, service area,
services offered, sources of revenues), the terms of the issue, and, in some cases, a
feasibility study of the project being financed.
The Steps in the Bond Issuance Process
Once an organization decides to use bonds as its source of capital, it must go through
a long and arduous process before it actually receives any cash. The bond issuing
process for not-for-profit organizations using public markets is described below,
which can take 12–18 months before any cash is received.
1. The health care provider attempts to “get its house in order.” Over a year
before actually starting the bond issuance process, a health care agency needs to “get
its house in order” to receive a high bond rating.For example, it may attempt to build
up its cash reserves, decrease its receivables, and/or liquidate some of its existing
debt.In addition, it may update its strategic plan and improve its information system
or other parts of its infrastructure.
2. The health care agency is evaluated by a credit rating agency. When a
lender evaluates a health care facility as a potential borrower, it considers a range of
factors to evaluate risk, including financial, market, and management data.When
issuing either tax-exempt or taxable bonds, health care providers turn to investment
bankers and/or bond rating agencies to objectively evaluate their creditworthiness by
universal standards.(For conventional mortgage loans, a commercial bank or insurance
company performs the evaluation.) Regardless of the type of debt financing,
lenders examine both financial and non-financial data thoroughly.The information is
284 Financial Management of Health Care Organizations
Feasibility Study: A
study which examines
market and
management factors
which affect the
issuer’s ability to
generate the
necessary cash flows
to meet principal and
interest requirements.
Debt Service Coverage ratio is one of the primary financial ratios used to evaluate a health care provider’s ability
to meet debt service payments.
often assembled as a financial feasibility study performed by a management-consulting
firm.From the financial projections, the consultant determines whether the
health care provider has sufficient funds to make principal and interest payments over
the lifetime of the bonds in a timely manner.
Financial Evaluation
From a financial standpoint, the lender or rating agency is primarily interested in evaluating
a health care provider’s ability to pay. This can be measured by the debt service
coverage ratio as discussed in Chapter 4:
(Net income + Interest + Depreciation)
Debt Service Coverage = ___________________________________
Annual Debt Service Payments
The numerator represents the health care provider’s cash flow before its interest payments
and depreciation expense and is divided by the required annual loan payments
of principal and interest. Lenders or rating agencies expect a minimum debt service
coverage ratio of 2.0. They also measure ability to pay using several other financial
ratios, such as days cash on hand or operating margin.
Market Evaluation
In this step, the lender or rating agency evaluates the demand for the investment project.
A wide range of factors are considered in this step, including local demographics
(population growth, income levels, unemployment rate in the market area), competition
from other health care providers, penetration of managed care, and the industrial
base of the local economy.
Physician and Management Evaluation
Because physicians are responsible for admissions, lenders pay particular attention to
the characteristics of the staff including the number of medical staff members by specialties,
their ages, the percentage of admissions by staff members, the number of
board-certified physicians, and the recruitment and retention of staff.
The lender also examines the health care provider’s management staff for such
things as background and experience, how they are organized, and how they relate to
the medical staff. Any recent turnover of management staff and its effect on the organization
would be scrutinized closely.
3. The bond is rated by a bond-rating agency. Bond ratings assess the creditworthiness
or the likelihood of default of a bond.The higher the rating, the lower the
interest rate the organization has to pay (less risk to investors).The two primary rating
agencies are Moody’s and Standard & Poor’s (S&P).The rating assigned to an
issue affects the interest rate and marketability of the bond.Depending on the size
and complexity of the issue, simply getting a rating can cost the issuer from $1,000 to
Capital Financing for Health Care Providers 285
$50,000.The assigned ratings for both agencies are listed in Exhibit 8–4.
Investment grade ratings range from AAA to BBB (S&P), or Aaa to Baa (Moody’s),
of which the highest are called quality ratings. Junk bonds are rated BB and below
by S&P and Ba and below by Moody’s.Within the junk bond category are substandard
and speculative bonds, both of which are considered very risky investments.
Some providers may choose not to have their bonds rated because they are relatively
small in size or they will receive a “below investment grade” rating.
A health care provider rarely achieves the top AAA or Aaa rating. Health care
providers in the AA/Aa rating category not only have excellent financial strength, but
also have strong management, large bed size, and a superior medical staff. These hospitals
tend to rely less on Medicare and Medicaid revenues, exhibit low debt ratios,
generate strong profits, and possess large cash reserves. Health care providers in the
BBB/Baa and substandard categories are normally smaller facilities located in competitive
or rural markets and serve a high proportion of Medicare and Medicaid
patients. Furthermore, their cash reserves tend to be low and they possess a high
amount of debt. Exhibit 8–5 lists three S&P ratings for not-for-profit hospitals in 2000
and offers a sample of their respective operating and financial measures. Perspective
8–4 lists some of the criteria that affect a hospital’s rating.
A health care provider can strengthen its credit rating, and thereby lower its interest
cost and increase marketability, through either bond insurance or a letter of credit.
For a fee of 0.7–2 percent of the bond’s total face value, a facility can obtain bond
insurance that guarantees the timely payments of principal and interest to bondholders
in the unlikely event of default by the issuer. The rating then attributed to the
bond becomes a function of the credit strength of the bond insurance company.
However, if an insurer’s rating falls, so do the ratings of all its insured issues. The
major insurers include AMBAC, MBIA, and FGIC.
286 Financial Management of Health Care Organizations
Moody’s S & P’s Interpretation Grade of the Bond
Rating Rating
Aaa AAA Judged to be the best quality Quality
Aa AA High quality, smaller amount of protection than AAA Quality
A A Many favorable investment attributes Investment Grade
Baa BBB Medium grade; neither highly protected nor poorly secured Investment Grade
Ba BB Speculative elements; future cannot be considered as well assured Substandard Junk Bonds
B B Generally lack characteristics of desirable investment Substandard Junk Bonds
Caa CCC Poor standing; may be in default or have elements of danger Speculative Junk Bonds
Ca, C CC, C Very speculative; often in default; very poor prospects Speculative Junk Bonds
DDD D Bond in default Speculative Junk Bonds
Exhibit 8–4 Comparison of Moody’s and Standard & Poor’s Bond Ratings
Investment Grade bonds are at or above a S&P’s BBB rating or Moody’s Baa rating. Bonds below this rating in
either category may be considered Junk Bonds.
A letter of credit through a bank is another option to enhance the rating of the
issuer’s bond. The cost is an initial fee plus an ongoing percentage of the outstanding
amount remaining on the issue each year. Again, the bond’s rating is dependent upon
the strength of the bank.
The rating of a bond traded in the marketplace, called an outstanding issue, is
reviewed on a periodic basis and could be either upgraded or downgraded depending
on the issuer’s present financial or operational conditions. For example, in the 1990s,
Capital Financing for Health Care Providers 287
Perspective 8–4
Health Care Rating Process
Moody’s, a bond rating agency, uses both qualitative and quantitative factors to rate a hospital bond. These factors
include service area characteristics such as medical staff, governance, services and service area, competition, and
financial resources. Moody’s looks for board members with knowledge of national and local health care issues, and
it assesses a board’s ability to balance opportunities with prudent financial performance. Moody’s reviews the size
of the medical staff, average age, number of board certified physicians, top-revenue producing physicians, and
turnover. In terms of competition, Moody’s evaluates: all the hospital competitors, specifically other hospitals, physicians,
and surgery centers; the types and levels of services with respect to how they affect the hospital’s competitive
and financial position; and how well the hospital can influence or control a profitable patient population
compared to its competitors. The rating agency also assesses its contracting clout with managed care companies.
Last, Moody’s places emphasis on cash flow generated from core operations, and it focuses on ratios that incorporate
cash flow, and those ratios which are key to an organization’s ability to repay its debt.
Source: Moody’s Rating Methodology Handbook, Public Finance, November 2000.
Bond Rating
Measure AA A BBB
Average Daily Census 580 149 69
Net Patient Revenue ($000s) 601,458 125,217 48,419
Earnings Before Interest & Depreciation ($000s) 89,704 19,150 5,889
Bad Debt Expense to Operating Revenues 4.2% 3.3% 4.6%
Debt Service Coverage Ratio 4.4 3.3 2.4
Operating Margin 0.5% 1.4% 0.7%
Total Profit Margin 4.7% 4.0% 3.4%
Non-operating Revenue to Total Revenue 4.6% 2.7% 2.1%
Age of Plant (Years) 8.2 8.6 9.2
Days Cash on Hand 213 161 116
Days in Accounts Receivable 75.3 67.3 66.4
Average Payment Period (Days) 68.7 65.8 64.4
Long-term Debt to Total Capital 27.1% 32.7% 39.1%
Cash Flow to Total Debt 20.4% 19.2% 15.1%
Exhibit 8–5 Selected Not-for-Profit Hospital Industry Bond Ratings and Medians: 2000
Letter of Credit:
Offered through a
bank, this can be used
to enhance the
creditworthiness of an
institution, and hence,
a bond’s rating.
Source: Standard & Poor’s Median Health Care Ratios, October 19, 2000.
Moody’s lowered the rating of National Healthcare Inc.’s subordinated debenture
from B to Caa after it had already gone to market. The agency cited increased financial
leverage and expectations for minimum profits as the cause for the downgrade.
Recently, the pressures of competition and the constraints on reimbursement have
resulted in more downgrades than upgrades. In 1999, the ratio of downgrades to
upgrades stabilized at 5:1. See Perspective 8–5 for additional information on the factors
affecting the downgrading of bonds.
4. The health care provider enters into a loan agreement with the governmental
authority, the issuer of the bonds, via a trustee. The amount of the loan
agreement is equivalent to the bond payments.The health care provider must ensure
that the bond issuance process satisfies all federal regulations, which are designed to
help protect the investors.At the same time, since the health care provider is engaging
in a legally binding contract, it needs to ensure that the stated conditions are customized
appropriately and are not simply generic guidelines.By doing so, the health
care agency gives itself sufficient leverage and flexibility to pay off its debt should conditions
change.
5. The governmental authority delivers the bonds to the underwriters. The
governmental authority, sometimes called an industrial development authority, issues
the bonds to one or more underwriters, sometimes called investment bankers.By
playing the role of intermediary, the government is able to keep the transactions publicly
recorded.Some bond issuances can be worth hundreds of millions of dollars,
288 Financial Management of Health Care Organizations
Outstanding Bond
Issue: A bond that
trades in the
marketplace.
Perspective 8–5
Credit Rating Downgrade of Hospital Bonds
After downgrading much of the not-for-profit hospital industry during the past two years, two leading credit-rating
agencies said the carnage might be winding down. But they haven’t put away the ax. Last week, Moody’s Investors
Service predicted that not-for-profit hospital credit ratings will stabilize by the end of 2001. Its announcement followed
a report with similar conclusions issued by competitor Standard & Poor’s earlier this month. Both agencies,
which rate a total of about 1,000 hospital credits, said they still expect downgrades to exceed upgrades this year,
but at a smaller ratio than in the past.“We expect that the number of upgrades and downgrades will equalize toward
the end of the year,” said Bruce Gordon, a senior vice president at Moody’s.
In another positive sign, Moody’s last week changed its outlook for the for-profit hospital sector from negative to
stable. It said the credit quality of for-profits has benefited from a more stable Medicare environment, growth in
same-facility admissions, and organizations’ ability to leverage market share to win better managed-care contracts.
In the not-for-profit sector, downgrades have outpaced upgrades by about 5-to-1 in the past 24 months as rating
agencies have reacted to financial pressures on the industry from the impact of the Balanced Budget Act of 1997,
managed care, and failed business ventures. Last year, 1 in 10 hospitals with rated debt saw their ratings sink.
The for-profit sector still does face credit concerns including rising labor costs and the threat of less-favorable
managed-care rates, Moody’s said.To meet earnings targets, companies may turn to debt-financed acquisitions or
stock buybacks.
Source: Mary Chris Jaklevic, Modern Healthcare, January 29, 2001, p. 17.
and it is crucial that the health care provider, the underwriter, and the investor are
fully protected and are abiding by all the regulations.
6. The underwriters sell the bonds to bondholders at the public offering
price, and the trustee provides the health care provider with the net proceeds.
A pricing process actually begins several weeks before the true opening day
sale of the bonds, when the underwriters issue a preliminary OS to prospective buyers
called a red herring.At that time, underwriters construct a pre-pricing scale of
interest rates for various maturities.Their objective is to achieve an equilibrium price
that ensures marketability, yet avoids over-subscription of the issue.If over-subscription
occurs, this indicates the bond price is too favorable to investors and, thus,
unfavorable to the health care provider.In this case, the underwriter will either price
the bond higher or lower the interest rate.Though this will decrease the number of
bond orders, it makes the price fairer to the health care provider.Once the final price
has been set, an agreement is signed by the issuer and the leading underwriter.
Shortly thereafter, the underwriter purchases the bonds, sells them to investors at the
predetermined price, and then transfers the proceeds to the health care provider via
the governmental authority and then trustee.In short, the pricing period allows the
underwriter to obtain commitments from buyers to reduce its own risk before buying
the bonds.
After the issuance process has been completed, the health care provider makes its
interest and principal payments to the trustee, who in turn pays the investors/bondholders.
The health care facility is obliged to guarantee against bankruptcy for taxexempt
bonds.
Selected Roles of Underwriters and Trustees
Underwriters, sometimes referred to as investment bankers, help health care facilities
issue bonds. Specifically, they advise management on the terms of the structure of the
bonds (i.e. size, length, interest rate, loan restrictions, bond insurance, etc.). They also
may buy the bonds themselves from the issuer at a discount and in turn try to sell
them in the marketplace. In so doing, the investment banker incurs a major risk: a
potential decline in bond prices (rise in interest rates) from when the bonds were
originally purchased. This would result in reselling the bonds to investors at less
profit, if not a loss.
To spread the risk, the leading investment banker will syndicate with other
investment bankers to sell the bonds. The syndicate may consist of local investment
banking firms (in order to enhance marketability), or national investment banking
firms such as Prudential Securities, Smith Barney, Merrill Lynch, and Paine Webber.
On the other hand, the investment banker may avoid all risk by acting solely as an
agent for the health care facility to help sell the bonds. In this case, the risk shifts back
to the issuer, as all unsold bonds are returned to it.
The trustee, typically a bank, acts as an agent for the bondholders and performs
two important functions. First, the trustee makes the principal and interest payments
to the bondholders. Second, the trustee ensures that the health care provider
Capital Financing for Health Care Providers 289
Red Herring: A
preliminary OS offered
to prospective buyers
of a bond by the
underwriters to help
determine a fair
market price for the
bond.
Net Proceeds from a
Bond Issuance: Gross
proceeds less the
underwriter’s and
others’ issuance fees.
complies with the legal covenants of the bond. For example, if the health care
provider were required to maintain a debt service coverage ratio above 2.5 and debt
to total capital less than 50 percent, the trustee would monitor its performance with
respect to these ratios. If the health care provider did not comply, it would be in
default of the bond.
Lease Financing
As health care facilities find it more difficult to acquire capital to finance
equipment, many consider lease arrangements as a necessary and viable
alternative. Leasing now accounts for 20–25 percent of all health care provider
equipment spending. A lease involves two parties: the lessor, who owns the asset,
and the lessee, who pays the lessor for the use of the asset but does not own it.
Some reasons why a health care provider may decide to enter into a lease
arrangement are:
1. To avoid the bureaucratic delays of capital budget requests. Because
of the longer, closer scrutiny given capital budgeting requests by top
management and the board, an administrator may find it more convenient to
lease a piece of medical equipment rather than to request it in the capital
budget.This is especially true for state- or city-owned facilities whose
capital purchases require governmental approval.
2. To avoid technological obsolescence. Given the rapid changes in health
care technology, lessees can avoid paying for high-tech equipment that may
be outdated shortly.By leasing, a facility can continually upgrade its
equipment; the risk of technological obsolescence then shifts to the lessor.
3. To receive better maintenance services. Most full-service leases
include maintenance for the equipment.Some believe that since the lessor
owns the equipment, maintenance is better.
4. To allow for convenience. If an asset is to be used for only a short time,
leasing is less time-consuming and costly than buying and selling shortly
thereafter.Since leasing constitutes 100 percent financing, leasing
companies advertise that it frees cash for other purposes.A facility could also
avoid a cash down payment by borrowing enough to cover the full cost of the
lease, which is less than buying the asset outright.Thus, from a financial
perspective, lease financing appears equivalent to debt financing; the only
major difference being that a facility never actually owns a leased asset.
The two major types of leases are operating leases and capital leases.
290 Financial Management of Health Care Organizations
Trustee: An agent for
bondholders who
ensures that the
health care facility is
making timely
principal and interest
payments to the
bondholders and
complies with legal
covenants of the
bond.
Lessor: An entity who
owns an asset, which
is then leased out.
Lessee: An entity who
negotiates the use of
another’s asset via a
lease.
Lessor owns the asset while the lessee makes lease payments to the lessor for the use of the asset.
Operating Lease
An operating lease is for service equipment leased for periods shorter than the
equipment’s economic life, usually between a few days and a year. The lessor’s aim is
to lease for less than the equipment’s full cost, but to recover the cost by leasing the
asset many times over its economic life. The usual types of assets covered by operating
leases are computers, copier machines, and vehicles. The lessor incurs all the ownership
costs of maintenance, service, and insurance on the leased equipment.
Another characteristic of operating leases is a cancellation clause, giving the lessee
the option to return the leased asset to the lessor with little or no penalty at any time
during the life of the lease.
Capital Lease
In a capital lease, also called a financial lease, the lessor aims to lease the asset for
virtually all of its economic life. In return, the lessee is committed to lease payments
for the entire lease period. The lessee does not have the option to cancel a capital lease
immediately without a substantial penalty but does have an option to buy the leased
asset at the end of the lease agreement. The latter option tends to be more expensive
than if the facility had initially bought the equipment outright, because the lessor
always operates with a margin for profit.
One type of capital lease used by the health care industry is the sale/leaseback
arrangement, whereby a health care provider sells an owned asset (such as a clinic) to a
third party and simultaneously leases it back from the purchaser. By selling the owned
asset, the facility is able to obtain immediate capital, though it still retains use of the asset.
From a financial management perspective, a capital lease has implications similar to
buying an asset and financing it with debt. Buying through borrowing and negotiating
a capital lease are similar in that both require contractual payments (debt or lease
payments) over the life of the asset, and both options incur the costs of operating the
asset. The primary difference occurs at the end of the asset’s life, when the leasing
arrangement requires the asset to be returned to the lessor (the owner), unless the
contract stipulated an option to buy or renew. In contrast, under the buy/borrow
option, the owner may either sell or continue to use an asset at any point.
Analysis of the Lease versus Purchase Decision
One of the most common financial decisions made by a health care organization is
whether to buy or lease a needed asset. The usual approach is to compare the present
value cost of a buy decision with the present value cost of a lease decision over a specified
time period. From a purely financial standpoint, the option with the lower
present value cost is preferable. In making this assessment, several factors must be
considered. Taxpaying entities realize either an effective lower net lease payment from
Capital Financing for Health Care Providers 291
Operating Lease: A
lease that lasts shorter
than the useful life of
the leased asset,
typically one year or
less. This type of
leasing arrangement
can be canceled at any
time without penalty,
but there is no option
to purchase the asset
once the lease has
expired.
Capital Lease: A lease
that lasts for an
extended period of
time, up to the life of
the leased asset. This
type of lease cannot be
canceled without
penalty, and at the end
of the lease period, the
lessee may have the
option to purchase the
asset. Also called a
financial lease.
Financial Lease: See
capital lease.
the tax deduction of the lease payment, or an interest and depreciation tax shield from
buying the asset. The cost of ownership includes the outflow of cash to maintain the
asset offset by the inflow of cash from its salvage value. Interest and depreciation
expenses act as tax shields because they are tax-deductible expenses, which reduce
the taxes paid to the government. Last, the cash flows under the lease option are discounted
back at the after-tax cost of debt rather than at the cost of capital.
Suppose Five-Star General Hospital is undecided about purchasing a $10 million
piece of equipment or leasing it. If it decides to buy the asset, it can borrow the full
amount from its local bank at a rate of 10 percent; the equipment would be depreciated
at a rate of $2 million per year over its five-year life to a zero salvage value. Under
the lease arrangement, the gross lease payments would be $3 million per year, starting
one year from now. Assume the organization is a taxpaying entity with a 30 percent
tax rate.
Exhibit 8–6 presents the analysis of this purchasing versus leasing decision.
Because the present value sum of the financing flows for purchasing is the higher of
the two options,− $7,540,000 versus − $8,610,000, purchasing the asset is the desired
alternative to leasing.
A loan amortization schedule similar to the one in Exhibit G–3 is
presented in Columns A through D in the top section. The loan
amortization amount ($2,638,000, row 1) is calculated using the present
value factor for an annuity at 10 percent interest for five years (3.7908).
Column A represents the only cash outflows, which are the loan
payments.
Columns E and F present cash inflows from interest and depreciation
expense tax shields. The interest expense tax shield was computed by
multiplying the interest expense in Column B by the same tax rate of 30
percent (row 4). The depreciation tax shield inflow ($600,000) was
computed by multiplying the annual depreciation expense, $2 million, by
the tax rate, 30 percent (rows 3 and 4).
The net cash outflow, Column G, equals the annual loan payment from
Column A less the tax shield amounts. Finally, the net cash outflow is
discounted back at the net after tax cost of debt: 10 percent × (1 − 0.3) =
7 percent. Since the cash flows are net of taxes, the calculations should be
based on the net after tax cost of debt as well. Column H gives the present
value factors at 7 percent, while Column I shows the net present value of
the decision to purchase the asset, − $7,540,000.
The lower section shows the calculations for the leasing alternative. Cash
outflows, Column L, are also examined net of taxes; thus, the net payment
only equals $2.1 million per year [$3 million × (1 − 0.30)]. These
payments are also discounted back at the same net after tax cost of debt
rate of 7 percent. Column N shows the present value of the leasing
decision, − $8,610,000.
If Five-Star General were a non-taxpaying entity, there would be no tax shield
benefits. In this case, the analysis would be simplified by comparing only the
292 Financial Management of Health Care Organizations
Sale/Leaseback
Arrangement: A type
of capital lease
whereby an institution
sells an owned asset
and then
simultaneously leases
it back from the
purchaser. The selling
institution retains
rights to use the asset,
but benefits from the
immediate acquisition
of cash from the sale.
Tax Shield: An
investment, which
reduces the amount of
income tax, which has
to be paid, often
because interest and
depreciation expenses
are tax deductible.
Exhibit 8–6 Comparison of Purchasing Arrangement to Leasing Arrangement for Five-Star General Hospital
General Hospital
Givens:
1 Annual Annuity Payment1 $
2,638
2 Interest Rate 10%
3 Annual Depreciation Expense2 $
2,000
4 Tax Rate 30%
5 Depreciation Expense Tax Shield3 $
600
6 After Tax Cost of Debt4 7%
7 Before Tax Lease Payments $
3,000
1PVFA Formula: $
10,000 Initial Investment; i =
10%; n = 5
Years
2$10,000 Purchase Price/5
Years Useful Life = $
2,000 Depreciation Expense per Year
3$2,000 Depreciation Expense per Year ×
30% Tax Rate = $
600 Tax Shield per Year
4(Interest Rate) × (1 −
Tax Rate) =
10% × (1 −
30%) =
7%
Purchasing Arrangement
AB C D E F G H I
Interest Depreciation Net Cash PV PV of Net
Annuity Interest Principal Remaining Expense Expense Outflow Factor Cash Outflows
Payment Expense Payment Balance Tax Shield Tax Shield (if owned) from (if owned)
Year [Given 1] [D* × Given 2] [A − B] [D* − C] [B × Given 4] [Given 5] [A − (E + F)] [Given 6] [G × H]
0 $
10,000
1 $
2,638 $
1,000 $
1,638 8,362 $
300 $
600 $
1,738 0.9346 $
1,624
2 2,638 836 1,802 6,560 251 600 1,787 0.8734 1,561
3 2,638 656 1,982 4,578 197 600 1,841 0.8163 1,503
4 2,638 458 2,180 2,398 137 600 1,901 0.7629 1,450
5 2,638 240 2,398 0 72 600 1,966 0.7130 1,402
Total $7,540
Note: D* is the previous year’s Column D value. (
Continues)
present value of the loan payments to the present value of the lease payments, but
the cost of debt would be 10 percent, not 7 percent. Though normally it would be
necessary to go through these calculations if the payments differed each year, it can
easily be seen here that with flat payments every year under both options ($2.638
million borrowing versus $3.0 million leasing), purchasing would be less costly
than leasing. Therefore, the present value of the loan of $10,000,000 would be less
than the present value of the lease, and the decision should be to borrow the funds
and buy the asset.
Summary
There are three ways to finance assets: using debt (liabilities), equity, or a combination
of the two.
Assets = Debt + Equity
Any increase in assets must be balanced by a similar increase in debt and/or equity.
The structuring of debt relative to equity is called the capital structure decision,
and is increasingly important to both for-profit and not-for-profit providers. In
today’s environment, characterized by prospective and capitated payments, the
increased use of managed care and outpatient services, and increasing cutbacks
294 Financial Management of Health Care Organizations
Exhibit 8–6 (Contd)
Leasing Arrangement
J K L M N
PV of Net
Before Tax Lease Tax Net After PV Factor Cash Outflows
Lease Payments Shield Lease Payments from (if leased)
Year [Given 7] [J × Given 4] [J − K] [Given 6] [L × M]
0
1 $3,000 $900 $2,100 0.9346 $1,963
2 3,000 900 2,100 0.8734 1,834
3 3,000 900 2,100 0.8163 1,714
4 3,000 900 2,100 0.7629 1,602
5 3,000 900 2,100 0.7130 1,497
Total $8,610
Note: All figures expressed in ’000
Salvage or residual value of an asset should also be considered in the buy/borrow analysis evaluation. Residual
values are a cash inflow. Since the cash flow of the residual value is less certain than the debt and lease cash
flows, some financial analysts may use a higher rate than the after-tax cost of debt to discount this cash flow.
being forced by competition, obtaining debt and equity financing is a much more
complicated undertaking. Both types of financing have advantages and disadvantages.
The primary sources of equity financing for not-for-profit health care organizations
are internally generated funds, philanthropy, and government grants, whereas forprofit
facilities primarily rely on internally generated funds and stock issuances.
Unfortunately, internally generated funds – those funds retained from operations
(retained earnings) – are shrinking.
A general rule of thumb is to borrow short-term for short-term needs and longterm
for long-term needs. Short-term financing typically refers to a wide range of
financing, from debt that must be paid back almost immediately to debt that may not
have to be paid off for up to a year. Long-term financing typically refers to debt that
must be paid off in a period longer than a year. The two major types of long-term
financing are term loans, which must be paid off in one to ten years, and bonds, which
may have a final maturity of up to 20 to 35 years. Bonds are the primary source of
long-term financing for tax-exempt health care entities.
Types of debt financing available to not-for-profit health care organizations include
bank term loans, conventional mortgages, Federal Housing Administration (FHA)
insured mortgages, tax-exempt financing (available only to not-for-profit organizations),
and taxable bonds.
Organizations that decide to issue bonds generally go through a series of six
steps:
Step 1. The health care provider attempts to “get its house in order.”
Step 2. The health care agency gets evaluated by a credit rating agency.
Step 3. The bond is rated by a bond-rating agency.
Step 4. The health care provider provides a note or lease to the governmental
authority via a trustee.
Step 5. The governmental authority delivers the bonds to one or more investment
banking firms.
Step 6. The investment banking firms sell the bonds to investors at the public
offering price, and the trustee provides the health care provider with the net
proceeds.
Bonds can be issued with either fixed interest or variable rate interest, each of which
has advantages and disadvantages.
An alternative to traditional equity and debt financing is leasing. Leasing is undertaken
for four reasons: 1) to avoid the bureaucratic delays of capital budget requests,
2) to avoid technological obsolescence, 3) to receive better maintenance services, and
4) to allow for convenience.
There are two types of leases: operating and capital. An operating lease is for service
equipment leased for periods shorter than the equipment’s economic life, usually
between a few days and a year. Under a capital lease, also called a financial lease, the
lessor aims to lease the asset for virtually all of its economic life. In return, the lessee
is committed to lease payments for the entire lease period.
Capital Financing for Health Care Providers 295
Key Equations
Bond Valuation (Annual Coupon Payments):
Market Value = (Coupon Payment) × PVFA(k,n) + (Par Value) × PVF(k,n)
Bond Valuation (Other Semi-annual Periods for Coupon Payments):
Market Value = (Coupon Payment/2) × PVFA(k/2,n × 2) + (Par Value) ×
PVF(k/2, n × 2)
Questions and Problems
1. Definitions. Define the following terms:
a.Amortization.
b.Bond.
c.Capital Lease.
d.Collateral.
e.Discount.
f.Feasibility Study.
g.Financial Lease.
h.Fixed Income Security.
i.Hedging.
j.Lessee.
k.Lessor.
l. Letter of Credit.
m.Market Value.
n.Net Proceeds from a Bond Issuance.
o.Operating Lease.
p.Outstanding Bond Issue.
q.Par Value.
r.Premium.
s.Red Herring.
296 Financial Management of Health Care Organizations
Amortization
Bond
Capital Lease
Collateral
Discount
Feasibility Study
Financial Lease
Fixed Income Security
Hedging
Lessee
Lessor
Letter of Credit
Market Value
Net Proceeds from a Bond
Issuance
Operating Lease
Outstanding Bond Issue
Par Value
Premium
Red Herring
Required Market Rate
Sale/Leaseback Arrangement
Sinking Fund
Tax Shield
Term Loan
Trustee
Yield to Maturity
Key Terms
t.Required Market Rate.
u.Sale/Leaseback Arrangement.
v.Sinking Fund.
w.Tax Shield.
x.Term Loan.
y.Trustee.
z.Yield to Maturity.
2. Equity Position. What avenues are available for for-profit and not-for-profit
health care providers to increase their equity position?
3. Debt versus Equity Financing. What are the advantages and disadvantages
to a taxpaying entity in issuing debt as opposed to equity?
4. Debt Financing. Does adding debt increase or decrease the flexibility of a
health care provider? Why?
5. Basis Points. How much is a basis point? How many basis points between 6 5
8
percent and 6 3
4 percent?.
6. Debentures. Explain the difference between subordinated debentures and
debentures.
7. Bonds. Name at least two factors that might cause a facility to call in its bond.
8. Bonds. What are the advantages and disadvantages of a taxable bond relative to
a tax-exempt bond? Who is the issuer of tax-exempt bonds?
9. Bonds. What party acts on the behalf of bondholders to insure that the issuing
facility not only is complying with the covenants of the bond, but also is making
timely principal and interest payments to the bondholders?
10. Investment Bankers. Why would an investment banker syndicate a bond
issue with other investment bankers?
11. Bonds. Compare private placement bond issues with public placement bond
issues.
12. Credit Ratings. Identify two ways that a health care provider can strengthen
its credit rating.What are some of the ramifications of these options?
13. Credit Ratings. What can cause a health care provider’s credit rating to be
downgraded?
14. Market Rates. What impact do required market rate changes have on bonds of
longer maturities?
15. Leasing. What are the two types of leasing arrangements and their primary
differences?
16. Leasing. Why might an organization enter into a leasing arrangement?
17. Bond Valuation. If a $1,000 zero coupon bond with a 20-year maturity has a
market price of $311.80, what is its rate of return?
18. Bond Valuation. If a $1,000 zero coupon bond with a 15-year maturity has a
market price of $481.80, what is its rate of return?
19. Bond Valuation. A tax-exempt bond was recently issued at an annual 8
percent coupon rate and matures 20 years from today.The par value of the
bond is $1,000.
a.If required market rates are 8 percent, what is the market price of the bond?
b.If required market rates fall to 5 percent, what is the market price of the
bond?
Capital Financing for Health Care Providers 297
c.If required market rates rise to 15 percent, what is the market price of the
bond?
d.At what required market rate (5, 8, or 15 percent) does the above bond sell at
a discount? At a premium?
20. Bond Valuation. A tax-exempt bond was recently issued at an annual 7
percent coupon rate and matures 30 years from today.The par value of the
bond is $5,000.
a.If required market rates are 7 percent, what is the market price of the bond?
b.If required market rates fall to 4 percent, what is the market price of the
bond?
c.If required market rates rise to 14 percent, what is the market price of the
bond?
d.At what required market rate (4, 7, or 14 percent) does the above bond sell at
a discount? At a premium?
21. Bond Valuation. Assuming that the bond in Problem 19 matures in five years,
what would be the market prices under the various required market interest rate
changes?
22. Bond Valuation. Assuming that the bond in Problem 20 matures in ten years,
what would be the market prices under the various required market interest rate
changes?
23. Bond Valuation. Charles City Hospital plans on issuing a tax-exempt bond at
annual coupon rate of 6 percent with a maturity of 30 years.The par value of
the bond is $1,000.
a.If required market rates are 6 percent, what is the value of the bond?
b.If required market rates fall to 3 percent, what is the value of the bond?
c.If required market rates fall to 12 percent what is the value of the bond?
d.At what required market rate (3, 6, or 12 percent) does the above bond sell at
a discount? At a premium?
24. Bond Valuation. Assuming that the bond in problem 23 matures in ten years,
what would be the market prices under the various required interest rate
changes?
25. Bond Valuation. A $5,000 par value bond with an annual 8 percent coupon
rate will mature in six years.Coupon payments are made semiannually.What
is its market price if the required market rate is 6 percent?
26. Bond Valuation. A $1,000 par value bond with annual 7 percent coupon rate
will mature in eight years.Coupon payments are made semi-annually.What is
the market price if the required market rate is 4 percent?
27. Bond Valuation. Currently, Boston Common Community Hospital’s taxexempt
bond is selling for $847.48 per bond and has a remaining maturity of 15
years.If the par value is $1,000 and the coupon rate is 8 percent, what is the
yield to maturity?
28. Bond Valuation. Haven Hospital’s tax-exempt bond is currently selling for
$659.32 and has a remaining maturity of 12 years. If the par value is $1,000 and
the coupon rate is 5 percent, what is the yield to maturity?
29. Loan Amortization. Dinglewood Hospital needs to borrow $1,000,000 to
purchase an MRI.The interest rate for the loan is 6 percent.Principal and
298 Financial Management of Health Care Organizations
interest payments are equal debt service payments, made on an annual basis.
The length of the loan is five years.The CEO of Dinglewood wants to develop
a loan amortization schedule for this debt borrowing for tomorrow morning’s
meeting.Prepare such a schedule.
30. Loan Amortization. Petersville Hospital needs to borrow $40 million
dollars to finance its new facility.The interest rate is 11 percent for
the loan.Principal and interest payments are equal debt service
payments, made on an annual basis.The length of the loan is ten years.
The CFO would like to develop a loan amortization schedule for this debt
issuance.
31. Purchase versus Lease. Mercy Medical Mega Center, a taxpaying entity, has
made the decision to purchase a new laser surgical device.The device costs
$400,000 and will be depreciated on a straight-line basis over five years to a zero
salvage value.Mercy Medical could borrow the full amount at a 15 percent rate
for five years.The after-tax cost of debt equals 9 percent.Alternatively, it
could lease the device for five years.The before-tax lease payments per year
would be $80,000.The tax rate for this MegaCenter is 40 percent.From a
financial perspective, should Mercy lease the surgical device or borrow the
money to purchase it?
32. Purchase versus Lease. New Health Hospital Systems either wants to
borrow money to purchase a hospital or else enter into a lease agreement with
the City of Chesterville.The purchase price of the hospital is $15 million.
Assuming 100 percent financing, the interest rate is 12 percent for the loan with
an after tax cost of debt of 8 percent.The length of the loan is five years.The
before tax lease payments are expected to be $3 million per year.The tax rate is
40 percent for New Health System.Should New Health System lease or
borrow the money to purchase the hospital?
33. Purchase versus Lease. Carolina Ancillary Services for Hospitals (CASH),
a taxpaying entity, is considering the purchase of a CT scanner.The cost of
the scanner is $1 million.The scanner would be depreciated over ten years
on a straight-line basis to a zero salvage value.At the end of five years, the
scanner could be sold for its book value, $500,000.The tax rate is 40
percent.The financing options include either borrowing for the full cost of
the scanner and selling it at the end of Year 5, or leasing one.The lease
option is a five-year lease with equal before-tax lease payments of $320,000
per year.The borrowing alternative is a five-year loan covering the entire
cost of the scanner at an interest rate of 12 percent.The after-tax cost of
debt is 7 percent. Should CASH lease the scanner or borrow the full amount
to purchase it?
34. Purchase versus Lease. Tidewater Hospital, a taxpaying entity, is
considering leasing its ambulance fleet.The fleet of ambulances costs
$125,000 and will be depreciated over a ten year life to a salvage value of
$25,000.Tidewater could finance the entire fleet with equal annual debt and
principal payments at a before tax cost of debt of 14 percent and an after tax
cost of debt at 9 percent for ten years.Alternatively, it could lease the device
for ten years.The before tax lease payments are $25,000 per year for
Capital Financing for Health Care Providers 299
Par Value: The face value
amount of a bond. It is
the amount the
bondholder is paid at
maturity. It does not
include any coupon
payments.
Yield to Maturity: The
rate at which the market
value of a bond is equal
to the bond’s present
value of future coupon
payments plus par value.
Required Market Rate:
The market interest rate
on similar risk bonds.
Fixed Income Security:
A bond which pays fixed
amounts of interest at
regular periodic intervals,
usually semi-annually.
Market Value: What a
bond would sell for in
today’s open market.
ten years.Tidewater’s tax rate is 40 percent.From a financial perspective,
should Tidewater lease or borrow the money to buy the ambulances?
Appendix G
Bond Valuation and Loan Amortization
A facility plans to market bonds at the lowest possible interest rate, but to do so, it first
must carefully scrutinize the current market’s relationship between bond prices and yield
to maturity. Since many bonds have a call feature as well, the facility must also examine
how this will affect interest rates. The facility must understand the process of paying off its
debt.
Bond Valuation in Terms of Yield to Maturity
Most bonds are fixed income securities, which mean the investor receives a fixed amount
of interest periodically, usually semi-annually, over the lifetime of the bond. With fixed
interest rate securities, the coupon payment does not change from year to year, even though
the market interest rate may change. A bond’s market value is the price at which a bond
can be bought or sold today in the open market. While market value should not be confused
with par value, a bond’s face value, a bond may be issued with an equal market value and
par value.
The yield to maturity (YTM), or required market rate of a bond, is used by analysts to
determine the return on the bond. YTM is the rate at which the market value of a bond is equal
to the bond’s present value of future coupon payments plus par value. The bond valuation
formula is defined as:
where:
MV = Market value (price) of the bond
CP = Coupon payment on the bond
PV = Par value of the bond
n = Number of periods to maturity
t = 1, 2, 3, …, n periods
k = Yield to Maturity (required market rate)
Fortunately, it is not necessary to use this formula in its present form, which can get quite
lengthy and complicated. In fact, the first part of the formula after the summation sign is simply
the calculation for the present value of an annuity; the latter part of the formula reduces to
a basic present value term. In line with the terms discussed in Chapter 6, the formula can be
simplified to:
Market Value = (Coupon Payment) × PVFA(k,n) + (Par Value) × PVF(k,n)
Exhibit G–1 shows how to use the formula by proving that when the coupon rate equals the
required market rate, market value equals par value. Suppose a hospital wants to issue $100,000
MV =
n
t=1
[ Σ CPt /(1+k)t] + PV/(1+k)n
300 Financial Management of Health Care Organizations
worth of bonds with a 20-year maturity date. The present market interest rate is 8 percent, and
the hospital sets its coupon rate at 8 percent to equal the required market rate. Bonds are sold
in denominations of $1,000 or $5,000 each, which is the par value.
As with the techniques for finding the internal rate of return, trial and error is used to find
yield to maturity, k. For example, if the coupon rate is 9 percent, par value is $1,000, market
price is $1,200, and the time to maturity is 20 years, what is the yield to maturity? Solving for
k through trial and error yields a value of about 7 percent:
$1,200 = $90 × PVFA(k,20) + $1,000 × PVF(k,20)
$1,200 = $90 × 10.594 + $1,000 × 0.258 when k = exactly 0.07
Bond Valuation in Terms of Market Price
The formula can also be used to solve for the market value of a bond. It shows that market
value equals the present value of the cash flows in the form of principal and interest payments,
discounted back at the required market rate. The required market rate is estimated by
examining market rates from publicly traded bonds of similar risk and maturity. This market
rate is also how the market perceives the issuer’s financial condition, the loan covenants, and
a bond’s collateral. (A more complete discussion of how market rates change is in the next
section.)
There is an inverse relationship between market value and required market rate: when the
required market rate is higher than a bond’s coupon rate, the market value is less than par value;
when the required market rate is lower, the required market value is higher. And, as stated
before, when the coupon rate and the required market rate are equal, the market value will be
equal to the par value.
When the required market rate is higher than the coupon rate, a bond is selling at a discount
from its par value. The reason lies with the action of the market: no one will pay par value for
a bond with 9 percent coupon payments if the market rate is 10 percent. Consequently, the
Capital Financing for Health Care Providers 301
Givens:
1 Par Value $5,000
2 Market Rate (k) 8%
3 Time Horizon in Years (n) 20
4 Coupon Rate 8%
5 Coupon Payment1 $400
1Coupon Payment = (Coupon Rate) (Par Value)
Market Value = (Coupon Payment) PVFA(k,n) + (Par Value) PVF(k,n)
Market Value = $400 PVFA(0.08, 20) + $5,000 PVF(0.08, 20)
Market Value = $400 9.8181 + $5,000 0.2145
Market Value = $3,927 + $1,073
Market Value = $5,000
Exhibit G–1 Example of How to Use the Bond Valuation Formula Where Coupon Rate Equals Required
Market Rate
Discount: When the
market rate is higher than
the coupon rate, a bond
is said to be selling at a
discount from its par
value. See also Premium.
Premium: When the
market rate is lower than
the coupon rate, a bond
is said to be selling at a
premium. See also
Discount.
price of the outstanding bond must fall to a point that produces an effective market rate of 10
percent with the same coupon payment.
On the other hand, when the required market rate is lower than the coupon rate, a bond
is said to be selling at a premium. Market factors again are the reason for this: if the present
market rate is only 8 percent, but the coupon payments are at 9 percent, investors will
be willing to pay more for the bonds than their par value, which pushes the market price
up.
Though the focus to this point has been on the effect of changing interest rates in the
marketplace, no mention has been given to the impact of maturity dates. In fact, if
the required market rate equals the coupon rate, then regardless of the maturity date,
market value will always be equal to par value. It is only when these two rates differ
that maturity date has an effect. If a bond is selling at a discount (determined by interest
rates), longer maturity bonds sell at a lesser price than do bonds of shorter maturities.
Conversely, if a bond is selling at a premium, the longer maturity bonds sell for more
than those of shorter maturity. Exhibit G–2 shows the impact of both required market rates
and maturity on the market value for a $1,000 bond with 9 percent annual coupon
payments.
Longer maturity makes bond prices more sensitive to changes in required market interest
rates. Thus, in response to interest rate changes, the prices of longer maturity bonds
change more than do those of shorter maturity bonds. When the coupon rate and the
market rate are equal, the market price of a bond equals its face value, regardless of
maturity.
Bond Valuation for Other Payment Periods
Many bonds pay interest semi-annually – in some cases quarterly. If so, the bond valuation formula
can be adjusted to account for any number of payment periods within a year, q, using the
following formula:
where:
MV = Market value (price) of the bond
CP = Coupon payment on the bond
PV = Par value of the bond
n = Number of periods to maturity
t = 1, 2, 3, …, n periods
k = Yield to maturity (required market rate)
q = Number of payment periods per year
MV =
n
t=1
[ Σ CPt/q(1+k/q)t] + PV/(1+k/q)nq
302 Financial Management of Health Care Organizations
k = 0.08 k = 0.09 k = 0.10
Maturity = 10 years $1,067 $1,000 $939
Maturity = 20 years $1,099 $1,000 $915
Maturity = 30 years $1,112 $1,000 $905
k = market interest rate
Exhibit G-2 Effect of Market Rates and Maturity on a Bond’s Market Value
For example, suppose the previously described bond, which had an annual coupon rate of 9
percent, made its payments semi-annually instead of annually. If the term or maturity of the
bond were 15 years, required market rate 8 percent, and the par value $1,000, the market value
of the bond would be computed as follows:
Market Value = (Coupon Payment/2) × PVFA(k/2, n × 2) + (Par Value) × PVF(k/2, n × 2)
MV = ($90/2) × PVFA(0.08/2, 15 × 2) + $1,000 × PVF(0.08/2, 15 × 2)
MV = $45 × PVFA(0.04, 30) + $1,000 × PVF(0.04, 30)
MV = $45 × 17.292 + $1,000 × 0.308 = $1,086.14
Amortization of a Term Loan
The amortization of a term loan is the gradual process of paying off debt through a
series of equal periodic payments. Each payment covers a portion of the principal plus
current interest. The periodic payments are equal over the lifetime of the loan, but the
proportion going toward the principal gradually increases. For most long-term debt,
health care providers opt for this form of level debt service. This option usually is not
available for short-term financing. Some short-term debt loans require equal interest
payments over the life of the loan and a total principal payment at the end of the
loan.
To illustrate how an issuer computes its level debt service requirement, assume a health care
provider borrows $1,000,000 at an interest rate of 10 percent for ten years. The first step
is to determine the periodic debt service requirements, which equate to the present value of an
annuity:
$1,000,000 = (Annuity Payment) × PVFA(0.10, 10)
The present value interest factor for an annuity at 10 percent for ten years is 6.1446.
$1,000,000 = Annuity Payment × 6.1446
$1,000,000/6.1446 = Annual Payment
$162,745 = Annual Payment
Thus, the annual loan payment amount from the health care provider is $162,745 for
ten years. Also, one could use the Excel PMT function to arrive at annual payments,
which was discussed in Chapter 6. As noted earlier, each payment is composed of both
principal and interest. The loan amortization schedule for this example is given in Exhibit
G–3.
Capital Financing for Health Care Providers 303
Amortization: The
gradual process of paying
off debt through a series
of equal periodic
payments. Each payment
covers a portion of the
principal plus current
interest. The periodic
payments are equal over
the lifetime of the loan,
but the proportion going
toward the principal
gradually increases. The
amount of a payment can
be determined by using
the formula to calculate
the present value of an
annuity.
304 Financial Management of Health Care Organizations
Givens:
1 Annuity Payment $162,745
2 Interest Rate 10%
[A] [B] [C] [D]
Annuity Payment Interest Expense Principal Payments Remaining Balance1,2
Year [Given 1] [Given 2 × D] [A − B] [D − C]
0 $1,000,000
1 $162,745 $100,000 $62,745 937,255
2 162,745 93,725 69,020 868,235
3 162,745 86,823 75,922 792,313
4 162,745 79,231 83,514 708,799
5 162,745 70,880 91,866 616,933
6 162,745 61,693 101,052 515,881
7 162,745 51,588 111,157 404,724
8 162,745 40,472 122,273 282,451
9 162,745 28,245 134,500 147,950
10 $162,745 $14,795 $147,950 $0
1 D* is the previous year’s value of D
2 Columns may not total due to rounding
Exhibit G–3 Loan Amortization Schedule for a $1,000,000 Loan at 10 Percent Interest over 10 Years
C h a p t e r N i n e
USING COST INFORMATION TO
MAKE SPECIAL DECISIONS
Learning Objectives
After completing this chapter, you will be able to:
Define fixed and variable costs.
Compute price, fixed cost, variable cost per unit, or quantity, given the others.
Construct and interpret a breakeven chart.
Apply the concepts of contribution margin and product margin to the following types of decisions:
make/buy, adding/dropping a service, and expanding/reducing a service.
INTRODUCTION
BREAKEVEN ANALYSIS
Using the Breakeven Approach to Determine
Prices, Charges, and Reimbursement
Breakeven Analysis:The Role of Fixed Costs
Breakeven Analysis:The Role of Variable Costs
Using the Breakeven Equation
Expanding the Breakeven Equation to
Include Indirect Costs and Required Profit
The Breakeven Chart
A Shortcut to Calculating Breakeven:The
Contribution Margin
Effects of Capitation on Breakeven Analysis
PRODUCT MARGIN
Multiple Services
Multiple Payors
APPLYING THE PRODUCT MARGIN PARADIGM TO
MAKING SPECIAL DECISIONS
Make-or-buy Decisions
Adding-or-dropping a Service
Expanding-or-reducing a Service
SUMMARY
KEY TERMS
KEY EQUATIONS
QUESTIONS AND PROBLEMS
Chapter Outline
306 Financial Management of Health Care Organizations
Introduction
From time to time administrators face such decisions as:
Should we offer a particular service or group of services?
What volume of services do we need to provide in order to break even?
How much must we charge or be reimbursed for a service to be financially
viable?
Should we offer a service in-house or should we contract with another
organization?
Should we replace equipment?
Questions such as these are called special decisions because they are made on an “as
needed” basis as opposed to a standard schedule. This chapter provides tools to help
answer these and similar questions. It begins with a discussion of breakeven analysis and
the role of fixed and variable costs in decision-making. It then turns to the related topics
of the breakeven chart, contribution margin, and product margin.
Although this chapter focuses primarily on financial concerns, non-financial criteria
must also be considered when making special decisions. In certain cases, nonfinancial
criteria may even outweigh the results of a financial analysis. For instance,
though a financial analysis shows that a project meets the financial criteria, such as
breaking even, management may decide not to undertake the project because it does
not sufficiently meet its community service goals. As shown in Exhibit 9–1, the course
of action is clear only when it meets or fails to meet both financial and non-financial
criteria.
When the special decisions discussed in this chapter involve multi-year periods, the time value of money must
be considered, as discussed in Chapters 6 and 7.
Meets
Non-financial
Criteria Yes No
Yes Proceed ?
No ? Don’t Proceed
Meets Financial Criteria
Exhibit 9–1 The Relationship between Meeting Financial and Non-financial Criteria
Breakeven Analysis
One of the most fundamental financial criteria used to make special decisions is
whether or not, in the future, a service’s revenues will be sufficient to cover its costs.
In attempting to answer such a question, management must understand the relationship
of revenues, costs, and volume. Breakeven analysis, also called Cost-Volume-
Profit (CVP) analysis, provides tools to study these relationships. The remainder of
this section explores breakeven analysis and how it can be used to help answer numerous
questions facing health care organizations.
Using the Breakeven Approach to Determine Prices,
Charges, and Reimbursement
Suppose a home health director wants to know how much her agency must be reimbursed
per visit for her commercial home health service line to break even. Assuming
for the moment that the only costs for this service line are $200,000 for staffing (two
RNs and three nursing assistants), then to break even, revenues must also equal
$200,000.
Revenues = Costs
$200,000 = $200,000
Though knowing that $200,000 is necessary to cover costs is useful information, the
director still does not know how much she must be reimbursed for each visit to reach
her $200,000 target. The fewer the number of visits, the higher the reimbursement
needs to be; conversely, the higher the number of visits, the lower that reimbursement
needs to be to earn the $200,000. Thus, in order to determine the necessary per visit
reimbursement to break even, she must know the number of visits.
As shown in Exhibit 9–2, if only 1,000 visits were made, she would have to receive
$200 (Column D, $200,000/1,000) for each visit. However, if there were 5,000 visits,
she would have to receive only $40 per visit ($200,000/5,000). This inverse relationship
between price and volume to obtain a specified amount of revenue (i.e. $200,000)
is summarized in the equation:
Using Cost Information to Make Special Decisions 307
Breakeven Analysis:
A technique to analyze
the relationship
among revenues,
costs, and volume. It is
also called Cost-
Volume-Profit or CVP
analysis.
Formula to determine total revenue when price and quantity are known: Total Revenue = Price × Quantity.
The terms quantity, volume, and activity are often used interchangeably when referring to the number of visits,
number of patients, number of services, or the activities of providers and patients related to the delivery or
receipt of health care goods and services.
Total Revenue = Price × Quantity
where quantity is used generically to stand for such things as number of visits, number
of patients, number of services, etc. Since price times quantity equals total revenue,
and total revenues equal total costs, the basic breakeven formula can be restated
as:
(Price × Quantity) = Total Costs
This is shown in Modification I in Exhibit 9–3.
Breakeven Analysis:The Role of Fixed Costs
Just as price per visit varies inversely with volume, if total revenue remains constant
average fixed cost per visit is also inversely related to volume as long as total fixed cost
remains constant (Exhibit 9–2, column E). If the fixed costs remain at $200,000 and
only 1,000 visits are delivered, the average fixed cost per visit is $200 ($200,000/1,000
visits). But at 5,000 visits, the average fixed cost per visit drops to $40
($200,000/5,000 visits).
This example illustrates the two major attributes of fixed costs:
1. Fixed costs stay the same in total as volume increases (in Exhibit 9–2 they
remained at $200,000).
2. Fixed costs per unit change inversely with volume (in Exhibit 9–2 they
decreased from an average of $200 per visit to $40 per visit as volume
increased from 1,000 to 5,000 visits).
308 Financial Management of Health Care Organizations
A B C D E
Number of Total Total Fixed
Visits Revenues Fixed Costs Price/Visit Cost/Visit
[Given] [Given] [Given] [B/A] [C/A]
1,000 $200,000 $200,000 $200 $200
2,000 $200,000 $200,000 $100 $100
3,000 $200,000 $200,000 $67 $67
4,000 $200,000 $200,000 $50 $50
5,000 $200,000 $200,000 $40 $40
Exhibit 9–2 Illustration of the Inverse Relationship Between Volume and Both Price and Fixed Cost per Visit,
Holding Total Revenue and Total Fixed Costs Constant
For simplification purposes, the terms price and reimbursement are used interchangeably in the following discussion.
To the extent they differ in any particular situation, an adjustment should be made.
Although fixed cost per unit decreases as volume increases, it does so at a
decreasing rate. Exhibit 9–4 shows that cost per visit drops quickly at first, but as
the number of visits increases towards capacity, the less each additional visit
decreases the per unit visit cost. In other words, fixed assets provide the capacity
to provide service, and if these assets are being used inefficiently (low volume relative
to capacity), considerable gains can be made in per unit cost by increasing volume.
However, if these assets are already being used efficiently (high volume
relative to capacity), the less per unit cost decreases for each additional unit of
service provided. Perspective 9–1 illustrates how an e-commerce health care
organization has been forced to cut its fixed costs.
Using Cost Information to Make Special Decisions 309
The Basic Breakeven Concept Total Revenues = Total Costs
Modification I to Recognize: Price × Volume = Total Costs
a. Revenues = Price × Volume
Modification II to Recognize: Price × Volume = Fixed Costs + Variable Costs
a. Revenues = Price × Volume
b. Total Costs = Fixed Costs + Variable Costs
Modification III to Recognize1: Price × Volume = Fixed Costs + (Variable Cost Per
a. Revenues = Price × Volume Unit × Volume)
b. Total Costs = Fixed Costs + Variable Costs
c. Variable Costs = Variable Cost Per Unit × Volume
1 Modification III is commonly referred to as the Breakeven Equation
Exhibit 9–3 Using the Concept of Breakeven to Develop the Breakeven Equation
The term cost per unit is shorthand for average cost per unit. Thus, the terms average fixed cost per unit and
fixed cost per unit are used interchangeably. Similarly, the terms average variable cost per unit and variable cost
per unit are used interchangeably. Note: variable costs will be discussed shortly.
Cost per Unit
$0
$1,000
$2,000
$3,000
0 1,000 2,000
Visits
3,000
Exhibit 9–4 Illustration of How Fixed Cost per Unit Decreases at a Decreasing Rate
Of course, at some point, the capacity of the assets is reached and there is a need to
expand (for instance, by buying new equipment or hiring new staff). In such a case,
fixed costs would no longer remain fixed at $200,000, but would step up to a new
level. When the lower or upper limits of capacity are reached, and it becomes necessary
to add or drop capacity (e.g. full-time staff ), the organization is said to be going
beyond the relevant range of its fixed costs. However, within the relevant range,
fixed costs remain fixed.
Exhibit 9–5 shows that the fixed costs of $200,000 in labor are considered fixed up to
5,000 visits (Relevant Range 1). Then, assuming an additional full-time RN is needed if
volume extends past 5,000 visits, the fixed costs would take a step up to $250,000 (assuming
that each new RN costs $50,000). The fixed costs then remain at this level (Relevant
Range 2) until visits reach 7,500, at which point they step up to $300,000 (Relevant Range
3), when another full-time RN again has to be hired. To the extent that there are stepfixed
costs, the breakeven formula can become complicated. Thus, it is strongly suggested
that breakeven analyses with step-fixed costs be done on electronic spreadsheets.
310 Financial Management of Health Care Organizations
Perspective 9–1
Drkoop.com Lays Off Third of Work Force
AUSTIN,Texas – Online health company drkoop.com Inc. has slashed its work force for the second time in three
months, saying the layoffs are part of a new corporate restructuring plan aimed at cutting costs.
Late Tuesday, the Austin-based company said it was cutting 50 positions, about one-third of its current work force.
The move came on the heels of an announcement Monday that drkoop.com had secured $27.5 million in new financing
and revamped its management team.“We said from the beginning that we were going to run this company like
a real business,” said Ed Cespedes, the company’s newly appointed president. “There are real people behind these
layoffs and these were not easy decisions. However, we are ready to put the past behind us and move forward with
our plans to rebuild this company and maximize shareholder value.”
Source: The Boston Globe,August 31, 2000.
© Copyright 2000 Globe Newspaper Company.
The Relevant Range:
The range of activity
over which total fixed
costs and/or per unit
variable cost do not
vary.
Fixed Costs: Costs
that stay the same in
total over the relevant
range, but change
inversely on a per unit
basis as activity
changes.
Total Costs
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
0 2,500 5,000
Volume
7,500 10,000
Range 1 Range 2 Range 3
Exhibit 9–5 Step-Fixed Costs Occurring at 5,000 and 7,500 Visits
Caution. There are two major errors that must be avoided when using fixed cost
information to make decisions: 1) Assuming that cost per unit does not change when volume
changes; and 2) Using fixed cost per unit derived at one level to forecast total fixed
costs at another level. How fixed cost per unit costs changes with a change in volume was
just illustrated. In regard to the second type of error: suppose that the home health
agency, which has $200,000 in fixed costs, made 4,000 visits this year (Exhibit 9–6, second
row). Using this information, the administrator correctly calculates the average fixed
cost per visit to be $50 ($200,000/4,000 visits). The next year the agency plans to make
5,000 visits (third row). The administrator would be making an error if she assumed that
the average fixed cost per visit would remain at $50. Since volume increases from 4,000
visits to 5,000, and total fixed cost remains at $200,000 (it’s fixed!), the average fixed cost
per visit decreases from $50 per visit ($200,000/4,000 visits) to $40 per visit
($200,000/5,000 visits). Thus, if the administrator were trying to set her price to cover
her fixed cost, she may set it too high ($50) instead of recognizing that cost has decreased
(to $40) because of increased volume. Conversely, as shown in Exhibit 9–6, if the
administrator were using the $50 per visit derived at 4,000 visits to estimate her fixed cost
at 3,000 visits, her estimate would be too low.
Breakeven Analysis:The Role of Variable Costs
Thus far, it has been assumed that all costs are fixed or step-fixed. However, a home
health visit does not require just labor; each visit also requires certain items particular
to that visit (supplies, transportation, etc.). If these other costs average $25 a visit, then
100 visits would cost $2,500 (100 × $25). For 1,000 or 10,000 visits, costs would
increase to $25,000 (1,000 × $25) and $250,000 (10,000 × $25), respectively. Because
total cost varies directly with activity (in this case volume), these costs are called variable
costs, though the cost per unit remains the same, $25.
Thus, the two major characteristics of variable costs have been identified, and they
are just the opposite of those for fixed costs:
Using Cost Information to Make Special Decisions 311
Step-Fixed Costs:
Costs that increase in
total over wide,
discrete steps.
A B C D E
Assumed per Unit Estimated Total Actual Over (Under)
Volume Fixed Cost1 Fixed Cost Fixed Cost Estimate
[Estimated] [Given] [A × B] [Given] [C − D]
3,000 $50 $150,000 $200,000 ($50,000)2
4,000 $50 $200,000 $200,000 ($0)3
5,000 $50 $250,000 $200,000 $50,0004
1 All three examples use the unit cost derived at 4,000 units to estimate total fixed cost.
2 If the unit fixed cost is originally derived at a higher volume, the total fixed cost estimated will be too low.
3 If the unit fixed cost is originally derived at the same volume, the total fixed cost estimated will be just right
4 If the unit fixed cost is originally derived at a lower volume, the total fixed cost estimated will be too high.
Exhibit 9–6 Illustration of the Error of Using Fixed Cost per Unit Derived at One Level of Activity to Calculate
Total Fixed Cost at Another Level
Variable Costs: Costs
that stay the same per
unit but change
directly in total with a
change in activity over
the relevant range.
Total Variable Cost =
Variable Cost Per Unit
× Number of Units of
Activity.
1. Total variable cost changes directly with a change in activity; and
2. Variable cost per unit stays the same with a change in activity.
The formula that describes the relationship between variable cost and activity is:
Total Variable Cost = Variable Cost Per Unit
× Number of Units of Activity
As discussed earlier, when total fixed costs go beyond the relevant range, they
often take the form of step-fixed costs, though it is possible to substitute variable
costs for fixed costs (e.g. paying a home health nurse by the visit rather than hiring
another full-time nurse). When variable costs per unit go beyond the relevant
range, it is possible to have either an increase or decrease in cost per unit. For
instance, if volume increases significantly, an organization may be able to obtain a
volume discount on supplies. It would no longer be $25, but a lower amount. Of
course, if volume dropped, the opposite effect may occur – the loss of discounts
and an increase in variable cost per unit. As with fixed costs, as volume goes
beyond the relevant range, it becomes difficult to use the breakeven formula to
solve breakeven problems with variable costs, and using a spreadsheet model is recommended.
Exhibit 9–7 summarizes and compares the major characteristics of fixed and variable
costs in relation to volume within a relevant range. Fixed costs stay the same in
total but change per unit as volume changes, whereas variable costs change in total but
remain constant per unit with changes in volume. A method using physician education
to control costs is shown in Perspective 9–2, while Perspective 9–3 illustrates the
complex interaction between cost and inpatient care.
312 Financial Management of Health Care Organizations
By convention, when the terms fixed and variable costs are used, it is understood that they remain constant in
total (fixed costs) or on a per unit basis (variable costs), respectively, only within a relevant range.
Fixed Costs
Variable
Cost
Per Unit
Cost
Volume
Cost
Volume Volume
Cost
Total
Volume
Cost
Exhibit 9–7 Illustration of How Fixed and Variable Costs Are Affected by Changes in Volume
Using Cost Information to Make Special Decisions 313
Perspective 9–2
Targeting Disease Treatment Could Save States Thousands in Medicaid Costs and Improve Health
Outcomes for Patients with Asthma
Virginia Program Results Could Be Duplicated Nationwide
Washington, DC – The Virginia Health Outcomes Partnership (VHOP), a model disease management program,
conducted in eight Virginia counties and metropolitan Richmond between 1995 and 1997, saved thousands of dollars
in Medicaid costs for the treatment of asthma in fiscal year 1997, according to a peer-reviewed article appearing
today in the economics journal Inquiry. At the same time, rates of urgent care visits for patients with asthma in
the pilot area were reduced.
The study, the first of its kind in a Medicaid population, estimated annual savings of over $1 million if the program
was implemented statewide. . . .The program’s goals were to educate physicians to help them improve their communications
skills and their ability to educate patients on how to manage their asthma. . . .The dispensing of drugs
recommended by the guidelines for asthma also rose significantly during the study period in the intervention communities.
In some cases this increase was as much as 25 percent.“Asthma drugs can be very effective at keeping people
out of the emergency room when used properly,” said Rossiter. “The VHOP program was designed specifically
to help the low-income Medicaid population and their physicians and pharmacists tap into the potential cost savings
and health benefits of better adherence to treatment regimens.”
Source:AHA News,August 28, 2000
Perspective 9–3
Study: Reducing Hospital LOS by One Day Saves Little
Length of Stay’s Effect on Hospital Admission Cost Is Minimal
Cost containment and cost reduction in hospitals remain a focus of all sectors of the healthcare delivery industry.
It has been generally accepted that reducing the length of stay (LOS) for hospital inpatient admissions is one of the
best ways to reduce costs.A study published in the August 2000 Journal of the American College of Surgeons, however,
questions the veracity of this financial sacred cow.
The researchers reviewed the cost-accounting records of all surviving patients (n = 12,365) discharged from
University of Michigan Health System (UMHS) during fiscal year 1998 with LOS of four days or more. . . . Individual
patient costs were broken out on a per-day basis and further subdivided into variable-direct, fixed-direct, and indirect
costs.Then, the incremental resource cost of the last full day of the inpatient stay versus the total cost for the
entire stay was determined.The data also were stratified by LOS and by surgical costs. . . .
The researchers found that the average incremental costs incurred on the last full day of an inpatient stay was
$420, or just 2.4 percent of the $17,734 mean total cost per stay for all 12,365 patients. Mean end-of-stay costs
represented only a slightly higher percentage of total costs when the LOS was short (6.8 percent for patients
with an LOS of four days). Even when the data focused only on patients without major operations,the average
last-day, variable-direct cost of $432 was only 3.4 percent of the $12,631 average total cost of care.
The researchers focused on the trauma center to help explain this result.The variable-direct costs for the trauma
center accounted for 42 percent of the mean total cost per stay of $22,067. The remaining 58 percent comprised
fixed and indirect hospital overhead costs.The median variable-direct cost on the first day of a trauma center
admission was $1,246, and the median variable-direct cost on discharge was $304.Approximately 40 percent of the
variable costs were incurred during the first three days of admission.
(Continues)
Using the Breakeven Equation
The breakeven formula can now be expanded and modified to include variable costs
(see Exhibit 9–3, Modification II):
Price × Volume = Fixed Cost + Variable Cost
Expanding this equation based on the above discussion yields the basic breakeven
equation:
Price × Volume = Fixed Costs + (Variable Cost Per Unit × Volume)
as shown in Modification III in Exhibit 9–3.
Exhibit 9–8 illustrates how the breakeven formula can be used to find the price, quantity
(volume), fixed cost, or variable cost per unit needed to break even, if each of the other
factors is known. In Situation 1 of Exhibit 9–8, price is unknown; in Situation 2, quantity
(volume) is unknown; in Situation 3, total fixed cost is unknown; and in Situation 4, variable
cost per unit is unknown.
Expanding the Breakeven Equation to Include Indirect
Costs and Required Profit
Up to this point, the example has looked at situations where revenues exactly match
only those costs which the organization can directly associate with a service, those of
the two RNs and three nursing assistants, and miscellaneous variable costs such as
supplies and transportation. However, in many cases it is often desirable that revenues
cover other costs, such as overhead, and, perhaps, provide a margin (profit). As discussed
in more detail in Chapter 12, direct costs are those that an organization can
measure or trace to a particular patient or service (e.g. the time a nurse or nursing
assistant spends with a client), while indirect costs are those which the organization is
not able to associate with a particular patient or service (e.g. the cost of the billing clerk
or computer system). Exhibit 9–9 extends the breakeven equation in Exhibit 9–3 to
account for indirect costs and profit, while Exhibit 9–10 expands the example from
Exhibit 9–8 to illustrate how to use the extended equation. Since it is usually the case,
314 Financial Management of Health Care Organizations
The researchers concluded that for most patients, the costs directly attributable to the last day of a hospital stay
are an economically insignificant component of total costs. Reducing LOS by as much as one full day reduces the
total cost of care an average of 3 percent or less.The researchers suggest that physicians and administrators should
deemphasize reducing LOS and focus instead on process changes that make better use of capacity and resources
during the early stages of admission.
Source: P. A.Taheri, D. A. Butz, and L. J. Greenfield, Journal of the American College of Surgery,Volume 191, Number 2,
August 2000, pp. 123–30.
Perspective 9–3 (Contd)
Using Cost Information to Make Special Decisions 315
[A] [B] [C] [D] [E]
Givens. Total Fixed Variable
Situation Price Quantity1 Cost Cost per Unit2
Situation 1 ? 4,000 $200,000 $25
Situation 2 $100 ? $200,000 $25
Situation 3 $100 4,000 ? $25
Situation 4 $100 4,000 $200,000 ?
1 E.g. number of visits.
2 E.g. cost of supplies per visit.
Situation 1. Finding the breakeven price, given quantity, total fixed cost, and variable cost per unit.
Total Variable
Fixed Cost
Setup: ( Price × Quantity ) = Cost + (Per Unit × Quantity)
Solution: ( Price × 4,000 ) = $200,000 + ($25 × 4,000)
( Price × 4,000 ) = $200,000 + $100,000
( Price × 4,000 ) = $300,000
Price = $75
Situation 2. Finding the breakeven quantity, given price, total fixed cost, and variable cost per unit.
Total Variable
Fixed Cost
Setup: ( Price × Quantity ) = Cost + ( Per Unit × Quantity )
Solution: ( $100 × Quantity ) = $200,000 + ( $25 × Quantity )
( $75 × Quantity ) = $200,000
Quantity = 2,667
Situation 3. Finding the breakeven total fixed cost, given price, quantity, and variable cost per unit.
Total Variable
Fixed Cost
Setup: ( Price × Quantity ) = Cost + ( Per Unit × Quantity )
Solution: ( $100 × 4,000 ) = TFC + ( $25 × 4,000 )
$400,000 = TFC + $100,000
$300,000 = Total Fixed Cost
Situation 4. Finding the breakeven variable cost per unit, given price, quantity, and total fixed cost.
Total Variable
Fixed Cost
Setup: ( Price × Quantity ) = Cost + ( Per Unit × Quantity )
Solution: ( $100 × 4,000 ) = $200,000 + ( VCu × 4,000 )
$400,000 = $200,000 + ( VCu × 4,000 )
$200,000 = VCu × 4,000 )
$50 = Variable Cost Per Unit
Exhibit 9–8 Applying the Breakeven Formula
these examples assume that both indirect costs and profits are fixed amounts, though
the equation can be modified to account for other instances.
In Situations 1–3 of Exhibit 9–10, price is unknown and various combinations of
indirect costs and desired profit are added to the information originally provided in
Exhibit 9–8. Such analyses would be used when an organization is trying to determine
if the reimbursement it will receive is sufficient to cover its costs and desired profit for
a particular service. For example, in Situation 3, if the organization were not reimbursed
at least $111 per visit, management could conclude that the reimbursement
would be insufficient to cover its direct and indirect costs and desired margin and perhaps
decide not to provide the service at this rate, or try to renegotiate a higher rate.
In Situation 4 of Exhibit 9–10, all of the factors are given except for fixed costs. A situation
such as this occurs when an organization is given a set price (reimbursement) and
must control its costs in order to ensure that its costs don’t exceed that reimbursement. In
this case, given the indirect costs and desired profit, the organization must ensure that its
direct fixed costs do not exceed $156,000. Such an approach, called target costing, is
quite common in health care, where the government is the price-setter and the provider
is the price-taker. Perspective 9–4 shows how rather than cutting back, a number of hospitals
are attempting to increase both volume and profits through aggressive marketing.
Perspective 9–5 illustrates a wide number of tools available to group practices to both control
costs and increase revenues. Several of these are discussed in chapters 10, 11 and 12
of this book. Finally, Perspective 9–6 illustrates how one organization is attempting to
control its supply costs by managing its supply chain.
The Breakeven Chart
A breakeven chart graphically displays the relationships in the breakeven equation.
For instance, Exhibits 9–11a, b, and c present different ways to graph the data in
Exhibit 9–8, where the revenue per visit is $100, fixed costs are $200,000, and variable
cost is $25 per visit. Exhibit 9–11a presents this information in the traditional
breakeven chart format, but with considerable annotation. The three lines represent
fixed cost, total cost, and total revenues. The total revenue line begins at $0 (the
316 Financial Management of Health Care Organizations
The Basic Breakeven Equation1 Price × Volume = Fixed Costs + (Variable Cost per Unit × Volume)
The Basic Breakeven Equation Modified
to include Indirect Costs and Desired
Profit Price × Volume = Direct Costs + Indirect Costs2 + Desired Profit2
Direct Fixed Costs + (Direct Variable Cost per Unit × Volume)
1 From Exhibit 9–3, Modification III.
2 Indirect Costs and Desired Profits usually are given as an amount, though they could also be broken down into their fixed and variable
components, as are Direct Costs.
Exhibit 9–9 Expanding the Breakeven Equation to Include Indirect Costs and Desired Profit
Target Costing:
Controlling costs
and/or decreasing
profit margins in order
to meet or beat a
predetermined price or
reimbursement rate.
Using Cost Information to Make Special Decisions 317
Situation Price Quantity1 Total Variable Cost Indirect Desired
Fixed Cost Per Unit2 Costs Profit
Situation 1 ? 4,000 $200,000 $50 $24,000 $0
Situation 2 ? 4,000 $200,000 $50 $0 $20,000
Situation 3 ? 4,000 $200,000 $50 $24,000 $20,000
Situation 4 $100 4,000 ? $50 $24,000 $20,000
1 E.g. number of visits.
2 E.g. cost of supplies per visit.
Situation 1. Finding the breakeven price, given quantity, total fixed cost, variable cost per unit, and indirect costs.
Total Variable
Fixed Cost
Setup: (Price × Quantity) = Cost + (Per Unit × Quantity) + Indirect Costs + Desired Profit
Solution: (Price × 4,000) = $200,000 + ( $50 × 4,000) + $24,000 + $0
(Price × 4,000) = $200,000 + $200,000 + $24,000
(Price × 4,000) = $424,000
Price = $106
Situation 2. Finding the breakeven price, given quantity, total fixed cost, variable cost per unit, and desired profit
Total Variable
Fixed Cost
Setup: (Price × Quantity) = Cost + (Per Unit × Quantity) + Indirect Costs + Desired Profit
Solution: (Price × 4,000) = $200,000 + ($50 × 4,000) + $0 + $20,000
(Price × 4,000) = $200,000 + $200,000 + $20,000
(Price × 4,000) = $420,000
Price = $105
Situation 3. Finding the breakeven price, given quantity, total fixed cost, variable cost per unit, indirect costs,
and desired profit.
Total Variable
Fixed Cost
Setup: (Price × Quantity) = Cost + (Per Unit × Quantity) + Indirect Costs + Desired Profit
Solution: (Price × 4,000) = $200,000 + ($50 × 4,000) + $24,000 + $20,000
(Price × 4,000) = $200,000 + $200,000 + $44,000
(Price × 4,000) = $444,000
Price = $111
Situation 4. Finding the breakeven total fixed cost, given price, quantity, variable cost per unit, indirect costs
and desired profit.
Total Variable
Fixed Cost
Setup: (Price × Quantity) = Cost + (Per Unit × Quantity) + Indirect Costs + Desired Profit
Solution: ($100 × 4,000 ) = TFC + ($50 × 4,000 ) + $24,000 + $20,000
( $100 × 4,000 ) = TFC + $200,000 + $44,000
$400,000 = TFC + $244,000
$156,000 = Total Fixed Cost
Exhibit 9–10 Applying the Breakeven Formula to Situations with Indirect Costs and/or Desired Profit
318 Financial Management of Health Care Organizations
Perspective 9–4
M. D. Anderson Works to Build Ties With the HMOs It Once Combated
Houston – Five years ago, battered by the onslaught of managed care, M.D.Anderson Cancer Center seemed headed
for the intensive-care unit.
No matter that the half-century-old hospital had a reputation for saving patients told by others to begin planning
their funerals, or that it consistently scored at the top of national quality surveys. M. D.Anderson’s patient load was
dropping precipitously, as health-maintenance organizations began steering patients to lower-cost community hospitals.
Consultants prognosticated that by the millennium, overnight stays would drop by a third, and the cancer hospital
would be forced to shutter many of its facilities.“The consultants painted a doom-and-gloom picture,” remembers Harry
Holmes, the hospital’s vice president of governmental affairs,“with graphs sloping down like a slide.”
As it turned out, the graphs did slope steeply – but in the other direction. Revenue for the current fiscal year,
which ends Thursday, is expected to be $1.07 billion, up 85% from five years ago. The average number of patients
who stay each night at M. D. Anderson, a not-for-profit arm of the University of Texas, has risen 16% since the low
in 1996. And instead of shutting buildings, the hospital is expanding on a grand scale with a new research building,
more beds, and new rooms at the campus hotel.
M. D. Anderson’s turnaround is due in part to its savvy, aggressive effort to recruit patients from across the US
through the Internet and a heart-wrenching advertising campaign.The hospital also has gradually made its peace with
managed care, cutting some costs to please HMOs while simultaneously fighting those that refuse to send their
members to M.D.Anderson for the latest treatments. Its recent success is also due in part to demographics:As baby
boomers reach the age at which cancer often begins, the oncology business is picking up.
M. D. Anderson’s resurgence spotlights a striking development in American health care: Contrary to predictions,
the high-priced, top-tier hospital business is alive and well. Even as many prestigious hospitals struggle with federal
cutbacks, some of the best are figuring out how to thrive handsomely.
The University of California at Los Angeles has succeeded in funneling patients to its academic research hospital
with an aggressive strategy for setting up primary-care clinics in the surrounding community. Other hospitals, aided
by the draw of their national reputations, have capitalized on a growing pool of Internet-literate patients willing to
travel anywhere for care.
Memorial Sloan-Kettering Cancer Center in New York, after eliminating beds during a slump in the mid-1990s, has
now added back many of the beds it cut, and is building a giant new outpatient clinic to handle the influx of patients.
The Mayo Clinic of Rochester, Minn., unable to handle its burgeoning patient load, is building a giant $400 million
extension that it had postponed years back amid falling patient visits and anxiety over the Clinton administration’s
health-care plan.
Source: Laura Johannes,Wall Street Journal,August 29, 2000.
Perspective 9–5
Practices with the Best Practices
With many doc groups losing money, MGMA study shows what makes a “better performer.”
The Medical Group Management Association’s annual cost survey has been a mainstay of its member benefits for
50 years, offering detailed revenue and expense data on practices nationwide. . . .
Through interviews with practice managers and industry experts, the report also discusses the ingredients that
drive success.According to the report, there’s no magic formula but rather a blend of good practices.
(Continues)
Using Cost Information to Make Special Decisions 319
Perspective 9–5 (Contd)
For example, medical groups traditionally have placed more emphasis on generating revenues than controlling
costs, according to the report. But better-performing groups do both.The report identifies seven common tools:
Detailed cost accounting. Cost accounting systems enable practices to determine the cost of and revenues
generated by each procedure, allowing effective resource allocation.
Transaction costing. Knowing the true cost of delivering a unit of care improves a group’s negotiating
position with third-party payers and avoids money-losing contracts.
Zero-based budgeting. Better performers start each budget from scratch rather than applying a uniform
inflation factor to last year’s numbers.
Physician incentives. Better performers compensate physicians for controlling costs.They commonly
measure the types and numbers of support staff a physician uses as well as adherence to practice
protocols.Top performers also use lower-cost supplies.
Effective managed-care contracting. Better performers have sophisticated methods of negotiating and
monitoring managed-care agreements, including contract review committees that develop checklists of
parameters for each contract.
Effective coding. On the whole, medical groups “undercode” an estimated 50% to 60% of the time, meaning
they lose revenues they’re entitled to, according to the report.To enhance accuracy, better performers
emphasize coding training, develop explicit coding processes and undergo outside assessments of their
coding.
Improved service delivery. Better performers invest in computerized scheduling systems, maintain sufficient
support staff and often allocate three or more exam rooms per primary-care physician. E-mail
consultations and telephone triage are common.
Source: Mary Chris Jaklevic, Modern Healthcare, February 8, 1999, pp. 64–5.
Perspective 9–6
Mission to Stop Restocking Ambulances: Pardee, Park Ridge Hope to Continue
Bandages, endotracheal tubes and cold packs – necessities of Emergency Medical Services work – will continue to
move from hospital shelves to ambulances trying to make quick turn-arounds, hospital officials hope. Pardee and
Park Ridge hospitals hope to continue supplying ambulances with these and other types of equipment despite a decision
by Mission St Joseph’s Health System in Asheville to cut off the flow of such supplies by Aug. 1. Mission St
Joseph’s, under pressure from the Office of the Inspector General, the federal organization responsible for enforcing
Medicare fraud rules, said it will no longer swap out supplies used by ambulances on a one-for-one basis.
The hospital now passes on the costs of the supplies by bundling them with hospital bills. In August, however, patients
will pay for those costs at the front end with their ambulance bills, rather than the back end with their hospital bills.The
cost of ambulance service could increase by $100 as a result, Buncombe County EMS personnel have said.
The move came after the Office of the Inspector General determined hospitals might be using supply trade-outs
as enticements to draw ambulances and therefore patients to their doors. Because of this, the practice may violate
anti-kickback legislation, the OIG said.
Henderson County-affiliated Pardee Hospital, however, uses a different system.The hospital allows ambulances to
restock but keeps accounts and sends out bills, emergency room manager Ruby Icamina said.
Source: Joel Burgess, Hendersonville News, July 20, 2000.
amount of revenue earned if no services are offered) and increases by $100 for each
home health visit made. Since by definition fixed costs do not change with volume,
the fixed cost line begins at $200,000 and remains at that level. Since total cost is made
up of fixed cost plus variable cost, the total cost line begins at $200,000 (the level of
fixed cost at zero units of service) and grows by $25 (the variable cost per unit) for
each unit of service provided.
At 2,667 visits the total revenue and total cost lines cross. Before 2,667 visits net income
is negative, whereas after 2,667 visits, it is positive. Thus, the breakeven point, the point
at which total revenues equal total costs, is 2,667 visits. Before the breakeven point, the
size of the space between the total revenue line and the total cost line equals the amount of
loss. After the breakeven point, the size of the space between the total revenue line and the
total cost line equals the amount of profit. Exhibit 9–11b presents the breakeven chart from
Exhibit 9–11a in its traditional format; that is, without much of the annotation.
Since it is so difficult to visually determine how much the actual loss or profit is
by using the traditional version, increasingly a newer version is being used (see
Exhibit 9–11c). In addition to the information typically presented in Exhibit 9–11b,
the newer version presents net income, total revenues less total costs. Note that in
all three charts, breakeven is achieved at 2,667 visits. In general, the old version
should be used where detailed cost information is important, and the new version
should be used in cases where the amount of profit is the essential concern.
A Shortcut to Calculating Breakeven:The Contribution
Margin
Per unit revenue minus per unit variable cost is called contribution margin per unit,
because after covering incremental (variable) costs, this is the amount left to
contribute toward covering all other costs and desired profit. If the contribution margin is
known and all other costs are fixed, a shortcut formula to calculate breakeven can be used:
Breakeven Volume = Fixed Costs/Contribution Margin per Unit
320 Financial Management of Health Care Organizations
Profit
$0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
Fixed
Costs
Variable
Costs
Total
Costs
Total
Revenues
Breakeven Point
Loss
Volume
Exhibit 9–11a A Traditional Breakeven Chart with Annotation
Breakeven Point: The
point where total
revenues equal total
costs.
Contribution Margin
per Unit: Per unit
revenue minus per
unit variable cost.
Incremental costs:
Additional costs
incurred solely as a
result of an action or
activity or a particular
set of actions or
activities.
Assume that total fixed costs are $200,000, revenue per visit is $100, and variable cost
is $25 per visit. Thus, contribution margin per unit is $75 ($100 − $25), which means that
the organization makes $75 more on each visit than the incremental cost of that visit.
Thus, using the above formula, to cover the $200,000 in fixed costs, there must be 2,667
visits ($200,000/$75; see Exhibit 9–12). This is the same answer that was derived using
the longer formula in Exhibit 9–8, Situation 2.
Using Cost Information to Make Special Decisions 321
$0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
Total
Revenue
Profit
Breakeven Point
Loss
Total
Cost
Volume
Exhibit 9–11b A Traditional Breakeven Chart
$0
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
0 500 1,000 1,500 2,000 2,500
Volume
3,000 3,500 4,000 4,500 5,000
Total
Costs
Prof it
Breakeven Point
Loss
$ −200,000
$ −100,000
Net
Income
Total
Revenue
Exhibit 9–11c A Breakeven Chart Emphasizing Net income
Total Contribution
Margin: Total
revenues minus total
variable costs.
Note: Some presenters will include the fixed cost line. However, it is not absolutely necessary as it is equal to the amount where the
total cost line crosses the Y axis: $200,000.
Finally, notice that even if the organization does not reach breakeven, each unit of
service it delivers contributes $75 toward covering its fixed costs and overhead. This leads
to the Contribution Margin Rule: if the contribution margin per unit is positive and
no other additional costs will be incurred, then it is in the best financial interest of the
organization to continue to provide additional units of that service, even if the organization
is not fully covering all of its other costs. On the other hand, if the contribution
margin is negative, it is not in the best interest of the organization to continue to provide
additional units of service.
Effects of Capitation on Breakeven Analysis
With an increasing emphasis on cost control, various managed care companies have
turned to capitation as their preferred method of payment. As capitated payment systems
are discussed in detail in Chapter 13, the focus here is on how breakeven analysis
can be used with capitation. Briefly, under full capitation, the insurer prepays a health
care provider an agreed-upon amount per member that covers a designated set of
services for the insured population over a defined time period. Typically, these payments
are made on a per member per month (PMPM) basis. If there are no terms to the
contrary, in return for the capitated payments, the provider agrees to bear all the risk
for the costs of services provided. If the provider’s costs are below the global capitation
amount, the provider can keep the difference. If the provider’s costs are more
than the capitation, the provider is at risk for the difference. Obviously, negotiations
on both the capitated amount and any particulars of the contract (e.g. services not covered,
and arrangements which limit the financial risk of the provider) are critical to the
provider, who must estimate the volume and type of services that may have to be performed,
and the amount of money needed to cover them. The following example
shows a breakeven analysis for a health care provider under a capitated system.
Hospital A, which has a capitation arrangement with a managed care organization,
wants to negotiate a capitated contract with a multi-specialty group practice to provide a
322 Financial Management of Health Care Organizations
Given: Revenue per Visit $100
Variable Cost per Visit $25
Contribution Margin per Visit $75
Fixed Cost $200,000
To determine the breakeven quantity using the contribution margin approach:
Fixed Cost
=
$200,000
Contribution Margin per Unit $75 = 2,667 Visits
Exhibit 9–12 The Breakeven Equation Using the Contribution Margin Approach
Contribution Margin
Rule: If the
contribution margin
per unit is positive and
no other additional
costs will be incurred,
then it is in the best
financial interest of
the organization to
continue to
provide
additional units
of that service,
even if the
organization is
not fully
covering all of its
other costs. On the
other hand, if the
contribution margin is
negative, it is not in
the best interest of the
organization to
continue to provide
additional units of
service.
Contribution Margin can be determined on a total or a per unit basis. Total Contribution Margin = Total Revenue
− Total Variable Cost. Contribution Margin per Unit = Revenue per Unit − Variable Cost per Unit. It is the
amount of profit made on each additional unit produced if all other costs remain the same.
major portion of the medical services that Hospital A is obligated to provide. This type of
arrangement is commonly called a subcapitation arrangement. The population covered
under this subcapitation arrangement consists of 1,400 covered lives with no Medicare or
Medicaid beneficiaries.
The director of managed care contracts for the clinic is under pressure to bring in new
business. In weighing this opportunity, he must balance many factors, some of which will
not be known until the contract is actually in effect, including: 1) the per member per
month rate; 2) the expected proportion of members needing services; and 3) the average
cost of the services that the members will actually receive. Exhibit 9–13 offers three separate
scenarios, each varying one of these three factors while holding the other two constant.
In keeping with the same example used throughout the chapter, assume that fixed
costs equal $200,000, and that the variable cost per unit equals $25. However, the fixed
cost figure represents the annual amount, whereas capitation is being paid here on a
monthly basis (PMPM). Thus, annual fixed costs must be converted into equivalent
monthly amounts, or $16,667 ($200,000/12 months). Variable costs remain the same
and do not need to be converted.
In the first scenario (Exhibit 9–13), only the capitation rate is unknown. The clinic
either gains or loses depending upon whether the capitation amount is above or below
$14.40 PMPM. Note that in this scenario, total costs remain constant (columns H, I, J),
regardless of the capitation amount, but total revenues vary based on the capitation rate
to be paid (column A). While Exhibit 9–13 uses a spreadsheet approach to solving
scenerio 1, another way to solve this problem is to set it up as an equation:
PMPM × Enrollees = (Enrollees × Utilization Rate × Variable Cost/Unit)
+ Fixed Cost
PMPM × 1,400 = (1,400 × 0.10 × 25) + 16,667
1,400 PMPM = 20,167
PMPM = ∼ $14.40
In the second scenario, the percentage of members each month receiving services is
unknown, but capitation is held to $15 PMPM. As expected, the lower the percentage
of members receiving services, the greater the net income for the clinic. Note that
in this scenario, total revenues remain constant (column F), but total costs vary (columns
I, J). As with the previous scenario, scenario 2 can also be set up as an equation:
PMPM × Enrollees = (Enrollees × Utilization Rate × Variable Cost/Unit) +
Fixed Cost
15 × 1,400 = (1,400 × Utilization Rate × 25) + 16,667
4,333 = 35,000 × Utilization Rate
Utilization Rate = 0.1238
In the final scenario, capitation and percentage of members receiving services are
held constant, but average cost per member receiving services is unknown. As average
cost per member rises (column C), net income falls for the clinic (column K), as would
Using Cost Information to Make Special Decisions 323
324 Financial Management of Health Care Organizations
Givens Number of Total Fixed Utilization Variable
Members Cost PMPM Rate Cost/Unit
Scenario 1 1,400 $16,667 ? 10% $25
Scenario 2 1,400 $16,667 $15 ? $25
Scenario 3 1,400 $16,667 $15 10% ?
Scenario 1: Using the breakeven equation to determine breakeven PMPM subcapitation rate, given service cost
and utilization rates.
[A] Monthly Capitation Amount (PMPM) ?
[B] Fixed Costs per Month $16,667
[C] Average Costs of Services per Member Receiving $25
[D] Percentage of Members Receiving Services Each Month 10%
[E] Total Number of HMO Capitated Members 1,400
[A] [F] [G] [H] [I] [J] [K]
Monthly Members
Capitation Revenues w/Services Fixed Costs Variable Costs Total Costs Net Income
[Estimate] [A × E] [D × E] [B] [C × G] [H + I] [F − J]
$5.00 $7,000 140 $16,667 $3,500 $20,167 ($13,167)
$10.00 $14,000 140 $16,667 $3,500 $20,167 ($6,167)
$14.40 $20,167 140 $16,667 $3,500 $20,167 $0
$15.00 $21,000 140 $16,667 $3,500 $20,167 $833
$20.00 $28,000 140 $16,667 $3,500 $20,167 $7,833
$25.00 $35,000 140 $16,667 $3,500 $20,167 $14,833
Scenario 2: Using the breakeven equation to determine breakeven utilization rates, given service cost and
PMPM subcapitation rates.
[A] Monthly Capitation Amount $15
[B] Fixed Costs per Month $16,667
[C] Average Costs of Services per Member Receiving $25
[D] Percentage of Members Receiving Services Each Month ?
[E] Total Number of HMO Capitated Members 1,400
[D] [F] [G] [H] [I] [J] [K]
Average Members
Util Rate Revenues w/Services Fixed Costs Variable Costs Total Costs Net Income
[Estimate] [A × E] [D × E] [B] [C × G] [H + I] [F − J]
5.00% $21,000 70 $16,667 $1,750 $18,417 $2,583
10.00% $21,000 140 $16,667 $3,500 $20,167 $833
12.38% $21,000 173 $16,667 $4,333 $21,000 $0
15.00% $21,000 210 $16,667 $5,250 $21,917 ($917)
20.00% $21,000 280 $16,667 $7,000 $23,667 ($2,667)
25.00% $21,000 350 $16,667 $8,750 $25,417 ($4,417)
(Continues)
Exhibit 9–13 An Example of How to Perform a Breakeven Analysis under a Capitated Arrangement
be expected. Note that in this third scenario, like the one before it, total revenues
remain constant, but total costs vary. As with the previous scenarios, scenario 3 can also
be set up as an equation:
PMPM × Enrollees = (Enrollees × Utilization Rate × Variable Cost/Unit) + Fixed Cost
15 × 1,400 = (1,400 × 0.10 × Variable Cost/Unit) + 16,667
4,333 = 140 × Variable Cost/Unit
Variable Cost/Unit = $30.95
As with non-capitated payments, a breakeven chart can also be constructed under
a capitated payment environment. Exhibit 9–14 provides an illustration of this using
the same cost structure as in Exhibit 9–11 (FC = $16,667 and VC = $25/visit), but
revenue remains constant at $21,000 (PMPM = $15 × 1,400 patients). As opposed to
the non-capitated situation where net income increases as volume increases, the more
services provided here, the lower the net income. This is because revenues remain
constant, but costs increase at $25/visit.
The examples given in this chapter illustrate how a Cost-Volume-Profit analysis
can be used in both non-capitated and capitated environments. However, as the factors
being considered increase, a more thorough analysis is suggested. Such an
approach is presented in Chapter 10, where such things as acuity level, payor mix,
productivity, and labor force distribution are taken into account.
Product Margin
While the above discussion dealt with breaking even regarding a single service, health
care delivery is often quite complex. The next section of this chapter introduces tools
Using Cost Information to Make Special Decisions 325
Exhibit 9–13 (Contd)
Scenario 3: Using the breakeven equation to determine breakeven service cost, given PMPM subcapitation
rates and utilization rate.
[A] Monthly Capitation Amount $15
[B] Fixed Costs per Month $16,667
[C] Average Costs of Services per Member Receiving ?
[D] Percentage of Members Receiving Services Each Month 10%
[E] Total Number of HMO Capitated Members 1,400
[C] [F] [G] [H] [I] [J] [K]
Members
Service Costs Revenues w/Services Fixed Costs Variable Costs Total Costs Net Income
[Estimate] [A × E] [D × E] [B] [C × G] [H + I] [F − J]
$15.00 $21,000 140 $16,667 $2,100 $18,767 $2,233
$20.00 $21,000 140 $16,667 $2,800 $19,467 $1,533
$25.00 $21,000 140 $16,667 $3,500 $20,167 $833
$30.00 $21,000 140 $16,667 $4,200 $20,867 $133
$30.95 $21,000 140 $16,667 $4,333 $21,000 $0
$35.00 $21,000 140 $16,667 $4,900 $21,567 ($567)
and concepts applicable to situations involving multiple services. For instance, a home
health agency might offer the following services: nursing assistant services, infusion
therapy, physical therapy, registered dietitian services, and occupational therapy.
Later, the situation is expanded to cases where there are multiple payors.
Multiple Services
In instances where multiple services are being offered, both organizational fixed costs and
service-specific fixed costs must be considered. Fixed costs present only because a service
is being provided, and not otherwise, are called avoidable fixed costs. For instance,
continuing with the home health example, assume that of the $200,000 in fixed costs,
$50,000 is to be paid for a full-time RN for just one particular service (Exhibit 9–15, row
D), and, if the service were not delivered, this position would be eliminated (and not just
transferred to another service). In regard to the decision of whether or not to drop the
service, the cost of this position, $50,000, is an avoidable fixed cost.
Assume the other $150,000 of the original $200,000 of the home health agency’s
fixed costs will remain and must be covered regardless of whether or not the particular
service is dropped (Exhibit 9–15, row E). Since these costs cannot be eliminated,
they are called non-avoidable fixed costs. Assume in the case of the home health
agency that $100,000 of the $150,000 in non-avoidable fixed costs is for salaries and
benefits and $50,000 is for overhead (Exhibit 9–15, rows E1 and E2). Incidentally,
overhead (i.e. rent, administration, insurance, etc.) is a type of common cost: a cost
that is not attributable to any particular service, but must be covered by all of them.
Common costs are also called joint costs.
326 Financial Management of Health Care Organizations
Loss
Profit
Breakeven Point
Net Income
Total
Costs
Total
Revenue
($10,000)
($5,000)
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
0 50 100 150
Volume
200 250 300 350
Exhibit 9–14 A Traditional Breakeven Chart with Capitated Payments
Avoidable Fixed
Cost: A fixed cost that
is avoided if a service
is not performed.
Example: full-time
nursing costs saved if
a service were closed.
Non-avoidable Fixed
Costs: A fixed cost
that will remain even
if a particular service
is discontinued.
Example: full-time
nursing costs in an
organization that will
continue, even though
one of several services
is dropped.
Note that even if an organization drops a service, if the employees are transferred within the organization, their
costs are considered non-avoidable.
Just as subtracting total variable cost from total revenue yields the total contribution
margin, subtracting avoidable fixed cost from the total contribution margin yields
the product margin. The product margin decision rule is: if a service’s product
margin is positive, the organization will be better off financially if it continues with the
service, ceteris paribus.1 Conversely, if a service’s product margin is negative, the
organization will be better off financially if it discontinues the service, ceteris paribus.
It represents the amount which a service contributes toward covering all other costs
after it has covered those costs which are there solely because the service is offered (its
total variable cost and avoidable fixed cost) and would not be there if the service were
dropped. As shown in Exhibit 9–15, if an organization violates this rule and closes a
service with a positive product margin (column K), the organization increases its loss
by the amount of the product margin that it forgoes. Note that this rule holds for any
particular service, but does not work for all services taken together since common
costs would not be covered.
Presume the home health agency is trying to decide whether or not to continue this
service next year, and it forecasts it will make 2,000 visits (Exhibit 9–15, column F).
If the home health agency made its decision on the basis of net income, it would conclude
that it should drop the service, because it would conclude that it is losing
$50,000 (column N). However, if it drops the service, it will be $100,000 worse off (the
amount of the product margin, column K) than if it provided the 2,000 visits. Since
the product margin is the amount left over after the service has covered all of its own
costs, if the service were dropped, the home health agency would lose the $100,000 to
Using Cost Information to Make Special Decisions 327
Given: A Net Revenue Per Visit $100
B Variable Cost Per Visit $25
C Contribution Margin Per Visit [A − B] $75
D Avoidable Fixed Costs $50,000
E Other Fixed Costs $150,000
E1 Salaries and Benefits $100,000
E2 Overhead Costs $50,000
F G H I J K L M N
Total Total
Total Variable Contribution Avoidable Product Salaries & Overhead Net
Volume Revenues Costs Margin Fixed Costs Margin Benefits Costs Income
[Estimate] [A × F] [B × F] [G − H] [D] [ I − J] [E1] [E2] [K − L − M]
2,000 $200,000 $50,000 $150,000 $50,000 $100,000 $100,000 $50,000 ($50,000)
2,500 $250,000 $62,500 $187,500 $50,000 $137,500 $100,000 $50,000 ($12,500)
2,667 $266,700 $66,675 $200,025 $50,000 $150,025 $100,000 $50,000 $25
3,000 $300,000 $75,000 $225,000 $50,000 $175,000 $100,000 $50,000 $25,000
3,500 $350,000 $87,500 $262,500 $50,000 $212,500 $100,000 $50,000 $62,500
Exhibit 9–15 An Illustration of the Product Margin Rule
Common Costs:
Costs that benefit a
number of services
and whose costs are
shared by all.
Examples: rent,
utilities, and billing.
Also called joint costs.
Product Margin:
Total Contribution
Margin – Avoidable
Fixed Costs. It
represents the amount
which a service
contributes toward
covering all other
costs after it has
covered those costs
which are there solely
because the service is
offered (its total
variable cost and
avoidable fixed costs)
and would not be
there if the service
were dropped.
1. Ceteris paribus: with all else being the same.
help defray its other costs (rows E1 and E2). Note also, if they dropped the service,
net income would drop from −$50,000 to −$150,000.
Multiple Payors
It is possible to extend the analysis presented in Exhibit 9–15 from one payor to multiple
payors. The previous example assumed that revenues were $100 per visit, but in fact, this
is really an average of $100. Three scenarios are shown in Exhibit 9–16. Scenario 1 presents
the basic conditions of four payors paying different rates, with a weighted average
revenue of $100 (“Total” row, columns F/E). Scenario 2 explores the effect on the product
margin of increasing the rate for Payor 1 by 10 percent (from $110 to $121) with a corresponding
drop in volume of 10 percent (from 300 visits to 270 visits). The result is that
the product margin increases from $0 to $1,170 (column J). Scenario 3 shows the effect on
the original conditions if all patients in Payor Category 1 are on a flat fee contract fixed at
$33,000, and volume increases by 10 percent. Since there are no additional revenues for
these patients, the cost increases but there is no change in revenue. Therefore, the product
margin decreases from $0 to −$1,500. This same paradigm can be used to judge the
effects of similar changes occurring with any of the four payors.
Applying the Product Margin Paradigm to Making Special
Decisions
The product margin paradigm presented in Exhibits 9–15 and 9–16 can be used to
address a number of special decisions, commonly categorized as: 1) Make/Buy; 2)
Add/Drop; and 3) Expand/Reduce.
Make-or-buy Decisions
Decision rule: After comparing the product margins between the make and buy
alternatives, the alternative with the higher product margin should be chosen.
Example: Zacharias Community Clinic (ZCC) is deciding whether to produce a portion
of its non-urgent laboratory tests in-house, or purchase them from a reference
lab. ZCC has $100,000 in fixed costs for the lab (primarily for facilities, equipment,
and staffing), all of which would remain even if ZCC purchased the tests from a reference
lab. Variable cost (primarily for reagents and other supplies) is $3 per test. The
reference lab has offered to do the tests for a price of $9 each. Zacharias currently
receives $15 per test. If there are 10,000 tests to be performed, is ZCC better off producing
them in-house or contracting with the outside lab?
The solution is shown in Exhibit 9–17, solution 1. The product margin of the buy
alternative is $60,000 less than that of the make alternative (line K). Therefore the make
alternative is preferred. Notice that fixed costs do not have to be included in the analy-
328 Financial Management of Health Care Organizations
Product Margin
Decision Rule: If a
service’s product
margin is positive, the
organization will be
better off financially if
it continues with the
service, ceteris paribus.
Conversely, if a
service’s product
margin is negative, the
organization will be
better off financially if
it discontinues the
service, ceteris
paribus.
Using Cost Information to Make Special Decisions 329
Scenario 1: Original Conditions
Payor A Payment/Unit
1 $110 B Variable Cost/Unit = $50
2 $105 C Avoidable Fixed Costs = $50,000
3 $101
4 $85
D E F G H I J
Payor Total Total Total Avoidable Product
Category Volume Revenues Variable Costs Contrib. Margin Fixed Costs Margin
[Given] [Given] [A × E] [B × E ] F − G] [ [C] [H − I]
1 300 $33,000 $15,000 $18,000
2 175 $18,375 $8,750 $9,625
3 250 $25,250 $12,500 $12,750
4 275 $23,375 $13,750 $9,625
Total 1,000 $100,000 $50,000 $50,000 $50,000 $0
Scenario 2: Original conditions with rate for Payor 1 patients increased by 10%, while Payor 1 volume is decreased by 10%.
Payor A Payment/Unit
1 $121 B Variable Cost/Unit = $50
2 $105 C Avoidable Fixed Costs = $50,000
3 $101
4 $85
D E F G H I J
Payor Total Total Total Avoidable Product
Category Volume Revenues Variable Costs Contrib. Margin Fixed Costs Margin
[Given] [Given] [A × E] [B × E ] F − G] [ [C] [H – I]
1 270 $32,670 $13,500 $19,170
2 175 $18,375 $8,750 $9,625
3 250 $25,250 $12,500 $12,750
4 275 $23,375 $13,750 $9,625
Total 970 $99,670 $48,500 $51,170 $50,000 $1,170
Scenario 3: Original conditions with Payor 1 patients being covered under a flat fee contract in which the total payment
remains $33,000, but Payor 1 volume is increased by 10%.
Payor A Payment/Unit
1 $33,000 B Variable Cost/Unit = $50
2 $105 C Avoidable Fixed Costs = $50,000
3 $101
4 $85
D E F G H I J
Payor Total Total Total Avoidable Product
Category Volume Revenues1 Variable Costs Contrib. Margin Fixed Costs Margin
[Given] [Given] [A × E] [B × E] [F − G] [C] [H − I]
1 330 $33,000 $16,500 $16,500
2 175 $18,375 $8,750 $9,625
3 250 $25,250 $12,500 $12,750
4 275 $23,375 $13,750 $9,625
Total 1,030 $100,000 $51,500 $48,500 $50,000 ($1,500)
1 For Payor 1, this formula is not used, and Total Revenues equals the fixed $33,000.
Exhibit 9–16 Expansion of the Product Margin Concept to Multiple Payors
sis, since they are the same for either alternative. However, if fixed costs do change
between the two alternatives, then they have to be considered. For instance, if $80,000
of the fixed costs were avoidable, the analysis would be as shown in solution 2 of Exhibit
9–17, line J. As a result, the buy alternative becomes the preferred choice. Though it has
a $60,000 lower total contribution margin (line I), it saves $80,000 in avoidable fixed
costs, resulting in positive product margin of $20,000 (line K).
Adding-or-dropping a Service
Decision rules: 1) If a proposed new service is expected to have a positive product
margin, it should be added; and 2) If an existing service has a negative product margin,
it should be dropped.
Example: Geiser HMO asked Nathaniel Clinic, a pediatric group practice, to provide
3,000 well-baby visits. Nathaniel has excess capacity to see more patients, but would
330 Financial Management of Health Care Organizations
Alternative Advantage
(Disadvantage)
Givens: Make1 Buy2 of Adding
A Volume of Tests 10,000 10,000
B Revenue per Test $15 $15
C Variable Cost per Test $3 $9
D Contribution Margin per Test $12 $6
E1 Avoidable Fixed Cost Original $0 $0
E2 Avoidable Fixed Cost Modified $80,000 $0
Solution 1: No Avoidable Fixed Costs
F Volume [A] 10,000 10,000 03
G Revenues [A × B] $150,000 $150,000 $04
H Variable Costs [A × C] $30,000 $90,000 ($60,000)5
I Total Contribution Margin [G − H] $120,000 $60,000 ($60,000)6
J Avoidable Fixed Cost [E1] $0 $0 $07
K Product Margin [I − J] $120,000 $60,000 ($60,000)8
Solution 2: Avoidable Fixed Costs: $80,000
F Volume [A] 10,000 10,000 03
G Revenues [A × B] $150,000 $150,000 $04
H Variable Costs [A × C] $30,000 $90,000 ($60,000)5
I Total Contribution Margin [G − H] $120,000 $60,000 ($60,000)6
J Avoidable Fixed Cost [E2] $80,000 $0 $80,0007
K Product Margin [I − J] $40,000 $60,000 $20,0008
1 Produce in-house.
2 Purchase from vendor.
3 Increase (decrease) in volume from choosing buy option.
4 Amount saved (lost) in revenue from choosing buy option.
5 Amount saved (lost) in variable costs by choosing buy option.
6 Total Contribution Margin gained (lost) by choosing buy option.
7 Amount saved (lost) in avoidable fixed costs from choosing buy option.
8 Increase (decrease) in product margin from choosing buy option.
Exhibit 9–17 Example of a Make/Buy Decision
have to hire additional staff for $85,000. It estimates additional variable costs (such as
disposable thermometers, linens, etc.) of $10 per visit. Geiser is willing to pay $65 per
visit. Should Nathaniel contract with Geiser and provide the well-baby clinic?
The solution is shown in Exhibit 9–18a. Since the project has a positive product
margin of $80,000, Nathaniel should agree to offer the service. But what happens now
if Geiser changes the terms of the contract and will only pay $35 per visit? In this case,
as shown in Exhibit 9–18b, Nathaniel would have a positive total contribution margin,
$75,000 (line I), but a negative product margin, −$10,000 (line K). Nathaniel should
not agree to offer the service at this price.
Expanding-or-reducing a Service
Decision rule: If only one alternative will or must be chosen, then the anticipated
product margin of both alternatives should be compared. The alternative with the
higher anticipated product margin should be chosen.
Example: Physicians Healthcare Group (PHG) is located in the greater Barnsboro
metropolitan area. One of its major revenue centers, a radiology service, receives its
revenues on a capitated basis: $55 per member per year to take care of all of their
routine radiology needs. Assume that 20 percent of the 10,000 members will receive
some routine radiological service each year, at an average cost of $50 per service.
Using Cost Information to Make Special Decisions 331
Alternative Advantage
Don’t (Disadvantage)
Givens: Add1 Add2 of Adding
A Volume 0 3,000
B Revenue per Visit $0 $65
C Cost per Visit $0 $10
D Contribution Margin per Visit $0 $55
E Avoidable Fixed Cost $0 $85,000
Solution:
F Volume [A] 0 3,000 3,0003
G Revenues [A × B] $0 $195,000 $195,0004
H Variable Costs [A × C] $0 $30,000 ($30,000)5
I Total Contribution Margin [G − H] $0 $165,000 $165,0006
J Avoidable Fixed Costs [E] $0 $85,000 ($85,000)7
K Product Margin [I − J] $0 $80,000 $80,0008
1 Do not open new clinic.
2 Open new clinic.
3 Increase (decrease) in volume from choosing add option.
4 Amount saved (lost) in revenue from choosing add option.
5 Amount saved (lost) in variable costs by choosing add option.
6 Total Contribution Margin gained (lost) by choosing add option.
7 Amount saved (lost) in avoidable fixed costs by choosing add option.
8 Increase (decrease) in product margin from choosing add option.
Exhibit 9–18a Example of an Add/Drop Decision
PHG operates six satellite clinics that offer general and specialty medicine services
to their customers. X-ray service is also available at every clinic so that patients can be
examined on-site immediately. This has been a very successful marketing feature as
shown by the annual patient satisfaction survey, but it has been costly. Stacy Helman,
the new clinic manager, has suggested centralizing the radiology operations to two
locations that could serve all six clinics. She feels this would help reduce the current
fixed costs of the organization by $200,000. However, if the services were relocated,
Ms. Helman predicts a 10 percent reduction in members, since they would probably
change HMOs. The solution is shown in Exhibit 9–19.
Discussion: Given the product margin results (row K), it appears that PHG should
centralize its radiology service. Even though 10 percent of the patient volume would
be lost, there would be significant equipment cost savings with this option. PHG
would be better off by $155,000 per year by centralizing.
Though these examples illustrate the application of the product margin paradigm,
it is important to understand that other financial analysis tools should also be
employed when making these decisions. For instance, the impact of these decisions on
the financial ratios of the organization should be considered (see Chapter 4). Similarly,
to the extent that these decisions have multi-year implications, a more thorough
analysis would discount future cash flows and assess the net present value of these
decisions (see Chapters 6 and 7). Finally, these financial concerns must be weighed
against non-financial concerns when making these decisions.
332 Financial Management of Health Care Organizations
Alternative Advantage
Don’t (Disadvantage)
Givens: Add1 Add2 of Adding
A Volume 0 3,000
B Revenue per Visit $0 $35
C Cost per Visit $0 $10
D Contribution Margin per Visit $0 $25
E Avoidable Fixed Cost $0 $85,000
Solution:
F Volume [A] 0 3,000 3,0003
G Revenues [A × B] $0 $105,000 $105,0004
H Variable Costs [A × C] $0 $30,000 ($30,000)5
I Total Contribution Margin [G − H] $0 $75,000 $75,0006
J Avoidable Fixed Costs [E] $0 $85,000 ($85,000)7
K Product Margin [I − J] $0 ($10,000) ($10,000)8
1 Do not new open clinic.
2 Open new clinic.
3 Increase (decrease) in volume from choosing add option.
4 Amount saved (lost) in revenue from choosing add option.
5 Amount saved (lost) in variable costs by choosing add option.
6 Total Contribution Margin gained (lost) by choosing add option.
7 Amount saved (lost) in avoidable fixed costs by choosing add option.
8 Increase (decrease) in product margin from choosing add option
Exhibit 9–18b Example of Add/Drop Decision
Summary
An understanding of fixed and variable costs provides a valuable tool to help make
decisions of what price to charge, whether to add or drop a service, or whether to make
or buy a service. Fixed costs are costs that do not vary in total but vary per unit over
the relevant range. Variable costs vary in total but do not vary per unit over the relevant
range. The relevant range is the range over which total fixed costs and/or per
unit variable cost do not vary.
The breakeven equation can be used to determine price, volume, fixed costs, or
variable cost per unit, if each of the other factors is known. The breakeven equation
is: (Price × Volume) = Fixed Costs + (Variable Cost per Unit × Volume). The
breakeven point is that volume where total revenues equal total costs. The results
of a breakeven analysis are often presented on a breakeven chart, which illustrates
fixed costs, total costs, total revenues, and volume. The distance between the total
cost and total revenue lines represents the amount of profit or loss the service is
experiencing at any particular volume of service. An alternative form of this chart
shows the difference between the total cost and total revenue lines: net income.
The breakeven equation can be applied to capitated situations to determine capitation
rates, utilization rates, or fixed or variable costs, given the others. The
breakeven equation can also be extended to multi-payor and multi-service situations,
though the latter is beyond the scope of this text. In conducting multi-payor
Using Cost Information to Make Special Decisions 333
Alternative Advantage
Don’t (Disadvantage)
Givens: Reduce1 Reduce2 of Reducing
A Members 10,000 9,000
B Utilization Rate 20% 20%
C PMPY $55 $55
D Cost per Test $50 $50
E Avoidable Fixed Cost $200,000 $0
Solution:
F Members [A] 10,000 9,000 (1,000)3
G Revenues [A × C] $550,000 $495,000 ($55,000)4
H Variable Costs [A × B × D] $100,000 $90,000 $10,0005
I Total Contribution Margin [G – H] $450,000 $405,000 ($45,000)6
J Avoidable Fixed Cost [E] $200,000 $0 $200,0007
K Product Margin [I – J] $250,000 $405,000 $155,0008
1 Don’t centralize radiology service.
2 Centralize radiology service.
3 Increase (decrease) in volume from choosing reduce option.
4 Amount saved (lost) in revenue by choosing reduce option.
5 Amount saved (lost) in variable costs by choosing reduce option.
6 Total Contribution Margin gained (lost) by choosing reduce option.
7 Amount saved (lost) in avoidable fixed costs by choosing reduce option.
8 Increase (decrease) in product margin from choosing reduce option.
Exhibit 9–19 Example of an Expand/Reduce Decision
analyses that include capitated and fixed-fee patients, it is important not to adjust
revenues for changes in volume, though variable costs may change. This caveat
also holds for fixed-fee patients, such as those who pay on the basis of DRGs.
Per unit contribution margin is calculated by subtracting per unit variable cost from
per unit revenues. It is the amount of profit made on each additional unit provided all
other costs (fixed costs and overhead) remain the same. It is also the amount of incremental
income from an average unit of service that is available to cover all other costs.
If the contribution margin is known, a shortcut formula to calculate breakeven can be
used: Breakeven Volume = Total Fixed Costs/Contribution Margin per Unit. If 1)
the decision has been made not to close down a service, 2) no other additional costs
will be incurred, and 3) the contribution margin is positive, then it is in the best financial
interest of the organization to continue to provide additional units of that service,
even if it is not fully covering all of its other costs.
In instances where multiple services are offered, it is likely that there are both
organizational fixed costs and service specific fixed costs. Fixed costs that are present
just because the service is being provided and would not be there if the service
were not offered are called avoidable fixed costs. Product margin is computed as follows:
Total Revenues − Total Variable Costs − Avoidable Fixed Costs. The product
margin decision rule states: if a service is covering its own variable and avoidable
fixed costs, even if it does not fully cover its full share of other costs (non-avoidable
fixed costs and common costs), the organization is better off delivering the service
than not, all other things being equal (there are no better alternatives). If the organization
violates this rule and closes a service with a positive product margin, the
organization increases its loss by the amount of the product margin that it forgoes.
The product margin concept is useful to help answer questions related to providing
a service in-house or going outside (make-or-buy decision), adding or dropping a
service, and expanding or reducing services. In all of these analyses, sunk costs
should not be considered.
It is important to understand that other financial analysis tools should also be
employed when making these decisions. For instance, the impact on the financial
ratios of the organization should be considered. Also, decisions that have multi-year
implications should include a more thorough analysis of future cash flows and net
present value. Finally, as noted earlier, the financial concerns must be balanced with
non-financial concerns to make these decisions.
334 Financial Management of Health Care Organizations
Avoidable Fixed Cost
Breakeven Analysis
Breakeven Point
Capitation
Common Costs
Contribution Margin
Contribution Margin Per Unit
Contribution Margin Rule
Fixed Costs
Incremental costs
Joint Costs
Non-avoidable Fixed Costs
Product Margin
Product Margin Decision Rule
Relevant Range
Step-Fixed Costs
Target Costing
Variable Costs
Key Terms
Key Equations
Breakeven for capitation: PMPM × Enrollees = (Enrollees × Utilization rate ×
Variable Cost/Unit) + Fixed Cost
Breakeven volume: Fixed Costs/Contribution Margin per Unit
Breakeven volume: Price × Volume = Direct Cost + Indirect Costs + Profit.
Where Direct Costs = Direct Fixed Costs + (Direct Variable Cost Per Unit ×
Volume)
Breakeven volume: Price × Volume = Fixed Costs + (Variable Cost Per Unit ×
Volume) + Desired Profit
Contribution margin per unit: Revenue Per Unit − Variable Cost Per Unit
Contribution margin: Total Revenue − Total Variable Cost
Product Margin: Total Contribution Margin − Avoidable Fixed Costs
Questions and Problems
1. Definitions: Define the following terms:
a. Avoidable Fixed Cost.
b. Breakeven Analysis.
c. Breakeven Point.
d. Capitation.
e. Common Costs.
f. Contribution Margin.
g. Contribution Margin Per Unit.
h. Contribution Margin Rule.
i. Fixed Costs.
j. Incremental Costs.
k. Joint Costs.
l. Non-avoidable Fixed Costs.
m. Product Margin.
n. Product Margin Decision Rule.
o. Relevant Range.
p. Step Fixed Costs.
q. Target Costing.
r. Variable Costs.
2. Breakeven Formulas. What are the formulas for:
a. The basic breakeven equation
b. The basic breakeven equation expanded to include indirect costs and desired
profit?
3. Understanding Fixed and Variable Cost. Briefly describe what happens to
each of the following as volume increases:
Using Cost Information to Make Special Decisions 335
a. Total Fixed Cost
b. Total Variable Cost
c. Fixed Cost per Unit
d. Variable Cost per Unit
4. Step Fixed Cost and the Relevant Range. Explain the relationship between
step-fixed costs and the relevant range.
5. Product Margin. Based on the product margin, when is it in the best interests
of an organization to continue or drop a service?
6. Make-or-buy Decision and related analyses.
a. What is a make-or-buy decision?
b. What other analyses are relevant to the types of decisions discussed in this
chapter?
7. Breakeven equation. Fill in the blank. The following table contains selected
data concerning several outpatient clinics in the new Ambulatory Care Center at
Hope University Hospital. Fill in the missing information.
[A] [B] [C] [D] [E] [F]
Price Variable Number Contribution Fixed Net
per Visit Cost/Unit of Visits Margin Costs Income
$85 3,000 $180,000 $80,000
$70 $20 $130,000 $90,000
$35 3,250 $78,000 $117,000
$65 $40 2,000 $60,000
8. Breakeven equation. Fill in the blank. Instead of the information in problem
7, assume Ambulatory Care Center’s data looked like this:
[A] [B] [C] [D] [E] [F]
Price Variable Number Contribution Fixed Net
per Visit Cost/Unit of Visits Margin Costs Income
$90 4,000 $200,000 $90,000
$85 $35 $150,000 $75,000
$55 4,500 $78,000 $120,000
$50 $60 2,000 $60,000
9. Expand/Reduce Decision. Laurie Vaden is a nurse practitioner with her own
practice. She has developed contracts with several large employers to perform
routine physicals, fitness for duty exams, and initial screening of on-the-job
injuries. She currently sees 150 patients per month, charging $50 per visit.
Her total costs are $7,500, of which $1,500 is for supplies. She has decided that
she needs to increase profit, so she is considering raising her fee to $65.
She expects to lose 10 percent of her business to competitors that charge an
average of $60 per visit. Determine her current and predicted: 1) revenues, 2)
variable costs, and 3) total contribution margin. What do you recommend she do?
Why?
336 Financial Management of Health Care Organizations
10. Expand/Reduce Decision. Janet Gilbert is director of labs. She has some
extra capacity and has contracted with some small neighboring hospitals to
run some of their lab tests. She has recently had a study conducted and has
determined that her costs of these contracts are $10,000 of which $7,000 are
for supplies and items related to each test. She currently charges an average
of $10.00 per lab test. She is thinking of lowering her price by 20 percent in
hopes of raising her current volume of 10,000 tests by 15 percent. Determine
her current and predicted: 1) revenues, 2) variable costs, 3) total contribution
margin, and 4) net income. What do you recommend she do? Why?
11. Calculating Breakeven. Ms Jasmine Gonzales, administrative director of
Physicians Associates, a group practice, has been asked if the group should
begin offering mammography screenings. The following are Ms Gonzales’s
projections:
Price per screening: $90
Equipment[1]: $60,000
Technicians’ salaries: $60,000
Operating costs per screening:
Supplies: $25
Developing: $10
[1] Useful life of 10 years (assume straight-line depreciation)
a. What annual volume must the unit operate at in order to break even on
the service?
b. How do breakeven projections change if the group practice required a
$22,000 profit?
c. Suppose reimbursement levels for mammography services provided only
$65 per screening. How many screenings per year would the group
practice have to perform to break even? (Assume no profit.)
12. Calculating Breakeven. Southern Regional Hospital is considering offering a
new specialty service which will be provided out of its urgent care center. A
pediatric cardiologist from the region’s teaching hospital is willing to provide
services 4 times a month to the facility. Not only will this add a needed service
to SRH, it will also generate revenues from the echocardiograms performed on
the children. The following represent the projections of the clinic:
Revenues per study: $500
Echo cardiograph lease (per study) $100
Physician salary (per day): $750
Other expenses[1]: $800
[1] Cost per month of high speed telephone line for transmission of digital data.
a. At what volume per month does this service break even?
b. What is the breakeven point if the clinic wants to make $800 profit?
c. What is the breakeven if the revenue per study drops to $400 and the
clinic wants to make $800 profit?
Using Cost Information to Make Special Decisions 337
13. Calculating Breakeven and Graphing. San Juan Health Department’s
dental clinic projects the following costs and rates for the year 20XX.
Total fixed costs: $56,012
Variable costs: $48 per patient
Charges: $70 per patient
a. Using this information, determine the breakeven point in units.
b. Using this information, determine the breakeven point in dollars.
c. Graph this scenario in a breakeven chart using a range of 0 to 3,500 patients
in 500 patient increments.
d. If the clinic decides it would like to make a profit of $5,500, what is the new
breakeven point in units?
e. If the clinic decides it would like to make a profit of $5,500, what is the new
breakeven point in dollars?
14. Calculating Breakeven and Graphing. The North Kingstown Cancer
infusion therapy division expects tremendous growth over the next year and is
projecting the following cost and rate structure for the service.
Revenue $750 per patient
Costs
Rent $3,600 per month
Staff $195,000 per month
Leases $10,000 per month
Other $20,000 per month
Pharmaceuticals $500 per patient
IV supplies $25 per patient
Other patient supplies $25 per patient
a. What volume of patients will it take for the Center to break even?
b. What is the breakeven point in dollars?
c. Graph the above scenario using a range of 0 to 2,500 patients in 500 patient
increments.
d. If the clinic needs to make a profit of $75,000, what is the new breakeven
point in volume and in dollars?
15. Determining breakeven price in a reduce/expand decision. QuickCare is
a health care franchise that functions as a primary family health clinic, seeing
unscheduled patients 24 hours a day. Several months after the grand opening, a
corporate office management engineering study showed that the clinic was
experiencing some dips in volume in the mid-afternoon hours. In order to
increase volume, efficiency, and revenues, the clinic administrator contracted
with the area high schools to provide after-school physicals for the sports teams.
The initial agreement was that QuickCare would charge $75 per exam, the
market average. With this increase, fixed costs remained at $30,000 and variable
costs at $35 per physical. Though this strategy proved somewhat successful,
gross profit margin lagged behind the corporate expectations. In order to
improve margin, the clinic is considering increasing the exam price to $85.
QuickCare’s administrator projects that this price increase will cause the high
338 Financial Management of Health Care Organizations
schools to send their athletes to other providers and that volume could drop by
33 percent. Last year, QuickCare performed 1,026 examinations. The
administrator feels that if the program closes down, all $30,000 in fixed costs
would be saved.
a. What should QuickCare’s decision be assuming that this price increase will
decrease the number of patients seen by one-third?
b. What price would QuickCare have to charge to make up for the loss of
patients?
c. Using the information from part a, should QuickCare make the same
decision if 40 percent of the fixed costs are avoidable? Would it be better or
worse off? Why?
16. Expand/Reduce. The administrator of ABC Hospital, Mr Stevens, has just
received the latest financial report and the news is not good. The hospital has been
losing money for over a year, and if things don’t improve, it may lose its AA bond
rating. Mr Stevens has met with his VP Finance, Mr Sanger, and has asked him to
identify areas for cutting costs, beginning with services that are operating at a loss.
The following information is for services provided at ABC Hospital’s ambulatory
care clinic:
Annual volume (in patient visits): 10,000
Charge per visit: $50
Variable cost per visit: $30
Fixed costs: $500,000
a. Suppose that all fixed costs are avoidable. What should Mr Sanger
recommend to Mr Stevens regarding the clinic?
b. What if only $150,000 of the fixed costs were avoidable? Would this change
his recommendation?
c. Are there any other considerations that should be taken into account when
making this decision?
17. Add/Drop Decision The Ancome County Health Department is considering
using 300 square feet of excess office space to provide a clinic for Healthchek visits.
These visits are reimbursed at $67.30 under a Medicaid program. Variable costs
per visit are $59, and providing the service requires an additional physician
assistant and nurse with prorated salaries of $48,000 and $30,000, respectively. The
state has mandated efforts to increase the utilization of Medicaid eligibility, so the
Department of Social Services is conducting interventions to increase eligibility
awareness in the community. As a result, the health department expects 10,000
Healthchek visits in the coming year. Unavoidable overhead costs for the Health
Department are $300,000 per year and will be allocated to each program based on
its proportional share of the Health Department’s total office space of 2,700 square
feet.
a. What are the total contribution margin and total product margin for a
Healthchek visit?
b. Considering the total product margin, should the health department provide
the service?
Using Cost Information to Make Special Decisions 339
18. Add/Drop Decision The Midtown Women’s Center offers bone densitometry
scans in the office as a convenience to its patients. The clinic volume is
expanding and Sam Loch, the Center’s administrator, is considering dropping
the bone densitometry service and converting the space to an exam room to
allow for more outpatient visits. The following information has been gathered to
help with the decision.
Number of scans per year 425
Reimbursement for bone densitometry scan $65
Bone densitometry supply cost per scan $15
Part-time, bone densitometry scan technician $15,000
Reimbursement per office visit $80
Supply cost per office visit $20
Expected increase in outpatient volume if additional exam space
is available 500
a. What is the contribution margin for the bone densitometry service per year?
b. Should this service continue as opposed to converting it to exam room space?
Why or why not?
c. How many office visits would it take to replace the income from the bone
densitometry service?
19. Breakeven. Sure Care Health Maintenance Organization is seeking a managed
care contract with a local manufacturing plant. Sure Care estimates that the cost
of providing care for the 300 employees will be $36,000 per month. The
manufacturing company offered Sure Care a premium bid of $200 per employee
per month.
a. If Sure Care accepts this bid and contracts with the manufacturing firm, will
Sure Care earn a profit or loss for the year? How much?
b. What premium per employee per month does Sure Care need to break even?
c. If Sure Care wants to earn $100,000 in profit for the year, what is the
required premium per employee per month?
d. What concerns do you have about this analysis?
20. Breakeven. Zack Millman Clinic is seeking to provide sports-related health
care services to high schools in the are a. Zack Millman estimates that the cost
to provide care would be $1,000 plus $12 per athlete per month on a ninemonth
basis. The high schools jointly offered to pay the clinic $10,000 for a
nine-month contract to cover 75 athletes.
a. If Millman Clinic accepts this bid and contracts with the high schools, will it
earn a profit or loss for the year? How much?
b. What would the contract price have to be for Millman to break even?
c. If Zack Millken wants to earn $5,000 in profit for the year, and the school
system preferred to pay on a per athlete per month basis, what would the
price have to be?
21. Contribution Margin, Product Margin and Breakeven. Dixon
Pharmaceuticals, a drug manufacturing company, produces prescription
medication for the treatment of respiratory infections. The company’s leading
product line is Cycladine. The wholesale price per tablet of Cycladine is $0.85. The
340 Financial Management of Health Care Organizations
variable cost associated with the production of 1,000 tablets of Cycladine is $250.
Other costs associated with the production include annual laboratory equipment
rental of $100,000, annual salaries of employees who work in the Cycladine division
of $180,000, and other miscellaneous fixed costs for the Cycladine division of
$45,000 per year. The 45,000 square foot Cycladine division is located in a 136,364
square foot facility with several other product lines of Dixon Pharmaceuticals.
Overhead totals $500,000 for the company and is allocated on the basis of the
percent of the total square footage a division uses. Dixon Pharmaceuticals expects
to sell 1,000,000 tablets of Cycladine in the upcoming year.
a. Determine the total contribution margin, total product margin, and net
income for the Cycladine division of Dixon Pharmaceuticals.
b. Determine the net income breakeven point in tablets of Cycladine.
c. Determine the breakeven point for Dixon Pharmaceuticals to cover just its
direct costs.
22. Contribution Margin, Product Margin and Breakeven. Capital
Community Hospital is opening a new Radiation Oncology division within its
Cancer Center. This service will add revenues while eliminating the costly
travel and inconvenience to many patients that heretofore have to travel over
150 miles to receive this service. The new service plans to share waiting space,
registration space, a full time medical director and a full time service line
manger with the other existing Cancer Center Programs. There are no plans
under foreseeable conditions that these positions would become part time. The
following information is available:
Total waiting space (sq. ft) 1,000
Total allocated cost $3,500
Space for radiation oncology (sq. ft) 400
Salary: Service Line Manager $65,000
% Service Line Manager and Medical Director assigned to
radiation oncology 30%
New space upfit cost (10 year useful life) $550,000
Utilities/year 6,000
Lease for linear accelerator/year $60,000
Film supplies/treatment $14
Other supplies/treatment $75
Medical Director salary $166,667
Staffing for radiation oncology $150,000
Revenue/treatment $212
Treatments/patient 25
Total patients/year 150
a. Determine the Total Contribution Margin, Total Product Margin and Net
Income for the new service.
b. Determine the breakeven point in number of patients.
c. Determine the breakeven point to cover the direct costs.
23. Determining Charges for Private Pay Residents. Shady Rest Nursing
Home has 100 private pay residents. The administrator is concerned about
Using Cost Information to Make Special Decisions 341
balancing the ratio of its private pay to non-private pay patients. Non-private
pay sources reimburse an average of $100 per day whereas private pay residents
pay on average 100 percent of full daily charges. The administrator estimates
that variable cost per resident per day is $25 for supplies, food, and contracted
services and annual fixed costs are $4,562,500.
a. What is the daily contribution margin of each non-private pay resident?
b. If 25 percent of the residents are non-private pay, what will Shady Rest
charge the private pay patients in order to break even?
c. What if non-private pay payors cover 50 percent of the residents?
d. The owner of Shady Rest Nursing Home insists that the facility earn $80,000
in annual profits. How much must the administrator raise the per day charge
for the privately insured residents if 25 percent of the residents are covered
by non-private pay payors?
24. Determining Charges for Private Pay Residents. Shady Rest Nursing
Home has 220 private pay residents. The administrator is concerned about
balancing the ratio of its private pay to non-private pay patients. Non-private
pay sources reimburse an average of $125 per day whereas private pay residents
pay on average 90 percent of full daily charges. The administrator estimates that
variable cost per resident per day is $45 for supplies, food, and contracted
services and annual fixed costs are $6,000,000.
a. What is the daily contribution margin of each non-private pay resident?
b. If 25 percent of the residents are non-private pay, what will Shady Rest
charge the private pay patients in order to break even?
c. What if non-private pay payors cover 50 percent of the residents?
d. The owner of Shady Rest Nursing Home insists that the facility earn $80,000
in annual profits. How much must the administrator raise the per day charge
for the privately insured residents if 25 percent of the residents are covered
by non-private pay payors?
25. Add/Drop with Net Present Value Analysis (Builds on material in
Chapters 6 and 7). Franklin County Hospital, a non-profit hospital, bought and
installed a new computer system last year for $65,000. The system is designed to
relay information between labs and medical units. Charlene Walker, the hospital’s
new computer specialist, had a meeting with Lou Campbell, Vice President of
Finance. She began: “Lou, today I read in a journal that a new computer system
has just been introduced. It costs $42,000, but I believe that by replacing our old
system, we could reduce operating and maintenance costs that are now being
incurred.” The following are Ms Walker’s estimates:
Present System New System
Purchase and installment price $65,000 $42,000
Useful life when purchased 6 years 5 years
Computer operating costs per year $30,000 $20,000
Computer operating and maintenance costs per year $20,000 $18,000
Depreciation expenses per year $10,833 $18,000
Cost of capital 10% 10%
342 Financial Management of Health Care Organizations
a. Based on an analysis, what advice do you recommend that Charlene give
Lou?
b. At what price for the new computer system would Lou be indifferent?
c. Is this a typical make-or-buy decision? Why?
26. Complex Make/Buy. Dr Mike Roe is the Medical Director of the labs at
Parkside Hospital, the acute care provider for the Sunstone HMO. The lab is
looking to reduce its costs to remain competitive in the capitated market. One
service that the laboratory offers is in-house cyclosporin (an anti-rejection drug)
assays for immuno-compromised (low tolerance to infection) patients. This is a
low-volume, fairly expensive procedure. Recently, Loache Laboratories, a
reference lab, offered to perform these studies for Parkside. Loache has offered to
produce the necessary results at a cost of $70 each. Parkside has projected the
following data for the upcoming year to continue to perform the test in-house:
Volume: 960 tests or assays
Patient charges per lab test: $75
Variable expenses per lab test: $28.63
Annual expenses associated with Cyclosporin:
Rent: $10,000
Equipment rental: $9,250
Laboratory technician salary: $18,400
Allocated overhead: $6,840
a. Should Parkside continue to perform the assays or purchase them from
Loache?
b. Assume that it was highly likely that the volume would not reach 960 assays.
At what volume should Dr Roe change his decision from the first question?
c. If Loache discounted the price by 10 percent for each test after the purchase
of 900 assays, what should Dr Roe’s decision be?
27. Income statement and add/drop. Lakespring Retirement Village is home to
senior citizens who are fairly independent, but need assistance with basic health care
and occasional meals. Jill Thompson, a licensed beautician, works on salary 16 hours
a week at Lakespring. Funds at the retirement village have been getting quite tight,
due to an increase in the number of Medicaid and other low-income residents. Carl
Jones, Lakespring’s administrator, told Ms Thompson that the hair salon might
have to be closed. Mr Jones is sympathetic because he knows that it will be
inconvenient for many residents to get this service elsewhere, and Ms Thompson’s
charges are about all the residents can afford, but he wonders how he can keep any
unit open that does not break even. Mr Jones is looking for a way to save the hair
salon and has provided you with the following information for your input:
Hair Cuts Permanents Brief Visits
Charge per resident $8.00 $14.00 $4.50
Variable costs per service performed
Cleaning/styling/setting products 0.50 3.50 3.00
Variable water expense 0.15 0.25 0.25
Laundry expenses for towels, smocks, etc. 0.10 0.30 0.30
Using Cost Information to Make Special Decisions 343
Jill is currently doing an average weekly business of 16 hair cuts, seven
permanents, and four brief visits, which take half an hour, an hour, and 15
minutes, respectively. The hair salon is currently allocated rent of $150.00 per
month and other upkeep expenses of $45.00 a month. Jill is paid $9 per hour,
and she earned $576.00 last month.
a. Prepare a monthly income statement and determine the total contribution
margin and total product margin for each service line. Determine net income
for the service taken as a whole.
b. How would you advise Mr Jones: Should he close the hair salon? Why or
why not?
c. Should Mr Jones try to persuade Jill to drop any service she now offers?
344 Financial Management of Health Care Organizations
C h a p t e r T e n
BUDGETING
Learning Objectives
After completing this chapter, you will be able to:
State the purposes of budgeting.
Describe the planning/control cycle and list the five key dimensions of budgeting.
List the major budgets and explain their relationship to each other and to the income statement and balance
sheet.
Construct each of the major budgets.
INTRODUCTION
The Planning/Control Cycle
Strategic Planning and Planning
Controlling Activities
Organizational Approaches to Budgeting
Participation
Budget Models
Budget Detail
Budget Forecasts
Budget Modifications
TYPES OF BUDGETS
The Statistics Budget
The Operating Budget
The Cash Budget
The Capital Budget
Pro Forma Financial Statements and Ratios
AN EXTENDED EXAMPLE OF HOW TO DEVELOP
A BUDGET
The Statistics Budget
Developing Volume Projections
Converting Visit Projections to Weighted Visits
The Operating Budget
The Revenue Budget
The Expense Budget
The Supplies Budget
The Administrative and General Expense Budget
The Cash Budget
The Capital Budget
SUMMARY
Key Terms
Key Equation
Questions and Problems
Chapter Outline
Introduction
The budget is one of the most important documents of a health care organization and is
the central document of the planning/control cycle. The budget serves not only as a planning
document that identifies the revenues and resources needed for an organization to
achieve its goals and objectives, but also as a control document that allows an organization
to monitor the actual revenues generated and its use of resources against what was planned.
The Planning/Control Cycle
As illustrated in Exhibit 10–1, the planning/control cycle has four major components:
strategic planning, planning, implementing, and controlling. Budgeting is the central
element that affects all these areas.
Strategic Planning and Planning
Strategic planning and planning activities provide the basis to develop the budget.
The purpose of strategic planning is to identify the organization’s vision, mission,
goals, and strategy in order to position itself for the future. The purpose of planning
is to identify the goals, objectives, tasks, activities, and resources necessary to carry
out the strategic plan over a defined time period, commonly one year. The organization’s
mission is usually set forth in a mission statement, which is a broad, enduring
statement of its vision and purpose. The mission statement guides the organization
into the future by identifying the unique attributes of the organization, why it exists,
and what it hopes to achieve (see Perspective 10–1).
346 Financial Management of Health Care Organizations
Strategic Planning:
Identifying an
organization’s mission,
goals, and strategy to
best position itself for
the future.
Planning: The process
of identifying goals,
objectives, tasks,
activities, and
resources necessary to
carry out the strategic
plan of the
organization over the
next time period,
typically one year.
Mission Statement: A
statement which
guides the organization
by identifying the
unique attributes of
the organization, why
it exists, and what it
hopes to achieve. Some
organizations divide
these attributes
between a vision and a
mission statement.
Strategic
Planning Planning
Controlling Implementing
Budgeting
Exhibit 10–1 The Planning/Control Cycle
A major activity of the strategic planning process is to assess the organization’s
external and internal environments. The external environment of most health care
organizations is quite complex, and an environmental analysis must include surveying
the local, regional, national, and international environments for changes that may
occur in a variety of areas including the economy, regulation, technology, and health
status of populations. Other areas of the external environment that must be examined
are listed in the top part of Exhibit 10–2. Failing to thoroughly and correctly assess
even one of these domains could lead to major problems for, or even the demise of,
the organization. In addition to its external environment, a health care organization
also has to examine its internal environment, which includes both tangible factors, such
as financing, staff, services, and structure, and intangible factors, such as its history,
reputation, and the strength of its Board.
An important outcome of the strategic planning process is to identify goals and
objectives. In the past, goals and objectives for many health care organizations were
fairly narrowly restricted to the nature and scope of services the organization hoped to
provide. More recently, however, they have included population impacts (e.g. to
reduce low-weight births in the covered population by 15 percent over the next five
years); market penetration (e.g. to capture 25 percent of the HMO market within the
next five years); and financial position (e.g. to increase return on assets by 10 percent
over the next three years). The goals and objectives the organization chooses to pursue
impact the revenues and resources the organization will need, and these in turn
must be reflected in the budgets.
Whereas the organization’s strategic planning process focuses on the long-term, the
organization also develops shorter-term plans to help it achieve its short-term objectives.
While the strategic plan is fairly general, short-term plans are more specific and
identify short-term goals and objectives in more detail, primarily in regard to marketing/
production, control, and financing the organization.
Controlling Activities
Planning activities provide input to develop a budget. Once the budget has been
approved and implementation begins, controlling activities provide guidance
Budgeting 347
Perspective 10–1
Mission Statement and Objectives of a Children’s Hospital
The Shriners Hospitals’ mission is to provide the highest quality care to children with neuro-musculoskeletal conditions,
burn injuries and certain other special healthcare needs within a compassionate, family-centered and collaborative
care environment.This mission is carried out without cost to the patient or family and without regard to
race, color, creed or sex.And today Shriners operates the only health care system that is funded totally through philanthropy.
The Chicago Shriners Hospital provides expert, family-centered medical care for children needing orthopedic,
plastic and reconstructive surgery and spinal cord injury care.
Source: Shriners Hospitals for Children in Chicago (http://www.shrinerschicago.org/welcome.html)
Short-term Plans:
Specific plans which
identify an
organization’s shortterm
goals and
objectives in more
detail, primarily in
regard to
marketing/production,
control, and financing
the organization.
Controlling
Activities: Activities
which provide
guidance and feedback
to keep the
organization within its
budget once it has
been approved and is
being implemented.
and feedback to keep the organization within its budget (see Exhibit 10–1). Control
tools vary from organizational structure and information systems to financially
related controlling activities such as monthly reports to department managers
regarding their expenditures against budget, and mid-year bonuses based upon
financial performance.
Organizational Approaches to Budgeting
Exhibit 10–3 lists five key dimensions over which organizations vary in regard to
budgeting:
Participation.
Budget Model.
Budget Detail.
Budget Forecast.
Budget Modifications.
348 Financial Management of Health Care Organizations
• Financial
Etc.
Strategy
Budgets
• Markets
• Programs//Services
• Staff
• Resources
• Location
••
• Organizational Structure
• Reward/Accountability Structure
• Roles
• Responsibilities
• Performance Measures
• Information Systems
• Etc..
• Short-term Debt
• Long-term Debt
• Reimbursement
• Capitation
• Appropriations
• Contributions
• Etc..
Statistics
Budget
Operating Budget
Revenue Budget
Expense Budget
Cash
Budget
Capital
Budget
Proforma Financials
Income Statement
Balance Sheet
External Environment Internal Environment
• Economic
• Social
• Political
• Regulatory
• Physical
Technological
Epidemiological
Industry
• Patients
• Payors
• Funding Sources
• Financial Markets
• Labor Markets
• Competitors
• Suppliers
• Stakeholders
• Other
• Service Mix
• Staff
• Capital Resources
• Other Resources
• Organizational Structure
• Organizational Culture
• Performance Measures
• Stakeholders
• Other
Tactics and
Operations
Mission
Goals and
Objectives
• Markets/Services
• Quality
•
Etc.
term Debt
term Debt
Etc.
Marketing/Production System
••••••
Price
• Etc.
Control Structure
•••••••
Financing Structure
•••
Et
• • • Exhibit 10–2 Relationship of Budgeting to Strategy,Tactics, and Operation
Participation
The budgeting process can vary considerably from one organization to the next in
terms of the roles and responsibilities of various positions in the organization. Under
an authoritarian approach, the environmental assessment and planning of future activities
are largely concentrated in a few hands at the top of the organization, and the
budget is essentially dictated downward. The authoritarian approach is often
called top-down budgeting. Perspective 10–2 illustrates a case where an outside
authority dictates budget cuts. Perspective 10–3 illustrates a case where an inside,
overriding authority dictates program cuts.
The opposite of the authoritarian approach is the participatory approach, in
which the roles and responsibilities of the budgeting process are diffused throughout
the organization. The participatory approach often begins with some general guidelines
from the top, based on top management’s knowledge of the environment. Within
the restrictions of these general guidelines, department heads and service line managers
(e.g. women’s services, emergency services, outreach services) have great latitude
to develop their own budgets to submit to upper management for approval. This
approach is often called a top-down/bottom-up approach. The roles and responsibilities
of various positions in the organization in the participatory approach are
summarized in Exhibit 10–4.
The participatory approach to budgeting has a number of advantages beyond just
forcing management to plan (see Exhibit 10–5). These advantages include:
Developing a shared understanding of the goals and objectives of the
organization by those who have participated in the budgeting process.
Developing cooperation and coordination among the various departments.
Clarifying roles and responsibilities throughout the organization (thus
preventing overlap).
Budgeting 349
Authoritarian
Incremental/
Decremental
Line-item
Participation
Budget Model
Budget Detail
Budget
Modifications
Budget Forecast
Controlled
Annual
Static
Participatory
Zero-based
Performance
Latitude
Multi-year
Flexible
Dimension
Program
Approaches
Exhibit 10–3 Key Budgeting Dimensions
Authoritarian
Approach: Budgeting
and decision-making
which are done by
relatively few people
concentrated in the
highest level of the
organizational
structure. Opposite of
the participatory
approach.
Top-down
Budgeting: See
Authoritarian
Approach.
Participatory
Approach: A method
of budgeting in which
the roles and
responsibilities of
putting together a
budget are diffused
throughout the
organization, typically
originating at the
department level. There
are guidelines to
follow, and approval
must be secured by top
management. Opposite
to the authoritarian
approach.
Motivating staff (by allowing them input into their roles, responsibilities, and
accountability).
Bringing about cost awareness as a result of being involved in resource
allocation decisions.
Although the participatory approach has many advantages, it has three important disadvantages:
Participation may result in loss of control.
350 Financial Management of Health Care Organizations
Perspective 10–2
Services for Poor Put at Risk
Up to 50 jobs and a shopping cart of services could be gradually scrapped to accommodate $6.2 million in budget
cuts that Wake County (North Carolina) Human Services must make.
At the Human Services board meeting Thursday, Director Maria Spaulding and board members lamented the political
reality in which a prosperous county shunts aside its poorest.
Still, the bleak picture faced by Human Services is brighter now than it was.The agency originally was told to trim
$9.6 million of its $400 million budget. But the actual cuts still took several board members by surprise. Spaulding,
who has been mulling what to cut for weeks now, fairly bristled when board members complained about their
nature.
“Don’t talk to me about pain,” she said, “because I can tell you a lot about it.”
A seven-member committee representing various facets of the agency closeted itself away for nearly four days to
draw up a list of potential cuts. Committee members went through each service provided and categorized it according
to whether it was a mandated service and how closely it corresponded to the agency’s 12 goals. Spaulding said
she and other managers accepted 95 percent of the committee’s recommendations.
Commissioner Linda Coleman said it may be time to aggressively pursue other funding sources, including a local
sales tax option.
Those employees who find their jobs on the chopping block will be offered voluntary severance plans and retirement
options, said Bob Sorrels, director of operations. Managers will try to find other positions within Human
Services or county government for those employees who don’t want to leave.
These are some of the Wake Human Services areas to be eliminated or reduced:
Breast and cervical cancer prevention and mammography will be eliminated as a county service and possibly
shift to Rex Healthcare.
Adolescent/Women’s Clinic, which serves more that 1,200 women a month, will revert to a family planning/
pregnancy prevention clinic.
Brentwood, a residential program for three to five severely mentally ill adults, will be eliminated.
Dental Heal Promotion, which targets schoolchildren and some adults, will be discontinued.
Crosby Clinic in downtown Raleigh, which examines children with attention deficit disorder, will be closed.
Wake House and Garner Home, short- to medium-term residential care facilities for children – mainly those
in the custody of the county – will be closed.
WIC, a federal program that provides services to women, infants and children, will no longer be open after
business hours, which have been paid for by the county.
Cornerstone, which used federal dollars for health care to the homeless, will be transferred to another service
provider.
Top-down/Bottom-up
Approach: See
Participatory Approach.
Participation is time-consuming and uses resources (mainly staff time) that
could be devoted to other purposes.
Participation may result in disappointment.
Budget Models
There are two basic budget models: incremental/decremental budgeting and zerobased
budgeting (see Exhibit 10–3). The incremental/decremental approach
begins with what exists and gives a slight increase, no change, or slight decrease to
various line items, programs, or departments. In some cases, all programs may receive
an equal increase or decrease. In other instances, management may differentially give
increases or decreases.
Budgeting 351
Perspective 10–3
Beth Israel to Cut Back Services: Community Hospitals in Network to Assume Many Basic Functions
Dramatically altering the city’s medical landscape, Beth Israel Deaconess Medical Center will close a range of services
– including psychiatry, dermatology, and orthopedics – in a tough decision that will affect thousands of patients and
medical residents but that executives hope ultimately will rescue the struggling Harvard teaching hospital.
The announcement yesterday that the hospital will eliminate or scale back seven clinical departments marks a significant
departure for Beth Israel Deaconess, which instead of keeping with its tradition as a full-service hospital will
focus on a few lucrative high-level specialties.
Community hospitals in the Beth Israel Deaconess network, called CareGroup, will position themselves to take
over many of those services, a major shift in a city where patients visit expensive teaching hospitals far more often
than the national average, even for basic care.
“This is the beginning of the rationalization of health care – deciding who gets what kind of care where – in
Massachusetts,” said Ellen Trager, head of the health-care consulting practice at Brown Rudnick and a consultant for
New England Medical Center, a Beth Israel Deaconess competitor.
The turnaround plan, which CareGroup and the medical center will implement over four years, includes:
Moving certain services to other CareGroup hospitals, including general dermatology, ophthalmology, the pain
management clinic, post-acute care, and rehabilitation services.The moves will occur over four years.
Dermatology, for example, educates one-quarter of all Harvard Medical School dermatology residents, doctors said.
Transferring elective orthopedic surgery and procedures to New England Baptist Hospital. Beth Israel Deaconess
will continue to provide acute trauma services to patients with broken bones and other injuries.
Expanding core services including cardiology, cardiac surgery, organ transplantation, and cancer care.
“The Beth Israel Deaconess board has a real enthusiasm for what is believed to be a very strong plan,” he [the
CEO] said. “It will produce the kind of financial support to actually drive our mission on into the future.We have
not had that kind of strong plan for the past couple of years.” CareGroup lost $7 million to $8 million in July, about
$2 million more than the organization predicted, CareGroup executives said earlier this month.
Physicians and staff were upset yesterday about possibly losing their jobs and the elimination of long-time services.
Some felt the hospital network eventually would be taken over by its biggest competitor, Partners HealthCare System,
another Harvard network headed by Brigham & Women’s Hospital and Massachusetts General Hospital.
Source: Liz Kowalczyk, Boston Globe, September 27, 2000, p. E1.
Incremental/Decremental
Approach: A
method of budgeting
which starts with an
existing budget to plan
future budgets.
Where incremental/decremental budgeting begins by asking the question “How
much of an increase or decrease should each program receive?,” zero-based budgeting
(ZBB) continually questions both the need for each program and its level of funding.
It asks: “Why does this program or department exist in the first place?” and “What
will happen by changing (increasing or decreasing) its level of funding?”
In preparation for the zero-based budgeting process, each budgeting unit (department,
program, or service line) prepares a budget package that provides: 1) an overall justification
for the program; and 2) a series of requests to show what the program would look like
at various levels of funding. After receiving all budget packages from all budgeting units,
management chooses from among them to find the best combination of programs and levels
of programs to meet the goals of the organization within existing resource constraints.
The following scenario illustrates what a zero-based budgeting package might look like
at the general level for a small rural hospital establishing a physician practice. In this
instance, three alternative levels of service are proposed: minimum (level 1), adequate
(level 2), and comprehensive (level 3). In addition to the information used in this example,
most organizations would also require further detail of various line items. Such information
can be found in the next section, Budget Detail.
352 Financial Management of Health Care Organizations
Strategic Planning
• Budget Guidelines
• Goals and Objectives
• Environmental Analysis
Environmental Analyses
• Marketing
• Financial
• Other
Focused Environmental
Assessment
Budget Preparation
•
Programming
• Budget preparation
Budget Submission
Programming
Resource
Identification
Budget Approval
Budget Revision
Top Management
Planning/Marketing/
Treasurer/Controller
Department Heads/
Product-line Managers
Physicians Staff
Others
Board
Budget Review
Begin here
1− 3 Months
5 − 6 Months
•••
•••
End here
Exhibit 10–4 The Participatory Approach to Budgeting
Advantages Disadvantages
Shared Understanding Loss of Control
Cooperation and Competition Time-consuming
Clarified Roles and Responsibilities High Resource Use
Motivation Potential Disappointment
Cost Awareness
Exhibit 10–5 Advantages and Disadvantages of the Participatory Approach to Budgeting
Zero-based
Budgeting (ZBB): An
approach to budgeting
that continually
questions both the
need for existing
programs and their
level of funding, as
well as the need for
new programs.
The Situation
San Maro is a rural town with a population of 20,000. The 125-bed local hospital provides
comprehensive services except for obstetrics and pediatric care. Some of the
local patients who need these services use the emergency room. This often results in
a long wait and a frustrating experience for both patient and physicians. Many
patients, unfortunately, leave the area and travel 50 miles to another facility.
In order to keep the majority of business at her hospital and to decompress the
emergency room, the hospital administrator is proposing that the hospital board agree
to create an in-house local obstetric and pediatric practice. According to estimates by
the Chief Financial Officer, the hospital would gain substantial additional revenues
from this new service, and patient satisfaction would improve.
Proposal to Create an In-house Obstetric and Pediatric Practice in San Maro
Purpose: To provide adequate primary care to pregnant women and children in San
Maro.
Savings to the Hospital: Non-quantifiable decompression of emergency room. Last
year 125 obstetric and 247 pediatric cases were seen in the emergency room. It is estimated
that 75 percent of these cases were non-emergent.
Potential Revenue to the Hospital: The majority of women leave the local area to receive
prenatal care and give birth because there is no local obstetrician. It is estimated that
300 babies are birthed annually by the local population. Only 23 babies were born at
San Maro last year. A significant number of pediatric admissions also leave San Maro
for their secondary care. It is estimated that up to 150 cases would receive their care
at San Maro Hospital if there was an in-house pediatrics practice.
Three alternative levels of care are being proposed (see Exhibits 10–6a, 10–6b, 10–6c,
and 10–6d). The incremental revenues that accrue to the hospital would be the result of
increased inpatient volume. San Maro would receive no revenues from the physician
Budgeting 353
Assumptions: Level 1 Level 2 Level 3
A New Patient Days 450 700 1,320
B Incremental Hospital Revenues/day $900 $900 $900
C Incremental Inpatient Costs/day $290 $290 $290
D Incremental Practice Costs/Year $261,000 $329,000 $782,500
Calculations: Formula
E New Patient Days [A] 450 700 1,320
F Incremental Hospital Revenues [A × B] $405,000 $630,000 $1,188,000
G Incremental Inpatient Costs [A × C] $130,500 $203,000 $382,800
H Incremental Practice Costs [D] $261,000 $329,000 $782,500
I Net Income [F − G − H] $13,500 $98,000 $22,700
Note: Details found in Exhibits 10–6b, c, and d, respectively.
Exhibit 10–6a Incremental Revenue and Cost Summary for Three Levels of Service
practice itself. Exhibit 10–6a presents the incremental projections resulting from the
three levels of care considered.
Staffing Concerns: Due to recent decreases in length of stay and shifts of patients to the
outpatient area, the only additional cost is the variable daily care costs that total approximately
$290 per day.
Recommendation: Level 3 practice with semi-annual review to assess need for additional
resources. This will optimally decompress the emergency room and keep
patients from leaving the area to receive these services elsewhere.
Concluding Remarks About Zero-based Budgeting
Zero-based budgeting was introduced and broadly used in the mid-1960s, but it soon
dropped out of favor – primarily because it was such a laborious process. Many organizations
felt that too much time was being spent preparing and reviewing budget packages,
when in fact major changes rarely occurred. There are some signs, though, that
zero-based budgeting is reemerging as health care organizations face an increasingly
354 Financial Management of Health Care Organizations
Package: Salary, Benefits, Capital, and Space Needs
Organization: Physician Practice
Purpose: To provide minimum primary obstetric care to the local population.
Methodology: Hospital must recruit 1 physician, 1 nurse, and 1 receptionist and arrange for backup coverage
for weekends, vacation, sick leave, and holidays on a per diem basis from the local hospital. It must also lease,
equip, and furnish office space for this practice.
Consequences of not approving this package: Were this practice not created, the local population either would
have to visit the emergency room at the local hospital for its non-acute and routine care, or else travel outside
the area (approximately 50 miles) to obtain primary obstetrical care. When patients use the emergency room
for this coverage, oftentimes very long waits clog the flow in the ER area creating inefficiency that is both
costly and frustrating. If patients leave the area, they are also more prone to obtain secondary and tertiary care
elsewhere, which decreases market share for the local hospital. Given this minimum obstetrical coverage, patients
could receive primary obstetrical care at a physician’s office locally during the week, only needing to visit the emergency
room for acute needs.
Assumptions:
A New Patient Days 450
B Incremental Hospital Revenues/day $900
C Incremental Inpatient Costs/day $290
D Incremental practice costs/year $261,000
Calculations: Formula
E New Patient Days [A] 450
F Incremental Hospital Revenues [A × B] $405,000
G Incremental Inpatient Costs [A × C] $130,500
H Incremental practice costs [D] $261,000
I Net Income [F − G − H] $13,500
Exhibit 10–6b Zero-Based Budget Package: Level 1
competitive environment, seek to implement new revenue enhancement and cost avoidance
activities, and try to capture new market niches.
Budget Detail
Based on the amount of detail they contain, budgets can be classified into three categories:
line-item, program, and performance. A line-item budget has the least
detail, merely listing revenues and expenses by category, such as labor, travel, and
supplies. A line-item budget for the comprehensive level of care for the San Maro
Medical Clinic is shown in Exhibit 10–7.
A program budget not only contains the line items, but also lists them by program.
Exhibit 10–8 shows how the line-item budget for the comprehensive level of service for
the San Maro physician practice would look as a program budget by providing detail about
its four programs: general practice, prenatal care, well-baby care, and walk-in services.
Budgeting 355
Line-item Budget:
The least detailed
budget, showing only
revenues and expenses
by category, such as
labor or supplies.
Package: Salary, Benefits, Capital, and Space Needs
Organization: Physician Practice
Purpose: To provide adequate primary obstetric practice and half-time pediatric coverage for the local
population.
Methodology: Hospital must recruit 1.5 physicians, 1 nurse, and 1 receptionist and arrange for backup
coverage for weekends, vacation, sick leave, and holidays on a per diem basis from the local hospital. It must
also lease, equip, and furnish office space for this practice.
Consequences of not approving this package: Were this practice not created, the local population either would
have to visit the emergency room at the local hospital for its non-acute and routine care, or else travel outside
the area (approximately 50 miles) to obtain primary obstetrical care. When patients use the emergency room
for this coverage, oftentimes very long waits clog the flow in the ER area creating inefficiency that is both
costly and frustrating. If patients leave the area, they are also more prone to obtain secondary and tertiary care
elsewhere, which decreases market share for the local hospital. Given this adequate coverage, patients could
receive primary obstetric and pediatric care at a physician’s office locally during the week, only needing to visit the
emergency room for acute needs.
Assumptions:
A New Patient Days 700
B Incremental Hospital Revenues/day $900
C Incremental Inpatient Costs/day $290
D Incremental practice costs/year $329,000
Calculations: Formula
E New Patient Days [A] 700
F Incremental Hospital Revenues [A × B] $630,000
G Incremental Inpatient Costs [A × C] $203,000
H Incremental practice costs [D] $329,000
I Net Income [F − G − H] $98,000
Exhibit 10–6c Zero-based Budget Package: Level 2
Program Budget: An
extension of the lineitem
budget which
shows revenues and
expenses by program
or service lines.
Finally, a performance budget lists revenue and expenses by line item for each
program or service covered by the budget like a program budget. In addition, it specifies
performance objectives. Exhibit 10–9 shows how the line-item and program
budgets for San Maro would look as performance budgets.
Exhibit 10–10 compares the level of detail shown in line-item, program, and performance
budgets.
Though virtually all organizations have annual budgets, increasingly each is part of a
multi-year budget. Rather than forecast revenues and expenses for just one year,
organizations are finding it necessary to use multi-year budgets to forecast three to five
years in advance. Since conditions change, many organizations use rolling budgets,
which are regularly updated and extended multi-year forecasts. For example, the budget
submitted for 20X1 would cover the years 20X1 through 20X5. When the 20X2
budget is prepared, it will cover the years 20X2 through 20X6. In this way, the budget
is always forecasting five years ahead. Some organizations “roll forward” their budgets
more often than every year, updating their multi-year forecasts on a semi-annual or even
quarterly basis.
356 Financial Management of Health Care Organizations
Performance Budget:
An extension of the
program budget which
also lays out
performance
objectives.
Package: Salary, Benefits, Capital, and Space Needs
Organization: Physician Practice
Purpose: To provide comprehensive primary obstetric and pediatric physician coverage for the local population.
Methodology: Hospital must recruit 4 physicians, 1 nurse practitioner, 1.5 nurses, and 1 receptionist and
arrange for backup coverage for weekends, vacation, sick leave, and holidays on a per diem basis from the local
hospital. It must also lease, equip, and furnish office space for this practice.
Consequences of not approving this package: Were this practice not created, the local population either would
have to visit the emergency room at the local hospital for its non-acute and routine care, or else travel outside
the area (approximately 50 miles) to obtain primary obstetrical care. When patients use the emergency room
for this coverage, oftentimes very long waits clog the flow in the ER area creating inefficiency that is both
costly and frustrating. If patients leave the area, they are also more prone to obtain secondary and tertiary care
elsewhere, which decreases market share for the local hospital. Given this comprehensive coverage, patients could
receive all obstetric and pediatric care at a local physician’s office in expanded hours, including weekends.
Assumptions:
A New Patient Days 1,320
B Incremental Hospital Revenues/day $900
C Incremental Inpatient Costs/day $290
D Incremental practice costs/year $782,500
Calculations: Formula
E New Patient Days [A] 1,320
F Incremental Hospital Revenues [A × B] $1,188,000
G Incremental Inpatient Costs [A × C] $382,800
H Incremental practice costs [D] $782,500
I Net Income [F − G − H] $22,700
Exhibit 10–6d Zero-based Budget Package: Level 3
Multi-year Budget: A
budget which is
forecast multiple years
out, rather than just for
the upcoming year.
Single year and multi-year budgets vary by the time horizon they forecast, whereas
static and flexible budgets vary on the basis of volume projections. Static budgets
forecast for a single level of activity and flexible budgets forecast revenues and
expenses for various levels of activities. For example, whereas a static budget in an
ambulatory care setting might forecast revenues and expenses for 15,000 visits, a flexible
budget would forecast revenues and expenses for a range of visits between 14,000
and 16,000 visits. The use of flexible budgets is an important tool for controlling
expenses, and is discussed in detail in Chapter 11.
Budget Modifications
In most health care organizations, criteria are established beyond which managers must
request permission to make changes to their budgets. The criteria are usually set as dollar
amounts and/or a need to move funds from one category to another. For example, an
administrator may be able to move amounts under $1,000 within a category (such
as labor) without needing higher approval, but not from one category to another (such as
from labor to equipment). Particularly dramatic examples of the need for budget revisions
often occur during nursing shortages, when hospitals have to continually ask their
boards to approve increases in nursing salaries or contract labor in the middle of the year.
Budgeting 357
Rolling Budget: A
multiyear budget
which is updated more
frequently than
annually, such as semiannually
or quarterly.
Static Budget: A
budget which uses a
single or fixed level of
activity.
Incremental Hospital Revenues Total
New Patient Days 1,320
Hospital Revenues/Day $900 $1,188,000
Expenses
Inpatient Costs/Day $290 382,800
Costs associated with physician practice:
Salaries and Benefits # Units Cost/Unit Cost
General Practitioners 2.0 $100,000 $200,000
Pediatricians 2.0 $100,000 200,000
Nurse Practitioner 1.0 $50,000 50,000
Nurses 1.5 $40,000 60,000
Receptionist 1.0 $20,000 20,000
Subtotal 530,000
Fringe (as a % of Subtotal) 25% 132,500
Malpractice Insurance 77,000
Subtotal 209,500
Supplies and Equipment
Medical 13,500
Office 6,500
Subtotal 20,000
Lease (Sq. Ft/Year) 2,300 $10 23,000
Total Costs for Physician Practice 782,500
Net Income $22,700
Exhibit 10–7 Line-Item Budget for a Proposed Physician Practice – Comprehensive Level of Care (Level 3)
Flexible Budget: A
budget which
accommodates a range
or multiple levels of
activities.
Incremental Hospital Revenues General Well-Baby Pediatric
Givens Givens OB Practice Care Walk-In Subtotal Total
New Patient Days 1,320 $1,188,000
Hospital Revenues/Day $900
Expenses
Inpatient Costs/Day $290 382,800
Costs associated with physician practice:
Salaries and Benefits # Units Cost/Unit Cost
General Practitioners 2.0 $100,000 $200,000 $200,000
Pediatricians 2.0 $100,000 $100,000 $100,000 200,000
Nurse Practitioner 1.0 $50,000 25,000 25,000 50,000
Nurses 1.5 $40,000 20,000 20,000 20,000 60,000
Receptionist 1.0 $20,000 10,000 5,000 5,000 20,000
Subtotal 255,000 150,000 125,000 530,000
Fringe (as a % of Subtotal) 25% 63,750 37,500 31,250 132,500
Malpractice Insurance 62,000 8,000 7,000 77,000
Subtotal 125,750 45,500 38,250 209,500
Supplies and Equipment
Medical 9,500 2,000 2,000 13,500
Office 5,000 500 1,000 6,500
Subtotal 14,500 2,500 3,000 20,000
Lease (Sq. Ft/Year) 2,300 $10 12,000 11,000 0
23,000
Total Costs for Physician Practice 407,250 209,000 166,250 782,500
Net Income $22,700
Exhibit 10–8 Program Budget for a Proposed Physician Practice – Comprehensive Level of Care (Level 3)
Programs
Incremental Hospital Revenues General Well-Baby Pediatric
Givens Givens OB Practice Care Walk-in Subtotal Total
New Patient Days 1,320 $1,188,000
Hospital Revenues/Day $900
Expenses
Inpatient Costs/Day $290 382,800
Costs associated with physician practice:
Salaries and Benefits #Units Cost/Unit
General Practitioners 2.0 $100,000 $200,000 $200,000
Pediatricians 2.0 $100,000 $100,000 $100,000 200,000
Nurse Practitioner 1.0 $50,000 25,000 25,000 50,000
Nurses 1.5 $40,000 20,000 20,000 20,000 60,000
Receptionist 1.0 $20,000 10,000 5,000 5,000 20,000
Subtotal 255,000 150,000 125,000 530,000
Fringe (as a % of Subtotal) 25% 63,750 37,500 31,250 132,500
Malpractice Insurance 62,000 8,000 7,000 77,000
Subtotal 125,750 45,500 38,250 209,500
Supplies and Equipment
Medical 9,500 2,000 2,000 13,500
Office 5,000 500 1,000 6,500
Subtotal 14,500 2,500 3,000 20,000
Lease (Sq. Ft/Year) 2,300 $10 12,000 11,000 0
23,000
Total Costs for Physician Practice $407,250 $209,000 $166,250 782,500
Net Income $22,700
Performance Objectives
1) To assure that by the first year of operation, the practice is caring for 50% of the Obstetric and Pediatric patients in the community.
2) To assure that by the second year of operation, the practice is caring for 60% of the Obstetric and Pediatric patients in the community.
3) To assure that by the third year of operation, the practice is caring for 75% of the Obstetric and Pediatric patients in the community.
Performance Measures 20X1
Number of Obstetric Visits 2,700
Number of Well-Baby Visits 1,800
Number of Pediatric Visits 80
Total 4,580
Number of Inpatient Days 1,320
Exhibit 10–9 Performance Budget for a Proposed Physician Practice – Comprehensive Level of Care (Level 3)
Types of Budgets
Although the term “the budget” is often used as if there were only one budget, most
health care organizations develop four interrelated budgets: a statistics budget, an
operating budget, a cash budget, and a capital budget. An overview of the relationship
among these budgets is presented in Exhibit 10–11.
The Statistics Budget
The first budget to develop is the statistics budget. The statistics budget identifies
the amount of services that will be provided, usually listed by payor type:
360 Financial Management of Health Care Organizations
Type of Budget Budget by Line Item Budget by Program Performance Criteria
Line-item X
Program X X
Performance X X X
Exhibit 10–10 Major Characteristics of Three Types of Budgets by Level of Detail
Labor
Expense
Budget
A & G*
Expense
Budget
Non-operating
Expense
Budget
Revenue Budget Expense Budget
Statistics Budget
*Administrative and General
Operating Budget
Cash Budget Capital Budget
Revenue
Budget
Expense
Budget
Patient
Service
Revenues
Non-patient
Service
Revenues
Supplies
Expense
Budget
Capital
Budget
Exhibit 10–11 Overview of the Four Major Budgets
Charge-based payors pay what is charged or some percentage of charges
(such as 80 percent of charges).
Cost-based payors pay based on an estimate of what it costs an organization
to deliver the service for which they are paying. The cost is usually figured
on a basis determined by the payor or a percentage of costs (such as 80
percent of average costs).
Flat fee payors pay a predetermined fee per unit of service (such as a normal
office visit, or a particular DRG), regardless of costs or charges.
Capitated payors pay a fixed amount per enrollee for a fixed period of time,
regardless of utilization, costs, or charges. The most common form of
capitated payment is per member per month (PMPM).
Exhibit 10–12 presents the statistics budget for Walk-In Clinic. Note that these
volume estimates are not stated in terms of the number of visits that will be made, but
rather as weighted visits. Weighted visits take into account the amount of resources
needed for various types of visits. This is necessary because not all visits consume
equal resources. A patient who comes in complaining of a sore throat will likely consume
far fewer resources than would a patient with a broken arm that must be X-rayed
and put into a cast.
The Operating Budget
The operating budget (see Exhibit 10–13) is actually a combination of two budgets
developed using the accrual basis of accounting: the revenue budget and the expense
budget. Some organizations, especially those with relatively small non-operating
items such as parking lot and gift shop revenues and expenses, include their nonoperating
budget with their operating budget.
The revenue budget is a forecast of the operating revenues that will be earned
during the budget period (see Exhibit 10–13, rows A through E). It has two components:
net patient revenues (row C) and non-patient revenues (row D). The expense
budget lists all operating expenses that are expected to be incurred during the budget
period (see Exhibit 10–13, rows F through G). Perspectives 10–4 and 10–5 illustrate
some of the major concerns healthcare organizations face with one part of the
expense budget, labor.
Whether an item is classified as operating or non-operating is subject to interpretation
by each organization. Though this matter has received considerable attention over the
years by both the accounting and health care financial management professions, there
remains a lack of standardization among health care organizations in classifying specific
line items.
Budgeting 361
Statistics Budget: The
first budget to be
prepared. One of the
four major types of
budgets. It identifies
the amount of services
that will be provided,
typically categorized by
payor type.
Operating Budget:
One of the four major
types of budgets, it is
comprised of the
revenue budget and
the expense budget.
The bottom line for this
budget is net income.
Revenue Budget: A
subset of the operating
budget, which is a
forecast of the
operating revenues
that will be earned
during the current
budget period.
Expense Budget: A
subset of the operating
budget, which is a
forecast of the
operating expenses
that will be incurred
during the current
budget period.
Throughout this chapter, the numbers in the exhibits may be slightly different from those computed on a calculator
and between exhibits due to the internal rounding rules used in the computer program upon which this
example is based.
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC TOTAL
Charge-based 992 992 992 992 992 992 945 945 945 945 945 945 11,622
Cost-based 937 1,101 1,020 669 519 697 653 763 937 997 833 833 9,959
Flat-fee 223 112 112 112 112 112 112 268 246 112 112 112 1,745
Capitation 1,116 482 1,132 326 820 1,154 2,444 3,170 3,234 3,110 3,186 2,234 22,408
Total 3,268 2,687 3,256 2,099 2,443 2,955 4,154 5,146 5,362 5,164 5,076 4,124 45,734
Note: Numbers are weighted visits (RVUs). The large fluctuation in capitated patients reflects a dynamic pattern of the clinic’s disengaging from managed care contracts and contracting
new ones.
Exhibit 10–12 Statistics Budget for Walk-In Clinic
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC TOTAL
A Patient Revenues $243,466 $200,182 $242,572 $156,376 $182,004 $220,148 $309,473 $383,377 $399,469 $384,718 $378,162 $307,238 $3,407,183
B Deductions & (57,503) (6,284) (52,738) 14,319 (19,206) (46,931) (125,335) (197,990) (203,062) (185,253) (180,281) (113,240) (1,173,503)
Allowances
C Net Patient Revenues 185,963 193,898 189,834 170,695 162,798 173,216 184,139 185,387 196,407 199,466 197,881 193,998 2,233,680
D Non-Patient Revenues 2,914 3,271 3,945 3,890 4,418 4,600 4,703 5,069 5,128 5,122 5,585 5,886 54,531
E Total Revenues 188,877 197,168 193,779 174,585 167,216 177,816 188,842 190,456 201,535 204,588 203,466 199,884 2,288,211
F Operating Expenses
Labor 69,774 67,786 71,887 67,651 69,261 72,902 78,042 82,082 83,066 82,163 82,930 79,200 906,746
Supplies 33,430 27,620 33,310 21,740 25,180 30,300 42,290 52,210 54,370 52,390 51,510 41,990 466,340
A & G Expenses1
Interest 891 889 887 959 956 953 963 959 956 952 948 945 11,258
Depreciation 1,498 1,498 1,498 1,498 1,656 1,656 1,656 1,669 1,669 1,669 1,669 1,669 19,305
Utilities 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 144,000
Rent 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 60,000
Cleaning 500 500 500 500 500 500 500 500 500 500 500 500 6,000
Telephone 600 600 600 600 600 600 600 600 600 600 600 600 7,200
Travel 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 30,000
Insurance 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 144,000
Equipment Maintenance 150 150 150 150 150 150 150 150 150 150 150 150 1,800
Bad Debt 4,083 4,358 4,223 3,634 3,383 3,6813,488 3,673 3,964 4,065 3,790 3,790 46,132
Total Operating Expenses 142,426 134,902 144,554 128,233 133,186 142,242 159,189 173,343 176,775 173,989 173,598 160,344 1,842,782
G Non-Patient Care 97 97 97 97 97 97 97 97 97 97 97 97 1,164
Expenses
H Total Expenses 142,523 134,999 144,651 128,330 133,283 142,339 159,286 173,440 176,872 174,086 173,695 160,441 1,843,946
Excess of Revenues
I Over Expenses $
46,354 $
62,170 $
49,128 $
46,255 $
33,933 $
35,477 $
29,556 $17,015 $
24,663 $
30,501 $
29,771 $
39,443 $
444,265
1 Administrative and General
Exhibit 10–13 Operating Budget for Walk-In Clinic
364 Financial Management of Health Care Organizations
Perspective 10–4
Hospital Makes Work Hour Cuts Voluntary
A mandatory 10 percent reduction in hours and pay for employees at Lexington Memorial Hospital has been lifted,
effective with the payroll period that begins Sunday, according to hospital officials.
The cost reduction plan now is to be voluntary.
Budget deficits earlier in the fiscal year had led hospital administrators to require the mandatory cuts, but after
learning of some “undue hardships” hospital employees were facing, the hospital’s administrative council made the
change to voluntary, said Kathy Sushereba, the hospital’s community relations director.The administrative council is
comprised of LMH President John Cashion and four vice presidents.
“All department managers are requested to continue scheduling as much time off as possible in their departments,
along with sending employees home early, etc., as patient census or office workloads fluctuate,” the announcement
from the hospital administrative council states.“Department managers are also encouraged to take days off as
scheduling permits.”
The letter, which is addressed to hospital employees, medical staff, board of directors members and the hospital foundation’s
board of directors, also cautioned that overtime should be used only in emergency situations.The administrative
council also plans to possibly reconsider the hiring freeze on a case-by-case basis as positions are vacated.
“We need to continue our reduction of the salaries and other expenses through the end of this fiscal year (Oct.
31),” the letter states.
The Dispatch received several calls from upset employees about the mandatory work hour cuts and hiring freeze
in June.
The decision to cut employees’ work hours came after a May review of the hospital financial report, which was
released June 14.The May reports showed the hospital had experienced another month of over-budget salary expenditures.
Salary expense overages began in the fall of 1999, as employees worked overtime preparing for the hospital’s Joint
Commission Accreditation.Then, high numbers of patients in January, February and March resulted in the need for more
overtime hours. In April, the hospital moved into its new business wing, resulting in additional payroll expenses.
The salary overages in May could not be justified, however, Cashion said, so the mandatory cutback was put in
place in until the end of LMH’s fiscal year on Sept. 30. He said last month the hospital wanted to avoid layoffs and
continuing to go further over the $17 million budget allotted for salaries for the fiscal year.
All five of the hospital’s nurse anesthetists resigned earlier this month. Callers to The Dispatch suggested that part
of the reason for the mass departure was the hospital’s mandatory 10 percent cut in work hours.
“As far as that having an impact on this change, I’m sure it was a consideration,” Sushereba said.“Was it the primary
reason for the change? I don’t think so. It’s a cumulative situation.”
Source: Jill Doss-Raines, The Dispatch, July 26, 2000.
Perspective 10–5
Shortage of Nurses Looming?
When a hospital doesn’t have enough nurses, it can become a matter of life or death.
Such dramatic scenarios haven’t occurred here yet, but medical professionals are concerned about the future.
There is an acute shortage of people graduating from nursing programs, which has resulted in vacancies in the state
and the nation – and, to a lesser degree, in Moore County.
(Continues)
Budgeting 365
The Cash Budget
While the operating budget describes the expected revenues and the related resource
flows, the cash budget (see Exhibit 10–14) represents the organization’s cash inflows
and outflows. The bottom line in the operating budget is the net income for the
period; the bottom line in the cash budget is the amount of cash available at the end
of the period. In addition to showing cash inflows and outflows, the cash budget also
details when it is necessary to borrow to cover cash shortages and when excess funds
are available to invest.
The Capital Budget
The capital budget (see Exhibit 10–15) summarizes the anticipated purchases
for the year. Capital budgets in outpatient facilities may be fairly small, but those
for large systems with inpatient facilities may contain millions of dollars’ worth of
items.
Cash Budget: One of
the four major types of
budgets, it displays all
of the organization’s
projected cash inflows
and outflows. The
bottom line for this
budget is the amount
of cash available at the
end of the period.
The operating budget is developed using the accrual basis of accounting. Cash inflows and outflows of each
line item must be estimated to convert the operating budget to the cash budget.
Capital Budget: One
of the four major types
of budgets, it
summarizes the
anticipated purchases
for the year. Typically, to
be included, all items in
this budget must have
a minimum purchase
price, such as $500.
Perspective 10–5 (Contd)
FirstHealth Moore Regional Hospital has been largely immune to the growing nationwide shortage so far.About
20, or 4 percent, of its 500 budgeted nursing positions are unfilled, according to Linda Wallace, director of nursing
and other medical services at the hospital.
We see fewer people going into nursing, so there are fewer graduates for us to hire,Wallace said.The average age
of the RN is older now, about 44, as they age out of the profession.
Patient surveys indicate they feel that the hospital’s nurses are doing a good job providing care,Wallace said.
Wallace said nursing isn’t attracting so many people now, partly because of other career opportunities. Nursing
can take a toll on family life. It means working at nights, on weekends and on holidays. It is also taxing mentally and
emotionally.
People are also a lot sicker now, when they are hospitalized, than they used to be,Wallace said.That creates additional
stress on a profession that has become more and more of a highly specialized, high-tech field – one in which
the nurturing side of nursing isn’t as prominent anymore, some say.
FirstHealth does everything it can to keep nurses from being overloaded, which is the chief cause of burnout.
Compounding the national shortage, some say the profession has suffered because of managed care, which has shifted
the decision-making on patient care from doctors and nurses to administrators. But that may be changing, some say.
Pay is also an issue. Earlier this year, a study showed that of most hospital personnel in the state and nation, nurses
got smaller raises than the others did, according to the North Carolina Center for Nursing in Raleigh. All predictions
are that by the year 2010 we’ll have the worst nursing shortage we’ve ever had in the United States.
Source: Sara Lindau, The Pilot LLC,August 21, 2000. Copyright © 2000.
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC SUMMARY
A Beginning Balance $35,029 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $35,029
B Net Revenues 98,316 161,512 185,360 183,930 172,746 166,373 179,677 176,756 183,658 190,675 200,035 195,225 2,094,263
C Net Expenditures (122,445) (99,273) (127,794) (153,853) (123,201) (116,774) (161,928) (137,762) (148,821) (192,287) (159,936) (152,896) (1,696,970)
Cash Available
D Before Borrowing 10,900 73,239 68,567 41,076 60,545 60,598 28,750 49,994 45,837 9,388 51,099 53,329 432,322
E Cash Requirement 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 11,000 132,000
F Cash Shortage (100) 0
0
0
0
0
0
0
0
(1,612) 0
0
(1,712)
G Cash Excess 0
62,239 57,567 30,076 49,545 49,598 17,750 38,994 34,837 0
40,099 42,329 423,034
H From S-T Investment 100 0
0
0
0
0
0
0
1,612 0
0
0
1,712
I Remaining Deficit 0 0 0 0 0 000 0 0 0 0 0
J From L-T
Investment 0 0 0 0 0 0 0 0 0 0
K Remaining Deficit 0
0
0
0
0
000 0
0
0
0
0
LFrom Additional Debt 0
0
0
0
0
0
0
0
0
0
M Cash From All Sources 11,000 73,239 68,567 41,076 60,545 60,598 28,750 49,994 45,837 11,000 51,099 53,329 555,034
Less: Transfer of
Excess to Short-term
N Investments 0
(62,239) (57,567) (30,076) (49,545) (49,598) (17,750) (38,994) (34,837) 0
(40,099) (42,329) (423,034)
O Ending Balance $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000
Exhibit 10–14 Cash Budget for Walk-in Clinic
Exhibit 10–15 Capital Budget for Walk-in Clinic
Anticipated Purchase Life Residual Depreciable Monthly Date of Percent of Percent
Purchases Price (Years) Value Base Depreciation Purchase Depreciation Debt Financed
Financing from Cash
Laboratory Equipment $10,000 5
$500 $9,500 $158 1-Apr N/A 100% 0%
Office Equipment $2,000 8
$750 $1,250 $13 1-Jul N/A 90% 10%
Total $12,000
Pro Forma Financial Statements and Ratios
Based on the information contained in these budgets, together with a small amount of
additional information, an organization can develop pro forma financial statements.
Pro forma financial statements are prepared to show what the organization’s regular
financial statements will look like if all budgets are met exactly as planned. The regular
financial statements are prepared after the accounting period ends and present the
actual results of the organization’s activities during the period. As an example of the
relationship between the budgets and financial statements, Walk-In Clinic’s operating
budget (see Exhibit 10–13) could serve as its statement of operations, with only a few
modifications in format. Developing the balance sheet and statement of cash flows is
not quite so straightforward, but it can be done with only a small amount of additional
information.
Once the pro forma financial statements have been developed, they can be subjected
to ratio analysis just as with regular financial statements. This process is reversed in
strategic financial planning, where the organization first identifies its goals in terms of
the various categories of ratios (liquidity, profitability, capitalization, and activity) and
then develops its budgets, over time, to meet the targets it has set for itself.
An Extended Example of How to Develop a Budget
This section shows how to develop the numbers in a budget, using Walk-In Clinic as
an example. The term “a budget” really is shorthand for four interrelated budgets: the
statistics, operating, cash, and capital budgets.
The Statistics Budget
The statistics budget is created in two steps: 1) develop volume projections; and 2)
convert volume projections into weighted visits. Incidentally, though an ambulatory
setting is used for the example, the same principles are applied in inpatient settings.
Developing Volume Projections
The first step is to scan the environment and develop a projection of the number of
visits classified by payor type. A common approach is to begin with the previous year’s
actual results and make adjustments for any anticipated changes. For charge-based,
cost-based, and flat fee patients, projecting next year’s visits is just a matter of estimating
a percentage change from the previous year. However, this procedure must be
revised slightly in the case of capitated patients. First, the number of enrollees for the
next year is estimated, and then the percentage of these enrollees who will actually
make a visit is forecasted (see Exhibit 10–16).
Budgeting 367
Exhibit 10–16 Calculation of Number of Visits by Payor Type
Payor Type JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC TOTAL
Charge-based
Projected This Year 350 350 350 350 350 350 350 350 350 350 350 350 4,200
Projected Growth 2.00% 2.00% 2.00% 2.00% 2.00% 2.00% -3.00% -3.00% -3.00% -3.00% -3.00% -3.00% -0.43%
Projected Next Year 357 357 357 357 357 357 340 340 340 340 340 340 4182
Cost-based
Projected This Year 386 454 421276 214 287 278 324 398 423 354 354 4,169
Projected Growth 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% -2.00% -2.00% -2.00% -2.00% -2.00% -2.00% -0.50%
Projected Next Year 390 459 425 279 216 290 272 318 390 415 347 347 4148
Flat-fee
Projected This Year 100 50 50 50 50 50 50 120 110 50 50 50 780
Projected Growth 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 12.00% 11.92%
Projected Next Year 112 56 56 56 56 56 56 134 123 56 56 56 873
Capitated
Last Month’s 6,010 6,130 6,171 6,213 6,256 6,300 6,343 7,830 7,172 7,320 7,476 8,165 6,010
Enrollment
Projected Growth 2.000% 0.663% 0.676% 0.692% 0.708% 0.686% 23.440% -8.401% 2.061% 2.134% 9.221% -4.329% 29.983%
20X1 enrollment 6130 6171 6213 6256 6300 6343 7830 7172 7320 7476 8165 7,812 7,812
Visit Rate 7.0% 3.0% 7.0% 2.0% 5.0% 7.0% 12.0% 17.0% 17.0% 16.0% 15.0% 11.0% 10.3%
Projected Next Year 429 185 435 125 315 444 940 1,219 1,244 1,196 1,225 859 8,616
Total Visits 1,288 1,057 1,273 817 944 1,147 1,608 2,011 2,097 2,007 1,968 1,602 17,819
Historical information the organization has developed can provide the basis for
many estimates used in the budgeting process. However, when new services are
offered or when new patients are seen, estimation becomes a more difficult process. In
such cases, the organization may try to draw on experiences of similar organizations
with which it has a good relationship (perhaps elsewhere in its network), or it may
turn to statistics that have been compiled by national professional associations, such
as the Medical Group Management Association or the American Hospital
Association.
Incidentally, although it is probably more common for health care organizations to
develop their promotions by payor class (i.e. fee-for-service, cost-based, flat fee, and capitation),
it is becoming increasingly necessary to project utilization by individual payor.
For example, Walk-in Clinic might project its capitated visits for each managed care
organization (Kaiser, Health Source, etc.).
Converting Visit Projections to Weighted Visits
Converting visit projections into weighted visits involves three steps: determining categories
of visits and their relative resource consumption; estimating the percentage
distribution by level by payor; and converting visits to weighted visits based upon the
information developed in the first two steps.
Determining Categories of Visits and Their Relative Resource Consumption
Once a projection of the number of visits has been made as illustrated in Exhibit
10–16, the next step is to convert these visits into weighted visits, commonly called
relative value units (RVUs). Although theoretically any number of categories can
be used, Walk-In Clinic uses three:
Brief visits taking an average of 15 minutes each.
Routine visits taking an average of 30 minutes and, thus, using twice the
resources (mainly clinician time and supplies) as brief visits.
Complex visits taking, on average, one hour and, thus, using an average of
four times the amount of resources as brief visits.
In relative value unit terms, a routine visit consumes twice the resources of a brief
visit, and a complex visit consumes four times the resources of a brief visit. Therefore,
using a brief visit, which counts as one relative value unit, as the base, whenever Walk-
In Clinic has a routine visit it counts as two relative value units, and each complex visit
counts as four relative value units.
Estimating the Percentage Distribution by Level by Payor
Once the categories of visits and their relative levels of intensity have been developed,
the next step is to determine the percentage distribution of visits by level by payor.
For instance, Walk-In Clinic estimates that there will be considerable diversity
by payor in the percentage of patients making brief, routine, and complex visits
Budgeting 369
Relative Value Units
(RVUs): A standardized
weighting applied to
services which reflects
the amount of resource
consumption to
provide that service. A
service assigned two
RVUs consumes twice
the resources as does a
service assigned one
RVU.
(see Exhibit 10–17). Capitated patients are of particular interest in this step, for they
may have different utilization patterns than do patients in other payor categories. For
example, in addition to common life-cycle and gender-related visit patterns, first-time
enrollees in an HMO tend to have higher utilization patterns.
Converting Visits to Weighted Visits
Converting visits to weighted visits is relatively straightforward and involves applying
the information about intensity levels and visit distribution to the visit information
developed in Step 1. Exhibit 10–18 shows how Walk-In Clinic converts its projected
429 capitated visits in January (see Exhibit 10–16) into the 1,116 RVU-weighted visits
shown in the statistics budget for January (see Exhibit 10–12).
Walk-In Clinic began by estimating 429 capitated visits. After categorizing these
visits by intensity of resources to be used per visit, it determined that these visits
require the same resources as 1,115 brief visits. All the numbers in the statistics budget
(see Exhibit 10–12) were derived similarly. Note that the difference between the
number derived here (1,115) and that appearing in Exhibit 10–12 (1,116) is due to
rounding.
Rounding differences aside, the importance of the accuracy of the numbers used in
the statistics budget cannot be overemphasized. The utilization projections developed
in the statistics budget serve as the foundation to project revenues, expenses, and cash
flows.
370 Financial Management of Health Care Organizations
Exhibit 10–17 Estimated Percent of Visits by Intensity Level and by Payor
Charge-based Cost-based Flat-fee Capitation
Brief (Level I) 6% 12% 10% 10%
Routine (Level II) 52% 62% 85% 55%
Complex (Level III) 42% 26% 5% 35%
Total 100% 100% 100% 100%
Exhibit 10–18 The Conversion of Visits into Weighted Visits
Source I II III Total
A Total Number of Capitated Visits Forecast in January Exhibit 10–16 429
B Percent of Visits by Level Exhibit 10–17 10% 55% 35%
C Number of Visits by Level [A × B] 43 236 150
D RVU Weight [1] 1 2 4
E RVU-weighted Visits [C × D] 43 472 601 1,1152
1 Level I = Basic Visit. Levels II and III require 2 times and 4 times the resources as basic visits, respectively. These numbers would
come from an internal study.
2 Difference between the number derived here and appearing in Exhibit 10–12 for January is due to rounding in the computer model
from which this example was derived.
The Operating Budget
As noted earlier, the operating budget (see Exhibit 10–13) comprises two budgets
developed using the accrual basis of accounting: the revenue budget and the expense
budget. Development of each of these budgets for Walk-In Clinic follows.
The Revenue Budget
The revenue budget has two primary parts: net patient revenues and non-patient revenues.
Net Patient Revenues
As discussed in Chapter 2, there is a difference between gross charges and net charges.
Gross charges are the amount the organization would bill if everyone paid full
charges. Net charges are the amount the organization bills after taking into account
all discounts and allowances (except bad debt). Discounts and allowances include such
items as contractual agreements between the health care provider and the payor, charity
care, and sliding fee schedules.
Assume that Walk-In Clinic has the information about the different payors as shown
in Exhibit 10–19. For Walk-In Clinic to determine gross patient charges, the number of
RVUs for each payor is multiplied by the full charge. For example, as shown in the top
half of Exhibit 10–20, January’s total of $243,466 was calculated by multiplying 3,268
RVUs by $74.50 per RVU (rows A, B, and C, Total column).
The determination of net patient revenues is a little more complex. Walk-In Clinic
determines net patient revenues as follows:
As noted above, 15 percent of charge-based payors are considered charity
patients. Therefore, only 85 percent of the charge-based RVUs are multiplied
by the full charge. Net patient revenues for Walk-In Clinic in January
($62,818) are calculated as follows: [(992 RVUs × 0.85) × $74.50] (see Exhibit
10–20).
Since cost-based payors are paying 75 percent of charges, net patient revenues for
these patients is calculated by multiplying the number of visits by 75 percent of
charges. For Walk-In Clinic in January, the $52,355 in net patient revenues is
Budgeting 371
Gross Charges: The
amount that an
organization would bill
its patients if they all
paid full charges.
Net Charges: The
amount that an
organization bills its
patients after
accounting for
discounts and
allowances.
Exhibit 10–19 Walk-In Clinic’s Basic Information About Various Payors
Full-charge Payors pay an average of $74.50 per RVU (15 percent of charge-based payors are considered
charity patients).
Cost-based Payors pay an average of 75 percent of charges.
Flat-fee Payors have contracted to pay $30.00 per visit.
Capitated Payors pay an average of $11 PMPM.
Exhibit 10–20 Walk-In Clinic’s Calculation of Gross and Net Charges for January
Charge-based Cost-based Flat-fee Capitated Total
Determination of Gross Charges:
A Number of RVUs [Exhibit 10–12] 992 937 223 1,116 3,268
B Price per RVU [Exhibit 10–19] $74.50 $74.50 $74.50 $74.50 $74.50
C Gross Charges [A × B] $73,904 $69,807 $16,614 $83,142 $243,466
Determination of Net Charges:
D Payment Basis 843 RVUs1 937 RVUs 112 Visits 6,130 Members2
E Payment Arrangement [Exhibit 10–19] $74.50 /RVU $55.88 /RVU $30.00 /Visit $11.00 PMPM
F Net Charges [D × E] $62,818 $52,355 $3,360 $67,430 $185,963
G Discounts and Allowances [C − F] $11,086 $17,452 $13,254 $15,712 $57,503
1 There are 992 full-pay RVUs, of which 15% are charity care. Therefore, net revenues are based upon 85 percent of the 992 full-pay RVUs (992 × 85% = 843 RVUs).
2 From Exhibit 10–16, January Capitated 20X1 Enrollment.
computed as follows: [($74.50 × 0.75) × 937 RVUs]. In this case it is assumed that
cost-based payors have determined in advance what percentage of charges per
RVU they will pay, based upon the payors’ internal calculations of an appropriate
ratio of Walk-in Clinic’s cost to its charges.
Flat fee net patient revenues are determined by multiplying the number of
units on which payment is based by the price per unit. Assume Walk-In
Clinic negotiated a contract to do physicals for $30.00 each. RVUs are
ignored. To determine net charges, the number of physicals (visits) is
multiplied by the price per visit. For January, this would be $3,360 (112 visits
× $30.00/visit).
Net patient revenues for capitated payors is determined by multiplying the
PMPM fee by the number of enrollees. RVUs are ignored. Net patient
revenues for Walk-In Clinic in January is determined as follows: 6,130
members (Exhibit 10–16) $11.00 PMPM = $67,430.
Using this information, the total net patient revenues for Walk-In Clinic for
January is computed as follows (see Exhibit 10–20, row F):
Charge-based patients $62,818
Cost-based patients 52,355
Flat fee patients 3,360
Capitated patients 67,430
Total net patient revenues $185,963
The net patient revenues for the other months in Exhibit 10–13 were found in a
similar manner. Note that the last line of Exhibit 10–20, discounts and allowances,
shows that the difference between gross charges (the amount that Walk-In Clinic
would bill if there were no discounts and allowances) and net charges (the amount
Walk-In Clinic can actually bill after taking into account discounts and allowances) is
$57,503 (differences due to rounding). Of this:
$11,086 is due to charity care.
$17,452 is due to cost-based payors paying an average of 75 percent of
charges.
$13,254 is due to a negotiated fee for physicals.
$15,712 is due to receiving $11.00 PMPM from capitated payors.
Non-patient Revenues
In addition to patient service revenues, most organizations also have non-patient revenues.
In the case of Walk-In Clinic, the non-patient revenues are interest and consulting
fees. The estimate of interest earned is developed on a separate schedule
related to the cash budget (not shown here). The estimate of consulting fees is based
Budgeting 373
In this situation, gross charges and gross revenues are used interchangeably.
on a review of the organization’s plans for this service. The calculation of the $54,531
of non-patient revenues in the operating budget (see Exhibit 10–13, Total column) is
shown in Exhibit 10–21, Total column.
The Expense Budget
The second part of the operating budget (see Exhibit 10–13, rows F through H) is the
expense budget. The expense budget itself is made up of three other budgets: the
labor budget, supplies budget, and administrative and general budget (see Exhibit
10–22).
The Labor Budget
Note that the first item listed under expenses in the operating budget (see Exhibit
10–13) is labor, for it consumes the largest amount of the organization’s resources.
The amount listed for labor expense is developed in the labor budget (see Exhibit
10–23), which itself is composed of two budgets: the fixed labor budget and the variable
labor budget. The fixed labor budget forecasts the costs of salaried personnel;
the variable labor budget accounts for additional labor costs, which vary as additional
part-time personnel or overtime hours are needed. Development of Walk-In
Clinic’s labor budget follows.
The Fixed Labor Budget
The numbers on the fixed labor budget come from salary information, usually kept by
position and/or person occupying the position. For example, the basic information used
to construct Walk-In Clinic’s fixed labor budget (see Exhibit 10–25) are found in
Exhibit 10–24.
Exhibit 10–26 illustrates how the basic information in Exhibit 10–24 was
converted to the fixed labor budget in Exhibit 10–25 (for example, see the case of
Physician I for January).
The Variable Labor Budget
The second component of the labor budget is the variable labor budget, which accounts
for wages of non-salaried employees and overtime. Health care organizations are
increasingly turning to part-time employees because, often at less cost, they can meet
flexible demands and cost less, as benefits do not need to be paid to these workers.
Because the number of part-time and overtime hours per month vary depending on
the workload, it is not necessary to develop this budget by position as was done for the
fixed labor budget. Instead, this budget is developed by: 1) estimating how many
hours will be covered by full-time staff; 2) estimating how many hours will not be covered
by full-time staff; 3) determining how many of these non-covered hours will be
filled by overtime and how many will be filled by part-time personnel; and 4) applying
the full-time and part-time rates to the full- and part-time hours to calculate fulland
part-time wages.
374 Financial Management of Health Care Organizations
Labor Budget: A
subset of the expense
budget, this budget is
composed of the fixed
labor budget and the
variable labor budget.
Fixed Labor Budget:
A subset of the labor
budget which forecasts
the cost of salaried
personnel.
Variable Labor
Budget: A subset of
the labor budget which
forecasts non-salary
labor costs, such as
part-time employees
and overtime hours.
Exhibit 10–21 Forecast of Non-Patient Revenues for Walk-In Clinic
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC TOTAL
Interest $2,414 $2,771 $3,445 $3,390 $3,918 $4,100 $4,203 $4,569 $4,622 $4,628 $5,085 $5,386 $48,531
Consulting 500 500 500 500 500 500 500 500 500 500 500 500 6,000
Total $2,914 $3,271 $3,945 $3,890 $4,418 $4,600 $4,703 $5,069 $5,122 $5,128 $5,585 $5,886 $54,531
Supplies Expense Budget Labor Expense Budget
Fixed
Supplies
Budget
Variable
Supplies
Budget
Administrative and General Expense
Interest
Penalties
Depreciation
Rent
Utilities
Telephone
Equipment
Maintenance
Travel
Insurance
Bad Debt
Other
Fixed
Labor
Budget
Variable
Labor
Budget
•
•
•
•
•
•
•
•
•
•
•
•
Exhibit 10–22 Overview of the Operating Expense Budget
Exhibit 10–23 The Labor Budget
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC TOTAL
Fixed Salaries $52,538 $52,704 $54,693 $54,783 $54,783 $56,557 $57,256 $57,256 $57,407 $57,407 $57,944 $
57,944 $671,273
Fixed Benefits 7,881 7,906 8,204 8,217 8,217 8,484 8,588 8,588 8,611 8,611 8,692 8,692 100,691
Subtotal 60,419 60,610 62,897 63,000 63,000 65,041 65,845 65,845 66,018 66,018 66,635 66,635 771,963
Variable Wages 9,355 7,176 8,990 4,651 6,261 7,861 12,198 16,238 17,048 16,145 16,295 12,565 134,783
Total $69,774 $67,786 $71,887 $67,651 $69,261 $72,902 $78,042 $82,082 $83,066 $82,163 $82,930 $
79,200 $906,746
Exhibit 10–24 Data Used to Construct Walk-In Clinic’s Fixed Labor Budget
Annual Salary1 Benefits Raise Date % Raise
Physician I
$140,634 15% Jan 5%
Physician II $138,745 15% Jul 5%
Physician’s Assistant $68,428 15% Nov 5%
Physician’s Assistant $60,32115% Nov 5%
RN $49,354 15% Jan 5%
LPN I
$36,276 15% Sep 5%
LPN II $39,987 15% Feb 5%
Nurse’s Aide $28,987 15% Jul 5%
Office Manager $35,000 15% Jan 5%
Office Staff $21,473 15% Apr 5%
Office Staff $23,864 15% Mar2 N/A
Office Staff $21,296 15% Jun2 N/A
1 All salaries and wages are paid twice monthly. The second payment is made on the last day of the month.
2 To be hired on this date.
Exhibit 10–25 Walk-In Clinic’s Fixed Labor Budget
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC TOTAL
Position
Physician I
$14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $14,151 $169,816
Physician II 13,296 13,296 13,296 13,296 13,296 13,296 13,961 13,961 13,961 13,961 13,961 13,961 163,546
Physician’s 6,558 6,558 6,558 6,558 6,558 6,558 6,558 6,558 6,558 6,558 6,886 6,886 79,348
Assistant
Physician’s 5,7815,7815,7815,781 5,7815,7815,781 5,781 5,781 5,781 6,070 6,070 69,947
Assistant
RN 4,966 4,966 4,966 4,966 4,966 4,966 4,966 4,966 4,966 4,966 4,966 4,966 59,595
LPN I
3,476 3,476 3,476 3,476 3,476 3,476 3,476 3,476 3,650 3,650 3,650 3,650 42,413
LPN II 3,832 4,024 4,024 4,024 4,024 4,024 4,024 4,024 4,024 4,024 4,024 4,024 48,093
Nurses Aide 2,778 2,778 2,778 2,778 2,778 2,778 2,917 2,917 2,917 2,917 2,917 2,917 34,168
Office Manager 3,522 3,522 3,522 3,522 3,522 3,522 3,522 3,522 3,522 3,522 3,522 3,522 42,263
Office Staff 2,058 2,058 2,058 2,161 2,161 2,161 2,161 2,161 2,161 2,161 2,161 2,161 25,620
Office Staff 0
0
2,287 2,287 2,287 2,287 2,287 2,287 2,287 2,287 2,287 2,287 22,870
Office Staff 0
0
0
0
0
2,0412,0412,041 2,041 2,0412,041 2,04114,286
Total $60,419 $60,610 $62,897 $63,000 $63,000 $65,041 $65,845 $65,845 $66,018 $66,018 $66,635 $66,635 $771,963
Exhibit 10–26 Calculating Salaries and Benefits for Walk-In
Clinic – Example of Physician I
Item Source Amount
A Annual Base Salary [Exhibit 10–24] $140,634
B Raise [Exhibit 10–24] 5%
C New Base Salary [A × (1 + B)] $147,666
D Monthly Salary [C/12] $12,305
E Benefits Percentage [Exhibit 10–24] 15%
F Benefits Amount [D × E] $1,846
G Monthly Salary and Benefits [D + F] $14,151
1. Estimate how many hours will be covered by full-time staff. To
calculate how many hours will be covered by full-time staff, the first step is to
determine how many RVUs each LPN can serve per day. For Walk-In
Clinic, the background information used to determine the number of RVUs
per LPN per day is found in Exhibit 10–27. For January, an LPN spends an
average of 22.5 minutes per RVU (row C). Of this time, 15 minutes is spent
directly with the patient (row A), and an additional 7.5 minutes is spent in
non-direct patient care activities such as meetings, phone calls, and
paperwork (row B). Since it takes 22.5 minutes per RVU per LPN, one LPN
can serve an average of 2.67 RVUs per hour (row D: 60 minutes per
hour/22.5 minutes per RVU). If one LPN can serve 2.67 RVUs per hour, she
can serve 21.33 RVUs per eight-hour day (row F: 2.67 RVUs/hour × 8
hours). As before, the numbers in the exhibits may be slightly different from
those computed on a calculator due to computer rounding.
2. Determine how many hours will not be covered by full-time staff.
That the LPN staff can serve 21.33 RVUs per day becomes the basis to
determine how many additional staff are needed (see Exhibit 10–28). For
Walk-in Clinic in January, if an LPN can serve 21.33 RVUs per day (row B),
then he or she can serve almost 427 in 20 days (row C) and two LPNs can
serve 853 RVUs (row E). From the information provided in the statistics
budget, 3,268 RVUs are expected during this month (row F). Therefore,
2,415 RVUs will not be covered by the full-time LPN staff (row G). Since
an LPN can serve 2.67 RVUs per hour (row H), it will take an additional 906
hours to serve the 2,415 unserved RVUs (row I).
3. Determine how many of the non-covered hours will be filled by
overtime and how many will be covered by part-time hours. The two
existing LPNs will only work 60 overtime hours each month (row J), leaving
846 hours to be covered by part-time personnel (row K).
4. Apply the full-time and part-time rates to the full and part-time
hours to calculate full and part-time wages. Overtime wages are $15
per hour; part-time wages are $10 per hour (rows L, M). At $15 per hour,
the overtime wages amount to $900 (row N) and the part-time wages are
$8,455 (row O). Thus, Walk-In Clinic’s non-fixed wages for January are
$9,355 (row P).
The information from the fixed labor budget is added to the variable labor budget and
placed in the labor budget. For Walk-In Clinic, fixed labor is $60,419 and variable
labor is $9,355. Therefore, total labor for January is $69,774 (see Exhibit 10–23).
The Supplies Budget
The second expense item in the operating budget is supplies (see Exhibit 10–13). The
information for this figure comes from the supplies budget (see Exhibit 10–29), which
itself is made up of two budgets: a variable supplies budget and a fixed supplies budget.
The fixed supplies budget covers items such as office supplies, which do not vary
378 Financial Management of Health Care Organizations
Exhibit 10–27 Background Information for Walk-In Clinic’s Variable Labor Budget
JAN FEB MAR APR MAY JUN JULAUG SEP OCT NOV DEC
Number of RVUs/LPN/Day:
A Direct Minutes/RVU/LPN [Given] 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00
B Indirect Minutes/RVU/LPN [Given] 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50 7.50
C Total Minutes/RVU/LPN [A + B] 22.50 22.50 22.50 22.50 22.50 22.50 22.50 22.50 22.50 22.50 22.50 22.50
D RVUs/Hour/LPN [60 min/C] 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67
E Work Hours/LPN/Day [Given] 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
F RVUs/LPN/Day [D × E] 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33
Other Information:
G Full-Time LPNs 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00
H Part-Time LPN Pay Rate Per Hour $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00 $10.00
I Overtime LPN Rate Per Hour $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00 $
15.00
J Work Days Per Month 20.00 20.00 22.00 22.00 20.00 22.00 23.00 21.00 21.00 22.00 19.00 20.00
K Maximum LPN OT Hours/Month 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00 60.00
Exhibit 10–28 Variable Labor Budget
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TOTAL
A Work Days/Month 20 20 22 22 20 22 23 212122 19 20 252
B RVUs/LPN/Day 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33 21.33
C Monthly RVU Capacity/LPN [A × B] 427 427 469 469 427 469 491448 448 469 405 427 5,376
D Fixed LPN FTEs 2
2
2
2
2
2
2
2
2
2
2
2
2
E Monthly LPN RVU Capacity [C × D] 853 853 939 939 853 939 981896 896 939 811853 10,752
F Budgeted RVUs This Month 3,268 2,687 3,256 2,099 2,443 2,955 4,154 5,146 5,362 5,164 5,076 4,124 45,734
G Understaffed RVUs [F − E] 2,415 1,834 2,317 1,160 1,590 2,016 3,173 4,250 4,466 4,225 4,265 3,271 34,982
H LPN RVUs/Hour 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 2.67 3.00
I Excess LPN Hours Needed [G /
H] 906 688 869 435 596 756 1,190 1,594 1,675 1,585 1,600 1,227 13,118
J Maximum Overtime Hours
/Month 60 60 60 60 60 60 60 60 60 60 60 60 60
K Part-time Hours Needed [I − J] 846 628 809 375 536 696 1,130 1,534 1,615 1,525 1,540 1,167 12,398
L Hourly Overtime Rate $15 $15 $15 $15 $15 $15 $15 $15 $15 $15 $15 $15 $15
M Hourly Part-time Rate $10 $10 $10 $10 $10 $10 $10 $10 $10 $10 $10 $10 $10
N Overtime Wages [J × L] $900 $900 $900 $900 $900 $900 $900 $900 $900 $900 $900 $900 $10,800
O Part-time Wages [K × M] $8,455 $6,276 $8,090 $3,751 $5,361 $6,961 $11,298 $15,338 $16,148 $15,245 $15,395 $11,665 $123,983
P Variable Wages [N + O] $9,355 $7,176 $8,990 $4,651 $6,261 $7,861 $12,198 $16,238 $17,048 $16,145 $16,295 $12,565 $134,783
Note: The numbers in this exhibit may be slightly different from those computed on a calculator due to the internal rounding rules used in the computer program on which this
example is based. For example, January’s part-time wages, Row O, are $8,455. When calculated by hand, they are $8,460 ($10/hr × 846 hrs). Obviously, the computer was storing
the 846 hours as 845.5 hours.
with the number of patients seen. The variable supplies budget includes those
items that do vary with the number of patients seen, such as disposable syringes, disposable
gloves, and X-ray film. The assumptions for compiling both the fixed and
variable supplies budgets are in Exhibit 10–30.
The Fixed Supplies Budget
The fixed supplies budget (Exhibit 10–31) is composed mainly of items used in the
office, such as office supplies and stamps. For Walk-In Clinic, the cost is estimated at
$750 per month, as shown in the supplies budget assumptions (Exhibit 10–30, row 1).
The Variable Supplies Budget
The variable supplies budget for Walk-In Clinic, shown in Exhibit 10–32, is based on
the following formula:
Opening Inventory + Purchases − Cost of Goods Used = Ending Inventory
Because accrual accounting is used, cost of goods used (COGU) is the only number
to actually appear on the final supplies budget (see Exhibit 10–29, Variable
Supplies, and Exhibit 10–32, Cost of Goods Used), for it represents the amount of
resources consumed in providing service. However, the other items are necessary to
derive cost of goods used. The components of Walk-In Clinic’s variable supplies
budget are as follows:
Opening Inventory: For Walk-In Clinic in January, the opening inventory is
$5,154 (Exhibit 10–32), which is also the ending inventory for December of
the previous year (Exhibit 10–30, row 5).
Purchases: The amount of supplies to be purchased in January is calculated
based upon both the cost of goods used and the desired ending inventory at
the end of the month. Walk-in Clinic is required to have its ending inventory
for one month be 20 percent of the forecasted amount of cost of goods that
will be used the next month (discussed further below).
Cost of Goods Used: Cost of goods used is calculated by multiplying the
number of RVUs provided during the month by the cost per RVU. In the
case of Walk-In Clinic, the statistics budget shows that there are 3,268 RVUs
to be provided in January (see Exhibit 10–12) and the cost of supplies per
RVU is $10 each (see Exhibit 10–30, Total). Thus the cost of goods used is
$32,680 (3,268 RVUs × $10/RVU).
Ending Inventory: Since the ending inventory must equal 20 percent of the
next month’s COGU, the ending inventory for Walk-In Clinic in January,
$5,374, is calculated by taking 20 percent of February’s projected COGU (see
Exhibit 10–32: $26,870 × 0.20).
Purchases (revisited): Once the cost of goods used and the desired ending
inventory for Walk-In Clinic have been calculated, the amount of purchases
for January can be determined by using the formula presented earlier:
Budgeting 381
Fixed Supplies
Budget: A subset of
the supplies budget
that covers those items
which do not vary by
patient volume.
Variable Supplies
Budget: A subset of
the supplies budget
that includes those
items which do vary
based upon the volume
of patients seen.
Exhibit 10–29 Supplies Budget for Walk-In Clinic
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TOTAL
Variable Supplies $32,680 $26,870 $32,560 $20,990 $24,430 $29,550 $41,540 $51,460 $53,620 $51,640 $50,760 $41,240 $457,340
Fixed Supplies 750 750 750 750 750 750 750 750 750 750 750 750 9,000
Total Supplies $33,430 $27,620 $33,310 $21,740 $25,180 $30,300 $42,290 $52,210 $54,370 $52,390 $51,510 $41,990 $466,340
Exhibit 10–30 Supplies Budget Assumptions
1 Fixed Supply Purchases Each Month This Year and Last Year $
750
2 Supply Cost/RVU $
10
3 Desired Ending Inventory as a
Percent of Next Month’s COGU1 20%
4 Payment for Goods Purchased (
made the following month)
5 Ending Inventory, December of Previous Year $
5,154
1 Cost of Goods Used.
Exhibit 10–31 Fixed Supplies Budget for Walk-In Clinic
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TOTAL
Fixed Supplies $750 $750 $750 $750 $750 $750 $750 $750 $750 $750 $750 $750 $9,000
Exhibit 10–32 Variable Supplies Budget for Walk-In Clinic
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TOTAL
Opening Inventory $5,154 $5,374 $6,512 $4,198 $4,886 $5,910 $8,308 $10,292 $10,724 $10,328 $10,152 $8,248 $5,154
Purchases 32,900 28,008 30,246 21,678 25,454 31,948 43,524 51,892 53,224 51,464 48,856 39,693 458,887
Goods Available 38,054 33,382 36,758 25,876 30,340 37,858 51,832 62,184 63,948 61,792 59,008 47,941 464,041
Cost of Goods Used (32,680) (26,870) (32,560) (20,990) (24,430) (29,550) (41,540) (51,460) (53,620) (51,640) (50,760) (41,240) (457,340)
Ending Inventory $5,374 $6,512 $4,198 $4,886 $5,910 $8,308 $10,292 $10,724 $10,328 $10,152 $8,248 $6,701 $6,701
Beginning inventory $5,154 (Exhibit 10–30)
+ Purchases 32,900 Derived by subtracting beginning inventory
from goods available
Goods available 38,054 Derived by adding ending inventory and
COGU
– COGU 32,680 Calculated by multiplying RVUs ×
Cost/RVU (Exhibits 10–12, 10–30)
Ending inventory $5,374 Calculated as 20% of February’s COGU
(Exhibit 10–32)
The information from the fixed supplies budget and the COGU from the variable
supplies budget is added and placed in the supplies budget. For January, Walk-In
Clinic had fixed supplies of $750 and variable supplies of $32,680. Therefore, total
supplies for January is $33,430 (see Exhibit 10–29).
The Administrative and General Expense Budget
The last part of the expense section of the operating budget (see Exhibit 10–13) is
administrative and general (A & G) expenses, which are developed in the general
and administrative budget (see Exhibit 10–33). They comprise the day-to-day
expenses that are not contained in the labor or supplies budgets. The assumptions for
the A & G expenses for Walk-In Clinic are listed in Exhibit 10–34. Incidentally, some
organizations will consider interest and penalties as non-operating expenses.
The Cash Budget
As discussed in detail in Chapter 5, the cash budget is developed by determining when
payments will be received from others and when payments will be made by the organization.
Since it draws on information from the other budgets, the cash budget is the
last budget to be developed.
The cash budget is organized into two sections. The first section determines how
much cash is available before borrowing; the second section compares the cash available
to the cash required and then determines if cash will be needed from other
sources (there is a shortfall) or if cash will be invested (there is an excess of cash).
To determine cash available, the cash inflows (revenues) are added, and outflows
(expenditures) are subtracted from the beginning balance (see Exhibit 10–14, rows A,
384 Financial Management of Health Care Organizations
The reason that COGU is used in the supplies budget rather than the cost of goods purchased is that accrual
accounting is being used.
Exhibit 10–33 Administrative and General Expense Budget
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TOTAL
Administrative & General
Interest $891$889 $887 $959 $956 $953 $963 $959 $956 $952 $948 $945 $11,258
Penalties 0
0
0
0
0
0
0
0
0
0
0
0
0
Depreciation 1,498 1,498 1,498 1,498 1,656 1,656 1,656 1,669 1,669 1,669 1,669 1,669 19,305
Utilities 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 144,000
Rent 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 5,000 60,000
Cleaning 500 500 500 500 500 500 500 500 500 500 500 500 6,000
Telephone 600 600 600 600 600 600 600 600 600 600 600 600 7,200
Travel 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 2,500 30,000
Insurance 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 144,000
Equipment
Maintenance 150 150 150 150 150 150 150 150 150 150 150 150 1,800
Bad Debt 4,083 4,358 4,223 3,634 3,383 3,6813,488 3,673 3,964 4,065 3,790 3,790 46,132
Subtotal $39,223 $39,495 $39,357 $38,842 $38,745 $39,040 $38,857 $39,051$39,339 $39,436 $39,157 $39,154 $469,696
Exhibit 10–34 Information Used to Construct the Administrative and General Expense Budget
Item Amount Occurrence and Payment
Interest Varies Calculated on an amortization schedule1
Penalties Varies Calculated in the Cash Budget
Depreciation Varies Calculated on a depreciation schedule1
Utilities $12,000 Per month, payable each month
Rent $5,000 Per month, payable each month in advance
Cleaning $500 Per month, payable each month
Telephone $600 Per month, payable each month
Travel $2,500 Per month, payable each month
Insurance $12,000 Per month, payable each month
Equipment Maintenance $150 Per month, payable each month
Bad Debt Varies 4% of charge-based and 3% of cost-based net patient revenue
1 Not included; assume the number as a given for this example
B, C, and D). As how to determine these inflows and outflows was discussed in
Chapter 5, the following shows how accrual data are converted into cash. As noted in
Exhibit 10–20, row F, Walk-In Clinic earned $62,818 in January on its full-charge
patients. Under the assumption that 31 percent will be collected in January, 56 percent
in February, 6 percent in March, and 3 percent in April, and that the remaining
4 percent will be written off, the cash inflow pattern is shown in Exhibit 10–35.
The second part of the cash budget determines whether the organization has sufficient
cash to begin the next month. Walk-in Clinic has decided that it should begin
each month with $11,000 cash on hand. If it does not have $11,000, it would have to
either obtain such funds from its own short-term or long-term investments (perhaps
with some penalty for early withdrawal), or else borrow the funds from outside the
organization. Fortunately, Walk-In Clinic does not find itself in such a position. If
Walk-In Clinic has over $11,000, it invests the excess in short-term investments (see
Exhibit 10–14, row N).
The Capital Budget
The capital budget was initially presented in Exhibit 10–15. Though the budget for
Walk-In Clinic is relatively small, large organizations may have capital budgets totaling
millions of dollars. The items that appear on the capital budget are likely to have
been part of a much larger list of requests that various departments submitted.
Summary
The budget is one of the most important documents of a health care organization
and is the central document of the planning/control cycle. It identifies the revenues
and resources that are needed for an organization to achieve its goals and objectives
and allows the organization to monitor the actual revenues generated and its use of
resources against what was planned.
386 Financial Management of Health Care Organizations
Exhibit 10–35 Converting Accrual Information into Cash Flows:Walk-In Clinic’s Revenues for January
Janury’s Net Revenues
Using the Accrual Basis
of Accounting – Full-charge
Patients. Amount Collected in: Percent to be Received by Month Cash Inflow by Month1
January 31% $19,474
February 56% 35,178
March 6% 3,769
April 3% 1,885
Written off 4% 2,513
Total 100% $62,819
1 Differences due to rounding.
The planning/control cycle has four major components: strategic planning, planning,
implementing, and controlling. The purpose of strategic planning is to identify the
organization’s mission and strategy in order to position the organization for the future.
A primary activity of the strategic planning process is an assessment of the organization’s
external and internal environments. The organization also develops specific tactical and
operational plans that identify short-term goals and objectives in marketing/production,
control, and financing the organization.
Five key dimensions along which organizations vary in regard to budgeting are: participation,
budget models, budget detail, budget forecasts, and budget modifications.
Participation in the budgeting process varies from authoritarian to participative. The
authoritarian approach is often called top-down budgeting, since the budget is
essentially dictated to the rest of the organization. In the participatory approach, the roles
and responsibilities of the budgeting process are diffused throughout the organization.
Advantages of the participatory approach include developing a shared understanding of
the goals and objectives of the organization, developing cooperation and coordination,
clarifying roles and responsibilities, motivating staff, and bringing about cost awareness.
Its disadvantages are loss of control and excessive use of time and resources.
There are two budget models: incremental/decremental budgeting and zero-based
budgeting. The incremental/decremental approach begins with what exists and gives a
slight increase, no change, or a slight decrease to various line items, programs, or departments.
Zero-based budgeting continually questions both the need for each program and
its level of funding. In zero-based budgeting, each budgeting unit provides: 1) an overall
justification for its program; and 2) a series of requests to show what the program would
look like at various levels of funding.
Based on the amount of detail they contain, budgets can be classified into three categories:
line-item, program, and performance. A line-item budget has the least detail
and merely lists revenues and expenses by category. A program budget not only lists
the line items, but also lists them by program. A performance budget not only lists line
items and programs, but also lists the performance goals that each program is
expected to attain.
Since environmental conditions change, many organizations use rolling budgets,
which are multi-year forecasts regularly updated and extended. Single-year and
multi-year budgets vary by the time horizon they forecast; static and flexible budgets
vary on the basis of volume projections. Static budgets forecast for a single level of
activity; flexible budgets forecast revenues and expenses for various levels of activities.
Most health care organizations actually develop four interrelated budgets: a statistics
budget, an operating budget, a cash budget, and a capital budget. The statistics
budget identifies the amount of services that will be provided, usually by payor type.
The operating budget is a combination of two budgets developed using the accrual
basis of accounting: the revenue budget and the expense budget. The revenue budget
is a forecast of the operating revenues that will be earned during the budget period. It
consists of net patient revenues and non-patient revenues. The expense budget lists
all operating expenses that are expected to be incurred during the budget period, both
fixed and variable.
The cash budget represents the organization’s cash inflows and outflows. The bottom
line of the cash budget is the amount of cash available at the end of the period. In
Budgeting 387
addition to showing cash inflows and outflows, the cash budget also details when it is
necessary to borrow when there are cash shortages, and when excess funds can be
invested.
The capital budget summarizes the purchases to be made during the year. Capital
budgets for outpatient facilities may be fairly small; those from large systems with
inpatient facilities may contain millions of dollars’ worth of items.
Based on the information contained in these budgets, plus small amount of additional
information, the organization develops pro forma financial statements. Pro
forma financial statements are prepared before the accounting period and present
what the organization’s financial statements will look like if all budgets are met
exactly as planned. Once the pro forma financial statements have been developed, they
can be subjected to ratio analysis just as with regular financial statements.
Key Equation
Opening Inventory + Purchases – Cost of Goods Used = Ending Inventory
Questions and Problems
1. Definitions. Define the following terms:
a. Authoritarian Approach.
b. Capital Budget.
c. Cash Budget.
d. Controlling Activities.
e. Expense Budget.
f. Fixed Labor Budget.
g. Fixed Supplies Budget.
h. Flexible Budget.
388 Financial Management of Health Care Organizations
Authoritarian Approach
Capital Budget
Cash Budget
Controlling Activities
Expense Budget
Fixed Labor Budget
Fixed Supplies Budget
Flexible Budget
Gross Charges
Incremental/Decremental
Approach
Labor Budget
Line-item Budget
Mission Statement
Multi-year Budget
Net Charges
Operating Budget
Participatory Approach
Performance Budget
Planning
Program Budget
Relative Value Units (RVUs)
Revenue Budget
Rolling Budget
Short-term Plans
Static Budget
Statistics Budget
Strategic Planning
Top-down Budgeting
Top-down/Bottom-up Approach
Variable Labor Budget
Variable Supplies Budget
Zero-based Budgeting (ZBB)
Key Terms
i. Gross Charges.
j. Incremental/Decremental Approach.
k. Labor Budget.
l. Line-item Budget.
m. Mission Statement.
n. Multi-year Budget.
o. Net Charges.
p. Operating Budget.
q. Participatory Approach.
r. Performance Budget.
s. Planning.
t. Program Budget.
u. Relative Value Units (RVUs).
v. Revenue Budget.
w. Rolling Budget.
x. Short-term Plans.
y. Static Budget.
z. Statistics Budget.
aa. Strategic Planning.
bb. Top-down Budgeting.
cc. Top-down/Bottom-up Approach.
dd. Variable Labor Budget.
ee. Variable Supplies Budget.
ff. Zero-based Budgeting (ZBB).
2. What is the purpose of the budget? Why are requests for budget revisions
necessary? When should a formal request for a budget revision be submitted?
3. What are the major components of the planning/control cycle?
4. Discuss the role of strategic planning in the budgeting process. How does it
differ from short-term planning?
5. What are the advantages and disadvantages of the participatory approach to
budgeting?
6. What are the four major budgets of a health care organization? Briefly discuss
each.
7. Using Exhibits 10–6 through 10–8 as examples, construct line-item,
program, and performance budgets for a service or program in a health care
organization.
8. Using the data provided in Exhibit 10–16, explain the difference in predicting
this year’s visits for non-capitated and capitated patients.
9. The Statistics Budget: Forecasting Visits. Instead of its current forecast,
Walk-In Clinic estimates that it will not obtain a major HMO contract, and
its enrollment July—December will only go up 0.5 percent a month.
Assuming these are the only changes to Exhibit 10–16, prepare a new
forecast of the number of visits that will be made by capitated patients
during the whole year.
10. The Statistics Budget: Forecasting Visits. Instead of its current forecast,
Walk-In Clinic estimates that it will not obtain a major HMO contract, and its
Budgeting 389
enrollment July–December will only go up 6 percent a month. Assuming these
are the only changes to Exhibit 10–16, prepare a new forecast of the number of
visits that will be made by capitated patients during the whole year.
11. The Statistics Budget: RVU Weighted Visits. What are RVU weighted
visits? Why is it necessary to weight visits by their intensity level?
12. The Statistics Budget: Changing Intensity. How would the statistics
budget change if Walk-In Clinic used the following distribution instead of the
distribution of visits by intensity shown in Exhibit 10–17.
Charge-based Cost-based Flat Fee Capitation
Brief (Level I) 10% 12% 10% 10%
Routine (Level II) 50% 62% 85% 55%
Complex (Level III) 40% 26% 5% 35%
Total 100% 100% 100% 100%
13. The Statistics Budget: Changing Intensity. How would the statistics
budget change if Walk-In Clinic used the following distribution instead of the
distribution of visits by intensity shown in Exhibit 10–17.
Charge-based Cost-based Flat Fee Capitation
Brief (Level I) 10% 15% 25% 15%
Routine (Level II) 40% 60% 60% 50%
Complex (Level III) 50% 25% 15% 35%
Total 100% 100% 100% 100%
14. The Revenue Budget: Types of Payors. What is the difference between
charge-based, cost-based, flat fee, and capitated payors?
15. The Revenue Budget: Calculating Gross Revenues. Calculate Walk-In
Clinic’s January, February, and March gross revenues if it lowers its fee to
$64.50 from $74.50 per RVU (assuming that cost-based payors continue to pay
75 percent of charges). (See Exhibits 10–19 and 10–20.)
16. The Revenue Budget: Calculating Gross Revenues. Calculate Walk-In
Clinic’s January, February, and March gross revenues if it lowers its fee to
$70.00 from $74.50 per RVU (assuming that cost-based payors continue to pay
75 percent of charges). (See Exhibits 10–19 and 10–20.)
17. The Revenue Budget: Gross and Net Charges. What is the difference
between gross charges and net charges?
18. The Revenue Budget: Calculating Net Revenues. Calculate Walk-In
Clinic’s January, February, and March net revenues if it lowers its fee to $64.50
from $74.50 per RVU. (See Exhibits 10–19 and 10–20.)
19. The Revenue Budget: Calculating Net Revenues. Calculate Walk-In
Clinic’s January, February, and March net revenues if it lowers its fee to $70.00
from $74.50 per RVU. (See Exhibits 10–19 and 10–20.)
390 Financial Management of Health Care Organizations
20. The Labor Budget: Fixed and Variable Labor. What is the difference
between a fixed and a variable labor budget?
21. The Labor Budget: Calculating the Fixed Labor Budget. Instead of the
raises stated in Exhibit 10–24, assume that all benefits are 13 percent and all
raises are 7 percent and calculate the fixed labor budget. Assume all the other
assumptions in the exhibit remain the same. Explain why only LPN II’s wages
and benefits change from January to February.
22. The Labor Budget: Calculating the Fixed Labor Budget. Instead of the
raises stated in Exhibit 10–24, assume that all benefits are 20 percent and all
raises are 5 percent and calculate the fixed labor budget. Assume all the other
assumptions in the exhibit remain the same. Explain why only LPN II’s wages
and benefits change from January to February.
23. The Labor Budget: Variable Labor. In the variable labor budget, why is it
necessary to determine how many RVUs can be handled by full-time
employees?
24. The Variable Labor Budget: Direct and Indirect Time. In the variable
labor budget, what is the main difference between direct and indirect “minutes
per RVU” per LPN?
25. The Labor Budget (each part builds on the previous part).
a. Calculating the Effects of Changes in Indirect Time on RVU Capacity per
LPN. How many RVUs per day could an LPN serve if the indirect time in
Exhibit 10–27 were reduced to 6 minutes? All other information not
dependent on indirect time in Exhibit 10–27 remains the same.
b. Calculating the Effects of Changes in Indirect Time on Understaffed LPN
Hours. If the indirect time in Exhibit 10–27 were cut to 6 minutes per RVU
as in part a, how many understaffed hours would Walk-in Clinic have in
January, February, and March? All other information not dependent on
indirect time in Exhibit 10–27 remains the same.
c. Calculating the Effects of Changes in Part-time and Overtime Wages on the
Variable Labor Budget. Assume part-time wages change to $9 and overtime
wages change to $14 per hour. If all other information in Exhibit 10–28
remains the same, what will Walk-in Clinic’s variable labor budget be in
January, February, and March?
26. The labor budget. [Each part builds on the previous part.]
a. Calculating the Effects of Changes in Indirect Time on RVU Capacity
per LPN. How many RVUs per day could an LPN serve if the indirect time
in Exhibit 10–27 were reduced to 5.5 minutes? All other information not
dependent on indirect time in Exhibit 10–27 remains the same.
b. Calculating the Effects of Changes in Indirect Time on Understaffed
LPN Hours. If the indirect time in Exhibit 10–27 were cut to 5.5 minutes
per RVU as in part a, how many understaffed hours would Walk-in Clinic
have in January, February, and March? All other information not dependent
on indirect time in Exhibit 10–27 remains the same.
c. Calculating the Effects of Changes in Part-time and Overtime Wages
on the Variable Labor Budget. Assume part-time wages change to $12
and overtime wages change to $18 per hour. If all other information in
Budgeting 391
Exhibit 10–28 remains the same, what will Walk-in Clinic’s variable labor
budget be in January, February, and March?
27. Calculating the Variable Supply Budget. Calculate the variable supplies
budget, assuming Walk-in Clinic changes its requirements so that ending
inventory is 25 percent of next month’s COGS. No other assumptions in
Exhibit 10–30 change.
28. Calculating the Variable Supply Budget. Calculate the variable supplies
budget, assuming Walk-in Clinic changes its requirements so that ending
inventory is 15 percent of next month’s COGS. No other assumptions in
Exhibit 10–30 change.
392 Financial Management of Health Care Organizations
C h a p t e r E l e v e n
RESPONSIBILITY ACCOUNTING
Learning Objectives
After completing this chapter, you will be able to:
Define decentralization and identify its major advantages and disadvantages.
Identify the major types of responsibility centers found in health care organizations and describe their
characteristics.
Explain the relationship of responsibility, authority, and accountability in the performance measurement of
responsibility centers.
Compute volume and rate variances for revenues.
Compute volume and cost variances for expenses.
Introduction
Decentralization
Advantages of Decentralization
Time
Information Relevance
Quality
Speed
Talent
Motivation and Allegiance
Disadvantages of Decentralization
Loss of Control
Decreased Goal Congruence
Increased Need for Coordination and Formal
Communication
Lack of Managerial Talent
Types of Responsibility Centers
Service Centers
Cost Centers
Profit Centers
Traditional Profit Centers
Capitated Profit Centers
Administrative Profit Centers
Investment Centers
Measuring The Performance of
Responsibility Centers
Responsibility,Authority, and
Accountability
Performance Measures
Budget Variances
Revenue Variances
Chapter Outline
(Continues)
394 Financial Management of Health Care Organizations
Introduction
Health care organizations have become increasingly complex over the past quarter
century. One of the major changes is decentralization, which presents interesting
problems when measuring financial performance. Whereas Chapter 4 dealt with
measuring the financial performance of the organization as a whole, this chapter identifies
the types of organizational units within a health care organization and measures
their financial performance. These units may be as large as subsidiaries or as small as
departments. This chapter begins with a discussion of decentralization, and then discusses
the types of responsibility centers that exist in decentralized organizations.
Next, the concepts of responsibility, authority, and accountability are explored.
Finally, questions of how to measure the performance of responsibility centers are
addressed.
Decentralization
Decentralization is the degree of dispersion of responsibility within an organization.
Decentralization can evolve out of working arrangements and/or may be more formally
prescribed in the organization’s policies, procedures, and organizational structure.
There are various advantages and disadvantages to decentralization, and each
organization has to decide what level of decentralization is in its best interest.
Advantages of Decentralization
The advantages and disadvantages of decentralization are presented in Exhibit
11–1. The advantages (in no particular order) include: time, information relevance,
quality, speed, talent, and motivation and allegiance.
Step 1. Develop the Flexible Budget Estimate
for Revenues
Step 2. Calculate the Revenue Variance Due to
Changes in Volume and Rate
Expense Variances
Step 1. Explain the Amount of Variance Due to
Fixed Costs
Step 2. Develop a Flexible Expense Budget
Step 3. Calculate the Expense Variance Due to
Changes in Volume and Other Factors
Summary of the Example
Beyond Variances
Other Financial Performance Measures
Summary
Key Terms
Key Equations
Questions and Problems
Chapter Outline (Contd)
Decentralization: The
degree of dispersion of
responsibility within a
health care
organization.
Time
From the point of view of central management, a major advantage of decentralization
is an increase in time available to devote to other tasks. Ideally, decentralization should
relieve the central office of day-to-day operational decision-making, instead allowing
it to concentrate more on tactical and strategic-level concerns.
Information Relevance
By spreading the responsibility for decision-making within the organization, the
organization moves more toward a “need to know” environment, where information
is filtered at each level, and only the information needed for decision-making
at higher levels is passed on.
Quality
Those closer to a problem may be better suited to understand the specifics of the problem
and be more responsive to the local context, thus leading to higher quality decisions.
Speed
Decentralized decision-making allows those closest to the problem to respond more
quickly by shortening six time-consuming steps in communication. The person who
identifies the problem must:
Communicate the problem up the organization
To those who must receive it. Then they
Become aware of it,
Decide a course of action, and
Communicate their response down through the organization,
Where it is ultimately received by the person authorized to respond.
Responsibility Accounting 395
Advantages Disadvantages
Time Loss of Control
Information Relevance Decreased Goal Congruence
Quality Increased Need for Coordination
Speed and Formal Communication
Talent Lack of Managerial Talent
Motivation and Allegiance
Exhibit 11–1 Advantages and Disadvantages of Decentralization
Talent
A health care organization must ensure that it is developing the management capability
to allow it to reach its objectives. Although occasionally it may want to look outside
the organization for “new blood,” this process can become expensive, intrusive,
and time-consuming. It can also be demoralizing to those within the organization.
Decentralization helps to draw upon and develop the expertise of existing staff.
Motivation and Allegiance
By delegating responsibility to others, a health care organization can develop increased
motivation and allegiance. Increased involvement in the planning, implementation,
and control process encourages buy-in by the staff, who may then experience an
increased sense of ownership, belonging, and pride in their work.
Disadvantages of Decentralization
In considering what degree of decentralization to have, a health care organization has
to balance the advantages of decentralization with its disadvantages, which include:
Loss of control.
Decreased goal congruence.
Increased need for coordination and formal communication.
Lack of managerial talent.
Loss of Control
By spreading responsibility throughout the organization, upper management loses
direct control. For administrators who have an authoritarian style and for organizations
that need top level management’s expertise, this can be a significant problem.
The specific ramifications of loss of control also appear in the other disadvantages of
decentralization, which are all highly interrelated.
Decreased Goal Congruence
To the extent that responsibility is decentralized within the organization, organizational
units tend to develop their own goals. To avoid this, considerable effort
must be exerted to ensure that each division or unit is making consistent decisions
that support the organization’s strategic plan and are in the best interest of the
organization as a whole, not just the division.
396 Financial Management of Health Care Organizations
Increased Need for Coordination and Formal Communication
If responsibility is decentralized within the organization, there is an increased need to
coordinate efforts among the various units and divisions. This results in the need for
more formal communications, meetings, policies, and procedures.
Lack of Managerial Talent
If an organization decentralizes and does not have the talent available at lower levels
to manage the new responsibilities, the organization as a whole could suffer greatly.
This particular problem was all too common during the early stages of HMO development
in the United States. Since no one in the organization had previous experience
running HMOs, organizations placed people with experience running other
health care entities in charge.
Types of Responsibility Centers
When responsibility is formally decentralized into organizational units, rather than
informally to specific individuals, these units are called responsibility centers. A
responsibility center is an organizational unit that has been formally given the
responsibility to carry out one or more tasks and/or to achieve one or more outcomes.
The four most common types of responsibility centers in health care are: service centers,
cost centers, profit centers, and investment centers (see Exhibit 11–2).
Service Centers
Service centers, the most basic type of responsibility center, are primarily responsible
for ensuring that services are provided to a population in a manner that meets the
volume and quality requirements of the organization. Since service centers have no
budgetary control, their main responsibilities revolve around scheduling, directing,
and monitoring the staff, and providing direct patient care. Although service centers
Responsibility Accounting 397
Responsibility
Center: An
organizational unit that
has been formally
given the responsibility
to carry out one or
more tasks and/or to
achieve one or more
outcomes.
Areas of Responsibility
Type of Center Services Costs Profits Investment
Service Center X
Cost Center X X
Profit Center X X X
Investment Center X X X X
Exhibit 11–2 The Four Main Types of Responsibility Centers and Their Main Areas of Responsibility
use resources and thus affect costs, the actual budgetary control rests at a higher level
in the organization. It is not unusual for nursing units to find themselves defined as
service centers. They are responsible for patient care, but the budget is kept at the
next higher level in the organization. Patient admitting and patient transportation are
also often defined as service centers.
Cost Centers
Cost centers, the most common type of responsibility center in health care organizations,
are responsible for providing services and controlling their costs. Ideally,
they should be integrally involved in the planning, budgeting, and control process,
for they are primarily responsible for resource utilization within the organization.
Since payment cannot be directly tied to services under both flat fee (i.e. DRG) and
capitated payment systems, a large number of responsibility centers are categorized
as cost centers rather than profit centers.
There are two types of cost centers in health care organizations: clinical cost centers
and administrative cost centers. Clinical cost centers provide health care-related services
to clients, patients, or enrollees. Examples include nursing units, pharmacy, radiology,
laboratory, and dietary services. Administrative cost centers support the
clinical cost centers and the organization as a whole. Included in this category are general
administration, the business office, information services, quality control, admitting,
medical records, and housekeeping. Administrative cost centers are often considered the
infrastructure of the organization. As with nursing, units that may be classified as cost
centers in one organization may be considered service centers in another.
Profit Centers
Though many profit centers are responsible for service-related activities, all
profit centers are responsible for controlling their costs and earning revenues. In
some cases, the costs may be larger than the revenue they generate. For example,
a pediatric screening program in a health department, which has to be offered,
might be charged with earning sufficient revenues to cover just half of its $100,000
cost. Thus, although the pediatric screening program is considered a profit center
by the health department, the amount of profit in this case is actually a loss of
$50,000.
There are three types of profit centers in health care organizations: traditional
profit centers, capitated profit centers, and administrative profit centers.
Traditional Profit Centers
Traditional profit centers are primarily responsible for providing health care
services and earning a profit based on the health care services provided. Traditional
398 Financial Management of Health Care Organizations
Service Centers:
Organizational units
that are primarily
responsible for
ensuring that health
care-related services
are provided to a
population in a manner
that meets the volume
and quality
requirements of the
organization. They
have no direct
budgetary control.
Cost Centers:
Organizational units
responsible for
providing services and
controlling their costs.
Clinical Cost Centers:
Cost centers that
provide health carerelated
services to
clients, patients, or
enrollees.
Administrative Cost
Centers: Cost centers
that support clinical
cost centers and the
organization as a
whole. They are often
considered the
infrastructure of the
organization.
Profit Centers:
Organizational units
responsible for
controlling costs and
earning revenues.
profit centers have proliferated recently. Much of this growth can be traced back to
the emergence of product-line management in health care in the later part of the
twentieth century. Common product (or service) lines include cardiology, women’s
and children’s services, and oncology. Traditional profit centers profit through a
combination of markups on service and controlling costs in fee-for-service situations,
as well as by controlling costs in flat fee arrangements such as the DRG payment
system.
Capitated Profit Centers
Capitated profit centers earn revenues by agreeing to take care of the health care
needs of a population for a per-member fee, often regardless of the amount of services
needed by any particular patient. Such organizations are commonly called HMOs,
PPOs, or managed care organizations. Interestingly enough, many managed care
organizations purchase services from traditional profit centers. For example, an HMO
may purchase its cardiology services from one health network and many of its oncology
services from a different hospital system. Since it receives a set amount to cover
the health care needs of a population, providers receiving capitation have considerable
incentive to control costs through efficiency (the most service for any level of cost),
economy (low costs), and prevention.
Administrative Profit Centers
There are two types of administrative profit centers: those that sell inside the
organization and those that – although they do not deliver health services – are
responsible for generating new revenues from outside the organization. Examples of
administrative profit centers that may be required to sell their services inside the
organization are legal services, computer services, and management engineering. The
prices for these services that are charged internally to other organizational units are
called transfer prices.
The setting of transfer prices is a very delicate matter, and if they are set too high
there are several possible negative consequences. They may encourage potential users
to buy these services outside the organization. If internal units (i.e. departments, subsidiary
organizations) must use these resources, then they may suboptimize their use
in order to cut costs and/or use the services, but be unhappy about it (causing morale
problems).
Examples of administrative profit centers that are responsible for generating new
revenues from outside the organization include development offices (whose primary
function is to encourage donations and contributions to the organization), and field
representatives for HMOs and PPOs, whose primary responsibility is to sign up markets
for the organization. Other primary examples would be food services, gift shops,
parking decks, and motel services. Incidentally, although their effects on profit are
difficult to identify, marketing, advertising, and public relations may be considered
Responsibility Accounting 399
Traditional Profit
Centers:
Organizational units
responsible for earning
a profit by providing
health care services.
Revenues are earned
either on a fee-forservice
or a flat fee
basis. Examples include
cardiology, women’s
and children’s services,
and oncology.
Capitated Profit
Centers:
Organizational units
responsible for earning
a profit by agreeing to
take care of the health
care needs of a
population for a permember
fee (which is
not directly tied to
services). Examples
include HMOs, PPOs,
and various managed
care organizations.
Administrative Profit
Centers:
Organizational units
that do not provide
health care-related
services, but are
responsible for their
profit. There are two
types: those who sell
their services internally,
and those whose
primary responsibility
is to bring revenues
into the organization.
Transfer Prices: The
prices for products or
services that are
charged internally to
other organizational
units.
administrative profit centers in some organizations (others may consider them cost
centers).
Investment Centers
In addition to having all the responsibilities of a traditional profit center, investment
centers are responsible for making a certain return on investment. For
example, where a profit center might be content with a simple $100,000 profit, an
investment center might find this unacceptable if it does not provide the desired
return on investment. An example of this is shown in Exhibit 11–3, where a surgicenter
earns $100,000 in profit, but this is an insufficient amount of revenue to
earn a required 15 percent return on investment. Perspective 11–1 provides an
example of an investment center in a physician group that did not generate a promised
return.
Investment centers have proliferated in the last few decades, and include all investorowned
health care entities that require their operating units to make a certain return.
However, not all investment centers are investor-owned, for many not-for-profit health
care organizations require various responsibility centers to make a certain return. It is not
the ownership status that makes a responsibility center an investment center, it is the
requirement that it make a certain return.
Measuring the Performance of Responsibility Centers
The previous section categorized the different types of responsibility centers in
terms of their increasing level of financial responsibility. However, measuring the
performance of responsibility centers rests on the assumption that a responsibility
center only be held accountable for those things over which it has control. Thus,
responsibility is only one of three major attributes of a responsibility center. The
other two are authority and accountability (see Exhibit 11–4).
400 Financial Management of Health Care Organizations
Investment Centers:
Organizational units
which not only have all
the responsibilities of a
traditional profit
center, but also are
responsible for making
a certain return on
investment.
A Investment in New Surgi-Center [Given] $1,000,000
B Desired Return on Investment (ROI) [Given] 15%
C Desired ROI in Dollars [A × B] $150,000
Actual Results:
D Net Revenues [Given] $500,000
E Expenses [Given] $400,000
F Net Income [D − E] $100,000
G ROI [F/A] 10%
Conclusion: Although the surgi-center made a profit of $100,000, it did not meet the desired ROI of 15%.
Exhibit 11–3 An Example Evaluating an Investment on Its Profit and on Its Return
Responsibility,Authority, and Accountability
The relationship among responsibility, authority, and accountability is straightforward.
Ideally, managers should be given the authority to carry out their responsibilities.
To the extent that this occurs, managers should expect to be held accountable for the
performance of their responsibility centers (see Perspectives 11–2 and 11–3).
Responsibility refers to the duties and obligations of a responsibility center,
authority is the power to carry them out, and accountability means the sanctions,
both positive and negative, attached to carrying out responsibilities. Exhibit 11–4
shows that these three attributes do not always coincide, and the larger the discrepancy,
the more organizational problems and individual frustrations can be expected.
Responsibility Accounting 401
Perspective 11–1
Wake County, NC, Hospital to Shed Its Network of Physician Groups
Rex Healthcare,Wake County’s second-largest hospital, is getting out of the doctor business after seven years of
trying – and failing – to make its network of physician practices profitable. Over the next year, the hospital plans to
sell all but a few practices back to the doctors who work in them. Rex acquired the doctor groups in a buying spree
beginning in 1994, hoping to ensure a steady stream of patients to its facility. The Rex network cares for about
250,000 patients in the region, but has never made money.“We think we’ve done an excellent job taking care of
patients, but financially, it isn’t the direction Rex needs to be going in,” said David Coulter, Rex’s vice president for
operation.“We want these physicians to remain in the Rex family, but we think it works best for them and for us if
they are in private practice.”
Hospital management of physician practices has been generally acknowledged as a failed strategy. Hospitals across
the country are selling their affiliated physician groups back into private practice. “I can’t think of a single example
of where it’s worked,” said Lendy Pridgen, president of the Raleigh consulting firm Capital Health Management. But
it is clear that some doctors chafed under corporate management and constant pressure from Rex officials to boost
the bottom line.“We felt we were working at maximum capacity, but there was always this undercurrent that we
needed to be doing something to make the bottom line look better,” said Dr Robert E. Littleton, whose OB/GYN
practice reverted to private status Aug. 1.
Source: Jean P. Fisher, Business News, The News & Observer, Raleigh, North Carolina,August 16, 2001.
Responsibility
Authority Accountability
Exhibit 11–4 The Basic Attributes of a Responsibility Center
Responsibility: Duties
and obligations of a
responsibility center.
Authority: Power to
carry out a given
responsibility.
Accountability:
Sanctions, both
positive and negative,
attached to carrying
out responsibilities.
Performance Measures
Although responsibility centers should be held accountable for both financial and
non-financial performance, this discussion is limited to an introduction to financial
performance measures. Exhibit 11–5 shows that cost, profit, and investment centers,
respectively, are held accountable for increasing levels of financial responsibility (note
that service centers have no direct financial responsibilities). Budget variances are the
most universal measure of financial performance.
Budget Variances
A budget variance is the difference between what was budgeted and what actually
occurred. Exhibit 11–6 shows an example of an ambulatory care clinic that originally
budgeted to serve 25,000 enrollees of an HMO and predicted they would make 1,000
visits during the month. However, during the month, the clinic actually served
26,000 enrollees who made 1,200 visits. Their expected net income was $0, and their
402 Financial Management of Health Care Organizations
Perspective 11–2
Reviving Ailing Hospitals: Turnaround Specialists Offer Antidote to Chronic Factors Afflicting Industry
Freeman Memorial Hospital in Inglewood, Calif., gave life to Catherine Fickes’ healthcare career. Nearly 40 years
later, she’s come back to return the favor. Fickes, who trained as a nurse at the hospital in the mid-1960s, became
Daniel Freeman’s interim chief executive officer in October. She was part of a turnaround team that arrived at the
hospital in early September. As CEO, she was given the task of reviving the 360-bed facility and its sister hospital,
Daniel Freeman Marina Hospital in Marina del Rey, Calif.The hospitals were losing a combined $2 million per month
before Fickes came on board with a mission to trim expenses and speed payment of collectibles, among other tasks.
During an interview last month, Fickes estimated that the hospitals would break even this month. That’s a far cry
from just three months earlier, when there was talk in the local provider community that Daniel Freeman Memorial
might soon close its doors. . . . When Fickes’ work is done and the Daniel Freeman hospitals are back in the black,
Carondelet plans to sell them to another operator, a common ending for turnarounds.
The factors creating a need for a turnaround firm can be extraordinarily varied, experts say. Not-for-profit
institutions are more likely to need a turnaround because they tend to be more mission-focused and have fewer
internal fiscal checks or have drained their on-hand capital. Although managed care and the budget law both have
received a lot of the blame for healthcare’s financial ailments, there are plenty of other factors. Experts specifically
cite mismanagement, lack of governance or a combination of the two. Hospitals or healthcare systems can pursue
business expansions that go sour and devour cash, such as when they purchase medical groups, or as in the case of
UCSF-Stanford, fail to recognize economies of scale from a merger. Facilities can hire without care, and over a period
of years become grossly overstaffed. Purchasing can lack standardization. Fear of fraud crackdowns often prompts
overcautious coding, resulting in lost patient revenue. Bill collection isn’t aggressively pursued. And just a few maverick
physicians can do a lot of damage to a hospital’s bottom line.
Source: Ron Shinkman, Modern Healthcare, April 9, 2001.
Budget Variance: The
difference between
what was planned
(budgeted) and what
was achieved (actual).
actual net income was $10,000. Though it is tempting to assume that the $10,000
increase in net income was due to changes in the number of enrollees and visits, often
more than one factor is responsible for budget variances. The rest of this section
presents an approach to systematically explain why a budget variance occurs.
As shown in Exhibit 11–7, it is common for health care organizations to separate
their total budget variance (variance in net income) into the portion due to changes
in revenue and the portion due to changes in expenses. The revenue variance is
then broken down into the portion attributable to volume and the portion attributable
to rate differences. The expense variance is subdivided into the portion due to
volume and the part due to other factors. This model will now be used to explain
the net income variance of $10,000 in Exhibit 11–6.
Revenue Variances
In Exhibit 11–6, both the number of enrollees covered and the revenues earned
from them increased beyond what was budgeted. This resulted in a positive revenue
Responsibility Accounting 403
Perspective 11–3
Blue All Over: Novant Health Selling HMO Despite Plan’s Profitability
In contrast to many other hospital systems, Novant Health, of Winston-Salem, NC, found running an HMO to be a
profitable business. In the end, though, three years of profits at Partners National Health Plans, Novant’s managedcare
subsidiary, were not enough for Novant to justify keeping the HMO. Falling in line behind scores of other
provider organizations that have divested their managed-care businesses, Novant said June 18 it was selling its
400,000-enrollee managed-care business to Blue Cross and Blue Shield of North Carolina. Blues officials said they
intend to run Partners, a for-profit subsidiary of not-for-profit Novant, as a wholly owned subsidiary and maintain it
as an independent business.
“Novant Health’s primary mission is to provide healthcare services and provide patient care,” said Jim Tobalski,
Novant’s spokesman.“In the future,we felt for Partners to continue to be successful that we would have to be linked
up to an organization whose primary mission was to provide health plans to area residents.” “Partners turned a $1.2
million profit on $623.4 million in premium revenue for 2000 and enjoyed a $3 million profit for its first quarter this
year alone,” said Stuart Veach, vice president of Partners.
With its HMO profits helping the delivery side of its business rather than hurting it, eight-hospital Novant last
year reported overall net income of $4.9 million on revenue of $1.5 billion.The profitability of Novant’s managedcare
business stands in stark contrast to most of the other provider-owned plans in North Carolina, which have lost
money in recent years. Novant’s decision to sell Partners and its 116,000-enrollee third-party administrator business,
ACS Benefit Services, was announced within weeks of a decision by Carolinas HealthCare System, its chief rival
in the Charlotte, NC, market, to shut down its 29,000-enrollee Medicaid HMO, the Wellness Plan, by Sept. 30.
Partners, meanwhile, was beginning to suffer from Novant’s strategy of limiting its provider network to Novant hospitals
in its two major markets, Charlotte and Winston-Salem,Tobalski said. In an environment where choice was
becoming more highly valued among insurers, Partners was at a disadvantage because of its ties to Novant’s hospitals.
Source: Barbara Kirchheimer, Modern Healthcare, June 25, 2001.
404 Financial Management of Health Care Organizations
Cost Centers Profit Centers Investment Centers
Budget Variances Volume Variances Volume Variances Volume Variances
Cost Variances Cost Variances Cost Variances
Acuity Variances Acuity Variances Acuity Variances
Revenue Variances Revenue Variances
Liquidity Ratios Current Ratio Current Ratio
Quick Ratio Quick Ratio
Days Cash on Hand Days Cash on Hand
Activity Ratios Asset Turnover Asset Turnover
Receivable Turnover Receivable Turnover
Payables Turnover Payables Turnover
Capitalization Ratios Debt to Equity Debt to Equity
Times Interest Earned Times Interest Earned
Debt Service Coverage Debt Service Coverage
Profit & Profitability Ratios Profit Profit
Operating Margin Operating Margin
Return on Equity
Return on Assets
Exhibit 11–5 Typical Financial Performance Measures Used to Evaluate the Financial Performance of
Responsibility Centers
Givens:
Budgeted Actual Variance
A Enrollees 25,000 26,000 1,000
B Visits 1,000 1,200 200
C Revenues $100,000 $117,000 $17,000 Favorable
D Expenses $100,000 $107,000 $7,000 Unfavorable
E Net Income $0 $10,000 $10,000 Favorable
Exhibit 11–6 Revenue and Expense Variance Information for an Ambulatory Care Clinic Serving HMO Enrollees
Net Income Variance
Revenue Variance Expense Variance
Volume Variance Rate Variance Volume Variance Other Variance
Net Income Variance
Revenue Variance Expense Variance
Volume Variance Rate Variance Volume Variance Other Variance
Exhibit 11–7 Common Variances Used by Health Care Organizations
variance of $17,000. This is called a favorable variance because more income was
received than was budgeted. Using just this information, it is tempting to conclude
that the increase in revenues was due to the increase in employees covered. In fact, a
variance analysis of the change in revenues shows that this is only partly the case.
Step 1. Develop the Flexible Budget Estimate for Revenues
In addition to the budgeted estimate and actual results, a variance analysis involves
one more piece of information, called a flexible budget estimate. The flexible
budget estimate adjusts for the actual volume being different from what was
planned. The flexible budget estimate is what would have been budgeted had the
actual volume been known ahead of time. Determining the flexible budget estimate
involves two steps: calculating the budgeted rate and then using this number to
determine how much would have been budgeted had the actual volume been
known.
Step 1A. Determine the Budgeted Revenue per Unit
To determine the budgeted revenue per unit, first determine what measure of volume
will be used. In Exhibit 11–6, there are two measures of volume: enrollees and visits.
Though in a fee-for-service or flat rate payment environment revenues might be
expected to vary with the number of visits, in a capitated situation revenues fluctuate
with the number of enrollees. Using enrollees as the measure of volume, the
budgeted revenues are $4 per member per month (PMPM). This is determined by
dividing budgeted revenues, $100,000, by the budgeted number of enrollees, 25,000
(see Exhibit 11–8, Step 1A).
Step 1B. Develop the Flexible Budget Estimate
The flexible budget estimate is the budgeted revenue PMPM multiplied by the actual
volume ($4.00 PMPM × 26,000 = $104,000). This is the amount that would have been
budgeted for revenues had it been known when the original budget was made that the
actual volume would be 26,000 rather than 25,000 enrollees (see Exhibit 11–8, Step
1B).
A flexible budget estimates the revenues, expenses, or both over a range of volumes
in order to forecast what the revenues would be at various levels. For example, by
multiplying the $4.00 PMPM by a range of enrollees from 24,000 through 28,000, the
clinic could develop a range of revenue estimates at selected levels (see Exhibit 11–8,
rows D–F).
Both the range of volume estimates (in this case the number of enrollees) and the
gap between each estimate are open to judgment. However, the range should
include both the budgeted and actual volumes. Using this approach, the clinic just
as easily could have estimated the results for a range of 24,500 to 27,500 using
steps of 500. Either way, at 26,000 enrollees the budget estimate would have been
$104,000.
Responsibility Accounting 405
Flexible Budget: A
budget which
accomodates a range
or multiple levels of
activities.
Step 2. Calculate the Revenue Variance Due to Changes in Volume
and Rate
This step begins by laying out, side by side, the three revenue budget figures: budgeted
amount, flexible budget, and actual revenues (see Exhibit 11–8, rows G–I).
All that remains is to compare these three figures. The difference between the original
budget, $100,000, and the flexible budget, $104,000, shows how much of the revenue
variance is due to volume: $4,000 (Exhibit 11–8, row J). The difference between the flexible
budget, $104,000, and actual results, $117,000, is the amount of the revenue variance
that is due to a change in rate: $13,000.
These differences can also be derived a different way. Looking at the volume variance,
since the rate is held constant at $4.00 PMPM, the only difference between the
406 Financial Management of Health Care Organizations
Givens:
Budgeted Actual Variance
1 Enrollees
2 Visits
3 Revenues Favorable
4 Expenses Unfavorable
5 Net Income
25,000
1,000
$100,000
$100,000
$0
26,000
1,200
$117,000
$107,000
$10,000
1,000
200
$17,000
$7,000
$10,000 Favorable
Step 1. Develop Flexible Revenue Budget Estimate
Step 1A. Calculate Budgeted Revenue Per Unit Based on Given Information
A Budgeted Revenue Per Month [Given 3] $100,000
B Budgeted Volume Of Enrollees [Given 1] 25,000
C Budgeted Service Revenue [A/B] $4.00 Per Member per Month (PMPM)
Step 1B. Develop a Flexible Revenue Budget Containing The Actual Volume
D Volume (Flexible) 24,000 25,000 26,000 27,000 28,000
E Revenue PMPM [C] $4.00 $4.00 $4.00 $4.00 $4.00
F Total Revenue [D 3 E] $96,000 $100,000 $104,000 $108,000 $112,000
Step 2. Compare the Budgeted Amount, the Flexible Budget at the Actual Volume, and the Actual Budget.
Budgeted
Revenues
Flexible
Budget
Actual
Revenues
G Volume 25,000 26,000 26,000
H Revenues $100,000 $104,000 $117,000
I Rate [H/G] $4.00 $4.00 $4.50
J $4,000 $13,000
Volume Variance1
Favorable
Rate Variance2
Favorable
1Volume Variance = (Actual Volume − Budgeted Volume) 3 Budgeted Rate = (26,000 − 25,000) 3 $4.00 = $4,000
2Rate Variance = (Actual Rate − Budgeted Rate) 3 Actual Volume = ($4.50 − $4.00) 3 26,000 = $13,000
Summary:
1$4,000 due to an increase in enrollment from 25,000 budgeted to 26,000 actual.
2$13,000 due to an increase in capitation from $4.00 budgeted to $4.50 PMPM actual.
$17,000 Total Revenue Variance to be explained.
Exhibit 11–8 Analysis of a Revenue Variance by Volume and Rate Variances
original budget and the flexible budget is volume (26,000 rather than 25,000
enrollees). Thus, using the formula:
Revenue Volume Variance = (Actual Volume – Budgeted Volume)
× Budgeted Rate
the revenue volume variance is $4,000 [(26,000 − 25,000) × $4.00]. That is, since
volume increased by 1,000 at $4.00 per member, $4,000 extra was earned.
The $13,000 rate variance can be analyzed similarly. Since the flexible budgeted
revenue PMPM was $4.00 and the actual revenue is $4.50 PMPM ($117,000/26,000)
there is a rate increase of $0.50 PMPM. Using the formula:
Revenue Rate Variance = (Actual Rate − Budget Rate)
× Actual Volume
the revenue rate variance is $13,000 [($4.50 − $4.00) × 26,000]. Thus, since the
organization earned $0.50 more PMPM than was budgeted, and it served 26,000
enrollees, the variance due to a change in rate is $13,000.
The procedure to calculate revenue volume and rate variances is summarized in
Exhibits 11–9a and b.
Expense Variances
This section explains why the ambulatory clinic was $7,000 over its budgeted expenses
($107,000 − $100,000). As shown in Exhibit 11–10, analyzing expense
variances is quite similar to analyzing revenue variances.
Step 1. Explain the Amount of Variance Due to Fixed Costs
Though variable costs are directly affected by volume, fixed costs should not be.
There are a number of reasons why fixed costs might have been incurred beyond what
was budgeted. For example, there may be additional depreciation taken on the purchase
of new equipment, unanticipated raises given, or new employees hired.
(Consider that perhaps volume went beyond the relevant range into a higher “step” of
Responsibility Accounting 407
Revenue Volume
Variance: The portion
of total variance in
revenues due to the
actual volume being
either higher or lower
than the budgeted
volume. It is the
difference between the
revenues forecast in
the original budget and
those in the flexible
budget. It can be
computed using the
formula: (actual
volume − budgeted
volume) × budgeted
rate.
Revenue Rate
Variance: The amount
of the total revenue
variance that occurs
because the actual
average rate varies
from the one originally
budgeted. It is the
difference between the
revenues forecast in
the flexible budget and
those actually earned.
It can be calculated
using the formula:
(actual rate – budgeted
rate) × actual volume.
Number Used
to Estimate: Original Budget Flexible Budget Actual Budget
Volume
Rate
Budgeted Volume
Budgeted Rate
Actual Volume
Budgeted Rate
Actual Volume
Actual Rate
Difference Due
to Volume
Difference Due
to Rate
Exhibit 11–9a Derivation of the Revenue Volume and Rate Variances
408 Financial Management of Health Care Organizations
Number Used
to Estimate: Original Budget Flexible Budget Actual Budget
Volume 25,000 26,000 26,000
Rate $4.00 $4.00 $4.50
Revenue $100,000 $104,000 $117,000
Volume Variance
Rate Variance
$4,000
$13,000
Exhibit 11–9b Actual Numbers Used to Compute the Revenue Volume and Rate Variances
Step 1. Explain the amount of variance due to non-variable expenses
Budgeted Actual Variance
A Volume
B Non-Variable Expenses Unfavorable
C Expenses Unfavorable
D Total Expenses Unfavorable
Step 2. Develop Flexible Expense Budget Estimate
Step 2A. Calculate Budgeted Expense Per Unit Based on Information in Step 1.
E Budgeted Total Variable Expenses [C] $100,000
F Budgeted Visits [A] 1,000
G Budgeted Variable Expenses [E/F] $100.00 Per Visit
Step 2B. Develop a Flexible Expense Budget Using Budgeted Expense Per Unit
H Volume (Flexible) 1,000 1,100 1,200 1,300 1,400
I Budgeted Variable Expenses per Visit [G] [G] $100 $100 $100 $100 $100
J Total Variable Expenses [H I] [H I] $100,000 $110,000 $120,000 $130,000 $140,000
Step 3. Compare the Budgeted Expenses, the Flexible Budget at the Actual Volume, and Actual Expenses
Budgeted
Expenses
Flexible
Budget
Actual
Expenses
K Volume [A] 1,000 1,200 1,200
L Total Variable Expenses [C] $100,000 $120,000 $102,000
M Expense per Visit [L/K] $100.00 $100.00 $85.00
N $20,000 ($18,000)
Volume Variance1
Unfavorable
Other Variance2
Favorable
1 Volume Variance = (Actual Volume − Budgeted Volume) Budgeted Rate = (1,200 − 1,000) $100.00 = $20,000
2 Cost Variance = (Actual Cost − Budgeted Cost) Actual Volume = ($85.00 − $100.00) 1,200 = −$18,000
Summary:
Visits 1,200
Total Variance to be explained $7,000
Non-Variable Variance $5,000
Volume Variance $20,000
Variance due to other factors ($18,000)
Total Unexplained Variance $0
1$20,000 increase in expenses due to an increase in visits from the 1,000 which were budgeted to 1,200.
2$18,000 in other savings were gained due to a decrease in per visit cost from the $100.00 budgeted to $85.00 actual.
1,000
$0
$100,000
$100,000
1,200
$5,000
$102,000
$107,000
200
$5,000
$2,000
$7,000
Exhibit 11–10 Breaking Down the Expense Variance into Fixed,Volume, and Cost Variances
step-fixed costs.) This example assumes that fixed expenses increased because one
contract nurse was hired for $5,000 per month.
Original expense variance (Exhibit 11–6, row D): $7,000
Amount explained by fixed expenses (Exhibit 11–10, row B): $5,000
Amount of expense variance still unexplained: $2,000
This explains $5,000 of the $7,000 expense variance. The following steps explain the
remaining $2,000 unfavorable expense variance – due to variable expenses.
Step 2. Develop a Flexible Expense Budget
This step involves developing a flexible budget in order to determine how much
would have been budgeted had it been known at the time the budget was prepared that
the actual number of visits would be 1,200 and not 1,000.
Step 2A. Determine the Budgeted Cost per Unit
Determining the budgeted cost per unit requires selecting the measure of volume.
Whereas revenues vary with enrollees under capitation, expenses are more likely to
vary with the number of visits. The budgeted cost per unit in the example then is calculated
by dividing the $100,000 in budgeted expenses by the 1,000 budgeted visits
(see Exhibit 11–10, Step 2A, rows E, F). Thus, the budgeted cost per visit is $100.00
(see Exhibit 11–10, Step 2A, row G).
Step 2B. Develop the Flexible Budget Estimate
The flexible expense budget estimate is the budgeted cost per unit multiplied by the actual
volume ($100.00 × 1,200 = $120,000). This is the amount that would have been budgeted
for expenses had it been known when the original budget was made that the actual
volume would be 1,200 rather than 1,000 visits (see Exhibit 11–10, Step 2B, rows H–J).
Step 3. Calculate the Expense Variance Due to Changes in Volume
and Other Factors
As in Step 2 of the revenue variance analysis presented earlier (Exhibit 11–8), this step
begins by laying out, side by side, the three expense budget figures: budgeted, flexible,
and actual expenses.
From Exhibit 11–10, Step 3, the difference between the original budget, $100,000,
and the flexible budget, $120,000, is the amount of the variance due to volume,
$20,000 (rows L, N). The difference between the flexible budget and the actual results
($120,000 − $102,000 = $18,000) is due to a change in costs per unit (also rows L, N).
Note that this is a cost saving and is therefore considered favorable. Costs actually
decreased from what was expected.
Responsibility Accounting 409
Expense Volume
Variance: The portion
of total variance in
expenses due to the
actual volume being
either higher or lower
than the budgeted
volume. It is the
difference between the
expenses forecast in
the original budget and
those in the flexible
budget. It can be
computed using the
formula: (actual
volume – budgeted
volume) × budgeted
rate.
As with the revenue variances, expense variances can also be derived a different
way. In regard to the volume variance, since the cost per unit is held constant ($100
per visit), the only difference between the original budget and the flexible budget is
volume (1,200 rather than 1,000 visits). Thus, using the formula:
Expense Volume Variance = (Actual Volume − Budgeted
Volume) × Budgeted Cost per Unit
the expense volume variance is $20,000 [(1,200 − 1,000) × $100.00]. This is
because 200 more members than budgeted were seen at a $100 cost per visit. The
expense volume variance is the portion of total variance in variable expenses that is
due to the actual volume being either higher or lower than the budgeted volume. It is
the difference between the expenses forecast in the original budget and those in the
flexible budget. It can be computed using the following formula: (actual volume −
budgeted volume) × budgeted cost per unit.
The $18,000 savings shown in the cost variance can be analyzed similarly. Since the
flexible budgeted cost per visit was $100 and the actual cost per visit is $85
($102,000/1,200), there is a decrease in the cost per visit of $15. Using the formula:
Expense Cost Variance = (Actual Cost per Unit – Budgeted
Cost per Unit) × Actual Volume
the expense cost variance is −$18,000. Thus, since the organization spent $15 less
per visit than had been budgeted, and it provided 1,200 visits, the variance due to a
change in cost per visit is −$18,000 (−$15 × 1,200).
The procedure to calculate expense volume and cost variances is summarized in
Exhibits 11–11a and 11–11b.
Though the amount of the cost variance was calculated, the reason for it is unclear.
The cost variance could be due to a variety of factors, including changes in quality,
case mix, intensity of services, efficiency, and wages. Although it is possible to decompose
the cost variance into other variances, that methodology is beyond the scope of
this text.
Summary of the Example
When considering both revenues and expenses, the total variance was $10,000. Of
this, a change in volume resulted in increased revenues of $4,000 and increased costs
of $20,000. On the other hand, the change in rate from $4.00 to $4.50 PMPM brought
in an extra $13,000, and the change in cost per unit from $100 to $85 accounted for
$18,000 in savings from what was budgeted. In addition, a step-fixed cost was
incurred by hiring a contract nurse at $5,000 per month.
410 Financial Management of Health Care Organizations
In the formula for expense volume variance, the sign of the answer is crucial. A negative answer indicates a
decrease in volume, but this is considered a favorable variance because it leads to a decrease in costs. A positive
answer indicates an increase in volume, and this is considered an unfavorable variance because it leads to
an increase in costs.
Expense Cost
Variance: The amount
of the variable expense
variance that occurs
because the actual cost
per unit varies from
that originally
budgeted. It is the
difference between the
variable expenses
forecast in the flexible
budget and those
actually incurred. It can
be calculated by the
formula: (actual cost
per unit − budgeted
cost per unit) × actual
volume.
Total variance $10,000 Favorable
Variance explained by a change in volume:
Increase in enrollees from 25,000 to 26,000 (revenues) $4,000 Favorable
Increase in visits from 1,000 to 1,200 (expenses) $20,000 Unfavorable
Increase in rates from $4.00 to $4.50 PMPM $13,000 Favorable
Decrease in cost per visit from $100 to $85 per visit $(18,000) Favorable
Increase in fixed costs by hiring a contract RN $5,000 Unfavorable
Total variance explained $ 10,000 Favorable
Beyond Variances
Budget variances are usually associated with the operating budget, which focuses on
short-term revenue attainment (earning the amount of revenue budgeted) and cost
containment (not spending more than budgeted). A more long-term focus is neces-
Responsibility Accounting 411
Number Used
to Estimate: Original Budget Flexible Budget Actual Budget
Volume
Cost/Unit
Budgeted Volume
Budgeted Cost/Unit
Actual Volume
Budgeted Cost/Unit
Actual Volume
Actual Cost/Unit
Difference Due Difference Due
to Volume to Other Factors
Exhibit 11–11a Derivation of the Expense Volume and Cost/Unit Variance
Number Used
to Estimate: Original Budget Flexible Budget Actual Budget
Volume 1,000 1,200 1,200
Cost/Unit $100.00 $100.00 $85.00
Expense $100,000 $120,000 $102,000
Volume Variance
Cost/Unit Variance
$20,000
(Unfavorable)
$18,000
(Favorable)
Exhibit 11–11b Actual Numbers Used to Compute the Expense Volume and Cost/Unit Variances
In the formula for expense cost variance, the sign of the answer is crucial. A negative answer indicates a
decrease in variable cost per unit, but this is considered a favorable variance since it leads to decreased costs.
A positive answer indicates an increase in variable cost per unit, but this is considered an unfavorable variance
because it leads to increased costs.
Revenue Attainment:
Earning the amount of
revenue budgeted.
sary to effect major efficiencies in the organization. Measures must be implemented
to promote revenue enhancement (finding new sources of revenue) and cost
avoidance (finding new ways to operate that eliminate certain classes of costs) in the
long term. For instance, just-in-time (JIT) inventory methods deliver supplies “automatically”
to the organization as needed, and they avoid many of the traditional costs
of ordering, storing, and keeping track of inventories that flow through health care
organizations. If only a short-term focus were used, the initial costs might discourage
an administrator from installing such a system; however, long-term measures might
encourage such a decision.
Other Financial Performance Measures
Though budget variances are the most used financial measure, various ratios are
increasingly being used as financial performance measures for profit and investment
centers. Though the use of these indicators is basically the same for profit
centers and investment centers as it is for the organization as a whole, some complications
arise when using these measures to judge the financial performance of
divisions within the organization. The most common are:
1. They may promote a lack of goal congruence; that is, they may encourage the
organizational unit to make decisions that are in its own best interest, but not
in the best interest of the organization as a whole.
2. They may introduce complicated measurement problems. For instance,
when two organizational units share the same assets, it is difficult to partition
the assets between the two units to calculate such measures as return on
assets.
3. They may promote short-term thinking.
Summary
A growing trend in the structure of health care providing organizations is decentralization,
which presents some interesting problems in the measurement of financial
performance of the organizational units. Decentralization is the degree of dispersion
of responsibility within an organization.
The advantages of decentralization include: time, information relevance, quality,
speed, talent, and motivation and allegiance. The disadvantages include loss of control,
decreased goal congruence, increased need for coordination and formal communication,
and lack of managerial talent.
A responsibility center is an organizational unit that has been formally designated
with the responsibility to carry out one or more tasks and/or to achieve one or more
outcomes. There are four major types of responsibility centers:
1. Service centers are responsible for ensuring that health care-related
services are provided to a population in a manner that meets the volume and
412 Financial Management of Health Care Organizations
Revenue
Enhancement: Finding
supplemental sources
of revenue.
Cost Avoidance:
Finding new ways to
run a business that
eliminate certain
classes of costs.
Cost Containment:
Not spending more
than is budgeted in the
expense budget.
quality requirements of the organization. They have no direct budgetary
control.
2. Cost centers are responsible for providing services and controlling their
costs. They are the primary level in the organization with direct budget
control. The two types of cost centers in health care organizations are clinical
cost centers and administrative cost centers. Clinical cost centers provide
health care-related services to clients, patients, or enrollees. Administrative
cost centers provide support to the clinical cost centers and the organization
as a whole. Included in this category are general administration, the
business office, information services, admitting, medical records, and
housekeeping.
3. Profit centers are responsible for controlling costs and earning revenues. The
three types of profit centers are traditional profit centers, capitated profit
centers, and administrative profit centers.
4. Investment centers are responsible for attaining a return on investment.
The relationship between responsibility, accountability, and authority is straightforward.
Ideally, managers should be given the authority to carry out their responsibilities.
To the extent that this occurs, managers are held accountable for the
performance of their responsibility centers. Responsibility refers to the duties and
obligations of a responsibility center, authority is the power to carry out a given
responsibility, and accountability means the sanctions, both positive and negative,
attached to carrying out responsibilities.
Cost, profit, and investment centers, respectively, are held accountable for increasing
levels of financial responsibility. (Service centers have no direct financial responsibilities.)
Budget variances are the most universal measure of financial performance.
A budget variance is the difference between what was budgeted and what actually
occurred. It is common for health care organizations to separate their total budget
variance (variance in net income) into revenue variances and expense variances. The
revenue variance is broken down into volume and rate variances. The expense variance
is separated into volume variance and other factors.
The revenue volume variance is the portion of total variance in revenues due to the
actual volume being either higher or lower than the budgeted volume. It is the difference
between the revenues forecast in the original budget and those in the flexible
budget. It can be computed using the following formula: (actual volume − budgeted
volume) × budgeted rate. The rate variance is the amount of the total revenue variance
that occurs because the actual average rate received varies from that originally
budgeted. It is the difference between the revenues forecast in the flexible budget and
those actually earned. It can be calculated using the formula: (actual rate − budgeted
rate) × actual volume.
The expense volume variance is the portion of total variance in variable expenses
due to the actual volume being either higher or lower than the budgeted volume. It is
the difference between the expenses forecast in the original budget and those in the
flexible budget. It can be computed using the following formula: (actual volume −
budgeted volume) × budgeted cost per unit.
Responsibility Accounting 413
The expense cost variance is the amount of the variable expense variance that occurs
because the actual cost per visit varies from that originally budgeted. It is the difference
between the variable expenses forecast in the flexible budget and those actually
incurred. It can be calculated by the formula: (actual cost per unit − budgeted cost per
unit) × actual volume. The cost variance could be due to a variety of factors including
changes in quality, case mix, intensity of service, efficiency, and wages.
Key Equations
Expense Cost Variance: (Actual Cost per Unit − Budgeted Cost per Unit) ×
Actual Volume
Expense Volume Variance: (Actual Volume − Budgeted Volume) × Budgeted
Cost per Unit
Revenue Rate Variance: (Actual Rate − Budgeted Rate) × Actual Volume
Revenue Volume Variance: (Actual Volume − Budgeted Volume) × Budgeted Rate
Questions and Problems
1. Definitions. Define the following terms:
a. Accountability.
b. Administrative Cost Centers.
c. Administrative Profit Centers.
d. Authority.
e. Budget Variance.
f. Capitated Profit Centers.
g. Clinical Cost Centers.
h. Cost Avoidance.
414 Financial Management of Health Care Organizations
Accountability
Administrative Cost Centers
Administrative Profit Centers
Authority
Budget Variance
Capitated Profit Centers
Clinical Cost Centers
Cost Avoidance
Cost Centers
Cost Containment
Decentralization
Expense Cost Variance
Expense Volume Variance
Profit Centers
Responsibility
Responsibility Center
Revenue Attainment
Revenue Enhancement
Revenue Rate Variance
Revenue Volume Variance
Service Centers
Traditional Profit Centers
Key Terms
i. Cost Centers.
j. Cost Containment.
k. Decentralization.
l. Expense Cost Variance.
m. Expense Volume Variance.
n. Profit Centers.
o. Responsibility.
p. Responsibility Center.
q. Revenue Attainment.
r. Revenue Enhancement.
s. Revenue Rate Variance.
t. Revenue Volume Variance.
u. Service Centers.
v. Traditional Profit Centers.
2. Advantages of decentralization. List and discuss the advantages associated
with decentralization.
3. Disadvantages of decentralization. List and discuss the disadvantages of
decentralization.
4. Types of responsibility centers. Describe the four types of responsibility
centers, including the characteristics of each.
5. Responsibility centers.
a. What is the most common type of responsibility center?
b. What is the most basic type of responsibility center?
6. Identifying responsibility centers. Identify each responsibility center below
as either a service center, cost center (clinical or administrative), profit center
(capitated or administrative), or investment center. Explain your choices:
a. Radiology department that must control its own costs.
b. Admitting department of a hospital.
c. HMO.
d. Stand-alone outpatient clinic that must earn a 10 percent ROI.
e. Volunteer department with no budget.
f. Development office.
7. The relationship among accountability, responsibility, and authority.
What is the relationship of accountability, responsibility, and authority with
respect to a responsibility center?
8. Transfer prices. What are transfer prices? Discuss their major disadvantages.
9. Performance measures. What is the most commonly used financial
performance measure?
10. Performance measures. Name two financial measures used to judge the
performance of investment centers that are not used to measure the financial
performance of profit centers.
11. Performance measures. What are major disadvantages of using traditional
performance measures?
12. Variance analysis. What does the term “variance analysis” mean when applied
to financial performance of health care organizations?
Responsibility Accounting 415
13. Budget variances. What are the most common types of budget variances used
in health care organizations?
14. Cost variances. What can account for cost variances?
15. ROI for an investment center. An outpatient clinic invests $2,300,000. The
desired ROI is 12 percent. In the first year, revenues are $750,000 and expenses
are $370,000. Does the clinic meet its ROI requirement that year?
16. ROI for an investment center. A new cardiac catheterization lab was
constructed at Havea Heart Hospital. The investment for the lab was $450,000
in equipment costs and $50,000 in renovation costs. A desired return on
investment is 12 percent. Once the lab was constructed, 5,000 patients were
served in the first year and were charged $340 for each procedure. The annual
fixed cost for the catheterization lab is $1 million and the variable cost is $129
per procedure. What is the catheterization lab’s profit? Did this profit meet its
desired ROI?
17. Detailed variance analysis. The following are planned and actual revenues
for Cutting Edge Surgery Center. Since they are one of four surgery centers in
the community, the administrator is very concerned with his rates in relation to
those of his competitors.
Planned Actual
Surgical volume 1,200 1,400
Gift shop revenues $12,000 $15,000
Surgery revenues $500,500 $750,750
Parking revenues $15,000 $17,000
a. Determine the total variance between the planned and actual budgets.
b. Determine the service-related revenues and calculate variance still
unexplained.
c. Prepare a flexible budget estimate. Present side-by-side the budget, flexible
budget estimate, and actual surgical revenue (and related volumes).
d. Determine what variance is due to change in volume and what variance is
due to change in rates.
e. Determine the volume variance and rate variance based on per unit rates.
18. Detailed variance analysis. The administrator of Break-a-Leg Hospital is
very aware of the need to keep his cost down, since he just negotiated a new
capitated arrangement with a large insurance company. The following are
selected planned and actual expenses for the previous month.
Planned Actual
Patient days 24,000 30,000
Pharmacy $100,000 $140,000
Miscellaneous supplies $56,000 $67,500
Fixed overhead costs $708,000 $780,000
a. Determine the total variance associated with the planned and actual
expenses.
416 Financial Management of Health Care Organizations
b. Calculate the amount of unexplained variance and give a possible reason for
the change in fixed expenses.
c. Prepare a flexible expense estimate for variable costs. Compare budget,
flexible budget, and actual (show related volumes).
d. Determine what variance is due to change in volume and what variance is
due to change in rates.
e. Determine the volume variance and rate variance based on per unit rates.
19. Detailed variance analysis. A dermatology clinic expects to contract with an
HMO for an estimated 80,000 enrollees. The HMO expects 1 in 4 of its
enrolled members to use the dermatology services per month. At the end of the
year, the dermatology clinic’s business manager looked at her monthly figures
and saw that the number of enrolled members had increased by 5 percent over
the budgeted amount, and that 1 in 3 of the total HMO members had used the
dermatology services per month. Net monthly revenues of the dermatology
clinic were budgeted at $260,000 but were actually $450,000. Monthly expenses
for the clinic were budgeted at $200,000 but were actually $270,000.
a. Prepare a monthly revenue, expense, and net income variance budget for the
clinic.
b. Are these variances favorable or unfavorable? Why?
Responsibility Accounting 417
Introduction
Finding the costs to serve various populations (e.g. the elderly, Medicare patients,
rehabilitation patients), to produce various goods and services, and to work with
various payors (e.g. Medicaid, insurance companies) is an important activity for
most health care providers. A cost object is anything for which costs are being estimated,
such as a population, a test, a visit, a patient, or a patient day. This chapter
Learning Objectives
After completing this chapter, you will be able to:
Identify three methods for estimating costs.
Calculate costs using the Step-down Method.
Calculate costs using Activity-based Costing.
Understand the major advantages and disadvantages of Activity-based Costing.
Introduction
The Cost-to-charge Ratio
The Step-down Method
Allocating Utilities
Allocating Administrative Costs
Allocating Laboratory
Fully Allocated Costs
Activity-based Costing
Costing Terminology
An Example
SUMMARY
Key Terms
Questions and Problems
Chapter Outline
C h a p t e r Tw e l v e
PROVIDER COST FINDING METHODS
Provider Cost Finding Methods 419
discusses the three most commonly used approaches to find costs for various cost
objects: 1) the Cost-to-Charge Ratio; 2) the Step-down Method; and 3) Activitybased
Costing.
The Cost-to-charge Ratio
Historically, the cost to charge ratio, CCR, is one of the most common methods
used by hospitals, dentists, and doctors to estimate costs. It is based upon an
assumed relationship of costs to charges, usually determined by industry norms or
special studies. CCR begins with charges (or reimbursement) and assumes that
costs are a certain percentage of this amount. For example, a group planning a dental
office might use the rule of thumb that all non-direct labor expenses amounted
to 22 percent of charges.
The main advantage of this approach is simplicity. The disadvantages include: 1)
to the extent that the ratio used is typical for the industry or segment of the industry,
it may not apply well to any particular organization; 2) if the ratio were determined by
a study, to the extent that volume or service mix deviates from the figures used in the
study, the CCR may become inaccurate; 3) to the extent that the fixed/variable cost
composition has changed, the ratio may provide an inaccurate measurement; and 4) to
the extent that an overall ratio is used for all procedures, the CCR may underestimate
or overestimate the cost of individual procedures.
While CCR is relatively simple to implement, more complex health care organizations
usually use a Step-down or an Activity-Based Costing approach, either of which
is commonly thought to be more accurate.
The Step-down Method
The Step-down Method is a cost-finding method based on allocating those costs
that are not directly paid for to those products or services that are. The example in
Exhibit 12–1 shows three responsibility centers to which payment is not attached
(utilities, administration, and laboratory) and three to which revenues are
attached (walk-in services, pediatric services, and adolescent services). The goal of
the step-down method is to allocate the costs of the support centers (utilities, administration,
and laboratory) fairly among each of the three patient services. The full
step-down allocation is shown in Exhibit 12–2.
There are four steps to allocate the costs of non-directly paid for costs to services
for which payment is attached:
1. Determine an allocation base and compile basic statistics.
2. Convert basic statistics for the step-down.
3. Calculate allocation percentages.
4. Allocate costs from the support centers to each of the centers below it (thus,
the “down” in “step-down”).
Cost Object:
Anything for which
costs are being
estimated, such as a
population, a test, a
visit, a patient, or a
patient day.
Cost-to-charge Ratio
(CCR): A method to
estimate costs which
assumes that costs are
a certain percentage
of charges (or
reimbursements).
Step-down Method:
A cost finding method
based on allocating
those costs that are
not directly paid for to
those products or
services to which
payment is attached.
The method derives its
name from the stairstep
pattern that
results from allocating
costs.
These steps will now be followed to allocate utilities, administration, and laboratory
costs, respectively.
Allocating Utilities
An allocation base is an item used to allocate costs, based upon its relationship to
why the costs occurred. Some common allocation bases are listed in Exhibit 12–3. The
better the cause-and-effect relationship between why the cost occurred and the allocation
basis, the more accurate the cost allocation. Because of their causal relationship
to costs, allocation bases are also called cost drivers (discussed in more detail below). A
420 Financial Management of Health Care Organizations
Direct Costs
Utilities $50,000 These costs, which are
Administration 100,000 not paid for directly. . .
Laboratory 175,000
Walk-in Clinic Services 200,000 Must be folded into these services,
Pediatric Services 200,000 to which payment is attached.
Adolescent Clinic Services 300,000
Total $1,025,000
Exhibit 12–1 Example of Costs for which Payment Is Not Directly Attached and Those to which Payment Is
Directly Attached
A B C D E F
Sq. Feet Direct Costs Lab Tests Sq. Feet Direct Costs Lab Tests
Utilities $50,000
Administration 1,000 $100,000 1,000
Laboratory 2,000 $175,000 2,000 $175,000
Walk-in services 2,000 $200,000 250 2,000 $200,000 250
Pediatric services 2,500 $200,000 450 2,500 $200,000 450
Adolescent services 2,500 $300,000 300 2,500 $300,000 300
Total 10,000 $1,025,000 1,000 10,000 $875,000 1,000
G H I J K L M N
Utilities Administration Laboratory Direct Costs Utilities Administration Laboratory Total
[Sq. Feet] [Direct Costs] [Tests]
Utilities $50,000 ($50,000)
Administration 10% $100,000 $5,000 ($105,000)
Laboratory 20% 20.0% $175,000 $10,000 $21,000 ($206,000)
Walk-in services 20% 22.9% 25% $200,000 $10,000 $24,000 $51,500 $285,500
Pediatric services 25% 22.9% 45% $200,000 $12,500 $24,000 $92,700 $329,200
Adolescent services 25% 34.3% 30% $300,000 $12,500 $36,000 $61,800 $410,300
Total 100% 100% 100% $1,025,000 $0 $0 $0 $1,025,000
1Differences due to rounding.
Step 1: Compile Basic Statistics Step 2: Compute Converted Statistics
Step 3: Compute Allocation % Step 4: Allocate Costs1
Exhibit 12–2 The Step-down Method of Allocating Costs
Allocation Base: A
statistic (e.g. square
feet, number of fulltime
employees) used
to allocate costs,
based upon its
relationship to why
the costs occurred.
common base to allocate utilities is square footage, on the assumption that actual utility
usage is proportional to the size of the space a service occupies.
Exhibit 12–4 highlights those parts of Exhibit 12–2 relevant to allocating utilities.
Since administration occupies 1,000 of the 10,000 square feet of the facility (see
Exhibit 12–4, columns A and D), it is allocated 10 percent (column G) of the $50,000
direct cost of utilities, which is $5,000 (column K). Similarly, since the laboratory and
Provider Cost Finding Methods 421
Costs to Be Allocated Allocation Basis
Billing Office Number of Bills
General Administration Direct Costs of Department
Number of FTEs1
Laboratory2 Weighted Average Costs of Tests
Number of Tests
Medical Records Number of Records “Pulled”
Nursing2 Nursing Hours
Acuity-weighted Hours
Purchasing Number of Purchase Orders
Rent, Utilities, Cleaning Square Feet
1 Full-time Equivalent Employees.
2 Laboratory and Nursing are frequently charged directly to patients, rather than being allocated.
Exhibit 12–3 Some Common Allocation Bases
A B C D E
Sq. Feet Sq. Feet
Utilities
Administration 1,000 1,000
Laboratory 2,000 2,000
Walk-in services 2,000 2,000
Pediatric services 2,500 2,500
Adolescent services 2,500 2,500
Total 10,000 10,000
G H I J K
Utilities Direct Costs Utilities
[Sq. Feet]
Utilities $50,000 ($50,000)
Administration 10.0% $5,000
Laboratory 20.0% $10,000
Walk-in services 20.0% $10,000
Pediatric services 25.0% $12,500
Adolescent services 25.0% $12,500
Total 100% $0
Step 2: Compute Converted Statistics
Step 4: Allocate Costs
Step 1: Compile Basic Statistics
Step 3: Compute Allocation %
$50,000 in utilities
costs are being
allocated.
Exhibit 12–4 Steps in the Step-down Process Relevant to the Allocation of Utility Costs
the walk-in services each occupy 2,000 of the 10,000 square feet (columns A and D),
each is allocated 20 percent (column G), which is $10,000 (column K). Finally, since
the pediatric and adolescent services each occupy 2,500 square feet (columns A and
D), each is allocated 25 percent (column G), which is $12,500 (column K).
Allocating Administrative Costs
Exhibit 12–5 highlights those parts of Exhibit 12–2 relevant to allocating administrative
costs. Note that instead of allocating just the $100,000 in direct administrative
costs that were there at the beginning of the allocation (column J), $105,000 is allocated
from Administration, $100,000 in direct administrative costs, and an additional
$5,000 that has been allocated to Administration from Utilities.
The allocation base used to allocate administration is direct costs (see Exhibit
12–5, column E), based on the assumption that administrative costs are incurred
by each of the other responsibility centers in the same proportion as are their
direct costs. Another allocation base sometimes used to allocate administrative
costs is the number of FTEs (full-time equivalent employees) in each responsibility
center. This assumes that administrative costs are incurred in proportion to the
number of employees working in each responsibility center.
Though the procedure here is similar to allocating utilities, there is one major difference.
Note that in column B of Exhibit 12–5 there is $1,025,000 in direct costs,
including $50,000 in utilities and $100,000 in administrative direct costs, while in col-
422 Financial Management of Health Care Organizations
A B C D E F
Direct Costs Direct Costs
Utilities $50,000
Administration $100,000
Laboratory $175,000 $175,000
Walk-in services $200,000 $200,000
Pediatric services $200,000 $200,000
Adolescent services $300,000 $300,000
Total $1,025,000 $875,000
G H I J K L M N
Administration Direct Costs Utilities Administration
[Direct Costs]
Utilities
Administration
$100,000
$5,000 ($105,000)
Laboratory 20.0% $21,000
Walk-in services 22.9% $24,000
Pediatric services 22.9% $24,000
Adolescent services 34.3% $36,000
Total 100% $0
Note: Differences due to rounding.
1$100,000 Administrative Costs (Col. A) + $5,000 Allocated Utilities Costs to Administration (Exhibit 12−4, Col. K) = $105,000.
Step 3: Compute Allocation % Step 4: Allocate Costs
Step 1: Compile Basic Statistics Step 2: Compute Converted Statistics
Since no administrative costs are
being allocated to utilities or
administration, their costs are excluded.
$105,0001 in
administrative
costs are
being
allocated.
Exhibit 12–5 Steps in the Step-down Process Relevant to the Allocation of Administrative Costs
umn E there is only $875,000 in direct costs because utilities and administrative direct
costs have been omitted. This is done for two reasons. 1) By convention, the stepdown
allocation method always proceeds downward from one responsibility center to
those below it. Thus, no administrative costs are allocated (upward) to utilities.
Therefore, the $50,000 in utilities cost is excluded (column E) when determining the
proportional share of administration to be allocated on the basis of direct costs. 2)
Since administration is fully allocated to the services below it, it cannot give any of its
cost to itself. Therefore, in using direct costs as the basis to determine what percentage
of the administrative costs being allocated go to the services below it, the $100,000
in administrative direct costs are omitted (column E).
Without the $150,000 of utilities and administration, there is $875,000 in direct
costs over which to allocate administration. Laboratory has $175,000 in direct costs
(column E), and thus it receives $175,000/$875,000 or 20 percent (column H) of
the $105,000 in administration being allocated, which is $21,000 (column L). The
walk-in services clinic has $200,000 of direct costs (column E), so it receives
$200,000/$875,000 or 22.9 percent (column H) of the $105,000 in administrative
costs being allocated, which is $24,000 (column L). The remaining administrative
costs are allocated to the pediatric and adolescent services in a similar fashion
(column L).
Allocating Laboratory
The only costs that have not yet been allocated are those of the laboratory. Note that
in Exhibit 12–2, instead of the original $175,000 in direct laboratory costs, $206,000
is being allocated (column M). This is because in addition to its own direct costs,
laboratory also includes $10,000 in costs allocated from utilities and $21,000 in costs
allocated from administration.
Laboratory costs are allocated on the basis of lab tests under the assumption that
the fair share of the laboratory costs due to each of the three services is in proportion
to the number of tests each service ordered (see Exhibit 12–2, column C). Using lab
tests as a basis, the walk-in services clinic is allocated 25 percent (column I) of the
$206,000 (column M), which is $51,500 (column M). The pediatric services and the
adolescent services clinics are allocated 45 percent and 30 percent, respectively (column
I) of the $206,000 (column M), which are $92,700 and $61,800, respectively
(column M).
Fully Allocated Cost
After all the costs of the services that are not directly paid for have been allocated to
those services that are paid for, the totals are summed (see Exhibit 12–2, column N).
Rather than the $200,000 it costs to deliver walk-in services when only direct costs are
considered, the fully allocated costs are $285,500. Similarly, pediatric services
changed from $200,000 to $329,200, and adolescent services changed from $300,000
Provider Cost Finding Methods 423
Fully Allocated Cost:
The cost of a cost
object that includes
both its direct costs
and all other costs
allocated to it.
to $410,300 when allocated costs are included. Thus, the fully allocated cost reflects
both the original direct costs as well as all allocated costs, but the total cost,
$1,025,000, remains the same as before.
Several final comments regarding the step-down allocation method:
1. In finding costs, the order in which the services are allocated makes a
difference in the final costs. For example, if Administration were placed
ahead of Utilities in the allocation order, the costs of Walk-in, Pediatric,
and Adolescent Services would be different than in the example. There
are two sometimes conflicting rules of thumb to help choose a reasonable
order: a) rank-order the centers being allocated from highest dollar
amount to lowest dollar amount (according to this rule, in the example,
Laboratory and then Administration should have been listed ahead of
Utilities); or b) list the centers, from highest to lowest, in an order that
reflects the number of other centers they affect. It was for this reason that
the centers were ordered as they were in the example, with Laboratory
being last.
2. The allocation basis used to allocate costs makes a difference in the final
costs. If the number of FTEs instead of direct dollars were the allocation
basis for administration, and there were a low correlation between the two,
then the costs of Walk-in, Pediatric, and Adolescent services would be
different.
3. The number of centers to which costs are allocated makes a difference. For
example, if there were four services instead of three, then the costs allocated to
the original three services (Walk-in, Pediatric, and Adolescent) would be
different (probably less).
4. Though the step-down method is the most widely used method because of
its legacy from Medicare, there are several other related methods available to
providers to calculate costs. These are the direct method, the double
apportionment method, and the reciprocal method. Since they are used
relatively infrequently, they are not discussed here.
5. The step-down method is useful for pricing and reimbursement-related
decisions, but should not be used to control costs. There are other methods,
including activity-based costing, that are better for this purpose.
Most inpatient facilities use the step-down method to report their Medicare costs.
Though the Medicare Cost Report relies heavily on the step-down approach, in reality
it combines the step-down and CCR methods, as alluded to in Perspective 12–1.
As shown in Perspective 12–2, there is more to finding costs that just the cost allocation
method, one key point being that the costs being reported are allowable.
Activity-based Costing
Though the step-down method of cost allocation is widely used to find the cost
of services for pricing and reimbursement purposes, a newer cost-finding
424 Financial Management of Health Care Organizations
Provider Cost Finding Methods 425
Perspective 12–1
The Southwest Regional Consumers Union’s Interest in the Use of the Medicare Cost Report
House Committee on Public Health
Recommendations relating to Hospital Charity Care
& Hospital System Sales, Conversions, Partnerships and Mergers
June 28, 2000
Consumers Union appreciates the opportunity to testify before the House Committee on Public Health regarding
hospital charity care and the impact hospital system sales, conversions, partnerships and mergers have on the level
of charity care in their communities. Consumers Union has been actively involved with the development, passage
and implementation of the Texas charity care law since 1991.We currently serve on the Hospital Data Advisory
Committee and monitor the annual levels of charity care provided by Texas hospitals.
Consumers Union also has actively pursued the preservation of charitable assets when nonprofit hospitals and other
health care entities have changed their status due to a sale, conversion, partnership or merger, often referred to collectively
as “conversions.” Our expertise in this arena reaches beyond Texas, as our West Coast Regional Office has an active
national project providing technical assistance to states and local communities experiencing conversions.
What do these numbers tell us? $544 million in charity care was delivered in Texas in 1998 (using the Medicare
cost report method of calculation). It tells us that hospitals – nonprofit, for-profit DSH, and public – are contributing
significantly towards helping the uninsured. But the numbers tell us more . . .
Too many of these hospitals hover around the 4% requirement, suggesting that, as a standard, it has become a ceiling
rather than a floor. Of the 89 nonprofit hospitals required to meet the standard, 26 (13 of which reported as a
system) were within two percentage points of the 4% standard. . . .
Is it enough? Probably not, since these nonprofit hospitals have a mission to serve people in their community
regardless of the ability to pay. Charitable obligations go beyond simple tax deferment, the basis for the 4% of net
patient revenue standard (based on the average tax benefit received by a nonprofit hospital). Also, considering the
high numbers of uninsured Texans, we need help.
Recommendations relating to the charity care law.
1. Keep the charity care law in Texas. Consider raising the bar for charity and unreimbursed uncompensated
sponsored care above 4% of net patient revenue, especially if the current calculation method is
maintained (we oppose maintaining this method).
2. The Medicare Cost Report should be used to calculate the cost to charge ratio for hospital charity
care.The Medicare Cost Report provides a more true reflection of costs of patient care than the current
base using the hospital’s audited financial statement. For example, the current standard in the law,
using the hospital’s audited financial statement, allows the inclusion of bad debt charges in calculating
the cost to charge ratio.The Medicare cost report does not allow the inclusion of bad debt charges,
but only the cost of providing the care that results in bad debt. In theory, bad debt charges above
actual cost of providing care are not “expenses.”
Standardization provided by the Medicare cost report is important in order to get a fair comparison of hospital
charity care. For example: Hospital A provides luxury rooms, a specialty chef, a concierge, an office building for staff
doctors, large new covered parking garage. Hospital B provides basic patient care without the frills. When using
audited financial statements, all those Hospital A amenities are included in the base from which the hospital calculates
its cost to charge ratio, while the base for Hospital B will not include such items. In the end this method will
inflate Hospital A’s charity care numbers without actually increasing the charity care delivered.
Source: Testimony by the Consumers Union on Its Website
June 28, 2000 (http://www.consumerism.org/health/charitysw700.htm).
methodology, called activity-based costing (ABC), is receiving increased attention
by health care providers (see Perspective 12–3). ABC is based on the paradigm
that activities consume resources and products consume activities (see Exhibit
12–6). Therefore, if activities or processes are controlled, then costs will be controlled.
Similarly, if the resources for an activity can be measured, a more accurate
picture of the actual costs of services can be found, as compared to
traditional cost allocation. Such information can be extremely useful, as shown in
Perspective 12–4.
Traditional cost allocation is called a top-down approach because it begins with all
costs and allocates them downward into various services for which payment will be
received (see Exhibit 12–7a). ABC, on the other hand, is called a bottom-up approach
because it finds the cost of each service at the lowest level, the point at which resources
are used, and aggregates them upward into products (see Exhibit 12–7b).
For example, in Exhibit 12–8, the service “Normal Delivery” comprises three
intermediate products (or processes): prenatal visit, labor and delivery, and
postpartum care. Each of these intermediate products comprises a number of activities.
For example, the prenatal visit includes urinalysis, complete blood count (CBC),
vital signs, recent history, etc. Each of these activities might also include a portion of
what are usually considered indirect costs, such as those associated with ordering
supplies, medical records, or financial counseling.
426 Financial Management of Health Care Organizations
Perspective 12–2
Review of a Medicare Cost Report
This final report points out that Community Behavioral Services (CBS) claimed Medicare reimbursement totaling $4.5
million representing 31,951 services to 305 Medicare beneficiaries in Fiscal Year (FY) 1995. Our review of services provided
to 43 of these beneficiaries disclosed that: 7,868 (71 percent) of the services were provided to 31 beneficiaries
who, in the opinion of medical experts, did not meet the Medicare eligibility criteria for receiving partial hospitalization
program (PHP) services; and 286 (3 percent) of the services provided to 6 beneficiaries were considered unallowable
by medical review personnel because they were either not documented, the services were not reasonable and necessary,
the services were not ordered, or the supporting documentation was not dated, not signed, or duplicated.We recommended
that the fiscal intermediary (FI) recover the amount overpaid to CBS and place the four providers owned
by CBS under focused medical review with special emphasis on beneficiary eligibility.
This final reports points out that CBS claimed costs totaling $2.3 million in FY 1994. Our review disclosed that
the claimed costs included costs that were not allocable or reimbursable according to Medicare reimbursement
requirements. The cost report included $1.4 million that was not related to patient care, not reasonable and necessary
and costs that were not supported with sufficient documentation to determine whether the costs were
incurred, reasonable and necessary, and related to patient care.The FI notified CBS of the unallowed costs and took
recovery action.The Health Care Financing Administration took action to suspend payments to this provider until
the overpayments are recovered.We recommended that the FI review subsequent cost reports for similar unallowable
costs.The FI agreed with our recommendations.
Source: Department of Health and Human Services, Office of Inspector General – AUDIT, “Review of Partial
Hospitalization Services and Audit of Medicare Cost Report for Community Behavioral Services, a Florida
Community Mental Health Center” (A–04–96–02118 and A–04–96–02124).
Activity-based
Costing: A method to
estimate costs of a
service or product by
measuring the costs of
the activities it takes
to produce that
service or product.
Provider Cost Finding Methods 427
Perspective 12–3
An On-line Article Discusses Activity Based Costing in Healthcare
To achieve continuous improvement, management must be informed. In healthcare, as with other businesses, the key
is understanding the interrelationships of activities and taking actions to minimize waste and eliminate non-valueadded
costs. Simply put, that’s what activity-based costing and activity-based management are all about.
The ABC model
ABC provides a better and more detailed cost model by allocating costs to activities based on the resources they
consume.The model . . . links processes and resources.
For example, the case management department may assign case managers to specific clinical departments of
service lines. In the traditional cost accounting model the case manager cost is allocated to other departments
based on some gross measure such as patient days. This “peanut butter” allocation method assumes that case
management is a generic commodity that is the same for an OB patient as a frail elderly cardiac surgery patient. Not
likely.
The ABC model would look at each patient population and examine the case management process for each.What
are the activities involved? How much case management time is consumed by each activity? What other resources
are consumed? From this, more detailed cost allocation a more accurate picture or cost emerges. More importantly,
the relationship between activities and resources is more clear, making cost reduction easier.
Adding appropriate quality, patient satisfaction, outcomes, and clinical performance measures makes any process
improvement more intelligent and less likely to reduce the quality of care.
. . . In their quest to reduce costs and develop an advantaged marketplace position, healthcare providers are
discovering ABC. It offers an approach and the type of information required to realize performance breakthroughs:
It recognizes that cost and quality are the direct result of the activities providers undertake to deliver
services to their patients.
It is business-process and end-product focused, and invites cooperation, rather than competition, between
functional departments.
It is developed based on the process knowledge and insight of those directly involved in the delivery of the
service. In the case of patient care, physicians, nurses, therapists, et al, participate and contribute to its
development.
As a result, activity-based cost information is both intuitive and logical. In short, it makes sense to those charged
with the responsibility for improving performance and provides them with transparent information on the cost ramifications
of their decisions. Example applications include:
Evaluating the cost implications of alternative clinical pathways
Streamlining care delivery practices across the care continuum
Decision-making regarding management levels and spans of control
Enhancing staff utilization by time of day
Resourcing consolidated departments/deployed functions
Source: Robert Luttman & Associates Online Articles, Activity Based Costing, pp. 1–4
(http://www.robertluttman.com/activity_based_costing.html#Feature).
Costing Terminology
Before continuing, it is important to understand three key terms: direct costs, indirect
costs, and cost drivers. Direct costs are costs (e.g. nursing costs) that an organization
can trace to a particular cost object (e.g. a patient). Indirect costs are costs that an
organization is not able to directly trace to a particular cost object. For example, many
health care organizations have great difficulty tracing to a particular patient or service
such items as the cost of the billing clerk, rent, or information systems. Thus, a cost
is direct or indirect not by its nature, but by the ability of the organization to trace it
to a cost object.
An important difference between traditional cost allocation and ABC is how each
handles indirect costs. Traditional cost allocation methods usually deal with indirect
costs by allocating them to cost objects using relatively gross cause and effect relationships.
ABC attempts to overcome this problem by more directly tracing costs to
their cost objects and/or finding more precise cost drivers. Cost drivers are those
things that cause a change in the cost of an activity.
For example, under traditional step-down costing, purchasing costs might be bundled
with other administrative costs and allocated to a service based on the relative size
of its budget. Under ABC it is more likely that the costs of purchasing would be allocated
to that service more precisely on the basis of the number of purchase orders
428 Financial Management of Health Care Organizations
Admitting Screening Surgery Rehabilitation
Supplies Labor Equipment
Resources
Activities
& Processes
Products
Healthier Patient
Exhibit 12–6 Products Result from Activities and Processes, which Result from the Utilization of Resources
Direct Costs: Costs
which can be traced to
a particular cost
object.
Indirect Costs: Costs
which cannot be traced
to a particular cost
object. Common
indirect costs include
billing, rent, utilities,
information services,
and overhead.
Typically, these costs
are allocated to cost
objects according to an
accepted formula (e.g.
step-down method).
Cost Driver: That
which causes a
change in the cost of
an activity.
Provider Cost Finding Methods 429
Perspective 12–4
Cost for Pricing at Blue Cross and Blue Shield of Florida
During the early 1990s, Blue Cross and Blue Shield of Florida, Inc. (BCBSF) faced an increasingly competitive and
complex marketplace for its healthcare products and services, and its management structure and processes did not
respond adequately to the market’s different needs.To solve this problem, BCBSF identified specific objectives and
strategies that divided the state into regions and market segments and sought to improve its management information
tools and processes. . . .
BCBSF has a variety of products, customers, and delivery options that demand special services. Because the company
has large work units and shared processes, managers need to be able to accurately identify the processes and
administrative costs associated with the various products and customers. They do this through the CFP [Cost for
Pricing] cost assignment process. . . .
Each activity in the company is undertaken for one of three general purposes: 1) to build or maintain a product,
2) to serve or sell to a customer, or 3) to perform general corporate duties. Furthermore, all costs incurred by the
company must be recovered through the amounts that are charged to customers. Therefore, one policy decision
made during the CFP design phase was to allocate all costs to products and customers.
Some of the company’s activity costs relate directly to specific products and customers so are easy to allocate
if the correct basis (that is, cost driver) data are provided. Other activities are conducted in support of
broad categories of customers or products or even other cost centers. The allocations of these activity costs
are more difficult to relate to specific products or customers and require that cost center managers identify
who is supported and to what extent they consume the cost center resources. Finally, some activities are performed
for the company as a whole or for the benefit of all customers and cannot be related to specific products
or customers at all. These activity costs are allocated across all customers based on the total corporate
activity.
A major advantage of cost for pricing is that it tracks and reports the costs associated with performing activities
as they relate to particular products and customers in a timely, customized, and inexpensive manner. For
example, the cost of providing customer service activities to a small group customer with a health maintenance
organization (HMO) may be different from the cost of providing customer service activities to a larger, multistate
customer that has a preferred provider organization (PPO) product. This type of cost information is useful
for pricing and profitability analysis. Also, management uses CFP information to identify and analyze cost
variances and to benchmark and develop improvement programs.The model allows the company to manage and
lower administrative expenses by providing more specific information about where these costs are incurred and
their purpose. . . .
For example, the identification and costing of nonvalue-added administrative activities (processing unnecessary
forms or performing redundant activities) can prompt management efforts to lower costs through the reduction
and eventual elimination of such activities. The resources released could be used to improve the performance of
value-added activities. Also, benchmarking may reveal high-cost activities that subsequent investigations show
are the result of quality problems. For instance, low-quality explanations by associates to clients about their
health insurance or the sale of inappropriate health insurance products to clients may lead to excessive written,
telephone, and walk-in inquiries from subscribers. In addition to creating dissatisfied customers, these practices are
likely to lead to higher salary costs from the increased staffing needed to address the extra customer service
inquiries. . . .
Source: Kenneth L. Thurston, CPA, Dennis M. Deleman, and John B. MacArthur, Management Accounting Quarterly,
Spring 2000, pp. 4–13.
emanating from that service, or even more precisely by measuring the number of
minutes spent processing purchase orders from that department.
An Example
Exhibit 12–9 compares the results of a more traditional cost allocation approach to
that of an ABC approach. In this example, the organization is offering three outpatient
430 Financial Management of Health Care Organizations
Traditional Costing
Cost Pool
Departments
Costs (e.g. labor, supplies,
facilities) of various kinds of
functions (e.g. purchasing,
setup, monitoring, delivery of
services)
Organizational units which
deliver or support the delivery
of services
Various services (e.g. lab
tests, CBC, physical exam)
Product/
Service 1
Product/
Service 2
Product/
Service 3
Product/
Service N
Exhibit 12–7a Comparison of Traditional and Activity-based Costing (Top Half)
• Normal delivery, By-pass
surgery, etc.
•
Resources
Activity 1 Activity 2 Activity N
Physical, well-baby visit, meals,
lab tests, radiology procedures,
etc.
• Patient history, writing orders,
chest X-ray, urinalysis, test set-ups,
purchasing, billing, 15-minute
outpatient visit, echocardiogram,
telemetry, etc.
• Labor, supplies, materials
Activity-based Costing
Final Product/
Service 1
Final Product/
Service 2
Final Product/
Service N
Intermediate
Product 1
Intermediate
Product 2
Intermediate
Product N
Exhibit 12–7b Comparison of Traditional and Activity-based Costing (Lower Half)
services: an initial visit, a routine regular visit, and an intensive visit. It is assumed that
labor and materials can be directly traced to each type of visit, and, therefore, they do
not vary between the two approaches. Thus, the main difference between the two
approaches (as is often the case in practice) is the allocation of overhead. As explained
below, the traditional approach uses a single cost driver, visits, and thus assigns the
same overhead cost per visit, $17.50, to all three services (row 3, columns A, B, and
C). The ABC approach, on the other hand, uses three cost drivers, and derives an
overhead cost per visit of $28.88 for an initial visit, $13.65 for a regular visit, and
$16.33 for an intensive visit (row 3, columns D, E, and F). Thus, relative to the traditional
approach, the ABC approach estimates overhead cost to be $11.38 higher than
the average $17.50 for an initial visit, and $3.85 and $1.17 lower for a regular and
intensive visit, respectively (row 3, columns G, H, and I).
When spread across all 10,000 visits, these unit cost differences result in considerably
different estimates of the total cost for each type of visit. Using the $17.50 estimate
for overhead costs for each visit, the conventional method estimates the total costs of
an initial, regular, and intensive visit to be, respectively: $130,000, $237,500, and
$307,500 (row 8, columns A, B, and C). On the other hand, the ABC approach estimates
the total cost of initial, regular, and intensive visits to be, respectively: $152,750,
$218,250, and $304,000 (row 8, columns D, E, and F). Thus, the ABC approach estimates
the initial visit cost $22,750 more than what was estimated using a conventional
approach, and the regular and intensive visits cost $19,250 and $3,500 less, respectively,
than the conventional approach’s estimate (row 8, columns G, H, and I). Such
differences can be highly significant when making decisions. In the case of the initial
visits, the cost estimate differed by over 17 percent ($22,750/$130,000 = 0.175).
Exhibit 12–10 illustrates more closely how the numbers in Exhibit 12–9 were derived.
In Exhibit 12–10, the total overhead cost is $175,000 (row 4, column D). Under the
conventional method, it is assumed that all overhead costs are driven by visits. Thus, the
$175,000 in overhead is divided by the 10,000 visits made during the year to calculate
the average cost per visit for each type of visit, $17.50 (row 4, columns E, F, G, and H).
Provider Cost Finding Methods 431
Urinalysis
CBC
Vital signs
Weight
Recent history
Prenatal education
Other
External fetal monitoring
Coaching
Epidural
Maternal monitoring
Other
Maternal monitoring
Exercise therapy
Postpartum education
Other
Normal Delivery
Prenatal Visit Labor and Delivery Postpartum Care
Exhibit 12–8 Examples of Intermediate Products and Activities for a Normal Delivery
Exhibit 12–9 A Comparison of the Results of Using a Conventional versus an ABC Approach to Costing Three Services
AB C D E F
Conventional Cost Method Activity-based Costing
Visit Type Visit Type
Per Visit Costs Initial Regular Intensive Initial Regular Intensive
1 Direct Materials (etc.) $
2.50 $
3.00 $
10.00 $
2.50 $
3.00 $
10.00
2 Direct Labor $
45.00 $
27.00 $
75.00 $
45.00 $
27.00 $
75.00
3 Estimated Overhead $
17.50 $
17.50 $
17.50 $
28.88 $
13.65 $
16.33
4 Total Cost/Visit $
65.00 $
47.50 $
102.50 $
76.38 $
43.65 $
101.33
Total Visit Costs
5 Direct Materials (
etc.) $5,000 $
15,000 $
30,000 $
5,000 $
15,000 $
30,000
6 Direct Labor $90,000 $
135,000 $
225,000 $
90,000 $
135,000 $
225,000
7 Estimated Overhead $
35,000 $
87,500 $
52,500 $
57,750 $
68,250 $
49,000
8 Total Costs $
130,000 $
237,500 $
307,500 $
152,750 $
218,250 $
304,000
GH I
Difference in Cost Estimates
[ABC − Conventional]
Visit Type
Per Visit Costs Initial Regular Intensive
1 Direct Materials (
etc.) $
0.00 $
0.00 $
0.00
2 Direct Labor $
0.00 $
0.00 $0.00
3 Estimated Overhead $
11.38 ($3.85) ($1.17)
4 Total Cost/Visit $
11.38 ($3.85) ($1.17)
Total Visit Costs
5 Direct Materials (
etc.) $
0.00 $
0.00 $
0.00
6 Direct Labor $
0.00 $
0.00 $
0.00
7 Estimated Overhead $
22,750 ($19,250) ($3,500)
8 Total Costs $
22,750 ($19,250) ($3,500)
Total Cost by Visit Type Calculation of Cost/Unit by Visit Type
Basic Data
AB C D E F G H
Initial Regular Intensive Total Initial Regular Intensive Cost/Unit
[Given] [Given] [Given] [A+B+C] Formula:
1 Number of Visits 2,000 5,000 3,000 10,000
2 Direct Materials
(etc.) $5,000 $15,000 $30,000 $50,000 $2.50 $3.000 $10.00 [Row 2/Row 1]
3 Direct Labor $
90,000 $
135,000 $
225,000 $
450,000 $
45.00 $
27.00 $
75.00 [
Row 3 /
Row 1]
4 Estimated Overhead [
Total is a
Given] $
175,000 $
17.50 $
17.50 $
17.50 [
D4/D1]
5 Cost/Visit: Conventional Method $
65.00 $
47.50 $
102.50 [
Sum(Rows 2–4)]
1) Basic Data, Annual Projections of Overhead Costs by Activity; 2) Unit Cost Calculations for These Overhead Activities
IJ K L
Activity Cost Driver Information
Cost Driver Units Unit Cost
[Given] [Given] [Given] [I/K]
6 Intake $
17,500 New Visits 2,500 New Visits $
7.00 Per New Visit
7 Medical Records $
17,500 Hours Spent 2,040 Hours $
8.58 Per Hour
8 Billing $
35,000 Hours Spent 4,080 Hours $
8.58 Per Hour
9 Other $
105,000 Visits 10,000 Visits $
10.50 Per Visit
10 Total $175,000
Basic Data: Actual Annual Operating Results of Cost Drivers to Be Used in Assigning ABC Overhead Cost
MN O P
Visit Type
Initial Regular Intensive Total
[Given] [Given] [Given] [M+N+O]
11 New Visits 2,000 250 250 2,500
12 Medical Records 612 816 612 2,040
13 Billing 2,040 816 1,224 4,080
14 Other 2,000 5,000 3,000 10,000
Basic Data and Calculation of
Unit costs Using a Conventional
Approach
Additional Basic Data
Exhibit 12–10 A Comparison of a Conventional and an ABC Approach to Costing Three Services
(Continues)
Calculation of Total and Per Visit Overhead Costs Using ABC
QR S T U
Visit Type
Initial Regular Intensive Total Formula
15 New Visits $14,000 $1,750 $1,750 $17,500 [L6 × Row 11]
16 Medical Records $5,250 $7,000 $5,250 $17,500 [L7 × Row 12]
17 Billing $17,500 $7,000 $10,500 $35,000 [L8 × Row 13]
18 Other $21,000 $52,500 $31,500 $105,000 [L9 × Row 14]
19 Total $57,750 $68,250 $49,000 $175,000 [Sum (Rows 15–18)]
20 Per Visit $28.88 $13.65$16.33 $17.50 [Row 19/Row 1]
Unit Cost Estimates ABC
VW X Y
ABC Visit Type
Initial Regular Intensive Formula
21 Direct Materials $2.50 $3.00 $10.00 [Row 2, Cols E,F,G]
22 Direct Labor $45.00 $27.00 $75.00 [Row 3, Cols E,F,G]
23 Overhead $28.88 $13.65 $16.33 [Row 20]]
24 Total using ABC $76.38 $43.65 $101.33 [Sum(Rows 21–23)]
Derivation of Unit Costs Using an ABC Approach
Exhibit 12–10 (
Contd)
Comparison of Unit Costs: ABC v. Conventional
ZAA AB AC AD
Visit Type
Initial Regular Intensive Formula
25 Total Conventional $65.00 $47.50 $102.50 [Row 5, Cols E,F,G]
26 Amount ABC
Estimate is
More (Less) Than
Conventional $11.38 ($3.85) ($1.17) [Row 24 – Row 25]
Comparison of Total Costs: ABC v. Conventional
AE AF AG AH AI
Visit Type Total
Initial Regular Intensive [AE+AF Formula
+AG]
Acitivity Based Costing Method
27 Number of Visits 2,000 5,000 3,000 10,000 [Row 1]
28 Direct Materials $5,000 $15,000 $30,000 $50,000 [Row 2]
29 Direct Labor $90,000 $135,000 $225,000 $450,000 [Row 3]
30 Overhead $57,750 $68,250 $49,000 $175,000 [Row 27 × Row 23]
31 Total ABC $152,750 $218,250 $304,000 $675,000 [Sum (Rows 28–30)]
Conventional Method
32 Direct Materials $5,000 $15,000 $30,000 $50,000 [Row 2]
33 Direct Labor $90,000 $135,000 $225,000 $450,000 [Row 3]
34 Overhead $35,000 $87,500 $52,500 $175,000 [Row 27 × Row 5, E,F,G]
35 Total
Conventional $130,000 $237,500 $307,500 $675,000 [Sum(Rows 32–34)]
36 Amount ABC
Estimate is
More (Less) Than
Conventional $22,750 ($19,250) ($3,500) $0 Row 31 – Row 35
Comparison of Total Costs and Unit Costs: ABC v. Conventional
Rather than assuming that overhead costs are driven solely by the number of
visits, the ABC approach assumes multiple cost drivers. In this case, the ABC
approach breaks down overhead costs into four categories and looks more closely
at what may be driving the $175,000 overhead cost. The four categories are: the
intake process, medical records, billing, and other (see rows 6–9). The intake process
occurs when background information is gathered and an account is set up for each
new patient. It is assumed that these costs occur each time a new patient visit
occurs; thus, the cost driver is a new-patient visit (row 6, column J). Assuming
that the total salaries and benefits of all the employees engaged in this process are
$17,500 (row 6, column I) and there are 2,500 visits a year (row 6, column K), the
intake process costs the organization $7.00 ($17,500/$2,500) for each new patient
(row 6, column L). Since there were 2,000 new patients making initial visits, 250
new patients each making a regular visit (referrals), and 250 patients making an
intensive visit (row 11, columns M, N, O, and P), it costs $14,000 for the intake
process for these new patients ($7.00/patient × 2,000 new patients), and $1,750
each ($7.00/patient × 250 patients) for regular and intensive visits, respectively
(row 15, columns Q, R, S, T, and U).
The second category, medical records, refers to the process of coding and charting
the visit onto the medical records (row 7). Since it is assumed that these costs
are driven by the time spent coding and charting, the cost driver is hours spent
(row 7, column J). Since the salary and benefit costs associated with medical
records are $17,500 and there are 2,040 hours devoted to this activity, the cost per
hour is $8.58 (row 7, columns I, J, K, and L). The medical records staff estimates
that it spent 30, 40, and 30 percent of its time with initial, regular, and intensive
visit records, respectively. This equates to 612, 816, and 612 hours for each of the
respective types of visits (row 12, columns M, N, O, and P). At $8.58 per hour,
the initial visits medical record cost is $5,250 ($8.58/hour × 612 hours), while the
regular and intensive visit medical record costs are $7,000 ($8.58/hour × 816
hours) and $5,250 ($8.58/hour × 612 hours), respectively (row 16, columns Q, R,
S, T, and U).
The billing costs and other costs are derived in a similar manner to those just
discussed. When this process is completed, the estimated total overhead cost of
initial visits is $57,750, while those of regular and intensive visits are $68,250 and
$49,000 respectively (row 19, columns Q, R, and S). Dividing these numbers by
the number of visits in their respective categories (rows 1, 19, and 20) results in
the per visit cost estimates of $28.88 ($57,750/2,000 visits) for initial visits, $13.65
($68,250/5,000 visits) for regular visits, and $16.33 ($49,000/3,000 visits) for
intensive visits. As can be seen, these numbers are quite different from the $17.50
overhead cost per visit estimated using the conventional approach.
The various parts are now in place to compare costs using a conventional
approach and an ABC approach. Under the ABC approach, the per visit costs for
an Initial, Regular, and Intensive visit, respectively, are $76.38, $43.65, and
$101.33 (row 24, columns V, W, and X). Under the conventional method, they are
$65.00, $47.50, and $102.50, respectively, for these same types of visits (row 25,
columns Z, AA, and AB). Thus, on a comparative basis, the ABC approach estimates
that the cost of an Initial visit is $11.38 higher than that of the cost calcu-
436 Financial Management of Health Care Organizations
lated using the conventional approach, and the costs of a Regular and Intensive
visit, respectively, are $3.85 and $1.17 lower (row 26, columns Z, AA, and AB).
The differences between the cost per visit estimates using ABC and a conventional
approach are totally due to how the overhead is handled. The conventional
approach used a single cost driver, total visits, to derive a $17.50 per visit overhead
rate (row 4, columns E, F, and G). The ABC approach decomposed overhead
into four separate categories of activities: intake, medical records, billing, and
other. It then determined the unit cost of each type of activity based upon what
was driving these costs: new visits for intake, hours worked for medical records
and billing, and visits for all other overhead activities (rows 6–9, columns I, J, K,
and L). Thus, the ABC approach more closely matched the actual usage of
resources by each type of visit.
In today’s environment, the importance of having the more accurate estimate
from ABC cannot be overemphasized. For example, assume the practice was negotiating
a contract for Initial visits with a managed care organization that offered to
pay $75 per visit. If the provider thought its costs were $65.00, as derived by the
conventional method, it might accept the offer. However, with the more accurate
information of the cost being $76.38 per visit, the provider might very well reject
the offer, or certainly negotiate a higher rate. If it could not negotiate a higher rate,
and were it not for the ABC method, it might very well be satisfied under the conventional
method, for it would assume it was making a profit on each visit.
However, armed with the ABC cost estimate, it would be driven to look for cost
reductions to reduce its unit cost from $76.38 to closer to or below the $75 being
offered.
There are a number of other differences between the traditional step-down and
ABC methods, but a discussion of these is beyond the scope of this text. However,
in many cases these two methods are likely to yield vastly different estimates of
cost. While the step-down method is relatively inexpensive to implement and may
provide an adequate estimate in some cases, those using ABC feel it provides several
advantages, including increased accuracy and insights on how to control
processes and, thus, costs. In the future, the management of most health care facilities
will be faced with weighing the relatively low costs of the step-down method
against the added costs, greater precision, and cost-control of ABC. In an increasingly
cost-driven health care system, it is likely that ABC will gain greater prominence.
Summary
Because they are assuming more risk, providers must be able to measure their
costs accurately. Providers generally use one of three approaches: the cost-tocharge
ratio, the step-down method, or activity-based costing (ABC). The stepdown
method finds costs by allocating those costs that are not directly paid for
into those products or services to which payment is attached. It is a top-down
approach, because it begins with all costs and allocates them downward into
Provider Cost Finding Methods 437
438 Financial Management of Health Care Organizations
various services for which payment will be received. As a result of methodological
idiosyncrasies, those performing a step-down cost finding must pay considerable
attention to the order of allocation, the allocation basis, and the number of cost
centers. The step-down method is useful for pricing and reimbursement-related
decisions, but should not be used to control costs.
Activity-based costing (ABC) not only finds costs, but also helps to control
costs. ABC is a bottom-up approach, because it finds the cost of each service at the
point at which resources are used and then aggregates them upward into products.
ABC is based on the paradigm that activities consume resources and processes
consume activities. Therefore, since the use of resources is what causes cost (by
definition), if activities or processes are controlled, then costs will be controlled.
Similarly, if the resource use of an activity can be measured, then a more accurate
picture of the actual costs of services can be determined.
Activity-based Costing
Allocation Base
Cost Drivers
Cost Object
Cost-to-charge Ratio
Direct Costs
Fully Allocated Costs
Indirect Costs
Step-down Method
Key Terms
Questions and Problems
1. Definitions. Define the following terms:
a. Activity-based Costing.
b. Allocation Base.
c. Cost Driver.
d. Cost Object.
e. Cost-to-charge Ratio (CCR).
f. Direct Costs.
g. Fully Allocated Cost.
h. Indirect Costs.
i. Step-down Method.
2. Cost-to-charge Ratio. What is the basic concept of the cost-to-charge ratio
method of estimating costs? Give an example.
3. Cost-to-charge Ratio. Discuss the four major concerns of using the costto-
charge ratio method.
4. Step-down Method. Discuss how the step-down method of cost allocation
derives its name.
5. Cost Allocation and Cost Drivers. What is the relationship between the
concepts cost allocation basis as used in the step-down method and cost driver
as used in ABC?
Provider Cost Finding Methods 439
6. Fully Allocated Costs. What is the difference between a cost object’s
direct cost and its fully allocated cost? Give an example.
7. Step-down Method. Identify and discuss four points that must be
considered when using the step-down method of cost allocation.
8. ABC and Step-down Methods. What are the advantages and
disadvantages of ABC relative to the step-down method of cost allocation?
9. Activity-based Costing. In Exhibit 12–10, suppose that instead of 2,000,
5,000 and 3,000 visits for an initial, regular, and intensive visit, respectively,
the number of visits was 3,000, 5,000 and 2,000. Assume that the intake,
new visits, medical records, and billing costs do not change in number or
distribution.
a. Would there be a change in the overhead cost per visit of an initial visit
using either the conventional or ABC methods?
b. Would there be a change in the total overhead cost of initial visits using
either the conventional or ABC methods?
10. Activity-based Costing. In Exhibit 12–10, suppose that instead of 2,000,
5,000 and 3,000 visits for an initial, regular, and intensive visit, respectively,
the number of visits was 2,500, 6,000 and 1,500. Assume that the intake,
new visits, medical records, and billing costs do not change in number or
distribution.
a. Would there be a change in the overhead cost per visit of an initial visit
using either the conventional or ABC methods?
b. Would there be a change in the total overhead cost of initial visits using
either the conventional or ABC methods?
11. Cost Allocation. Use the information in Exhibit 12–11 to answer these
questions.
a. David Paul, the new administrator for the surgical clinic, was trying to
figure out how to allocate his indirect expenses. His staff were
complaining that the current method of taking a percentage of
revenues was unfair. He decided to try to allocate utilities based on
A B C
Square Direct Lab
Feet Costs Tests
Utilities $200,000
Administration 2,000 $500,000
Laboratory 2,000 $625,000
Day-op Suite 3,000 $1,400,000 4,000
Cystoscopy 1,500 $350,000 500
Endoscopy 1,500 $300,000 500
Total 10,000 $3,375,000 5,000
Exhibit 12–11 Basic Statistics for Cost Allocation in Surgery Clinic A
square footage for each department, to allocate administration based on
direct costs, and to allocate laboratory based on tests. What would the
results be?
b. Kathleen Aceti, the nurse manager of the cysto suite, was given approval
to add more space to her current area by converting 500 square feet of
administrative space into another cystoscopy bay. What will her new
fully allocated expenses be? (Assume there are no new additional costs
incurred by adding the 500 square feet.)
c. Mara Kelsey, the manager of the endoscopy suite, was concerned about
adding more space to cystoscopy. She contends that if the two units were
combined, fewer staff would be needed and direct costs could be reduced
by $50,000 ($25,000 in each unit). She also feels that the Day-Op area is
underutilized, and that 500 square feet could be used by a combined unit
when excess capacity was needed. Assuming the 500 square feet were to
be allocated equally between the endoscopy suite and cystoscopy, what
would the total allocated costs for each of these two services be under this
scenario?
12. Cost Allocation. Use the information in Exhibit 12–12 to answer these
questions.
a. David Paul, the new administrator for the surgical clinic, was trying to
figure out how to allocate his indirect expenses. He decided to try to
allocate utilities based on square footage of each department, to allocate
administration based on direct costs, and to allocate laboratory based on
tests. How would indirect costs be distributed as a result?
b. Nick Zeeman, the Director of Labs, was given approval to add 250
square feet of space to the lab by expanding into the Day-Op Suite,
which lost the space. What will his new fully allocated expenses be?
(Assume there are no new additional costs incurred by adding the 250
square feet.)
c. Callie Zev, the Manager of the endoscopy suite, was concerned about
adding more space to cystoscopy. She contends that if the two units were
combined, fewer staff would be needed and direct costs could be reduced
440 Financial Management of Health Care Organizations
Sq. Feet Direct Costs Lab Tests
Utilities $100,000
Administration 1,500 $400,000
Laboratory 3,000 $725,000
Day-op Suite 4,500 $1,200,000 4,000
Cystoscopy 2,500 $400,000 500
Endoscopy 3,000 $350,000 500
Total 14,500 $3,175,000 5,000
Exhibit 12–12 Basic Statistics for Cost Allocation in Surgery Clinic B
by $40,000 ($20,000 in each unit). She also feels that the Day-Op area is
underutilized, and that 200 square feet could be used by a combined unit
when excess capacity was needed. Assuming the 200 square feet were to
be allocated equally between the endoscopy suite and cystoscopy, what
would the total allocated costs for each of these two services be under this
scenario?
13. Traditional and Activity-based Costing. Use the information in Exhibit
12–13 to answer these questions.
a. What is the per unit cost of an initial, regular, and intensive visit using
the conventional and ABC approaches?
b. What is the total cost of initial, regular, and intensive visits using the
conventional and ABC approaches?
14. Traditional and Activity-based Costing. Use the information in Exhibit
12–14 to answer these questions.
a. What is the per unit cost of an initial, regular, and intensive visit using
the conventional and ABC approaches?
b. What is the total cost of initial, regular, and intensive visits using the
conventional and ABC approaches?
Provider Cost Finding Methods 441
442 Financial Management of Health Care Organizations
Total Cost by Visit Type
Basic Data
A B C D
Initial Regular Intensive Total
[Given] [Given] [Given] [A + B + C]
1 Number of Visits 5,000 10,000 5,000 20,000
2 Direct Materials (etc.) $21,000 $14,000 $35,000 $70,000
3 Direct Labor $80,000 $80,000 $240,000 $400,000
4 Estimated Overhead [Total is a Given] $150,000
5 Cost/Visit: Conventional Method
Basic Data: Annual Projections of Overhead Costs by Activity
I J K
Activity Cost Driver Information
Cost Driver Units
[Given] [Given] [Given]
6 Intake $22,500 New Visits 2,500 New Visits
7 Medical Records $22,500 Time Spent 2,040 Hours
8 Billing $45,000 Time Spent 4,080 Hours
9 Other $60,000 Visits 20,000 Visits
10 Total $150,000
Basic Data: Actual Annual Operating Results of Cost Drivers to be Used to Assign ABC
Overhead Cost
M N O P
Visit Type
Initial Regular Intensive Total
[Given] [Given] [Given] [M + N + O]
11 New Visits 1,500 750 250 2,500
12 Medical Records 204 612 1,224 2,040
13 Billing 2,040 816 1,224 4,080
14 Other 5,000 10,000 5,000 20,000
Exhibit 12–13 Data for Clinic C
Basic Data and Calculation of
Unit Costs Using a
Conventional Approach
Additional Basic Data
Provider Cost Finding Methods 443
Total Cost by Visit Type
Basic Data
A B C D
Initial Regular Intensive Total
[Given] [Given] [Given] [A+B+C]
1 Number of Visits 3,000 7,500 4,500 15,000
2 Direct Materials (etc.) $5,000 $10,000 $35,000 $50,000
3 Direct Labor $52,500 $70,000 $227,500 $350,000
4 Estimated Overhead [Total is a Given] $125,000
5 Cost/Visit: Conventional Method
Basic Data: Annual Projections of Overhead Costs by Activity
I J K
Activity Cost Driver Information
Cost Driver Units
[Given] [Given] [Given]
6 Intake $25,000 New Visits 1,000 New Visits
7 Medical Records $25,000 Time Spent 2,040 Hours
8 Billing $37,500 Time Spent 4,080 Hours
9 Other $37,500 Visits 15,000 Visits
10 Total $125,000
Basic Data: Actual Annual Operating Results of Cost Drivers to be Used to Assign ABC
Overhead Cost
M N O P
Visit Type
Initial Regular Intensive Total
[Given] [Given] [Given] [M+N+O]
11 New Visits 800 100 100 1,000
12 Medical Records 612 816 612 2,040
13 Billing 2,040 816 1,224 4,080
14 Other 3,000 7,500 4,500 15,000
Exhibit 12–14 Data for Clinic D
Basic Data and Calculation of
Unit Costs Using a
Conventional Approach
Additional Basic Data
C h a p t e r T h i r t e e n
PROVIDER PAYMENT SYSTEMS
Learning Objectives
After completing this chapter, you will be able to:
c Identify the history, theory, and characteristics of the major types of payment systems.
c Identify the tactics payors and providers use to reduce their financial risk.
c Determine the cost per member per month for specific procedures.
c Understand the new wave of innovations in health care payment systems.
Introduction
Historical Perspective on Payment Systems
The “Early” Years (1929–1965)
Blue Cross and Blue Shield Established
Kaiser Established
Hill-Burton Hospital Construction Act
The “Middle” Years (1965–1983)
Increasing Concerns about Costs and
Access
Medicare and Medicaid
The “Later” Years (1984 to the Present)
DRGs
Flat Fee Systems
Flat Fees for Hospitals
Flat Fees for Physicians
Flat Fees for Outpatient Care
Other Payors Follow Suit
Managed Care and Risk Sharing
Overview of “Managed Care”
Methods of Managed Care Payments
Capitation
The Future Is Now
Regulation
The Patients’ Bill of Rights
The Continued Search for Quality in the
New Millennium
Health Care Enters the Digital Age:
Technological Advancements Enable
Efficiencies
Information Technology
Summary
Key Terms
Questions and Problems
(Continues)
Chapter Outline
bIntroductionc
This chapter provides an introduction to the development of the health care payment
system in the United States and some of the basic methods used to determine health
care payments. The evolution of the payment system will be emphasized in light of
the ongoing public policy debate about the roles, responsibilities, and effects of the
payment system on various stakeholders, including:
l Patients.
l Providers, including physicians, institutional providers, and ancillary
providers (e.g. physical therapists, laboratories, hospices, and home care
providers).
l Employers.
l Payors, including various levels of government agencies and managed care
organizations.
l Regulators, including governmental and private agencies (e.g. the Joint
Commission on Accreditation of Healthcare Organizations and the National
Committee for Quality Assurance).
Simply put, this debate has been over “Who gets paid?,” “How much?,” “By whom?,”
“For what types of services?,” and “With what consequence?”
All health care systems attempt to balance cost, quality, and access. Over the
years, each of these three facets has received more or less emphasis in the US
health care system as various stakeholders have asked and attempted to answer
such questions as: “For the cost, are we getting sufficient quality and access?” (see
Perspective 13–1) and “What would it cost to provide better quality care to the
uninsured and underinsured?” While this debate continues, it largely focuses
on the roles of governmental entities, payors and providers, not individual consumers
(See Exhibit 13–1). Meanwhile, health care providers are on the front line
every day, trying to balance their missions and their margins, walking a fine
line between the art of healing, the science of medicine, and the business of health
care.
In order to truly understand the current health care payment system, it is important
to have insight into how it has evolved (see Exhibit 13–2).
Provider Payment Systems 445
Chapter Outline (Contd)
Appendix H: Payment Systems
Cost-based Payment Systems
Reasonable and Allowable Costs
Areas of Contention in Determining
Allowable Costs
Unit-Based Payment Systems
Units of Service
Charge-based Systems
Historical/Market/Payor Method
Weighted-average Method
Margin Approaches
Payor: An entity that is
responsible for paying
for the services of a
health care provider.
Typically, this is an
insurance company or
a government agency.
Prior to the late 1920s and early 1930s, health care was funded primarily by the
patient. The growth of the country’s population, however, brought additional costs in
the form of more doctors and more health care facilities. The burden of paying for
health care shifted to the employer and later to government. A summary of key events
in this evolution follows, ending with some future trends.
bHistorical Perspective on Payment Systemsc
The “Early” Years (1929–1965)
Defining events Industry trends
BC/BS established 1929 Advent of indemnity
insurance
Kaiser established 1930s Rapid growth of hospitals
(inpatient focus)
Hill-Burton Hospital Construction Act 1946 Employers largely passive
446 Financial Management of Health Care Organizations
Perspective 13–1
The World’s Health Care: How Do We Rank?
The United States spends a great deal on health care but gains too little, says the World Health Organization.
Health care in the United States is second to none. Right? Well, not according to the World Health Organization.
A recent WHO survey ranked the United States 37th in overall health system performance – sandwiched between
Costa Rica and Slovenia. This dismal showing occurred despite the fact that the United States spends more on
healthcare – 13.7% of its gross domestic product – than any other of the 191 WHO nations.
Source: Susan Landers,AMNews staff,August 28, 2000.
Access
Regulators
Providers
Cost
Quality
Payers
Employers
Patients
• Who gets paid?
• How much?
• By whom?
• For what types of services?
• With what consequences?
Exhibit 13–1 Key Elements in the Debate Undergirding the Health Care Payment System in the United States
The payment system during this period was largely composed of a combination of
charge-based, fee-for-service, and employer-based indemnity insurance.
Typically, regardless of the extent of employer involvement in the payment for health
services (whether the employer paid a portion, all, or none of the charges for the services),
the provider was the price setter. Despite the massive amount of government
funding created for facility development, there was relatively little federal or state
government involvement as payors.
Blue Cross and Blue Shield Established
In 1929, Justin Ford Kimball, an official at Baylor University in Dallas, introduced a
plan to guarantee schoolteachers 21 days of hospital care for $6 per year. Other groups
of employees in the area soon joined the plan, known as the Baylor Plan, and the idea
attracted national attention. By 1939, the Blue Cross symbol was officially adopted by
a commission of the American Hospital Association (AHA) as the national emblem for
plans like the Baylor Plan that met certain guidelines.
Blue Cross and Blue Shield (BC/BS) plans were attractive to both consumers
and providers. They guaranteed that payment would be made for covered services
(such as 21 days in the hospital). All covered individuals paid their premium
Provider Payment Systems 447
1929 BC/BS Established
1938 Kaiser Established
1965 Medicare/Medicaid
1972 HMO Act
Early 1980s Managed Care Growth
1999 APCs
1983 Diagnostic Related Groups
Healthcare Industry: Inpatient Focused
Facility Growth
Bearer of Cost Risk: Provider and Patient
Government: Mostly Uninvolved on
Payment Side
Employer: Largely Passive
Insurance: Just Beginning
(Indemnity Primarily)
Healthcare Industry: Still Inpatient Focused
Slower Facility Growth
Technology Boom
Bearer of Cost Risk: Payor
Government: Takes Major Role
Cost-based Payment
Employer: Concern about Costs
Insurance: Indemnity Growth
Managed Care Catches On
Healthcare Industry: Outpatient Medicine
Grows Rapidly
Costs Skyrocketing
Managing Care – Primary focus
Focus: Quality Control
Technology Still Booming
Bearer of Cost Risk: Shift to Providers
Government: Even More Aggressive Role
Employers: Adjusting Benefits to Control
Costs
Insurance: Managed Care (HMOs/PPOs)
Dominant
1946 Hill-Burton Act
1992 RBRVS
1997 Balanced Budget Act
Early Years Middle Years Later Years
Exhibit 13–2 Key Events in the Evolution of the Health Care Payment System in the United States
Charge-based: A
method of payment
which is based on the
charge of the provider.
Fee-for-service: A
method of
reimbursement based
on payment for services
rendered, with a specific
fee correlated to each
specific service. An
insurance company, the
patient or a government
program such as
Medicare or Medicaid
(discussed later) may
make payment.
based on “community rating,” and payment was made directly to the hospital.
In terms common today, a third party (the payor, BC/BS in this case) would pay
the second party (the provider, hospitals in this case) on behalf of the first party
(the patient).
As a result of wage freezes (due primarily to the United State’s involvement in the
Second World War) labor forces resorted to bargaining for more benefits, including
better health care coverage. It was at this time that private, for-profit, insurance companies
began to be major competitors with BC/BS plans. It was during this period
(the late 1930s) that the Kaiser Health Plan began. The Kaiser Engineering Company
provided a health care benefit for its employees who were involved in the construction
of the Grand Coulee Dam and the Los Angeles Aqueduct by providing physician
services in a company-sponsored clinic and hospital services at local hospitals.
Along with a few other prepaid health care plans, the Kaiser Plan grew throughout
the 1940s and 1950s, expanding beyond the realm of its own employees, and became
the prototypical staff model Health Maintenance Organization (HMO). In the Kaiser
Plan, physicians were salaried, patients received care in a controlled environment, and
all services (except hospital services) were provided in a single facility. (HMOs are
addressed in greater detail later in this chapter.)
With the population boom after the Second World War, and with the continued
industrialization of the USA, a great need arose for the development of adequate
health care facilities – in particular, hospital beds and support facilities. The Hill-
Burton Act of 1946 provided government supported grants to build and upgrade hospitals.
Prior to 1946, the US hospital system had evolved with great disparities in facilities
and accessibility. With about one-third of the country’s counties without a hospital
and many of the existing facilities of substandard quality, the intent of this legislation
was to fund development in geographic areas that were without health care facilities.
During the period between 1947 and 1975 (the end of Hill-Burton expenditures),
almost 7,000 hospitals received assistance, with many rural areas gaining access to hospital
care for the first time.
The “Middle” Years (1965–1983)
Defining events Industry trends
Medicare/Medicaid established Indemnity insurance growth
HMO Act Managed care catching on
Technology boom on the horizon
Cost risk shifts to payor
Employers concerned about costs
During the middle years, governments became heavily involved as payors through
two new programs (Medicare and Medicaid), employers played a relatively passive
role, and there was a trend toward trying to manage care and a movement away from
the provider as a price-setter.
448 Financial Management of Health Care Organizations
Indemnity insurance:
A plan which
reimburses physicians
for services performed,
or beneficiaries for
medical expenses
incurred. Typically, the
employer and/or
patient pays a monthly
premium to the plan
for a predetermined set
of health care benefits.
Price Setter: The
entity that controls the
amount paid for a
health care service.
Premium: A monthly
payment made by a
person and/or an
employer to an insurer
that makes one eligible
for a defined level of
health care for a given
period of time.
Community Rating: A
rating methodology
used by indemnity and
HMO insurers that
guarantees that there
will be equivalent
amounts collected from
members of a specific
group without regard
to demographics such
as age, sex, size of
covered group, and
industry type.
The First Party:
Typically, the patient in
a health care
encounter.
The Second Party:
Typically, the provider
(hospital/physician) in a
health care encounter.
Because of the influence of the government as a payor, the late 1960s and 1970s
represented a plateau in the evolution of payment systems. Medical costs, while
still rising during this period, were relatively manageable. Employers, while concerned
about cost, continued to pay for rich health care benefits. Technology was
beginning to boom but had not yet advanced to the point where it materially
affected the cost of providing or paying for services. Indemnity insurance
dominated, and providers were generally satisfied with the payment systems
employed during this time. For the most part, payment systems revolved around
cost-based and charge-based methodologies, an overview of which can be found in
Appendix H.
Increasing Concerns about Costs and Access
While the Hill-Burton Act improved access by catalyzing the construction of new hospitals,
paying for the care provided at these new and improved facilities (and new
technology associated with them) was becoming increasingly expensive. While being
employed was one way to access health care coverage, there was a growing concern
about the ability to pay for care by the unemployed, the under-insured (perhaps selfemployed
or employed by an employer not offering an insurance benefit, for example),
the poor, the young, the elderly, and the disabled. Thus, much of the national
debate focused on the issue of access to care.
Medicare and Medicaid
The government’s role in the payment of health care, which to this point had been
passive (on both a federal and a state-specific basis), changed dramatically in the
mid-1960s with President Lyndon Johnson’s administration. The formation of a
“Medical Care” program (Medicare), established largely to help pay for care of
those 65 years and older, and the creation of a companion “Medical Aid” program
(Medicaid), designed to provide assistance to the medically indigent and those with
certain categories of disabilities, marked the beginning of a new era in US health
care (see Exhibit 13–3).
At its inception, Medicare paid hospitals based on the hospital’s costs, using
Cost-based Reimbursement paid on a retrospective basis. At the end of a period
after care was provided (typically, at the end of a year), the hospital would submit
a report, the Medicare Cost Report, detailing all of the costs associated with the
provision of Medicare services throughout that period. The government, in turn,
would scrutinize the costs being claimed and would allow or disallow costs on the
basis of standards.
Also during this period, the HMO Act of 1972 was passed under the administration
of Richard Nixon. This had a major impact on the management of care in later
years by empowering the staff model HMO (discussed later) to become a common
system practiced outside of the mainstream medical society. The Act allowed certain
Provider Payment Systems 449
The Third Party:
Typically, the payor
(insurance
company/government
agency) in a health
care encounter.
Medicare: A
nationwide, federally
financed health
insurance program for
people age 65 and
older. It also covers
certain people under 65
who are disabled or
have chronic kidney
(end-stage renal)
disease. Medicare Part A
is the hospital insurance
program; Part B covers
physicians’ services.
Created by the 1965
amendment to the
Social Security Act.
Medicaid: A federally
mandated program,
operated and partially
funded by individual
states (in conjunction
with the federal
government) to provide
medical benefits to
certain low-income
people. The state,
under broad federal
guidelines, determines
what benefits are
covered, who is
eligible, and how much
providers will be paid.
Cost-based
Reimbursement:
Using the provider’s
cost of providing
services (i.e. supplies,
staff salaries, space
costs, etc.) as the basis
for reimbursement.
competitive advantages for qualifying HMOs, but these generally languished and
became more interested in cost containment.
The “Later” Years (1984 to the Present)
Defining events Industry trends
Diagnosis Related Groups Managed care is dominant theme
RBRVS Government taking more aggressive role
Balanced Budget Act Flat fee payment systems
APCs Costs shift back to provider
Technology booming
Employers adjusting benefits to control costs
Quality control becomes a major issue
Health care infrastructure and technology grew exponentially over the early and middle
years of the modern health care era. Programs such as Medicare and Medicaid, which
were originally designed to fill relatively small gaps in access, felt the brunt of this growth.
Because of this, the government was experiencing unexpected difficulties trying to pay for
the benefits it had created. Employers, as well, were growing increasingly concerned with
the question of cost containment, as health care costs and employee health benefits began
to eat into corporate profits. Other payors were also experiencing difficulties in matching
the premiums they were receiving with the payments they were making to providers. This
set the stage for a change of the locus of risk from the payor to the provider.
450 Financial Management of Health Care Organizations
Medicare Medicaid
Who Pays for Program? Federal Tax on Income Federal and State Tax on Income
(Feds pay larger share based on
State’s per capita income)
Who Is Covered? • People with disabilities
• The poor
• People aged 65 and older
• Some people with disabilities under age 65
• People with end-stage renal disease • Needy women and children
How Many Are Covered? 1980: 28.5 Million 1981: 20.2 Million
1990: 34.2 Million 1990: 23.9 Million
1999: 39.9 Million 1999: 42.2 Million
Percent of Americans Covered 14% 15%
Percent of Older Americans Covered (65+) 97% –
Expenditures 1980: 36 Billion 1980: 24.7 Billion
1990: 108 Billion 1990: 71.2 Billion
1999: 212 Billion 1999: 159.2 Billion
Percent of Total Health Care Expenditures
(1999)
17.6% 15.4%
Predicted Enrollment in 2010 46.6 Million (22% of total population) 46.7 Million (22.04% of total
population)
Source: Webpage: http://www.hcfa.gov, August, 2000
Exhibit 13–3 Medicare and Medicaid Entitlement Programs
Retrospective
Payment: Method for
reimbursing a provider
after the service has
been delivered.
Allowable Costs:
Costs which are
allowable under the
principles of
reimbursement under
government (Medicaid,
Medicare) and other
payors.
Managed Care: Any
of a number of
arrangements designed
to control health care
costs through
monitoring,
prescribing, or
proscribing the
provision of health
care to a patient or
population.
DRGs
It was at this point that the government changed its reimbursement methodology for
Medicare from a cost-based payment system to a Prospective Payment System,
commonly known as the DRG (Diagnostic Related Groups) system. Prospective
payment shifts the risk from payor to provider. In this system, the provider is paid a
predetermined flat amount for an inpatient admission. If the provider’s costs are
below that flat amount, the hospital retains the difference. However, they are at risk
for the amount their costs exceed the payment they receive. Therefore, it becomes
extremely important for the hospital to understand and control its costs, while maintaining
appropriate levels of access and quality.
Under the DRG system, the government’s payment to providers of inpatient services
for Medicare recipients is based upon a flat rate (see below) for all services rendered
in each of the over 500 diagnosis-based categories. Each DRG serves to group
clinically similar services together in a way that accounts for predicted resource consumption.
Each of these predetermined groupings is then assigned a DRG payment.
DRGs are ultimately intended to account for case mix, or the acuity of services
required in caring for the patient. For example, an inpatient stay involving neurosurgery
and an intense recovery will be paid a much higher rate than will one involving
a normal obstetric delivery.
DRG payments are based on an adjusted average payment rate. In essence, a relatively
minor, commonly performed procedure is established as a baseline (1.000)
against which all other procedures are weighted. These weights are then adjusted for
geographic differences. For example, a relatively simple procedure/diagnosis, such a
skin graft for injury, might be weighted slightly higher, at 1.709; a medical stay driven
by asthma might be slightly lower, at 0.5873; and a heart transplant requiring
extensive resources might be weighted at 19.0098 (see Exhibit 13–4). A hospital’s payment
is unaffected by the length of stay prior to discharge; it is expected that some
patients will stay longer than others, and hospitals will offset the higher costs of a
longer stay with the lower costs of a reduced stay. The government regularly updates
both the DRG weights and the geographic adjustments.
These efforts by the government defined the third era of payment systems: “The
Later Years” and the entry of many payors into the world of flat fee payment.
Provider Payment Systems 451
Prospective Payment
System: A payment
method that establishes
rates, prices or budgets
before services are
rendered and costs are
incurred. Providers
retain or absorb at least
a portion of the
difference between
established revenues
and actual costs.
Predetermined Rates:
A set fee paid to a
provider for an inpatient
episode of care.
Flat Fee: A predefined
amount of money paid
to a provider for a unit
of service.
DRGs: A patient
classification scheme
used by Medicare that
clusters patients into
categories on the basis
of patients’ illnesses,
diseases and medical
problems. These
classifications are then
used to pay providers a
set amount based on
the diagnostic related
group in which the
patient has been
classified.
RELATIVE
WEIGHT Geographic Average Payment Total DRG
DRG DESCRIPTION FY – 2001 Adjustment1 per Weighted Unit Payment
439 Skin Graft for Injury 1.7090 0.97 $4,100 $6,797
97 Bronchitis and Asthma > 17 0.5873 0.97 $4,100 $2,336
w/o Complications
103 Heart Transplant 19.0098 0.97 $4,100 $75,602
1 Geographic Adjustment varies by area.
Exhibit 13–4 Examples of Diagnostic Related Groups
Source:Webpage: http://www.hcfa.gov,August, 2000
Flat Fee Systems
Flat Fees for Hospitals
Flat fee systems in general pay a predefined amount for a unit of service. The fee may be
established by the payor alone or as a result of negotiations between the payor and
provider. As with cost-based systems, the units of service paid for vary widely and
include the following:
l Per procedure.
l Per inpatient day.
l Per admission.
l Per discharge.
l Per diagnosis.
By paying a flat fee, the payor is limiting its liability. By accepting a flat fee, the provider
is accepting the risk that it can offer the service for less than the payment. If a provider
cannot offer a service for less than it is paid, it has several alternatives: 1) absorb the cost;
2) transfer the cost to another payor; 3) improve efficiency; and/or 4) drop the service.
Flat Fees for Physicians
For professional (i.e. physician) services, the corresponding system is RBRVS
(Resource Based Relative Value System), which was developed by the government
in 1992. This system assigns a relative value to every one of over 7,000 professional
services (including pathology/laboratory and radiology), and establishes a flat
fee for those services based on their relative weight compared to a standard relative
value unit (RVU) of 1.000.
Flat Fees for Outpatient Care
APC, or the Ambulatory Payment Classification System, is a prospective payment
system which was implemented in 1999 by the government in accordance with The
Balanced Budget Act of 1997 (BBA 97). This legislation was enacted to reduce and
stabilize the amount of reimbursement hospitals receive for outpatient care. The development
of this system came in response to the exponential growth of the cost and the
volume of outpatient medicine. With the stringent DRGs in place and improved
technology that could not have been fully anticipated, an unexpected result was that
hospitals converted many procedures from inpatient to outpatient (including freestanding
ambulatory surgical centers). As seen in Exhibit 13–5, the amount of dollars
spent for Medicare enrollees also saw a dramatic shift from inpatient to outpatient
expenses. This rise in outpatient expenses drove the relatively speedy APC development
and implementation.
Outpatient care previously reimbursed on a cost basis is now paid under the APC
flat fee format, which has many similarities to the DRGs developed for inpatient care.
452 Financial Management of Health Care Organizations
RBRVS: A system of
paying physicians
based upon the
relative value of the
services rendered.
RVU: Relative Value
Unit.
APC: A flat fee
payment system
instituted by the
government to control
the payment for
outpatient services
provided to Medicare
recipients.
The original intent was to cluster outpatient services into a manageable number of
groupings. In the early stages of development, there were 290 total groups. Due to
comments and feedback to the government from concerned providers about the lack
of detail within these initial groupings, the total number of APCs is now over 900
(Journal of AHIMA, July/August 2000).
Services within these groups are clinically similar and require a comparable allocation
of resources. They are categorized into the following groupings:
l Significant Procedures, Therapies, or Services.
l Medical Visits.
l Drugs and Biologicals.
l Medical Devices/Implants.
l Partial Hospitalization.
l Ancillary Tests and Procedures.
To gain acceptance by the provider community as a valid and equitable methodology,
the new outpatient payment methodology needed a historical benchmark that
would be viewed as a globally accepted standard among providers. It used actual 1996
outpatient cost data from a large group of hospitals as a baseline. The costs were
grouped according to similar services (e.g. an outpatient MRI). A median was derived
for each service grouping, and then a new “value” for each service grouping was established
by determining a factor/percentage of the median average prospectively for the
group in the future. For example, if among 250 hospitals nationally the government
found a low cost of $500 for an outpatient MRI and a high cost of $1,000 and determined
the median was $750, the prospective APC for that service might be 90 percent
of the median, or $675.
As a safety measure, Medicare created an additional formula designed to guarantee
slow growth in APC reimbursement levels. On a going-forward basis, it was
Provider Payment Systems 453
0
200
400
600
800
1000
1200
1400
1600
1800
1970 1983 1998
Percent
Inpatient Outpatient
Exhibit 13–5 Percentage Increase in Medicare Expenditures (IP and OP), 1970–1998
Source: http://www.hcfa.gov (accessed August, 2000).
determined that the APCs would be increased annually by a percentage that would be
1 percent less than the medical cost inflation factor specific to outpatient services. As
an example, if the overall medical cost index for all services related to outpatient care
was 4.5 percent, then the APCs would be adjusted by 3.5 percent.
The governmental department which oversees the Medicare payment systems
(DRG and RBRVS, APCs and others) is known as the Center for Medicare and
Medicaid Services (CMS). Until 2001, it was called the Health Care Financing
Administration or HCFA.
Other Payors Follow Suit
Health care was so expensive that domestic employers complained they were spending
a disproportionate amount on health care compared to their peer employers in
other nations. Many US companies found it difficult to compete, when the cost of
their products had to be artificially inflated in order to cover the monies spent on
health care (see Exhibit 13–6). In 1995, General Motors noted that it was spending
more on the health care benefits for its employees than it was for the steel for the production
of its automobiles.
While some employers tried to organize in coalitions for leveraged buying power
and economies of scale in health care purchasing, this movement never fully caught
on nationally. The overall complaint against the fee-for-service medicine facing
employers was that service providers have inherent incentives to perform more surgeries,
hold patients in the hospital longer, and (arguably) even provide services that
are not medically necessary.
Following the lead of the government and its cost containment efforts, its use of
prospective payment on both the inpatient and outpatient sides, many commercial
payors adopted the same methodologies. Again, the use of these methods limited the
ability of the provider to a set dollar amount per inpatient stay or outpatient case. The
454 Financial Management of Health Care Organizations
CMS: The Center for
Medicare and Medicaid
Services. The acronym,
CMS, is pronounced
“sims.” See HCFA.
HCFA: The Health Care
Financing
Administration. The US
government’s
department that
oversaw the provision
of and payment for
health care provided
under its entitlement
programs (Medicare,
Medicaid) until 2001.
3
5
7
9
11
13
15
17
1940 1950 1960 1970 1980 1990 2000
Year
Percent
Exhibit 13–6 Health Care Expenditures as a Percentage of GNP, 1940–2000
Source: http://www.hcfa.gov (accessed August 2000).
use of prospective payment also provided greater predictability of medical expenditures
for payors.
Managed Care and Risk Sharing
During this period, the changing dynamic between payors and providers was driven
by a desire to shift the financial risk from the payors (who traditionally held it) to the
providers. The payment methodologies became increasingly creative and complex as
payors and providers became focused on “managing care” and cost containment. This
managed care concept created an entire industry devoted to controlling the expenditure
of the health care dollar.
A number of managed care organizations were publicly traded and earnings pressures
from Wall Street and/or demands from employers to keep fees “under control”
drove many managed care organizations to walk a fine line between an overriding concern
for patient/“member” care and the larger issues of profit and loss. America
developed a “love/hate” relationship with managed care organizations. When
President Clinton proposed a radical overhaul of the US health care system through
a government-led “Managed Competition” system, there was a strong reaction to
limit government involvement from a broad range of stakeholders in the health care
system, including employers, employees, providers, and managed care companies. By
the mid–1990s managed care, which had held considerable promise for controlling
costs while maintaining quality, became fixed in the public’s mind as a system which
limited the quality of and access to care for the sake of financial gain (see Perspective
13–2).
Despite all the public outcry against restriction of provider choice/access, and for
all the public distaste for some of the stringent medical management mechanisms that
came into being, the fact is that in the early 1990s, medical costs plateaued in the USA
for the first time in many years. By early in the next century, however, they began to
rise again.
Overview of “Managed Care”
The predominance of managed care in the “later years” catalyzed the evolution of
many payment schemes, a description of which follows.
The term managed care is often used as if it were referring to a specific type of
care and payment arrangement. In fact, the term is used to describe a wide variety of
options, with Health Maintenance Organizations (HMOs), Preferred Provider
Organizations (PPOs), and Point of Service plans (POS) being the three dominant
managed care models. They are arranged in Exhibit 13–7 according to the degree that
they manage the care giving process and share risks between payors and providers,
and are discussed in turn below.
Perhaps the easiest way to understand the structures and payment methodologies
of managed care is to contrast them to typical fee-for-service models of care. As discussed
previously, the fee-for-service arrangement is most commonly characterized
Provider Payment Systems 455
456 Financial Management of Health Care Organizations
Perspective 13–2
An Opinion of Managed Care
THE ISSUE: Some believe that the death knell is being sounded for managed healthcare.
OUR POSITION:The price pressures that gave us HMOs in the first place are still here.
Physicians who are hoping that managed care is dead, or at least losing its grip, need to think again.
All of the inflationary pressures that caused employers and the government to start herding people into HMOs
in the first place are still there, from the high cost of medical technology to the severe cost shifting that occurs when
large segments of the population have no insurance. And now, there are new pressures, such as the rising cost of
drugs, and the effect that opening the door to litigation will have on HMOs.
Many employers are now seeing sharp hikes in their HMO rates.As the year ends,we’ve seen 20 percent increases
locally. It won’t take more than a year or two of that before the next wave of managed care – or some other
form of medical rationing – takes place.
Rising medical costs have taken a huge cut of the nation’s billfold. And make no mistake, the lower and middle
classes have indirectly footed the bill for the lavish costs of healthcare in America. If not for managed care, where
would we be right now? Through the 1980s, when traditional postwar indemnity health plans were still common,
employers were seeing premium hikes of 15 percent to 25 percent a year. By 1990, $675 billion was spent on US
healthcare, or 12.2 percent of gross domestic product. In 1993, the Congressional Budget Office forecast that the
US would spend $1.6 trillion on healthcare by 2000 – 18.9 percent of projected GDP. At that rate of inflation, half
the nation’s gross domestic product would have gone to healthcare by 2050. But the tide was turned when employers
started contracting with HMOs, and the HMOs started squeezing the system. The current forecast is that by
next year, the US will spend $1.3 trillion.That’s plenty, but not as much as was expected.
Make no mistake, managed care has been ruthless and too often greedy as all get-out.The HMOs for too long
were able to insulate themselves from legal liability, for example, when they refused appropriate care and coldly
rationed medical treatment. But greed hasn’t been the exclusive domain of HMOs.A big part of what managed care
has been about is trying to put price pressure on medicine. That’s driven down some of the outrageous expenditures
in the industry.
We still need a national healthcare policy.We still need to achieve coverage for every American so that the risks
and costs can be spread more evenly among all of us.And we still need to be skeptical when medical specialists tell
us that cost controls are not good for us.
Source: Sacramento Business Journal, December 17, 1999.
Least Restrictive Provider Choice
More Expensive
Less Medical Management
Broader Provider Networkre
Most Restrictive Provider Choice
Less Expensive
More Medical Management
Smaller Provider Network
PPO POS IPA HMO Staff Model HMO
Exhibit 13–7 Managed Care Environments
by independent providers who are paid “reasonable charges” for providing “necessary”
services to patients who make an unrestricted choice to go to them.
PPOs
The PPO is a network of independent providers approved in advance by the payor to
provide a specific service or range of services at predetermined (usually discounted)
rates. It is based upon some restriction of access and utilization in return for a discount.
HMOs
HMO is a term used to describe a specific type of company/insurer that offers medical
care to a covered population. There are two general types of HMOs: the group
model HMO (consisting of a loose affiliation of providers that act as an entity and
contract to cover the health care needs of a covered population) and a staff model
HMO (whereby the providers are actually employed by the HMO), where patients
receive care in controlled/owned facilities (e.g. Kaiser Permanente plans).
POS
A POS arrangement is a hybrid between an HMO and a PPO. Though patients are
encouraged to see participating providers in order to receive their most financially
favorable benefit, at the point-of-service they may see a non-participating provider,
though usually at some additional cost or reduced benefit.
Methods of Managed Care Payments
The following methods of payment are used in various ways by the entities described
above to help manage care and share risk.
Steerage
Steerage is one of a variety of straightforward, market-driven techniques designed to
increase or maintain market share. In order to increase volume (and thus reduce fixed
costs per unit), providers give payors a discount in exchange for the payors agreeing
to employ mechanisms that direct patients to the participating provider. An example
of steerage is the “Center of Excellence” designation used by insurers. Typically, in
this situation, a provider has distinguished itself as a high-quality provider of one or
more services. This is most often accomplished by meeting or exceeding predetermined
criteria established by a payor. Once a provider is chosen as a “Center of
Excellence” by a payor, the payor agrees to steer those in need of the services covered
to the provider. Providers also implement strict benefit differentials to ensure that
their population utilizes participating providers who have joined the managed care
organization’s network. If a patient uses a participating provider, the copayments and
benefits might be very favorable, whereas if a non-participating provider is used, there
might be greatly reduced benefits, or even no benefits whatsoever. To help ensure that
Provider Payment Systems 457
Preferred Provider
Organization (PPO): A
network of
independent providers
preselected by the
payor to provide a
specific service or
range of services at
predetermined (usually
discounted) rates to
the payor’s covered
members.
Health Maintenance
Organization (HMO):
A legal corporation
that offers health
insurance and medical
care. HMOs typically
offer a range of health
care services at a fixed
price (see capitation).
Group Model HMO:
An HMO which
contracts with medical
groups for services.
Staff Model HMO: An
HMO which owns its
clinics and employs its
doctors.
Point of Service
(POS): A hybrid
between an HMO and
a PPO in which
patients are given the
incentive to see
providers participating
in a defined network,
but may see nonnetwork
providers,
though usually at some
additional cost.
patients are “steered” in a certain direction, providers and insurers look to the beginning
of the health care continuum: the patient’s primary care provider (PCP).
Many providers, including hospitals, integrated networks, HMOs, and PPOs, purchase
or affiliate with PCPs to make sure that the patient stays within their system.
These providers are known as gatekeepers. The gatekeepers control both the level of
care and who provides it. If the patient seeks care outside the network for anything
other than an emergency, there is usually a penalty in the form of a hefty copayment
or total denial of payment.
The members, then, have a very real financial incentive to stay within the network
of participating providers, and, subsequently, the participating providers get the volume
increases promised as a benefit of being in the managed care organization’s network.
In exchange for the added volume, the provider gives the payor a discount.
Depending on the competition, discounts can range from 5 to 40 percent of normal
charges. Though 40 percent seems like an enormous discount, many providers feel
that if their variable costs are being met, then the additional volume is worth the discount.
Steerage, discounts and allowances have only been partially successful in bringing
down costs to employers.
Copayments and Deductibles
One of the simplest methods of risk sharing is through copayments and deductibles,
where patients absorb some of the cost of service provision. With copayments, members
covered by the plan are required to pay part of the cost of the service. For
instance, if the fee for an office visit is $50, the patient may have to pay $10 and the
insurance pays the remainder of the allowable reimbursement, up to the remaining
$40. With deductibles, the person covered is responsible for paying a certain base
amount before coverage begins. For instance, a patient may be required to pay for the
first $250 of service before the third party pays any of the bill. Exhibit 13–8 shows an
example of a health care plan that uses copayments and deductibles.
Two risk-reducing outcomes occur as a result of copayments and deductibles: 1)
insurers do not have to pay the portion of the bill that the copayment and
deductible amounts cover; and 2) copayments and deductibles are designed to
encourage people to seek less care (especially in the common tiered copayment
schedule, where a primary care visit may cost $10 while a specialty visit is $25 and
an emergency room or urgent care copayment is $50). The copayments and
deductibles are generally low enough to be affordable if care is really needed, but
high enough to make people think twice before seeking unnecessary care and generally
to make people consider whether they are seeking care in the most appropriate
location.
Per Diem
Another method of payment is a per diem (or “per day”) rate. Similar to case rates,
a payor negotiates an amount that it will pay for one day of care, which includes all
hospital charges associated with the inpatient day (nursing care, surgeries, medications,
etc.). The day of care can be defined in several ways. Certainly a day in the
458 Financial Management of Health Care Organizations
Participating
Provider: A provider
who has contracted
with the health plan to
provide medical
services to covered
members at
predetermined rates.
Steerage: The process
of directing patients
towards certain
providers in exchange
for discounts or other
incentives.
Primary Care Provider
(PCP): A physician
(typically a Family
Medicine, Internal
Medicine, Pediatric and
sometimes Obstetrics
and Gynecology
provider) who is the
primary caregiver of a
patient.
Gatekeepers:
Providers (typically the
PCP) who must
preapprove care
received by a patient,
such as a visit to the
specialist. Gatekeepers
are utilized in most POS
plans and HMO plans.
Members: People who
are covered by a health
care plan. Typically the
member and/or the
employer of the
member pays a
premium to the plan
for the privilege of
being covered.
Discounts: A reduction
in the charge for
services.
Intensive Care Unit (ICU) is more expensive than a day on a regular unit. Therefore,
the per diem rate for the ICU might be $1,700 and for the regular unit might be
$1,000. For a patient who spends seven days in the hospital, two in the ICU, and five
on the regular unit, the payment would be:
2 Days @ $1,700 = $3,400
+ 5 Days @ $1,000 = $5,000
Total $8,400
To reduce their financial risk under per diems, payors place limits on length of stay.
They may even put limits within the length of stay. For example, in the seven-day
stay, the insurer may say (based on its analysis of the situation compared to its
national statistics) that a total of seven days is fine, but it may only allow one day in
the ICU, not two. Typically, per diems favor the managed care organization, which
has control over the number of days “allowed” as a benefit, even if it does not necessarily
have the ability to discharge the patient.
Another way that insurers attempt to manage their risk is by encouraging outpatient
treatment, only approving hospital admission for the sickest of patients. As the level of
acuity rises, so do the expenses associated with care. This can be a very troubling aspect
of per diems from the provider’s perspective. They are concerned that though a rate will
be negotiated on a wide variety of patient types, only the sickest and most complicated
cases will end up at their hospital. Thus their costs will rise above the per diem.
Case Rates
Another form of managing care and sharing risk is to negotiate a rate that is allinclusive
of everything that the hospital provides during the entire inpatient stay.
Provider Payment Systems 459
Copayment: Requiring
the patient to pay part
of the health care bill.
These payments are
used to prevent
overutilization of
services.
Deductibles: When
the patient covered is
responsible for paying
a certain base amount
before coverage
begins.
Per Diem: An amount
a payor will pay for
one day of care, which
includes all hospital
charges associated
with the inpatient day
(nursing care, surgeries,
medications, etc.).
Exhibit 13–8 Example of Employee Benefits Using Copayments and Deductibles
Service Plan Coverage Employee Responsibility
Participating Provider Non-participating Participating Provider Non-participating
Provider Provider
MD Office Visit 100% after Copayment 70% after Copayment $10 Copayment $25 Copayment
per Visit per Visit
Emergency Room 100% 100% Subject to Plan Subject to Plan
Visit Approval Approval
Inpatient Stay 100% after Deductible 70% after Deductible $200 Deductible per $200 Deductible
Stay/$1,000 Maximum per Stay/$1,000
per Year Maximum
per Year
Prescription Drugs 100% after Copayment 70% after Deductible $5 Copayment/ $10 Copayment/
Prescription Prescription
In this instance, the insurer and the provider agree to a fixed rate, which limits the
liability of the payor and shifts some of the financial risk to the provider. This
negotiated rate is known as a case rate. For example, a hospital might agree to
accept $30,000 for a patient who needs a coronary artery bypass graft (CABG). Of
particular concern to providers when considering case rates is the very complicated
case, referred to as an outlier, or, informally, a “train wreck,” that ends up costing
far more than the negotiated rate. The provider is taking a big risk if it is
guaranteed only $30,000 for a given procedure, but unusual complications of the
case cost hundreds of thousands of dollars.
The benefit to the provider, however, is that if the case is of lower severity or experiences
a shorter length of stay than expected, then the provider may indeed receive
a case rate well in excess of costs and sometimes even in excess of charges. While this
is uncommon, providers often have a false sense of confidence that they can manage
the care of the patients to such a level that they will “win” in the case-rate scenario.
What they fail to realize, often, is that once the financial risk for the provision of health
care services is handed from the payor to the provider, the payor may have no real
incentive to assist in the medical management of the patient. In fact, every penny the
managed care organization spends on administration by helping the hospital is really
a penny of annual profit lost. It is easy to see why hospitals have become increasingly
shy about contracting with this methodology unless they are very certain that they
have the medical management protocol in place to allow them to benefit.
One method providers use to limit the exposure that comes with the possibility
that charges will go far beyond negotiated rates is to negotiate a level of charges
over which the hospital is no longer totally liable, called a stop-loss limit. For example,
in the case just described, a hospital and insurer might agree that $50,000
is the maximum amount for which the provider is totally liable (see Exhibit 13–9).
If a patient’s charges exceed $50,000, the insurer will pay the provider for charges
over this amount. Many times insurers and providers share this risk by negotiating
a discount – for example, 20 percent – off the excess charges. Continuing with the
CABG example, if a patient incurs a total of $75,000 on a CABG case, this is a
stop-loss case. The insurer pays the provider $30,000 (the negotiated case rate)
plus 80 percent of the charges over the $50,000 stop-loss or $20,000 [80 percent ´
($75,000 – $50,000)]. This stop-loss reduces the loss to the provider from $45,000
to $25,000. Risk is shared between the provider and the insurer.
460 Financial Management of Health Care Organizations
Case Rates: A rate
that covers everything
that the hospital
provides during the
entire inpatient stay.
Stop-loss: A method
providers use to limit
the exposure that
comes with the
possibility that charges
will go far beyond
negotiated rates – a
level of charges over
which the provider is
no longer totally liable.
A Total Charges $75,000
B Negotiated Case Rate Payment 30,000
C Balance [A – B] 45,000
D Amount over Stop-loss ($50,000) [A – $50,000] 25,000
E Additional Payment from Insurer [0.8 ´ D] 20,000
F Total Insurance Payment [B + E] 50,000
G Remaining Balance (amount for which the provider is at risk) [A – F] $25,000
This stop-loss reduces the loss to the provider from $45,000 to $25,000. Risk is shared between the provider and the insurer. The
patient could also be at risk for the balance, but the patient is not usually a part of the negotiation.
Exhibit 13–9 Example of a Stop-loss Implementation
Capitation
In capitation, the basic premise is that a provider agrees in advance to cover the health
care needs of a defined population for a set amount (often per member per month
(PMPM) or per member per year (PMPY)), which is pre-paid to the provider. The gamble
for the provider, of course, is that the cost of the medical expenditures provided to the
HMO member will be less than the capitated payment amount pre-paid to the provider,
in which case the provider is able to retain the difference. The philosophy is that this payment
system will encourage prudent medical management and preventive care, which
will prevent more expensive inpatient care in the future, for example.
Inherent in capitation, however, is that the very act of providing services in any form
causes the provider to incur a cost that wouldn’t have been incurred if the service had
not been provided. In short, there is a perverse incentive in the short run to provide a
minimum level of care or not to provide care at all: to withhold care, to settle for a less
expensive but less effective course of treatment, or to create obstacles for the patients in
being able to access care (only having appointments available weeks or months in
advance, so as to discourage unnecessary utilization). In the instance of hospitals,
patients have allegedly been discharged prematurely or, again, have not received a more
expensive course of treatment when a cheaper “band-aid” approach would suffice. In
short, while capitation was initially intended to force a new level of fiscal accountability
on the providers – really forcing them to understand the costs of medical care and utilize
only the most cost-effective treatments – it has become a controversial payment form
because of the temptation it presents to focus more on the short-term financial aspects
of medical care than on the care of the patient itself.
Premium Rate-setting Methodologies
The methodologies for deriving the premiums used by managed care companies for capitation
(i.e. HMOs) are complicated, and accurate actuarial information is absolutely critical
to pricing the coverage appropriately. There are two basic methodologies that payors
use when developing premiums: community rating and experience rating. The obvious
difference is that community rating evaluates the health risk of a population as a
whole, whereas experience rating focuses on assessing the potential medical expenditures
of individuals and then aggregates them into a group premium.
Managed care organizations attempt to know as much information as possible about
the covered population in order to develop reliable predictions of how much health
care will be utilized. For example, the cost to cover the hospital care required for colon
and rectal cancer can be predicted if enough is known about the covered population.
Information such as the number of men (particularly white males since incidence is
higher among this group), 50 plus age group size (incidence increases over 50), general
diet of the population (higher fat content causes higher incidence), and income
level (income is a predictor of diet) can all provide valuable predictive input. Once a
predicted number of potential cases is determined and a potential length of stay
estimated, the potential cases are multiplied by the average length of stay, yielding the
total number of expected hospital days. The insurer then seeks the lowest price it can
find for this number of inpatient days. It often uses all the tools described in this
Provider Payment Systems 461
Capitation: A method
of payment in which
the provider is paid a
fixed amount over a
set period of time,
usually a month or a
year, for each person
served no matter what
the actual number or
nature of services
delivered.
Per Member per
Month (PMPM):
Generally used by
HMOs and their
medical providers as
an indicator of
revenue, expenses, or
utilization of services
per member per onemonth
period.
Experience Rating:
The method of setting
premium rates based
on the actual health
care costs of a group
or groups.
chapter to obtain this rate, such as promising steerage and contracting via per diems
and/or case rates.
For example, assume a payor covers 100,000 lives. After studying all the detailed
demographic data (age, gender, etc.), it is determined that 19.1 individuals from this
population could be diagnosed with colon or rectal cancer in a given year. The current
treatment for this illness requires an average stay in the hospital of 6.5 days. Thus, the
payor must be prepared to cover 124 days of hospital care (19.1 cases at 6.5 days/case). If
the payor can negotiate a rate with providers of $1,000 per day, the total cost will be
approximately $124,000 for the year. Taking this amount and dividing it by the number
of covered lives (100,000) gives a figure of $1.24 per year or $0.103 per month that it must
charge its members to cover this health care need. To cover its administrative costs and
desired profit, the payor may add an additional 15 percent (ranges between15 and 25 percent)
to the $0.103, creating a final figure of $0.12 PMPM (see Exhibit 13–10).
This methodology can be repeated for all covered health care needs to create the final
monthly premium. All events resulting in health care costs such as the number of
strokes, heart attacks, accidents, mental illnesses, and kidney failures must be accurately
predicted and their costs analyzed to create a viable premium. The premium amount
will obviously vary based on services covered and the size and demographics of the
covered population. It is also very dependent on the provider climate.
When rating various groups, payors may also consider such things as the types of
industry, applying conversion factors to account for potential differences in health
care expenditures. For example, covering a group of 25 men who are in an accounting
firm will probably result in fewer claims related to industrial accidents than covering
a construction crew of 25 men. Likewise, groups with women in the 25–40 age group
might be expected to have more pregnancy and subsequent well-child check-ups than
462 Financial Management of Health Care Organizations
Determine Total Number
of Cases for Specific Diagnosis
19.1 Colorectal Cancer Cases
Negotiate Rate/Day
with Provider and Multiply
by Number of Days
($1,000/day 3 124 = $124,000)
Add this Amount/Year
to All Other
Identifiable Health Care Needs
($1.24+$.89 for Pneumonia+$3.45 for Heart Disease, etc)
3 =
=
+
Administration
and Profit
(15-25%)
Population Demographics
(Age, Sex, Type of Work, etc.)
Length of Stay
( 6.5 Days)
Amount/Year
to Charge
Each Member
($1.24/year or
0.103/month)
Total Hospital
Days
124 Days
Number of
Covered Lives
(100,000)
Final Amount/Year
to Charge Members
(Average $1560/Year or
$130/Month)
Other Factors Affecting
Final Amount
Competition
Geographic Location
Exhibit 13–10 Premium Rate Setting Methodology
covering a group with older adults. Competition is also a factor which forces premiums
to be lower. For example, a West Coast premium, where competition among
HMOs for lives is fierce and competition between providers for patients is tight,
might be under $100 PMPM, whereas a premium in an area where few HMO options
are available for employees and benefit coverage levels are richer might exceed $130
PMPM.
Percent of Premium Capitation
To regain some of the control lost to insurers, in the early to mid–1990s a prominent
trend was for providers to accept a percentage of the managed care premium to provide all
of the care needed by that patient population. For example, if an insurer charges its members
a monthly premium of $130, the provider may say, “If you pay me 80 percent of that
premium [$104], I will provide everything your patient needs.” While this saves both the
provider and the payor from having to negotiate for every service the provider offers, it
does, however, place the financial burden of supplying all the health care needs directly
on the provider. This is similar to the case rates described earlier because it pays a fixed
price for a service. In this instance, however, it is much more global, in that the provider
is not simply accepting the risk for providing an entire episode of care, but rather is
responsible for the financial risk associated with the patient’s medical experience for a
predetermined period for covered services (generally, one month increments for a year).
The advantage to the provider is that it has an ongoing cash flow from a pool of
people who may or may not need health care. Again, this creates an incentive for the
provider to prevent illness and reduce the odds that a patient will need to seek a more
expensive form of care in the future. One of the disadvantages of these approaches is
that often, by the time prevention occurs, the patient may have moved on to another
provider, thus diminishing the reward to the initial provider for having provided preventive
care. If a payor agrees to such an arrangement, it typically retains about 15–20
percent of the premium for administrative services such as billing, collections, utilization
review, quality assurance, credentialing of providers, and, of course, profit.
To enter into an agreement such as a global percentage of premium contract, a
provider must be able to control its costs and provide a full range of services at all
levels of care. It must control through either ownership or affiliation anything a
patient might need. Exhibit 13–11 lists several services that should be offered by a
health care system to enable it to enter into this realm of risk-sharing.
The complexity and global nature of this type of arrangement was an important factor
for a trend among providers in the 1990s: integration. Within a brief period, an
entirely new set of acronyms sprang to life: PHOs (physician–hospital organizations),
POs (physician organizations), Super PHOs (an aggregation of PHOs on a more
regional basis), IDSs (integrated delivery systems), PSNs (provider sponsored networks),
etc. Both “vertically integrated delivery systems,” with health systems offering
womb-to-tomb care, and “horizontally integrated delivery systems,” with
providers owning broad networks of primary and specialty care providers throughout
a service region, were born. Providers became more organized and eager to provide a
complete scope of services, partially in response to the need to be able to survive and
compete in this changing environment.
Provider Payment Systems 463
Conversion Factor:
Actuarial based
formulas developed to
adjust rates allowing
for differences in
population
demographics.
Other Forms of Capitation
In the global percentage of premium capitation scenarios like the ones described above,
a large hospital or health system is most often the holder of the risk (because hospitals
and health systems typically are the only providers to have enough solvency to be able
to cover the downside risk if the overall medical expenditures exceed the capitation
revenues). However, often working beneath the surface of such global arrangements
are smaller, more specialized versions of capitation. Global professional (physician)
capitation, primary care or specialty care capitation, and ancillary capitation are some
examples. In all these formats, the basic premise is the same: capitation is simply a
prepayment for health care, with the provider being at risk for medical expenditures
that exceed the amount prepaid based on anticipated expenditures. Physician capitation
has some nuances, however, due to the many variations that exist.
In single-provider primary care capitation, the primary care gatekeeper physician
(whether a family medicine, internal medicine, or pediatric physician) will receive a
set amount for a fixed population and will have to provide all primary care services.
Depending on how the contract is negotiated between the primary care provider and
the payor, the capitated amount may also include all or some specialty services for the
fixed population, which the primary care physician must subsequently pay. This payment
may be on a fee-for-service or subcapitated basis, with the provider receiving
either a fixed amount (e.g. $2 PMPM) or a variable amount (e.g. 4 percent of the professional
capitation) to provide a subset of professional services, such as orthopedic
services.
Often, multi-provider capitation agreements are structured on the same premise,
except that a global amount will be allotted to the multi-provider group, and all professional
(non-hospital, non-ancillary) care must be paid from that single pool. The individual
providers within that group determine the most equitable way to divide the pool
of dollars, which takes the payor out of the equation in terms of this subdivision of professional
money but which often creates tensions and confusion among physicians who
are trying to standardize the values of services. In this case, negotiations must occur
between the primary care and specialty care physicians as a whole, in order to establish
two smaller budgets within the professional capitation amount. Tensions can flare even
more when the specialists themselves have to determine how to weight the value of the
services they provide. Is glaucoma surgery more “valuable” than setting a broken bone?
How much more difficult or simple is back surgery than urologic surgery?
464 Financial Management of Health Care Organizations
Primary Care Secondary Care Tertiary Care Quaternary Care Ancillary Services
General Practitioners Community Hospitals Trauma Centers Transplant Centers Home Health
Nurse Practitioners Birthing Centers Intensive Care Units Burn Centers Nursing Homes
Physician Assistants Emergency Services Specialty Physicians Emergent Air Hospice Care
Urgent Care Centers Ambulance Services Transport Dental Plans
Prescription Plans
Hotel Accomodations
Exhibit 13–11 Selected Services Offered by an Integrated Health Care System
Subcapitation: Where
the primary care
physician pays a
portion of the total
capitated dollars
received to another
provider (i.e.
specialist).
One method that providers have employed to equitably divide the specialty portion
of the professional capitation amount is through a zero-based budget, which is based
on dividing the entire medical budget through a sliding scale of RVUs. The sliding
scale is intended to equalize disparities between the ever-subjective assessment of how
difficult one procedure is compared to another (particularly when attempting to compare
two procedures or services which are dissimilar in nature, such as the back and
urologic surgeries mentioned above). In such a scenario, monies are distributed retrospectively
based on the number or “work units” that each physician has provided
(with the RVUs simply taken from the RBRVS scale discussed earlier), so that each
physician is rewarded commensurate with the number of RVUs provided.
A similar technique known as contact capitation creates a pool of funds for each
specialty. These funds are then divided among the physicians in that specialty based
on the number of “contacts” that the individual specialist receives during a specific
period of time (e.g. a month, six months, or a year), with one “contact” being
awarded during that time period for each specialty referral from a primary care
physician. The specialty care physician is then responsible for that patient for the time
period. Contact capitation, while interesting and effective in theory, has not been
employed on a large-scale because of the effort required to monitor the comparative
performance of the physicians within the group. Despite the administrative burden,
zero-based budgets and contact capitation are indicative of the types of techniques
being explored as providers seek more uniform and more equitable ways to be
compensated for care (see Exhibit 13–12 for an example of a Global Capitation Model).
Provider Payment Systems 465
Zero-based Budget
(Capitation): Dividing
the entire amount of
capitation (the
“budget”) among all
the providers,
essentially leaving
nothing or “zero” left
at the end of every
accounting period.
Contact Capitation: A
method of capitation
whereby each specialty
has its own capitation
pool and use of
services by a physician
only affects that
physician’s
compensation, not the
whole specialty
network’s
compensation.
HMO
$27 PMPM (20%)
Integrated
Health System
$108 PMPM (80%)
Hospital
$56 PMPM (52%)
Professional
$52 PMPM (48%)
Primary Care
$16 PMPM (30%)
Specialty
$36 PMPM (70%)
Employer
$135 PMPM
Exhibit 13–12 Global Capitation Model
Despite its early success and popularity, capitation as a payment method has come
under severe scrutiny by all parties and in the media in the past few years. While some
had predicted it would become the managed care payment system, its use as the dominant
method of payment for managed care in the future is uncertain. There is actually
a shift of risk back towards the payors under way. Many of the current
negotiations between payors and providers have returned to the methods of old such
as “percentage discounts.” Providers have seemed to reach their saturation point with
risk and are turning away business associated with capitation type arrangements.
bThe Future Is Nowc
In years to come, payment systems will continue to evolve in reaction to external
forces, such as federal and state budgets and regulations, demands for various levels
of access and quality, technology, the health status of the public, and costs.
Regulation
The struggle to balance cost, quality, and access will be an ongoing focus of our public
policy debate. The questions noted at the beginning of this chapter will continue
to be the focus of the ongoing evolution of payment systems in this country: “Who
gets paid?,” “How much?,” “By whom?,” “For what types of services?,” and “With
what effect?”.
Demands and counter demands regarding the role of government as a regulator and
payor can be anticipated in reaction to technological and pharmaceutical advances in
reaction to changing disease complexities and consumer demand. Safety controls to
monitor the efficacy and long-term outcomes of these new innovations will necessarily
follow.
Two current and evolving examples of regulatory measures that are being deliberated
and implemented are HIPAA and the Patients’ Bill of Rights.
HIPAA or the Health Insurance Portability and Accountability Act was introduced
in 1996 to improve the portability and continuity of health insurance coverage, to
combat waste, fraud, and abuse in the health insurance and delivery systems, to promote
the use of medical savings accounts, to improve access to long-term care, and
to simplify the administration of health insurance.
This legislation has evolved over time, with considerable national attention focusing
on the Administrative Simplification element. These regulations involve major
changes in how health care organizations handle all facets of information management,
including reimbursement, coding, security, and patient records. They impact on
every department of every entity that provides or pays for health care.
HIPAA is designed to ultimately lower the cost of administrative transactions by
eliminating the time and expense of handling paper by standardizing software to
accommodate all payors and plans, while protecting patients’ confidential health care
information.
466 Financial Management of Health Care Organizations
Medical Savings
Accounts: A limited
amount of money an
employee can take as
pre-taxed income to
pay for medically
related items such as
physician visits,
pharmaceuticals,
eyewear, and dental
visits. The pre-tax
income is placed in an
escrow account held by
the employer. The
employee must submit
receipts for care
received to get
reimbursed.
As is often true, however, improvements are costly, and complying with the new
HIPAA regulations has been predicted by some to cost more than ten times the
amount spent on preparing for the year 2000 (see Perspective 13–3).
The Patients’ Bill of Rights
Over the past decade, there has been a major public policy debate on a “Patients’ Bill
of Rights.” Democrats and Republicans have quite different perspectives and have
traditionally disagreed on the levels of controls that should be in place.
The primary substantive attributes of such a Bill of Rights include:
l An external appeals process to allow the patient to sue for damages that may
have occurred due to treatment being withheld.
Provider Payment Systems 467
Perspective 13–3
HIPAA Opinion
Praise HIPAA: Some providers embrace privacy regulations in hopes of securing long-term savings.
Jeremy Pierotti can envision a day when federal regulations will improve his health system’s cash flow by some
$68 million. Instead of subscribing to the notion that the Health Insurance Portability and Accountability Act of
1996 represents an expensive administrative nightmare, Pierotti views it as an opportunity. And he’s not alone.
As the HIPAA program director of Allina Health System in Minneapolis, Pierotti undertook a rigorous analysis of
one part of the regulation – the one that requires standardized electronic transactions – and found that it will cost
much less to implement than it will reap in hard savings.
Pierotti is part of a growing chorus singing the praises of HIPAA rather than wailing about its potential to divert
funds from other important areas and disrupt normal operations.Those have been some of the many criticisms of
the law, which was passed at the behest of the industry but has since become the whipping boy of providers and
payers alike.
HHS estimates that the industry will spend $3.8 billion complying with the controversial privacy regulations, but
an analysis paid for by the American Hospital Association pegs the cost at $22.5 billion, which does not cover all of
HIPAA’s privacy provisions.
One privacy provision left out of HHS’ estimate, the AHA says, is the “minimum necessary” rule, which limits the
patient information hospitals and staff members can share with one another as well as with outside organizations
such as insurers. Complying with that provision alone could cost hospitals as much as $19.8 billion over five years,
according to the AHA analysis. . . .
The privacy regulation controls how and when physicians and administrative staff can share protected patient
information, calls for formal agreements to ensure business partners use confidential data appropriately and requires
patient consent prior to using information even for the most routine clinical and administrative purposes.
Both the AHA and the AMA, and groups such as the American Association of Health Plans, have problems with the
privacy regulations, believing them to be administratively burdensome and a possible threat to clinical care. . . .
Snell and others argue that hospitals stand to benefit from aggressive implementation of the privacy regulations.
By convincing patients that they’re not just following the rules but placing a premium on protecting confidentiality,
hospitals may be able to win over customers – and keep the ones they have.
Source: Jeff Tieman, Modern Healthcare, March 26, 2001.
l Mastectomy length-of-stay rights.
l Protection for the self-insured consumer.
l Emergency care and what constitutes an “in-network” versus an “out-ofnetwork”
provider.
l Access to specialists.
l Point-of-service plan descriptions.
l Direct access to obstetricians and gynecologists.
l Continuity of care.
The most contentious issue, however, is the patient’s appeal process, which is fundamentally
about a patient’s right to sue his or her insurance company if a physicianrecommended
treatment regimen is either delayed or denied by the insurance
company and ultimately causes harm to the patient.
Democrats have favored an appeals process that includes an external review by a
third party that employs a broad definition of “medical necessity,” and large damages
are possible if the insurance company is found to be negligent.
Republicans have also favored an external review, but with a more limited definition
of “medical necessity” and lower damages.
The potential awards by the courts have sparked the interest of very powerful
groups to lobby on their respective sides. Insurers/payors favor more control and less
damages, while lawyers have favored higher cap and less control by the insurers.
However, as a Patients’ Bill of Rights evolves over time, it can be expected to have
numerous and diverse impacts on health care costs. If patients are more aware of any
right to sue insurance companies at any level, increased litigation could result. Awards
against payors will be passed on to the employer/patient in the form of higher premiums.
A concern is that employers may reduce benefit levels in an attempt to keep
premiums reasonable, which could lead to more uninsured Americans and more costs
being shifted to the government. Another concern is that physicians will be more
defensive in their practices, ordering additional tests in an attempt to legally protect
themselves.
The Continued Search for Quality in the New Millennium
There has been an ongoing effort to improve the quality of care and the data available
to make cost/quality comparisons. The early days of health care relied mostly on
“word of mouth” measurements of quality, which were limited to either cure or palliation.
Today practically every health care issue has a quality component in some form.
Patients are concerned with safety, outcomes, and satisfaction, while many payors
focus on the ability to differentiate which procedures and treatments provide the
greatest value for the dollars spent. Providers want to please both patients and payors
but are continually concerned about how to afford the quality that is being demanded
of them under a payment system which favors cost containment. Information compilation
and data mining are major industries, with organizations such as The National
Practitioner Data Bank, JCAHO, and NCQA heavily involved.
468 Financial Management of Health Care Organizations
As benchmarks have improved they have become much more complex. The focus
has changed from such items as infant mortality, length of stay, readmission rates, and
C-section rates to a new level of sophistication. Demographics and acuity of a patient
population, even analyzing aspects of genetic differentiation, are now being considered
when comparing providers. Episodes of care, including months and even
years surrounding a disease process, rather than single events/procedures, are being
analyzed and presented for consumption by providers, payors, and patients.
Health Care Enters the Digital Age:Technological
Advancements Enable Efficiencies
Another area that shows great promise for the future can be found in the integration
of technology into health care administration. While technology has enabled
clinical solutions that were unimaginable even a few short years ago, less apparent
is how technology is working “behind the scenes” to make health care more efficient
and, in many ways, more cost-effective.
The Internet is one example of a technological improvement that has had great utility
in health care already. From an administrative standpoint, for example, physician
office personnel are now able to submit medical claims electronically by using EDI
(electronic data interchange) technology, with software packages that have “rules
matrices” built in, so that a provider cannot submit a “dirty” claim (one that has
invalid medical coding or is lacking certain essential information for the claim to be
processed). This has reduced the necessity to refile claims and enhanced cash flows by
ensuring more timely payment. Claims filed through the Internet do not have to pass
through the mail and then be sorted and processed manually, all of which are time
consuming. As recently as the early 1990s, the average length of time between mailing
and receiving payment could easily be a month. Electronic filing, processing, and
payment transfer can reduce that time to a few days.
The Internet has also made it possible for providers to tackle administrative and
clinical tasks like checking insurance eligibility information and claims status, implementing
disease management programs, automatically reordering supplies (both medical
and general office supplies through e-commerce transactions), and being
connected with other providers (e.g. laboratory, radiology) via the Internet. With an
entirely new realm of applications being developed with the Internet as a platform, the
efficiencies and cost savings for providers and payors alike are likely to grow exponentially
in the future.
Another fascinating use of technology which is likely to grow is the use of personal
digital assistants (PDAs). With a simple handheld device, clinicians can have
up-to-the-minute patient data, including an electronic copy of the patient medical
record. Ready access to key information is or soon will be readily available, including
patient medication history, drug formularies from different payors (stipulating
which drugs are covered and not covered by the patient’s benefit plan), drug interaction
information, generic versus brand name drug information, and even electronic
scripting capabilities (where prescriptions can be electronically transferred
Provider Payment Systems 469
directly to a pharmacy). These capabilities can empower clinicians to make more
informed decisions at the point of care, which ultimately can result in better clinical
outcomes, higher patient and provider satisfaction, and perhaps a more efficient
delivery of health care.
PDAs have also duplicated many of the other applications once available only via
desktop computers, so now physicians can actually create and file electronic claims at
the point of care from their PDA. As with the brief discussion of Internet-enabled
technologies, this can reduce filing errors and enhance cash flow for the providers.
While only a small percentage of practicing physicians utilize this technology as of
2002, all indications are that PDAs will become an integral part of the typical physician’s
day-to-day practice operations. Given the rapid progress in this field (the integration
of medical record dictation capabilities into the same PDA, for example), the
possibilities in the future seem unlimited.
Information Technology
The business of health care continues to evolve as providers, payors, and employers
seek solutions to questions that have never previously been posed. While the
introduction of new technology addresses some of these issues, it also raises new
ones and often calls into question presumptions that were previously accepted as
true. Nowhere is this clearer than in one of the growing fields in health care that
offers astounding possibilities for the future: the area commonly known as “health
care informatics” or “information technology” (see Perspective 13–4).
Where employers and providers once thought health care data was an inessential
by-product of simple claims payment, today there is a strong, even urgent, need for
information that is timely, informative, and in a usable format. Throughout the
health care industry we see a constant need and desire to push the borders into areas
that have never been explored before. The information services arena has evolved
from an accounting-based, relatively basic means of analyzing charge and payment
data to an integral part of modern health care delivery and payment.
Early efforts focused on how components of the delivery system (physicians, hospitals,
etc.) performed and interacted financially with one another. Retrospective
analysis of this sort depended on analyzing post-payment claims data, understanding
where the health care dollar was spent, and comparing that to national and regional
benchmarks of what the financial performance should have been, based on industry
norms.
This was the next significant step beyond simply understanding cost structures and
whether charges were appropriate for specific procedures and in the marketplace.
Particularly with providers and payors involved in capitation arrangements, the need
for this sort of intricate information was critical to their ability to implement successful
medical management programs and, ultimately, to their financial success. An
entire sector of information technology and health care informatics companies has
grown to meet this need.
The level of complexity and sophistication of information available to providers,
payors, and employers is evolving quickly. New forms and formats of information
470 Financial Management of Health Care Organizations
are emerging to predict what might happen with the clinical and financial experiences
of a population. In some of the new information technologies being developed
and refined, the relationship between past and present medical data on a
patient-specific level can even be used to prospectively assess the medical risk of a
group population – information that was completely unavailable even two or three
years ago.
While these companies in health care technology are reinventing the future of
health care every day, it is important to stay vigilant in regard to patient confidentiality
and security (see Perspective 13–5).
Provider Payment Systems 471
Perspective 13–4
Technology’s Rip Van Winkles
First the dot-coms crashed.Then healthcare organizations learned they really would have to comply with sweeping
new patient-privacy regulations. It wasn’t too much longer before an Institute of Medicine report said the industry
can and should use information technology to prevent patients from being harmed as a consequence of care.
Three events, all within the past year, may seem unrelated, but they’re not: Each represents a challenge to employ
information systems for more than registering patients and sending invoices. Often viewed as an industry that neglects
or even abstains from such technology, healthcare finally may have little choice but to embrace computers and automation.
And, for the first time, not doing so can mean running afoul of the law as well as putting patient safety at risk.
In a recent study, it is predicted that annual Healthcare Information Technology expenditures will gain momentum
in 2002 and 2003, reaching $23 Billion by the end of 2003.
Source: Jeff Tieman, Modern Healthcare, July 16, 2001. Chart source: Sheldon Dorenfest and Associates, same article.
25
20
15
10
5
0
1993
$ in Billions
1994
1995
1996
1997
1998
1999
2000
2001
2003
Healthcare IT Spending
Actual
Forecast
bSummaryc
Health care services have grown along with the growth in the American population.
Different payment methodologies have been tried in order to find a reasonable balance
among costs, quality, and access. Health care payment in the United States has
remained a “living experiment”, from the early days of private, cash-based exchange
through the middle and later years where commercial and government payors were
involved in a massive exercise of trial-and-error, testing different payment methodologies
and structures of care delivery.
Systems include: charged-based payment, where providers receive payment based
on actual charges and payors bear the risk; cost-based payment, where providers are
paid based on the cost of providing services and payors still bear the risk; and finally
flat fee systems, where the provider is paid a predetermined amount and the providers
bears the risk.
472 Financial Management of Health Care Organizations
Perspective 13–5
Innovations through Information
Integrated Healthcare Information Services, Inc. (IHCIS) in Waltham, Massachusetts is a prime example of how the
healthcare informatics sector is creating an entirely new paradigm for our industry as we enter the new millenium.
By expanding the information that is available, groups like IHCIS have reengineered information from being a rear
window look at the road already traveled to being a tool that empowers payors, providers, and even employers to
be proactive and informed as they work to create more cost-effective, higher quality patient care.
Today IHCIS is breaking new ground by having developed a new approach to health risk assessment, which is
essentially using data and information to predict the medical expenditures and utilization of individuals and group
populations.This information is absolutely invaluable because it enables:
l The establishment of health plan premiums that reflect the acuity and potential medical expenditures of a
population more accurately than ever before;
l The identification of high-risk health plan enrollees (enabling both payors and providers to implement
proactive medical management for the patient, which in turn results in the prevention of unnecessary
health issues and expenditures); and
l The development of more accurate clinical and financial provider profiles that are more useful than anything
that has ever been developed in the past.
The primary tool that IHCIS uses is a technology they developed called “Episode Risk Groups” or “ERGsÔ.”
Episode risk groups were developed based upon the leading episode grouping methodology in the industry –
episode treatment groups or ETGs. In the same way that X-Ray technology paved the way for MRI technology, ERGs
would never have been possible but for the efforts of other informatics groups that laid the foundation by looking
at patient “episodes of care” as “events” defined by diagnoses and other work that has been done to categorize diagnoses
into similar groupings.
IHCIS and similar informatics groups are pioneers on the frontier of a new era in health care. Information is power
and may well be one of the most important pieces in finding a solution to the healthcare dilemma in our country.
Source: Matthew Ayotte, Strategic Planning, Duke University Medical Center,August 2001.
There has also been a growth in the types of health care payors. Indemnity companies,
governmental payors, and managed care have all played major roles in trying
to balance cost, quality, and access. Discounts, steerage, per diems, case rates, community/
experience rating, benchmarking, managed care, and capitation are all examples
of these methods.
After nearly 100 years of experimentation, we have learned that balancing cost quality
and access is an ongoing process and will be influenced in the future by the trends
discussed in the first chapter of this text.
Provider Payment Systems 473
Allowable Costs
APCs
Capitation
Case Rates
Charge-based
CMS
Community Rating
Contact Capitation
Conversion Factor
Copayment
Cost-based Reimbursement
Cost Shifting
Deductibles
Experience Rating
Diagnosis Related Groups
(DRGs)
Discounts
Fee-for-service
Financial Requirements
Flat Fee
Gatekeeper
Group Model HMO
Health Care Financing
Administration (HCFA)
Health Maintenance
Organization (HMO)
Indemnity Insurance
Managed Care
Medicaid
Medical Savings Account
Medicare
Members
Participating Provider
Payor
Per Diem
Premium
Predetermined Rates
Per Member per Month (PMPM)
Preferred Provider Organization
Premium
Price Setter
Primary Care Provider (PCP)
Point-of-service Plan (POS)
Prospective Payment System
(PPS)
Retrospective Payment
RBRVS (Resource Based Relative
Value System)
RVU
Staff Model HMO
Steerage
Stop Loss
Subcapitation
The First Party
The Second Party
The Third Party
Usual, Customary, and
Reasonable Charges
Zero-based Budget (Capitation)
bKey Termsc
bQuestions and Problemsc
1. Define the “Key terms” found in this Chapter.
a. Allowable Costs.
b. APCs.
c. Capitation.
d. Case Rate.
e. Charge-based.
f. CMMS.
g. Community Rating.
h. Contact Capitation.
i. Conversion Factor.
j. Copayment.
k. Cost-based Reimbursement.
l. Cost Shifting.
m. Deductibles.
n. Experience Rating.
o. Diagnosis Related Groups (DRGs).
p. Discounts.
q. Fee-for-service.
r. Financial Requirements.
s. Flat Fee.
t. Gatekeeper.
u. Group Model HMO.
v. Health Care Financing Administration (HCFA).
w. Health Maintenance Organization (HMO).
x. Indemnity Insurance.
y. Managed Care.
z. Medicaid.
aa. Medical Savings Account.
bb. Medicare.
cc. Members.
dd. Participating Provider.
ee. Payor.
ff. Per Diem.
gg. Premium.
hh. Predetermined Rates.
ii. Per Member per Month (PMPM).
jj. Preferred Provider Organization (PPO).
kk. Premiums.
ll. Price Setter.
mm. Primary Care Provider (PCP).
nn. Point-of-service Plan (POS).
oo. Prospective Payment System (PPS).
pp. Retrospective Payment.
qq. RBRVS (Resource Based Relative Value System).
rr. RVU.
ss. Staff Model HMO.
tt. Steerage.
uu. Stop Loss.
vv. Subcapitation.
ww. The First Party.
xx. The Second Party.
yy. The Third Party.
zz. Usual, Customary, and Reasonable Charges.
aaa. Zero-based Budget (Capitation).
2. What were the major events and trends that defined the “Early,” “Middle,”
and “Later” periods of the US health care system? In each period describe:
a. The major events and trends.
474 Financial Management of Health Care Organizations
b. The price-setter.
c. The risk bearer.
d. The predominant method of payment and the unit to which payment is
attached.
3. What was the driving force behind the development of Blue Cross/Blue Shield?
4. Name the units of service on which cost-based payers may pay providers.
5. What drove the development of Medicare? Who is covered under Medicare?
6. What drove the development of Medicaid? Who is covered under Medicaid?
7. Who pays for the Medicare and Medicaid programs?
8. How do copayments and deductibles reduce risk?
9. Why do providers desire “steerage”?
10. What do providers fear most under a case rate model?
11. What are some methods insurers use to limit their risk under per diem
arrangements?
12. Who bears the risk under a flat rate system? Why?
13. What factors determine what a flat rate payment to a provider should be?
14. Why was the DRG system developed?
15. What are APCs? Why were they developed?
16. Why do HMOs use prevention and case management?
17. How do HMOs determine their premiums?
18. If an HMO covered 150,000 lives, expected 25 myocardial infarctions (MI) to
occur each year within the covered lives, would expect a length of stay of 4.5
days for each MI, and had to pay an average of $950 per day for each day the
MI patient was in the hospital, what would the PMPM cost to the HMO be?
What would have to be charged to the patient/employer if the HMO had
administrative costs equaling 10 percent of its costs and it wanted a profit
margin of 7 percent?
19. Given the same scenario as in question 18, what if the HMO’s shareholders
demanded a 9 percent profit margin? What would the premium be in this case?
20. In question 19, what if the employer/patient refused to pay the new premium?
What would the HMO offer to pay the hospital for an inpatient day?
21. What if, in question 20, the hospital refused to take the new rate, the employer
refused to pay the new premium, and the employer decided to take its
employees (10,000) to another HMO. Also, suppose these departing
employees/members represented 6 percent of the MI total. What would the
new PMPM premium be for the 140,000 remaining members.
22. Who bears the financial risk in a capitated payment system?
23. Name and describe four different types of capitation.
24. Why would a provider be willing to accept a global capitation payment?
bQuestions from Appendix Hc
25. What are four factors to consider when developing charges in a charge-based
system?
Provider Payment Systems 475
26. What charge method primarily uses the market price to establish a charge?
27. What charge method relies on the case mix, volume, and financial requirements
of the institution?
28. What is the difference between determining charges on an average-cost basis
and a weighted-cost basis?
29. What are the steps in determining weighted-average costs?
30. Describe the two margin-based approaches to developing charges.
Appendix H
Payment Systems
Cost-based Payment Systems
Reasonable and Allowable Costs
In establishing cost-based payment systems, the natural tension that exists between providers and
payors revolves around five issues: reasonableness, case mix, service mix, staff mix, and efficiency.
Areas of Contention in Determining Allowable Costs
l Reasonableness issues are concerned with the cost of one provider versus others. In
this regard, payors often set boundaries to establish what is usual, customary, and/or
reasonable (UCR). For instance, a payor may only pay up to 85 percent of the cost of
a procedure, based on an analysis of a profile of all providers who have submitted cost
reports.
l Case mix issues revolve around patient eligibility. For instance, although a
hospital incurs legitimate costs in treating a patient who has a deviated septum, a
payor may decide to not pay for this surgery because the patient failed to receive
all necessary preadmission certification. Similarly, if a health department treats a
pregnant woman who resides outside its county, the county’s prenatal care
program may not pay for the treatment because the patient was outside the location
eligibility guidelines.
l Service mix issues focus on the appropriateness of care. For instance, in treating
stroke patients, the provider may feel that recreational therapy is an important part of
treatment. Though it may be, the payor may not pay for this service because it does
not consider it a necessary service within its guidelines.
l Staff mix issues pertain to the appropriateness of who provides service. In the mental
health field, for example, although a payor may agree that a patient needs
psychological services, it might not pay for care provided by a pastoral counselor who
is not a licensed psychologist.
l Efficiency issues address questions of the appropriateness of the cost of service per
unit rendered. A hospital with a low volume may have very high unit costs or a
radiology center with old equipment may have to take several X-rays just to get one
good one. In such instances, although the payor may agree to pay for some level of the
service, it will not pay for what it feels are inefficiencies.
Under any of these five conditions, if the payor denies payment and the service has already been
rendered, the provider has two choices: 1) absorb the cost; and/or 2) transfer the cost to
476 Financial Management of Health Care Organizations
another payor. This latter technique is called cost-shifting or cross-subsidization. Under
this system “over”-reimbursement or reimbursement in excess of total costs is used for one
service to cover the costs associated with “under”-reimbursement of another service where
reimbursement is less than total costs. This technique has been one of the major reasons for a
rise in the number of alternatives to cost-based systems.
Unit-based Payment Systems
Two key issues that arise in cost-based payment systems are “What is the unit of service to
which payments are attached?” and “What are reasonable and allowable costs?”
Unit of Service
There are a variety of units on which cost-based payors pay providers, including:
l Per procedure.
l Per inpatient day.
l Per admission.
l Per discharge.
l Per diagnosis.
Unfortunately for many providers, there is little consistency among third parties with respect
to the unit of service on which payment is made. It is not unusual for a single provider to receive
payments from Medicare on the basis of Diagnosis Related Groups, from private insurance
companies on the basis of reasonable charges, and from managed care organizations in the
form of capitation. Though it is relatively straightforward to have a cost-finding system that
establishes the costs for any one of these payment schemes, it takes a very complicated information
system to find costs along several of these bases at once.
Charge-based Systems
A charge-based system is based in large part on the assumption that a provider is entitled to a
reasonable return for its efforts. It relies heavily on the market to ensure that profits are not
excessive. While it would seem that charge-based payment systems are “reactionary” in nature
from the payor perspective (since, after all, it is the providers who establish the charges on the
front-end and seemingly dictate the level of payment), the dynamic is not that simple. Let us
look first at the reasoning that underlies the establishment of provider charges.
In setting charges, a provider must consider a wide range of costs that must be covered.
These fall into the same categories discussed in Chapter 5 (operations, opportunities, contingencies,
and return on investment). Together, these comprise the organization’s financial
requirements.
l Operations. This category includes covering all operating costs, now and into the
future. That is, charges: must cover costs associated with supplies, equipment, labor,
and working capital; have sufficient margin to ensure that staff remains current; and
keep technology and facilities sufficiently up-to-date.
l Opportunities. Providers must build into their charges a reasonable markup so they
can take advantage of opportunities to hold onto or expand existing markets, serve
new markets, and/or exit existing markets.
l Contingencies. The changing health care environment presents not only various
opportunities, but also various unforeseen events such as evolving payment systems,
Provider Payment Systems 477
Financial
Requirements: For
health care providers
this is a combination of
issues related to
operations,
opportunities,
contingencies, and
return on investment.
Cost-shifting:
Charging one group of
patients more in order
to make up for
underpayment by
others. Most
commonly, charging
some privately insured
patients more in order
to make up for
underpayment by
Medicaid or Medicare.
labor shortages, and uncovered catastrophic events. Therefore, charges must build in
a reasonable margin for such contingencies that siphon off the organization’s capital.
l Return on investment. For for-profit providers, charges must also sufficiently
compensate the organization and/or its owners for an investment.
Though all these methods have been employed, they all share a common concern from the
point of view of payors: are they reasonable? Two ways of dealing with this problem have been:
1) to limit payments only to that part of charge considered reasonable; or 2) to employ another
basis of payment altogether.
Historical/Market/Payor Method
The historical/market/payor method is extremely simple. Charges are established by
a combination of: 1) what the organization has traditionally charged; 2) what similar
organizations charge; and 3) what payors will pay. This approach to establishing charges is only
loosely related to costs, but it is widely used, especially in ambulatory care settings.
Weighted-average Method
The weighted-average method sets charges as a function of the number and type of procedures
an organization performs and the financial requirements of the organization. For instance,
assume a small health care clinic expects 10,000 visits and anticipates having $1,000,000 in
financial requirements next year (see Exhibit H–1). If visit type is ignored, the clinic could set
its price by charging the same price for each visit, $100 ($1,000,000/10,000). However,
charging each visit an average price of $100 overlooks questions of equity. Since each visit does
not consume the same resources, some patients would pay more than their fair share while others
would pay less.
An alternative to charging each visit the same amount is to take into account the type of visit
and to weight these visits by the relative amount of resources they consume. This is accomplished
through the following steps:
Step 1: Categorize visits by resource consumption. Exhibit H–1
assumes there are three types of visits: brief, routine, and complex. It
further assumes that 60 percent (6,000) of the 10,000 visits are brief,
30 percent (3,000) routine, and 10 percent (1,000) complex.
Step 2: Convert visits by category into weighted visit units by
category. Exhibit H–1 also assumes that routine visits consume
twice the resources, and complex visits consume four times the
resources of brief visits. Since the 3,000 routine visits consume twice
the resources of brief visits, they count the same as if they were
6,000 brief visits (row H: 3,000 ´ 2). Similarly, since the complex
visits consume four times the resources of a brief visit, the actual
1,000 complex visits count as if they were 4,000 brief visits (1,000 ´
4). Thus, the actual 10,000 undifferentiated visits become 16,000
weighted visit units (6,000 brief + 6,000 routine + 4,000 complex
visits, row H).
Step 3: Determine charge per weighted visit unit and apply charges to
categories. Rather than spreading the $1,000,000 in financial requirements
over 10,000 visits and charging $100, the $1,000,000 now can be
spread over 16,000 weighted visit units and the charge reduced to
478 Financial Management of Health Care Organizations
$62.50 ($1,000,000/16,000) per weighted visit unit. For instance, although
there are 3,000 routine visits, they equal 6,000 weighted visits. At $62.50 each,
they will raise $375,000 (row J).
Note in row L that there is a considerable difference between charging the average price
($100) to all visits, and charging by taking into account the amount of resources used. By
weighting for resource consumption, those making a brief visit pay $225,000 less and those
making routine and complex visits pay $75,000 and $150,000 more than they would under the
undifferentiated system. Some would argue that this is more equitable. This is the logic
Medicare used to establish the Resource Based Relative Value Scale (RBRVS) currently in use
in ambulatory care reimbursement along with Ambulatory Payment Classifications (APCs).
Margin Approaches
There are two margin-based approaches to setting charges: cost-plus and coverage. The costplus
approach starts with cost and adds a margin for profit. For instance, assume a freestanding
radiology center desires to make a 10 percent profit over and above its cost. If it has
determined that the cost of performing a certain radiological procedure is $125, then it adds a
10 percent surcharge of $12.50, creating a final charge of $137.50. The cost-plus approach is
most often used with ancillary services such as radiology, pharmacy, and laboratory services.
Provider Payment Systems 479
Given:
A Number of Procedures [1] 10,000
B Financial Requirements [2] $ 1,000,000
C Average Charge per Visit [B/A] $ 100
D Type of Visit [1] Brief Routine Complex Total
E % Distribution of Visit by
Type [1] 60% 30% 10% 100%
F Relative Weight of Visit by
Type [1] 1 2 4
G Number of Visits [A ´ E] 6,000 3,000 1,000 10,000
H Number of Weighted Visits [F ´ G] 6,000 6,000 4,000 16,000
I Charge per Weighted Visit [3] $ 62.50 $ 62.50 $ 62.50 $ 62.50
J Total Charges [H ´ I] $ 375,000 $ 375,000 $ 250,000 $ 1,000,000
K Charges Using Average
Charge [C ´ G] $ 600,000 $ 300,000 $ 100,000 $ 1,000,000
L Over or Under Charge
Compared to Weighted
Average Charge [J -K] $ (225,000) $ 75,000 $ 150,000 $ –
1 Given.
2 Includes all financial requirements of the organization, not just ongoing operating costs.
3 The financial requirements ($1,000,000) in Row B/the total number of weighted visits (16,000) in Row H.
Exhibit H–1 Selected Services Offered by an Integrated Health Care System
The coverage approach essentially sets charges using a breakeven type of formula.
Once the organization’s cost structure, desired profit, and projected volume are known,
charges can be set. Notice in Exhibit H–2 that the charge changes with volume. If the organization
thought that 5,000 visits could be expected, it would establish a charge of $48 per
visit, whereas if volume were forecast at 7,500 visits, it would establish a charge of $39 per
visit.
480 Financial Management of Health Care Organizations
Variable Cost per
A Unit: $20
B C D E F G H I
Direct Direct
Total Financial Fixed Variable Other Desired
Volume Charge (1) Charges Requirements Costs Costs Costs Profit
[Given] [D/B] [E] [F + G + H + I]
5,000 $48 $240,000 $ 240,000 $ 100,000 $ 100,000 $ 20,000 $ 20,000
5,500 $45 $247,500 $ 250,000 $ 100,000 $ 110,000 $ 20,000 $ 20,000
6,000 $43 $258,000 $ 260,000 $ 100,000 $ 120,000 $ 20,000 $ 20,000
6,500 $42 $273,000 $ 270,000 $ 100,000 $ 130,000 $ 20,000 $ 20,000
7,000 $40 $280,000 $ 280,000 $ 100,000 $ 140,000 $ 20,000 $ 20,000
7,500 $39 $292,500 $ 290,000 $ 100,000 $ 150,000 $ 20,000 $ 20,000
8,000 $38 $304,000 $ 300,000 $ 100,000 $ 160,000 $ 20,000 $ 20,000
8,500 $36 $306,000 $ 310,000 $ 100,000 $ 170,000 $ 20,000 $ 20,000
9,000 $36 $324,000 $ 320,000 $ 100,000 $ 180,000 $ 20,000 $ 20,000
9,500 $35 $332,500 $ 330,000 $ 100,000 $ 190,000 $ 20,000 $ 20,000
10,000 $34 $340,000 $ 340,000 $ 100,000 $ 200,000 $ 20,000 $ 20,000
Exhibit H–2 Illustration of the Coverage Approach to Setting Charges
Accountability: Sanctions, both positive and negative, attached to carrying out responsibilities.
Accrual Basis of Accounting: An accounting method which tracks the flow of resources and the revenues
those resources helped to generate. It tracks revenues when earned and resources when used,
regardless of the flow of cash in or out of the organization. This is the standard method in use today.
Accumulated Depreciation: The total amount of depreciation taken on an asset since it was put into
use.
Activity-based Costing: a method of estimating costs of a service or product by estimating the costs of
the activities it takes to produce that service or product.
Administrative Cost Centers: Cost centers that support clinical cost centers and the organization as a
whole. They are often considered the infrastructure of the organization.
Administrative Profit Centers: Organizational units that do not provide health care-related services,
but are responsible for their profit. There are two types: those that sell their services internally, and those
whose primary responsibility is to bring revenues into the organization.
Aging Schedule: A table which shows the percentage of receivables being collected in each month.
Allocation base: a statistic (e.g. square feet, number of full-time employees) used to allocate costs, based
on its assumed relationship to why the costs occurred.
Allowable Costs: Costs which are allowable under the principles of reimbursement of government
(Medicaid, Medicare) and other payors.
Ambulatory Procedure Classifications (APCs): Enacted by the federal government in 2000, a
prospective payment system for outpatient services, similar to DRGs, which reimburses a fixed amount
for a bundled set of services.
Amortization: 1) The allocation of the acquisition cost of debt to the period which it benefits. 2) The
gradual process of paying off debt through a series of equal periodic payments. Each payment covers a
portion of the principal plus current interest. The periodic payments are equal over the lifetime of the
loan, but the proportion going toward the principal gradually increases. The amount of a payment can be
determined by using the formula to calculate the present value of an annuity.
Annuity Due: A series of equal annuity payments made or received at the beginning of each period.
GLOSSARY
Annuity: A series of equal payments made or received at regular time intervals.
APC: A flat fee payment system instituted by the government to control the payment for outpatient
services provided to Medicare recipients.
Asset Mix: The amount of working capital an organization keeps on hand relative to its potential
working capital obligations.
Assets: Resources that the organization owns, typically recorded at their original costs.
Authoritarian Approach: Budgeting and decision-making which are done by relatively few people
concentrated in the highest level of the organizational structure. Opposite of the participatory approach.
Authority: Power to carry out a given responsibility.
Avoidable Fixed Cost: A fixed cost that is avoided if a particular alternative is chosen Example: fulltime
nursing costs saved if a service is closed.
Basic Accounting Equation: Assets = Liabilities + Net Assets.
Billing Float: Delay getting a bill to the patient or third-party payor (such as an insurance company).
This includes the time to assemble the bill in-house, as well as the time to send the bill to the correct
person or place.
Bond: A form of long-term financing whereby an issuer receives cash from a lender (an investor), and in
return issues a promissory note (a “bond”) agreeing to make principal and/or interest payments on
specific dates.
Breakeven Analysis: A technique to analyze the relationship among revenues, costs, and volume. It is
also called Cost–Volume–Profit or CVP analysis.
Breakeven Point: The point where total revenues equal total costs.
Budget Variance: The difference between what was planned (budgeted) and what was achieved (actual).
Cannibalization: When a new service decreases the revenues from other established services or product
lines. These are considered cash outflows.
Capital Appreciation: Occurs whenever an investment is worth more when it is sold than when it was
purchased.
Capital Budget: One of the four major types of budgets, it summarizes the anticipated purchases for
the year. Typically, to be included, all items in this budget must have a minimum purchase price, such as
$500.
Capital Investment Decision: Decisions involving major dollar investments that are expected to
achieve long-term benefits for an organization.
Capital Investments: Large dollar, multiyear investments.
Capital Lease: A lease that lasts for an extended period of time, up to the life of the leased asset. This
type of lease cannot be canceled without penalty, and at the end of the lease period, the lessee may have
the option to purchase the asset. Also called a financial lease.
Capitated Profit Centers: Organizational units responsible for earning a profit by agreeing to take care
of the health care needs of a population for a per-member fee (which is not directly tied to services).
Examples include HMOs, PPOs, and various managed care organizations.
Capitation: 1) A system which pays providers a specific amount in advance to care for the health care
needs of a population over a specific time period. Providers are usually paid on per member per month
482 Financial Management of Health Care Organizations
(PMPM) basis. The provider then assumes the risk that the cost of caring for the population will not
exceed the aggregate PMPM amount received. 2) A payment mechanism where the insurer prepays a
health care provider an agreed-upon amount per member that covers a designated set of services over a
defined time. Typically, these payments are made on a per member per month (PMPM) basis. If there are
no terms to the contrary, in return for the capitated payments, the provider agrees to bear all the risk for
the costs of services provided. If the provider’s costs are below the capitation, the provider can keep the
difference. If the provider’s costs are more than the capitation, the provider is at risk for the difference.
3) A method of payment in which the provider is paid a fixed amount, over a set period of time, usually a
month or a year for each person served no matter what the actual number or nature of services delivered.
Care Mapping: A process which specifies in advance the preferred treatment regimen for patients with
particular diagnoses. This is also referred to as a clinical pathway, clinical protocol, or practice
guideline.
Case Rate: A rate that covers everything that the hospital provides during the entire inpatient stay.
Cash Basis of Accounting: An accounting method which tracks when cash was received and when cash
was expended, regardless of when services were provided or resources were used.
Cash Budget: One of the four major types of budgets, it displays all of the organization’s projected cash
inflows and outflows. The bottom line for this budget is the amount of cash available at the end of the
period.
Charge-based: A method of payment which is based on the charge of the provider.
Charity Care Discounts: Discounts from Gross Patients Accounts Receivable given to those who cannot
pay their bills.
Clinical Cost Centers: Cost centers that provide health care-related services to clients, patients, or
enrollees.
CMS: The Center for Medicare and Medicaid Services. The acronym, CMS, is pronounced “sims.”
Collateral: 1) A tangible asset which is pledged as a promise to repay a loan. If the loan is not paid, the lending
institution as a legal recourse may seize the pledged asset. 2) An asset with clear value (such as land or
buildings) which is pledged against a loan to reduce risk to the lender. If the loan is not paid off satisfactorily,
the lender has a legal claim to seize the pledged asset.
Collection Float: The time between when a bill is paid and the time the payment is deposited.
Commitment Fee: A percentage of the unused portion of a credit line which is charged to the potential
borrower.
Common Costs: Costs that benefit a number of services and whose costs are shared by all. Examples:
rent, utilities, and billing. Also called joint costs.
Community Rating: A rating methodology required of indemnity and HMO insurers that guarantees
that there will be equivalent amounts collected from members of a specific group without regard to demographics
such as age, sex, size of covered group, and industry type.
Compensating Balance: A designated dollar amount on deposit with a bank which a borrower is
required to maintain.
Compliance: The need to abide by governmental regulations, whether they be for the provision of care,
billing, privacy, security, etc.
Compound Interest Method: A method which calculates interest on both the original principal and on
all interest accumulated since the beginning of the investment time period.
Glossary 483
Compounding: Converting a present value into its future value taking into account the time value of
money. See Compound Interest Method. It is the opposite of discounting.
Contact Capitation: A method of capitation whereby each specialty has its own capitation pool and use
of services by a physician only affects that physician’s compensation, not the whole specialty network’s
compensation.
Contra-asset: An asset which, when increased, decreases the value of a related asset on the books. Two
primary examples are Accumulated Depreciation, which is the contra-asset to Properties and Equipment,
and the Allowance for Uncollectibles, which is the contra-asset to Accounts Receivable.
Contribution Margin per Unit: Revenue per unit minus variable cost per unit. If all other costs (fixed
costs, overhead, etc.) remain the same, it is the amount of profit made on each additional unit produced.
Contribution Margin Rule: If the contribution margin per unit is positive and no other additional
costs will be incurred, then it is in the best financial interest of the organization to continue to provide
additional units of that service, even if the organization is not fully covering all of its other costs.
Contribution Margin: Revenue minus variable cost.
Controlling Activities: Activities which provide guidance and feedback to keep the organization within
its budget once it has been approved and is being implemented.
Conversion Factor: Actuarial based formulas developed to adjust rates allowing for differences in
population demographics.
Copayment: Requiring the patient to pay part of the health care bill. These payments are used to prevent
overutilization of services.
Corporate Compliance: Mandated legislation and regulations bestowed upon health care institutions
to ensure fairness, accuracy, honesty, and quality in the provision of and billing for health care services.
Corporate Compliance Officer: The individual (or department) responsible for knowing the
corporate compliance rules and regulations, and for ensuring that the organization strictly abides by them.
Cost Avoidance: The ability of an organization to find new ways to operate that eliminate certain classes
of costs.
Cost-based Reimbursement: Using the provider’s cost of providing services (supplies, staff salaries,
space costs, etc.) as the basis for reimbursement.
Cost of Capital: The rate of return required to undertake a project. The cost of capital accounts for
both the time value of money and risk. Also called the hurdle rate or discount rate.
Cost Centers: Organizational units responsible for providing services and controlling their costs.
Cost Containment: Not spending more than is budgeted in the expense budget.
Cost Drivers: Those things that cause a change in the cost of an activity.
Cost Object: Anything for which the cost is being estimated, such as a population, a test, a visit, a
patient, or a patient day.
Cost-shifting: Charging one group of patients more in order to make up for underpayment by others.
Most commonly, charging some privately insured patients more in order to make up for underpayment
by Medicaid or Medicare.
Current Assets: Assets which will be consumed (used up) within one year (or one time period).
Current Liabilities: Financial obligations due within one year (or one time period).
484 Financial Management of Health Care Organizations
Decentralization: The dispersion of responsibility within a health care organization.
Deductibles: When the patient covered is responsible for paying a certain base amount before coverage
begins.
Defensive Medicine: The tendency of health care practitioners to do more testing and to provide more
care for patients than might otherwise be necessary, simply to protect themselves against potential litigation.
Depreciation: A measure of how much a tangible asset (such as plant or equipment) has been “used up”
or consumed.
Diagnosis Related Groups (DRGs): A system to classify patients based upon their diagnoses. In the most
pervasive system, which is used by Medicare, there are approximately 500 different diagnostic categories.
Direct costs: Costs (e.g. nursing costs) that an organization can trace to a particular cost object (e.g. a
patient).
Disbursement Float: An organization’s practice of delaying payment as long as possible to its creditors,
without causing ill will.
Discount Rate: See Cost of Capital.
Discount: When the market rate is higher than the coupon rate, a bond is said to be selling at a discount
from its par value. See also Premium.
Discounted Cash Flows: Cash flows that have been adjusted to account for the cost of capital.
Discounting: Converting future cash flows into their present value taking into account the time value of
money. It is the opposite of compounding.
Discounts: A reduction in the charge for services.
Dividends: Represents the portion of profit that an organization distributes to equity investors.
DRGs: A patient classification scheme used by Medicare that clusters patients into categories on the
basis of patients’ illnesses, diseases and medical problems. These classifications are then used to pay
providers a set amount based on the diagnosis related group in which the patient has been classified.
Effective Interest Rate: The approximate annual interest rate incurred by not taking advantage of a
supplier’s discount offer to pay bills early.
Expansion Decision: Capital investment decision designed to increase the operational capability of a
health care organization.
Expense Budget: A subset of the operating budget, which is a forecast of the operating expenses that
will be incurred during the current budget period.
Expense Cost Variance: The amount of the variable expense variance that occurs because the actual
cost per visit varies from that originally budgeted. It is the difference between the variable expenses forecast
in the flexible budget and those actually incurred. It can be calculated by the formula: (actual cost per
unit – budgeted cost per unit) ´ actual volume.
Expense Volume Variance: The portion of total variance in variable expenses that is due to the actual
volume being either higher or lower than the budgeted volume. It is the difference between the expenses
forecast in the original budget and those in the flexible budget. It can be computed using the following
formula: (actual volume – budgeted volume) ´ budgeted cost per unit.
Experience Rating: The method of setting premium rates based on the actual health care costs of a
group of groups.
Glossary 485
Factoring: Selling accounts receivable at a discount, usually to a financial institution. The latter then
assumes the role of trying to collect upon the outstanding payment obligations.
Feasibility Study: A study which examines market and management factors that affect the issuer’s ability
to generate the necessary cash flows to meet principal and interest requirements.
Fee-for-service: A method of reimbursement based on payment for services rendered, with a specific
fee correlated to each specific service. An insurance company, the patient, or a government program such
as Medicare or Medicaid (discussed later) may make payment.
Financial Lease: See capital lease.
Financial Leverage: The degree to which an organization is financed by long-term debt.
Financial Requirements: For health care providers this is a combination of issues related to operations,
opportunities, contingencies, and return on investment.
Financing Mix: How an organization chooses to finance its working capital needs.
First Party: Typically, the patient in a health care encounter.
Fixed Costs: Costs that stay the same in total over the relevant range, but change inversely on a per unit
basis as activity changes.
Fixed Income Security: A bond which pays fixed amounts of interest at regular periodic intervals, usually
semi-annually.
Fixed Labor Budget: A subset of the labor budget which forecasts the cost of salaried personnel.
Flat Fee: A predefined amount of money paid to a provider for a unit of service.
Flexible Budget: A budget which accommodates a range or multiple levels of activities.
Float: The time delay of the process of assembling a bill until depositing the payment in the bank and
making subsequent payments to creditors.
Fully allocated cost: The cost of an item that includes both its direct costs and all other costs allocated
to it.
Fund Balance: A term used until 1996 for owners’ equity by not-for-profit health care organizations. It
was replaced with the present term, net assets, for non-governmental, not-for-profit organizations.
Future Value (FV): What an amount invested today (or a series of payments made over time) will be
worth at a given time in the future using the compound interest method, which accounts for the time
value of money. See also Present Value.
Future Value Factor of an Annuity (FVFA): A factor that when multiplied by a stream of equal payments
equals the future value of that stream. See also Present Value Factor of an Annuity.
Future Value Factor: The factor used to compound a present amount to its future worth. It is the
reciprocal of the present value factor and is calculated using the formula (1 + i)n.
Future Value of an Annuity Table: Table of factors which shows the future value of equal flows at
the end of each period, given a particular interest rate.
Future Value of an Annuity: What an equal series of payments will be worth at some future date using
compound interest. See also Future Value Factor of an Annuity and Present Value of an Annuity.
Future Value Table: Table of factors which shows the future value of a single investment at a given
interest rate.
486 Financial Management of Health Care Organizations
Gatekeepers: Providers (typically the PCP) who must preapprove care received by a patient, such as a
visit to the specialist. Gatekeepers are utilized in most POS plans and HMO plans.
Global Payments: A system to pay providers whereby the fees for all providers (hospitals, physicians, home
health care agencies) are included in a single negotiated amount. This is sometimes called “bundling” of services.
In non-global payment systems, each provider is paid separately.
Goodwill: An amount paid above and beyond the book value of an asset when it is sold, in part to offset
the seller from potential lost future earnings from the asset had it not been sold.
Gross Charges: The amount that an organization would bill its patients if they all paid full charges. See
Net Charges.
Group Model HMO: An HMO which contracts with medical groups for services.
HCFA: The Health Care Financing Administration. The US government department that oversaw the
provision of and payment for health care provided under its entitlement programs (Medicare, Medicaid)
until 2001.
Health Insurance Portability and Accountability Act (HIPAA): A set of federal compliance regulations
enacted in 1996 to ensure standardization of billing, privacy, and reporting as institutions enter a paperless age.
Health Maintenance Organization (HMO): A legal corporation that offers health insurance and
medical care. HMOs typically offer a range of health care services at a fixed price. See Capitation.
Hedging: The art of offsetting high variable rate debt payments with returns from high-rate investments.
Horizontal Analysis: A method of analyzing financial statements which looks at the percentage change
in a line item from one year to the next. It is computed by the formula (subsequent year – previous
year)/previous year.
Hurdle Rate: See Required Rate of Return.
Incremental Cash Flows: Cash flows that occur solely as a result of a particular action such as undertaking
a project.
Incremental costs: Additional costs incurred solely as a result of an action or activity or a particular set
of actions or activities.
Incremental/Decremental Approach: A method of budgeting which starts with an existing budget
to plan future budgets.
Indemnity Insurance: A plan which reimburses physicians for services performed, or beneficiaries for
medical expenses incurred. Typically, the employer and/or patient pays a monthly premium to the plan
for a predetermined set of healthcare benefits.
Indirect costs: Costs that an organization is not able to directly trace to a particular cost object.
Common indirect costs include the cost of the billing clerk, rent, computer costs and many so-called overhead
costs.
Interest: A payment to creditors, those who have loaned the organization funds or otherwise extended
credit.
Internal Rate of Return Method: A method to evaluate the financial feasibility of an investment decision
which compares the investment’s rate of return to that return required by the organization.
Internal Rate of Return: That rate of return on an investment which makes the net present value equal
to $0, after all cash flows have been discounted at the same rate. It is also the discount rate at which the
discounted cash flows over the life of the project exactly equal the initial investment.
Glossary 487
Joint costs: See Common Costs.
Labor Budget: A subset of the expense budget, this budget is composed of the fixed labor budget and
the variable labor budget.
Lessee: An entity that negotiates the use of another’s asset via a lease.
Lessor: An entity that owns an asset which is then leased out.
Letter of Credit: Offered through a bank, this can be used to enhance the creditworthiness of an institution,
and, hence, a bond’s rating.
Liabilities: The financial obligations of the organization (i.e. debts).
Line-item Budget: The least detailed budget, showing only revenues and expenses by category, such
as labor or supplies.
Liquidity: A measure of how quickly an asset can be converted into cash.
Lockbox: A post office box located near a Federal Reserve Bank or branch, from which the bank will
pick up and process checks quickly, but for a fee.
Managed Care: Any of a number of arrangements designed to control health care costs through monitoring,
prescribing, or proscribing the provision of health care to a patient or population.
Market Value: What a bond would sell for in today’s open market.
Medicaid: A federally mandated program, operated and partially funded by individual states (in conjunction
with the federal government) to provide medical benefits to certain low-income people. The
state, under broad federal guidelines, determines what benefits are covered, who is eligible, and how much
providers will be paid.
Medical Savings Accounts: A limited amount of money an employee can take as pretaxed income to
pay for medically related items such as physician visits, pharmaceuticals, eyewear, dental visits, etc. The
pretax income is placed in an escrow account held by the employer. The employee must submit receipts
for care received to get reimbursed.
Medicare: A nationwide, federally financed health insurance program for people age 65 and older. It also
covers certain people under 65 who are disabled or have chronic kidney (end-stage renal) disease.
Medicare Part A is the hospital insurance program; Part B covers physicians’ services. Created by the
1965 amendment to the Social Security Act.
Members: People who are covered by a health care plan. Typically the member and/or the employer of
the member pays a premium to the plan for the privilege of being covered.
Mission Statement: A statement which guides the organization by identifying the unique attributes of
the organization, why it exists, and what it hopes to achieve. Some organizations divide these attributes
between a vision and a mission statement.
Multi-year Budget: A budget which is forecast multiple years out, rather than just for the upcoming
year.
Net Assets: In not-for-profit organizations, the difference between assets and liabilities (assets minus
liabilities).
Net Charges: The amount that an organization bills its patients after accounting for discounts and
allowances. See gross charges.
Net Income: Excess of revenues over expenses.
488 Financial Management of Health Care Organizations
Net Present Value Method: A method to evaluate the financial feasibility of an investment decision
based solely upon the resulting net present value. It uses a specific discount rate which may not be equal
to the organization’s required rate of return.
Net Present Value: The present value of future cash flows related to an investment net (less) the cost
of the initial investment. It represents the difference between the initial amount paid for an investment,
and the future cash inflows that the investment will bring in, after adjusting for the cost of capital.
Net Proceeds from a Bond Issuance: Gross proceeds less the underwriter’s and others’ issuance fees.
Non-avoidable Fixed Costs: A fixed cost that will remain even if a particular service is discontinued.
Example: full-time nursing costs in an organization that will continue, even though one of several services
is dropped.
Non-current Assets: The resources of the organization that will be used or consumed over periods
longer than one year.
Non-current Liabilities: The financial obligations not due within one year.
Non-regular Cash Flows: Cash flows that occur spordically or on an irregular basis. A common non-regular
cash flow is salvage value, receipt of funds following a one-time sale of an asset at the end of its useful life.
Notes to Financial Statements: Additional key information written out in detail which is not presented
in the body of the financial statement.
Operating Budget: One of the four major types of budgets. It is comprised of the revenue budget and
the expense budget. The bottom line for this budget is net income.
Operating Cash Flows: Cash flows that occur on a regular basis, oftentimes following implementation
of a project. Also called regular cash flows.
Operating Income: Income derived from the organization’s main line of business.
Operating Lease: A lease that lasts shorter than the useful life of the leased asset, typically one year or
less. This type of leasing arrangement can be canceled at any time without penalty, but there is no option
to purchase the asset once the lease has expired.
Opportunity Cost: Proceeds lost by forgoing other opportunities.
Ordinary Annuity: A series of equal annuity payments made or received at the end of each period.
Outstanding Bond Issue: A bond that trades in the marketplace.
Owner’s Equity: In for-profit institutions, the difference between assets and liabilities (assets minus
liabilities).
Par Value: The face value amount of a bond. It is the amount the bondholder is paid at maturity. It does
not include any coupon payments.
Participating Provider: A provider who has contracted with the health plan to provide medical services
to covered members at predetermined rates.
Participatory Approach: A method of budgeting in which the roles and responsibilities of putting
together a budget are diffused throughout the organization, typically originating at the department level.
There are guidelines to follow, and approval must be secured by top management. Opposite to the authoritarian
approach.
Payback Method: A method to evaluate the feasibility of an investment by determining how long it would
take until the initial investment is recovered, disregarding the time value of money.
Glossary 489
Payor: An entity that is responsible for paying for the services of a health care provider. Typically, this
is an insurance company or a government agency. Commonly referred to as third parties.
Per Diem: An amount a payor will pay for one day of care, which includes all hospital charges associated
with the inpatient day (including nursing care, surgeries, medications, etc.).
Per Member Per Month (PMPM): Generally used by HMOs and their medical providers as an indicator
of revenue, expenses, or utilization of services per member per one-month period.
Performance Budget: An extension of the program budget which also lays out performance objectives.
Perpetuity: An annuity for an infinite period of time. Also called a perpetual annuity.
Planning: The process of identifying goals, objectives, tasks, activities, and resources necessary to carry
out the strategic plan of the organization over the next time period, typically one year.
Point of Service (POS): A hybrid between a HMO and a PPO in which patients are given the incentive
to see providers participating in a defined network, but may see non-network providers, though usually
at some additional cost.
Predetermined Rates: A set fee paid to a provider for an inpatient episode of care.
Preferred Provider Organization (PPO): A network of independent providers preselected by the
payor to provide a specific service or range of services at predetermined (usually discounted) rates to the
payor’s covered members.
Premium: A monthly payment made by a person and/or an employer to an insurer that makes one eligible
for a defined level of health care for a given period of time.
Premium: When the market rate is lower than the coupon rate, a bond is said to be selling at a premium.
See also discount.
Present Value (PV): The value today of a payment (or series of payments) to be received in the future,
taking into account the cost of capital.
Present Value Factor of an Annuity (PVFA): A factor that when multiplied by a stream of equal payments
equals the present value of that stream.
Present Value Factor: The factor used to discount a future amount to its current worth. It is the reciprocal
of the future value factor and is calculated using the formula 1/(1 + i)n.
Present Value of an Annuity Table: Table of factors which shows the worth today of equal flows at
the end of each future period, given a particular interest rate.
Present Value of an Annuity: What a series of equal payments in the future is worth today taking into
account the time value of money.
Present Value Table: Table of factors which shows what a single amount to be received in the future
is worth today at a given interest rate.
Price Setter: The entity that controls the amount paid for a health care service.
Primary Care Provider (PCP): A physician (typically a Family Medicine, Internal Medicine, Pediatric
and sometimes Ostetrics and Gynecology provider) that is the primary care giver of a patient.
Product Margin Decision Rule: If a service’s product margin is positive, the organization will be
better off financially if it continues with the service, ceteris paribus. Conversely, if a service’s product
margin is negative, the organization will be better off financially if it discontinues the service, ceteris
paribus.
490 Financial Management of Health Care Organizations
Product Margin: Total Contribution Margin – Avoidable Fixed Costs. It represents the amount which
a service contributes to covering all other costs after it has covered those costs which are there solely
because the service is offered (its total variable cost and avoidable fixed costs) and would not be there if
the service were dropped.
Profit Centers: Organizational units responsible for controlling costs and earning revenues.
Program Budget: An extension of the line-item budget which shows revenues and expenses by program
or service lines.
Prospective Payment System: The payment system used by Medicare to reimburse providers a predetermined
amount. Several payment methods fall under the umbrella of PPS, including: DRGs (inpatient
admissions); APCs (outpatient visits); RBRVS (professional services); and RUGs (skilled nursing
home care). DRGs were the first category to fall under this type of predetermined payment arrangement.
Prospective Payment System: 1) The payment system used by Medicare to reimburse providers a set
amount based upon the patient’s DRG. This system is commonly referred to as the PPS or DRG payment
system. 2) A payment method that establishes rates, prices, or budgets before services are rendered
and costs are incurred. Providers retain or absorb at least a portion of the difference between established
revenues and actual costs.
Ratio: An expression of the relationship between two numbers as a single number.
RBRVS: A system of paying physicians based upon the relative value of the services rendered.
Red Herring: A preliminary official statement offered to prospective buyers of a bond by the underwriters
to help determine a fair market price for the bond.
Regular Cash Flows: See Operating Cash Flows.
Relative Value Units (RVUs): A standardized weighting applied to services which reflects the amount
of resource consumption to provide that service. A service assigned 2 RVUs consumes twice the resources
as does a service assigned 1 RVU.
Relevant Range: The range of activity over which total fixed costs and/or per unit variable cost do not
vary.
Replacement Decision: Capital investment decision designed to replace older assets with newer ones.
Required Market Rate: The market interest rate on similar risk bonds.
Required Rate of Return: An organization’s minimally acceptable internal rate of return on any investment
to justify an initial investment. Also called Cost of Capital or Hurdle Rate.
Residual Value: See Salvage Value.
Responsibility Center: An organizational unit that has been formally given the responsibility to carry
out one or more tasks and/or achieve one or more outcomes.
Responsibility: Duties and obligations of a responsibility center.
Retained Earnings: A second type of benefit to an investor. These are in the form of the portion of the
profits the organization keeps in-house to use in growth and support of its mission.
Retrospective Payment: Method for reimbursing a provider after the the service has been delivered.
Revenue Attainment: Earning the amount of revenue budgeted.
Revenue Budget: A subset of the operating budget, which is a forecast of the operating revenues that
will be earned during the current budget period.
Glossary 491
Revenue Enhancement: Finding supplemental sources of revenue.
Revenue Rate Variance: The amount of the total revenue variance that occurs because the actual average
rate charged varies from the one originally budgeted. It is the difference between the revenues forecast
in the flexible budget and those actually earned. It can be calculated using the formula (actual rate –
budgeted rate) ´ actual volume.
Revenue Volume Variance: The portion of total variance in revenues due to the actual volume being
either higher or lower than the budgeted volume. It is the difference between the revenues forecast in the
original budget and those in the flexible budget. It can be computed using the formula (actual volume –
budgeted volume) ´ budgeted rate.
Risk Pools: A generally large population of individuals who are all simultaneously insured under the same
arrangement, regardless of working status. Health care utilization – and therefore cost – is more stable for
larger groups than it is for smaller groups, which makes larger groups’ cost more predictable for insurers.
Rolling Budget: A multi-year budget which is updated more frequently than annually, such as semiannually
or quarterly.
RVU: Relative Value Unit.
Sale/Leaseback Arrangement: A type of capital lease whereby an institution sells an owned asset
and then simultaneously leases it back from the purchaser. The selling institution retains rights to use
the asset, but benefits from the immediate acquisition of cash from the sale.
Salvage Value: The amount of cash to be received when an asset is sold, usually at the end of its useful
life. Also called terminal value.
Scrap Value: see Salvage Value.
Second Party: Typically, the provider (hospital/physician) in a health care encounter.
Service Centers: Organizational units that are primarily responsible for ensuring that health carerelated
services are provided to a population in a manner that meets the volume and quality requirements
of the organization. They have no direct budgetary control.
Shareholders’ Equity: Another name for Owners’ Equity.
Short-term Plans: Specific plans which identify an organization’s short-term goals and objectives in
more detail, primarily in regard to marketing/production, control, and financing the organization.
Simple Interest Method: A method to calculate interest only on the original principal amount. The
principal is the amount invested.
Sinking Fund: A fund into which monies are set aside each year to ensure that a bond can be liquidated
at maturity.
Staff Model HMO: An HMO which owns its clinics and employs its doctors.
Static Budget: A budget which uses a single or fixed level of activity.
Statistics Budget: The first budget to be prepared. One of the four major types of budgets. It identifies
the amount of services that will be provided, typically categorized by payor type.
Step Fixed Costs: Costs that increase in total over wide, discrete steps.
Step-down method: A cost finding method based on allocating those costs that are not directly paid for
to those products or services to which payment is attached. The method derives its name from the stairstep
pattern that results from allocating costs.
492 Financial Management of Health Care Organizations
Stop Loss: A method providers use to limit the exposure that comes with the possibility that charges will
go far beyond negotiated rates – a level of charges over which the provider is no longer totally liable.
Straight-line Depreciation: A method which depreciates an asset an equal amount each year until it
reaches its salvage value at the end of its useful life.
Strategic Decision: Capital investment decision designed to increase a health care organization’s strategic
(long-term) position.
Strategic Planning: Identifying an organization’s mission, goals, and strategy to best position itself for
the future.
Subcapitation: Where the primary care physician pays a portion of the total capitated dollars received
to another provider (i.e. specialist).
Sunk Costs: Costs incurred in the past. They should not be included in NPV-type analyses.
Target Costing: Controlling costs and/or decreasing profit margins in order to meet or beat a predetermined
price or reimbursement rate.
Tax Shield: An investment which reduces the amount of income tax that has to be paid, often because
interest and depreciation expenses are tax deductible.
Term Loan: A loan typically issued by a bank which has a maturity of one to ten years.
Terminal Value: See Salvage Value.
Third Party: Typically, the payor (insurance company/government agency) in a healthcare encounter.
Third Party Payors: Commonly referred to as third parties, these are organizations that pay on behalf
of patients.
Time Value of Money: The concept that a dollar received today is worth more than a dollar received
in the future.
Top-down Budgeting: See Authoritarian Approach.
Top-down/Bottom-up Approach: See Participatory Approach.
Traditional Profit Centers: Organizational units responsible for earning a profit by providing health
care services. Revenues are earned on either a fee-for-service or flat fee basis. Examples include cardiology,
women’s and children’s services, and oncology.
Trend Analysis: A type of horizontal analysis that looks at changes in line items compared to a base
year. It is calculated: [(any subsequent year – base year)/base year] ´ 100.
Trustee: An agent for bondholders who ensures that the health care facility is making timely principal and
interest payments to the bondholders and complies with legal covenants of the bond.
Variable Costs: Costs that stay the same per unit but change directly in total with a change in activity
over the relevant range. Total Variable Cost = Variable Cost Per Unit ´ Number of Units of Activity.
Vertical Analysis: A method to analyze financial statements which answers the general question: what
percentage of one line item is another line item? Also called common-size analysis because it converts
every line item to a percentage, thus allowing comparisons among the financial statements of different
organizations.
Working Capital Strategy: The amount of working capital that an organization determines it must
keep available as a cushion to protect against unforeseen expenditures.
Glossary 493
Yield to Maturity: The rate at which the market value of a bond is equal to the bond’s present value of
future coupon payments plus.
Zero-based Budget (Capitation): Dividing the entire amount of capitation (the “budget”) among all
the providers, essentially leaving nothing or “zero” left at the end of every accounting period.
Zero-based Budgeting (ZBB): An approach to budgeting that continually questions both the need for
existing programs and their level of funding, as well as the need for new programs.
494 Financial Management of Health Care Organizations
bBy Sourcec
1. Health Care Financial Alert Quarterly
URL: http://www.ushnet.com/programs/nl.htm
Steps: Click on the link to view the newsletter.
Other information: This is a quarterly publication of the US Health Network which provides
up-to-date information concerning health care providers of all types. This eight-page newsletter
is available without charge and is provided through the respective Network member in your area.
Written by experienced health care professionals, Health Care Financial Alert will inform and
alert the health care provider to reimbursement, strategic planning, accounting, tax, and management
issues on a timely basis.
2. AHA Financial Solutions Press Releases
URL: http://www.aha.org/fsi/press.asp
Steps: Click on the “News and Press” link.
Other information: The American Hospital Association (AHA) is a not-for-profit association
of health care provider organizations and individuals that are committed to the health improvement
of their communities.
3. AHA HIPAA Standards
URL: http://www.aha.org/hipaa/hipaa_home.asp
Steps: Click on the link for the current topic of interest
Other information: The American Hospital Association (AHA) is a not-for-profit association
of health care provider organizations and individuals that are committed to the health improvement
of their communities.
4. HFMA On-line; Health Care Financial Management Links
URL: http://www.hfmaiowa.org/links/html
WEB LINKS OF INTEREST FOR
HEALTH CARE FINANCIAL
MANAGEMENT
Steps: Click on the link of interest from the list.
Other information: HFMA is the USA’s leading personal membership organization for
health care financial management professionals.
5. National Association of Rural Health Clinics
URL: http://www.narhc.org/
Steps: Click on the HCFA RHC information link.
Other information: Legislative rules and regulations.
6. American Hospital Directory
URL: http://www.ahd.com/
Steps: Click to get free information or register for more detailed information.
Other information: The American Hospital Directory provides on-line data for over 6,000
hospitals. The database of information is built from Medicare claims data, cost reports, and other
public use files obtained from the federal Centers for Medicare and Medicaid Services (CMS,
formerly HCFA). The directory also includes AHA Annual Survey Data licensed from Health
Forum, an American Hospital Association company.
7. US Department of Health and Human Services
URL: http://www.hhs.gov/
Steps: Search for a topic of interest.
Other information: Home page for this federal agency.
8. HCFA’s Provider Reimbursement Review Board
URL: http://www.hcfa.gov/regs/prrb.htm
Steps: Click on the Board’s decisions by year at the bottom of the page.
9. Health Care Finance On-line
URL: http://www.hcfinance.com/
Steps: Click on the story of interest.
Other information: Health care financial information for not-for-profit providers.
10. National Association of Health Underwriters
URL: http://www.nahu.org/
Steps: Click on the link “The Issues.”
Other information: Provides numerous articles and information on governmental
regulations, managed care, long-term care, health insurance, and privacy.
11. CMMS (HCFA) APC Information
URL: http://www.hcfa.gov/regs/hopps/default.htm
Steps: Click on any report to be downloaded (Adobe Acrobat format).
Other information: Provides links to other federal government sites.
496 Web Links
12. Healthcare Finance Group (HFG)
URL: http://www.hfgusa.com/
Steps: Click on link to find out about available services.
Other information: Healthcare Finance Group Inc. (HFG) is a specialty finance company,
investing exclusively in the health care industry.
13. North Carolina Healthcare Information and Communications Alliance (NCHICA)
URL: http://www.nchica.org/
Steps: Click on links of interest.
Other information: NCHICA is dedicated to improving health care through information
technology and secure communications. It offers resources in HIPAA, privacy, EDI, etc.
14. Wall Street Journal
URL: http://public.wsj.com/home.html
Steps: Click on business news to find articles on health care finance.
Other information: Requires that the user become a subscriber to have on-line access to all
the information provided in the daily newspaper.
bBy Type of Informationc
1. Updated Hospital Bond Ratings Information
URL: http://www.standardandpoors.com/Forum/MarketAnalysis/Healthcare/index.html#
FA
Steps: Click on featured articles and methodology and credit statistics and look for articles on
non-profit median health care ratios.
Other information: Provides health care financial ratio information for non-profit hospitals.
2. Updated Information on Hospital Financial Data
URL: http://www.solucient.com/
Steps: Type in financial ratios in search menu to identify financial performance ratios of hospital
and 100 Top Hospitals: Benchmarks for Success.
Other information: Provides health care financial ratio information.
3. Selected Information on Hospital Financial Data from the State of California
URL: http://www.oshpd.cahwnet.gov/hid/infores/hospital/finance/annual_data/
Steps: Click on reports.
Other information: Provides detailed financial statement and utilization information for
California acute-care hospitals.
4. Selected HMO Operating and Financial Data from Interstudy
URL: http://www.hmodata.com/
Web Links 497
Steps: Click on sample reports and look for sample financial reports for selected HMOs.
Other information: Provides sample reports on HMO financial data and ratios.
5. Selected Information on Operating and Capital/Financial Leases
URL: http://www.fleethealthcare.com/content/page_render.asp?use_case=FHC2
Steps: Click on this site and it will provide further explanation of key terms used in leasing.
Other information: Useful site to understand the aspects of lease financing.
6. Selected Information on Tax-exempt Financing Process
URL: http://www.nchffa.com/financial_advisors.htm
Steps: Click on the site.
Other information: Provides information on structuring a particular bond issue and on hiring
investment bankers and negotiating financing terms with investment bankers, rating agencies,
and credit enhancers. The information is provided by the Financial Advisors from the
National Council of Health Facilities Finance.
7. Selected Information on the Capital Budgeting Process and Hospital Balance Sheet
URL: http://www.gemedicalsystems.com/services/financial/education/hfs_khtrain_menu.
html
Steps: Click on the site.
Other information: Provides information on financial statement analysis of hospitals and
explanation of analyzing a capital budgeting decision using net present value. The source of this
site is General Electric Healthcare Financial Services.
8. Selected Financial Statement Filings for US Securities and Exchange Commission (SEC)
for Publicly Traded Health Care Companies
URL: http://www.sec.gov/edgar.shtml
Steps: Click on search for company filings and general purpose search, quick form lookups.
Enter company name (for example, HCA-THE HEALTHCARE CO), and enter 10-k under
form type, which will provide detailed financial statement information that is registered with
the SEC.
Other information: Provides the annual financial reports submitted by publicly traded health
care companies.
9. Selected Trend Data on Medicare Payments, Costs, Profit and Utilization Data
URL: http://www.medpac.gov/publications/
Steps: Click on publications, click on reports. Payment reports will be titled “Report to the
Congress: Medicare Payment Policy (Date)”, and be PDF files.
Other Information: Presents detailed analysis of changes in Medicare costs and utilization for
acute care and post-acute care services. Also provides information on the effects of the Balanced
Budget Act of 1997 on hospitals.
498 Web Links
10. Key Financial, Inpatient, and Outpatient Services, Cost and Charge Measurements for a
Specific Hospital
URL: http://www.ahd.com
Steps: Click on free services, and type the specific name of the hospital and its address.
11. Timely News Stories that Affect Hospitals Nationally from the American Hospital
Association
URL: http://www.ahanews.com
12. Information on the Bond Rating Methodology for Moody Bond Rating Agency
URL: http://www.moodys.com/moodys/
Steps: Click on US public finance and then click on rating methodology and look for reports
for non-profit hospitals.
13. Information on How to Compute Cash Flows and the Cost of Capital in Computing a
Company’s Stock Price
URL: http://www.valuepro.net
Steps: Click on Learn the Valuepro approach and look for free cash flow and cost of capital.
Also in the initial page enter an investor-owned hospital management company’s stock symbol
(for example, HCA), and it will provide the company’s projected stock price and weighted
average cost of capital information.
14. Information on How to Find Information on Investor-owned Hospital Management
Companies’ Financial Measures and Weighted Cost of Capital Measures
URL: http://valuation.ibbotson.com
Steps: Click on “Learn about methodology,” click on “View sample,” click on “SIC code 8,”
to find sale growth rates, capital structure ratios, margins, return on equity, cost of capital, and
beta values for large investor-owned hospital companies.
15. On-line Monthly Trade Journal Regarding Health Care Finance Topics in the Hospital
Markets
URL: http://www.hcfinance.com
Steps: Click on web address.
Other information: Specific topics include rating changes, hospital performance and hospital
acquisitions and mergers.
Web Links 499
ABC, see activity-based costing
access, balancing with cost and quality,
445–6, 449, 466–72
accountability, 401, 413, 461, 481
accounting
key equations, 55
principles and practices, 75–102
process, 76, 84–9
see also accrual basis of accounting;
basic accounting equation; cash
basis of accounting
accounts payable, 33
see also trade payables
accounts receivable
as collateral, 178
days in, 116, 120–1, 177
management, 175–8, 182
methods to finance, 178
methods to monitor, 176–7
as a percentage of revenues, 177
selling, see factoring
accrual basis of accounting, 37, 78, 80,
95, 481
and asset turnover ratios, 131
comparison with cash basis, 77–80
expenses, 85
operating budget and, 365
revenues, 84, 85
rules for recording transactions,
82–4, 95–6
accrued expenses, 33
accumulated depreciation, 31, 88, 481
acid test ratio, 119–20, 141
acquisitions and mergers, 16–17
activity ratios, 112, 128, 129–32, 140
formulas, 141
activity-based costing (ABC), 15,
424–37, 437, 438, 481
adding-or-dropping a service, 330–1,
332
administrative cost centers, 398, 481
administrative costs, allocating, 422–3
administrative and general expense
budget, 384, 385
administrative profit centers, 399–400,
481
administrative simplification, 466
admissions screening, 166
age of plant ratio, 131, 141
aggressive approach to working capital
management, 158, 160, 181
aging population, and rising costs, 6
aging schedule, 177, 481
AHA, see American Hospital
Association
allocation base, 15, 420–1, 481
allowable costs, 450, 481
areas of contention in determining,
476
allowance for bad debt, see bad debt
expense
allowance for uncollectibles, 28, 884,
Ambulatory Procedure Classifications
(ApCs), 4, 11, 14, 452–4,479, 481
American Hospital Association (AHA),
369, 447
American Institute of Certified Public
Accountants, Audit and
Accounting Guide: Health Care
Organizations, 23, 64–74
amortization, 43–4, 206, 278, 303–4,
481
analytic methods, 231–43
annuity, 200–5, 208, 482
defined, 200
see also annuity due; ordinary
annuity; perpetuity (annuity)
annuity due, 202, 210, 481–2
future value of, 202–3, 211
present value, 204–5, 211
APCs (Ambulatory Procedure
Classifications), 4, 11, 14, 452–4,
479, 481
appreciation, see capital appreciation
approximate interest rate, 164–5
formula, 164, 181, 183
asset accounts, 82, 130
asset mix, 156, 157–8, 181, 482
aggressive approach, 158
conservative approach, 158
asset turnover ratios, 131
assets, 24, 26–32, 54, 90, 482
current, 26–9, 156, 484
financing, 274–304
limited as to use, 28
non-current, 29–32, 489
other, 32
prepaid, see prepaid expenses
see also contra-asset; net assets
auditors, 78
authoritarian approach, 349, 387, 482
authority, 401, 413, 482
average collection period, see days in
accounts receivable
average cost per unit, see cost per
unit
average fixed cost per unit, see fixed
cost per unit
INDEX
Index 501
average payment period ratio, 122–3,
141
average variable cost per unit, see
variable cost per unit
avoidable fixed cost, 326, 482
bad debt expense, 44, 89
balance sheet, 23–37, 90
assets, 26–32, 90
compared to statement of
operations, 37
for-profit hospital, 64
liabilities, 32–4, 90
net assets, 34–6, 90
non-current assets, 30
not-for-profit hospital, 25, 64
notes, 37
overview, 24–6
owners’ equity section, 36
Balanced Budget Act (1997), 14, 452
Balanced Budget Refinement Act
(1999), 14
bank loans, 160–2, 181
term loans, 279
bankruptcy, 275, 289
base year, 108, 109
basic accounting equation, 26, 34, 54,
55, 84, 96, 275, 482
basis points, 281
below the line items, 45–7
billing, 165–70
costs, 436
electronic, 168
fraud, 179
improving policies and procedures,
166–8
laws and regulations for compliance,
179–81
state variation in codes, 181
billing float, 165–8, 182, 482
Blue Cross and Blue Shield (BC/BS)
plans, 447–8
bond, 278, 280–3, 295, 482
defined, 275, 482
payable, 34
tax-exempt, 282
taxable, 282–3
terminology, 280–1
bond insurance, 286
bond issuance
fixed interest, 279, 295
net proceeds from, 289
variable interest, 279, 295
bond issuance process, 283–90
parties involved in a tax-exempt,
283
public versus private placements,
283–4
roles of underwriters and trustees,
289–90
steps in, 284–9, 295
bond rating, 281, 284, 285–6
investment grade, 286
not-for-profit organizations, 287
bond rating agencies, 135, 285–6
bond valuation, 300–4
equation, 296
formula, 300–1
for other payment periods, 302–3
in terms of market price, 301–2
in terms of yield to maturity,
300–1
books, the, 77
borrowing, long-term compared with
short-term, 159
bottom line, 45, 52
breakeven analysis, 307–25, 482
to determine prices, charges and
reimbursement, 307–8
effects of capitation, 322–5, 326
role of fixed costs, 308–11
role of variable costs, 311–14
breakeven chart, 316–20, 321, 333
breakeven equation, 309, 314, 315,
333, 335
expanding to include indirect costs
and required profit, 314, 316, 335
using the contribution margin
approach, 320–2, 334, 335
breakeven point, 320, 333, 482
budget variance, 402–12, 413, 482
expense variances, 407–11
favorable, 405, 409, 411
and operating budget, 411–12
revenue variances, 403–7
unfavorable, 411
budgeting, 345–92
organizational approaches to,
348–55
planning/control cycle, 346–8
relationship to strategy, tactics and
operation, 348
budgets, 346
detail, 355–7, 360
examples of development, 367–86
models, 351–5
modifications to, 357–9
overview, 360
relationship with financial
statements, 367
types of, 360–7
call price, 281
call protection period, 281
callable bonds, 281
cannibalization, 258, 482
capital appreciation, 230, 482
capital budget, 261–2, 365–6, 386, 388,
482
replacement cost example, 262–73
capital financing, 230, 274–304
bond issuance process, 283–90
debt financing, 277–83
equity financing, 276–7
lease financing, 290–4
capital investment decision, 226–73,
482
components, 227
expansion decisions, 227
objectives, 229–30
replacement decisions, 227, 229
strategic decisions, 227
capital investments, 482
analytic methods, 231–43
attracting future funds, 230
community benefits of, 229
financial returns, 229–30
internal rate of return (IRR),
239–41
net present value method, 234–9
non-financial benefits, 229
payback method, 232–4
capital lease, 291, 295, 482
capital structure decision, 275, 294
capital structure ratios, 112, 132–7,
140
formulas, 141
capitated profit centers, 399, 482
capitation, 4, 5, 13–14, 34, 168, 361,
461–6, 482–3
ancillary, 464
defined, 461
effects on breakeven analysis, 322–5,
326, 333
global model, 465
multi-provider, 464
percent of managed care premium,
463
physician, 464
primary care or specialty care, 464
see also contact capitation; zerobased
budget
care mapping, 17, 483
case mix, 476
case rate, 12, 459–60, 483
cash, 160
for daily operations, 160
disbursement policies, 165–70
ending balance, 175
forecasting surpluses and deficits,
173–5
inflows/outflows, 173–5, 261
for precautionary purposes, 160
reasons to hold, 160, 181
short-term investing, 170–3, 182
sources of temporary, 160–70, 181
for speculative purposes, 160
cash basis of accounting, 37, 78, 95,
483
comparison with accrual basis,
77–80
management manipulation, 78–9
cash budget, 173–5, 182, 365, 366,
387–8, 483
developing, 384–6
cash and cash equivalents, 27–8, 160
at the end of the year, 52–4
cash flows
conversion from accrual items, 232,
235–7, 386
determining annual, 257
effects on profit reporting, 78–80
forecasting, 173–5, 182
from financing activities, 52, 93, 94
from investing activities, 52, 93, 94
incremental, 257, 487
internal rate of return (IRR) and,
240–1
non-regular, 258, 259, 489
operating, 50, 53, 93, 257–8, 489
spillover, 258
see also statement of cash flows
cash on hand, days, 121–2
cash management, 160–75
working capital cycle, 156–60
CCR, see cost-to-charge ratio
CDs, see negotiable certificates of
deposit (CDs)
Center for Medicare and Medicaid
Services (CMS), 179, 454, 483
certainty, 192
Certificate of Need (CON), 11
certificates of deposit (CDs), 172
charge-based payment, 5, 361, 447,
472, 477–8, 483
charges
breakeven approach to determine,
307–8
see also billing
charity care discounts, 28, 483
chart of accounts, 77
chronic diseases, and rising costs, 7–8
claims processing
internal, 166–8, 180
use of Internet, 469
clinical cost centers, 398, 483
CMS (Center for Medicare and
Medicaid Services), 179, 454,
483
collateral, 178, 280, 483
using receivables as, 178
collection centers, decentralized, 169
collection float, 168, 182, 483
collections, 165–70
commercial paper, 172
commitment fee, 161, 483
common costs, 326, 327, 483
common-size analysis, see vertical
analysis
communication
formal with decentralization, 397
steps in, 395
community rating, 448, 461, 483
community service, 306
comparative approach
replacement decisions, 243:
for-profit organizations, 265,
268–9; not-for-profit
organizations, 265–7
comparative balance sheet, 24
compensating balance, 161–2, 483
compliance, 8–9, 483
laws and regulations for billing,
179–81
compound interest method, 192,
193–4, 195, 209, 483
compounding, 198, 205–6, 484
calculating growth rate, 206–8
CON, see Certificate of Need
concentration banking, 169
concurrent review, 11
confidentiality, 180
conservative approach to working
capital management, 158, 160,
181
consolidated balance sheet, 68
Consumer Price Index, versus medical
care inflation, 3
contact capitation, 465, 484
contingencies, 477
contra-asset, 88, 484
contractual allowances, 28
contribution margin per unit, 320–2,
334, 335, 484
see also total contribution margin
contribution margin rule, 322, 484
controlling activities, 347–8, 484
conversion factor, 463, 484
copayment, 12, 458, 459, 484
corporate compliance, 179, 484
corporate compliance officer, 179, 484
cost, balancing with quality and access,
445–6, 449, 466–72
cost accounting systems, 15
see also activity-based costing
cost allocation
activity-based costing, 424–37
bottom-up approach, 426, 438
step-down method, 419–24
top-down approach, 426, 437–8
traditional compared with ABC,
426, 428, 430–7
cost avoidance, 412, 484
cost of capital, 234, 484
determining, 239, 256–9
see also discount rate; required rate
of return
cost centers, 398, 413, 484
cost containment, 411, 412, 450, 455,
484
cost control, 10–17
ethical issues in, 17
cost drivers, 420, 428, 484
cost of goods used (COGU), 381, 384
cost information, using to make special
decisions, 305–44
cost object, 418–19, 484
cost per unit, 309
cost-based payment systems, 4–5, 361,
449, 472, 476–7, 484
cost-plus approach, 479
cost-shifting, 4, 5, 477, 484
cost-to-charge ratio(CCR), 419, 437
cost–volume–profit (CVP) analysis, see
breakeven analysis
costing terminology, 428
costs
cutting delivery, 14–17
estimating, 418–43
included and excluded in NPV
analysis, 256–7
overhead, 436
rising, 3–10, 17–18, 455
factors in, 4
502 Index
coupon, 281
coupon payment, 281, 300–1
coupon rate, 281, 301
covenant, 280
coverage approach to setting charges,
480
coverage period, 85
credit rating agencies, 284–5
cross-subsidization, 477
current assets, 26–9, 156, 484
internal control procedures, 27
prepaid expenses, 28–9
supplies, 28–9
current liabilities, 32–4, 156, 484
current portion of long-term debt, 33
current ratio, 117, 120, 141
CVP, see cost–volume–profit (CVP)
analysis
daily operations, 160
days in accounts receivable ratio, 116,
120–1, 141, 177
days cash on hand ratio, 121–2, 141
debenture, 281
debt
fixed interest rate, 209, 279
long-term, 33, 52
variable interest rate, 279
see also bad debt
debt financing, 276, 277–83, 294
bond issuance, 280–90
compared with stock, 277
loans, 279–80
and return on net assets, 127
sources
by maturity, 277–9
by type of interest rate, 279
tax exempt, 276
types of health care, 279–83, 295
debt service coverage ratio, 135–6,
141, 284, 285
decentralization, 394–7, 412, 485
advantages, 394–6, 412
disadvantages, 395, 396–7, 412
decentralized collection centers, 169
decremental approach, see incremental/
decremental approach
deductibles, 12, 458, 459, 485
defensive medicine, 8–9, 485
deferred revenues, 34
delivery systems, vertically and
horizontally integrated, 463
Department of Health and Human
Services (DHHS), 180
depreciation, 31, 43–4, 485
see also accumulated depreciation;
straight-line depreciation
Diagnosis Related Groups (DRGs),
11, 13, 451, 477, 485
direct costs, 314, 428, 485
disbursement float, 170, 182, 485
disbursement policies, 165–70
disclosure requirements, 284
discount rate, 197, 485
determining, 259
see also cost of capital
discounted cash flows, 234, 485
discounting, 198, 485
discounts, 12, 301, 458, 485
for credit, 162–5
taking versus not taking, 163–5
terms, 162
dividends, 230, 485
donations, 84, 277
doubtful accounts, allowance for, see
allowance for uncollectibles
DRGs (Diagnosis Related Groups),
11, 13, 451, 477, 485
effective interest rate, 161, 485
formula, 161, 182, 183
efficiency issues, 476
efficiency ratios, see activity ratios
electronic billing, 168
employers, effects of payment systems
on, 445
equipment
acquisition of, 46, 52
distinguished from supplies, 29
lease financing, 290–4
lease versus purchase decision, 291–4
pooled financing, 280
properties and, net, 31
equity financing, 276–7, 294
sources, 276, 295
equity to total assets ratio, 134, 141
estimated third-party payor
settlements, 33
ethical dilemmas, 17
Excel
computing periodic loan payments,
206, 209
to calculate future or present value,
200, 201, 202, 204, 205–9
to calculate internal rate of return
(IRR), 240–1
to calculate net present value
(NPV), 238–9
excluded costs, in NPV analysis,
256–7
expanding-or-reducing a service,
331–3
expansion capital investment decision,
227, 485
expenditure
annual US health care, 3
as percentage of GNP (1940–2000),
454
expense budget, 361, 374–8, 485
administrative and general expense
budget, 384
labor budget, 374
supplies budget, 378–84
expense cost variance, 410–11, 414,
485
expense variances, 407–11, 413
expense volume variance, 409–10, 413,
414, 485
experience rating, 461, 485
extraordinary items, 47
factoring, 178, 486
feasibility study, 284–5, 486
Federal Housing Administration
(FHA), program loans, mortgage
insurance, 280
fee-for-service, 447, 454, 464, 486
FHA, see Federal Housing
Administration (FHA)
financial accounting systems, and cost
accounting systems, 15
financial evaluation, 285
financial lease, see capital lease
financial leverage, 112, 486
financial objectives, 229–30
financial performance measures, see
performance measures
financial requirements, 477, 486
financial returns on capital
investments, 229–30
financial statements, 20–74
analysis, 103–54
balance sheet, 23–37, 54, 90
developing the, 90–4
horizontal analysis, 108–9
and hospital size, 112–13, 116
not-for-profit compared with
for-profit hospitals, 64–74
overview, 21–3
pro forma, 367, 388
ratio analysis, 112–37
relationship with budgets, 367
Index 503
financial statements (contd)
statement of cash flows, 49–54,
93–4
statement of changes in net assets,
47–9, 93
statement of operations, 37–47, 90–3
trend analysis, 109–10
vertical (common-size) analysis,
110–12
see also Notes to Financial
Statements
financial techniques, analytic methods,
231–43
financing mix, 158–60, 181, 486
first party, 448, 486
fixed assets turnover ratio, 130–1, 141
fixed cost line, 320
fixed cost per unit, 309, 311
fixed costs, 310–11, 333, 486
attributes, 308–11
and changes in volume, 312
expense variance and, 407–9
relevant range, 310
role in breakeven analysis, 308–11
see also avoidable fixed cost;
non-avoidable fixed costs; step
fixed costs
fixed income security, 300, 486
fixed interest rate debt, 279
fixed labor budget, 374, 377, 486
fixed supplies budget, 378, 381, 383
flat fee, 4, 361, 451, 452–4, 472, 486
flexible budget, 357, 387, 405–6, 409,
486
float, 164, 165, 182, 486
the concept of, 165–70
types of, 165
for-profit organizations, 21
basic accounting equation, 55
financial statements for, 37, 64–74
replacement decisions, 265, 268–9,
270, 272
return on assets, 126
return on equity, 126
sources of equity financing, 276,
295
tax implications in a capital
budgeting decision, 261–2
see also shareholders’ equity
fraud, 179–81
fully allocated cost, 423–4, 486
fund accounting, 26
fund balance, 26, 34, 486
see also net assets
fundamental accounting equation, see
basic accounting equation
future, ability to attract funds in the,
230
future value of an annuity, 200–3, 486
Future Value of an Annuity Table,
201, 210, 220–1, 486
future value factor of an annuity
(FVFA), 201, 486
future value factor (FVF), 196, 210,
486
future value (FV), 192–7, 209, 486
calculating in special situations,
205–9
comparison with present value, 193
and compound interest method, 195
defined, 194
equation, 196, 211
formulas to calculate, 194–6, 205,
211
relationship with present value, 199
spreadsheet to calculate, 197
tables to compute, 196–7
Future Value Table, 196–7, 209,
217–19, 486
FV, see future value
FVFA, see future value factor of an
annuity
GAAP, see generally accepted
accounting principles
gains, 39, 84
realized and unrealized, 45–6
gatekeepers, 11, 458, 487
general accounting equation, 55
generally accepted accounting
principles (GAAP), 78, 80
global payments, 14, 487
goal congruence, 396, 412
goodwill, 237, 487
government agencies, 21, 33
government regulation, 8, 466–7
gross charges, 371, 487
Group Model HMO, 457, 487
HCFA, see Health Care Financing
Administration
Health Care Financing Administration
(HCFA), 179, 454, 487
health care informatics, see information
technology
Health Insurance Portability and
Accountability Act (HIPAA)
(1996), 8, 179–81, 466–7, 487
Health Maintenance Organization
(HMO), 399, 448, 455, 457, 487
HMO Act (1972), 449–50
see also Staff Model HMO
hedging, 279, 487
Hill–Burton Act (1946), 448
HIPAA, see Health Insurance
Portability and Accountability
Act (1996)
historical/market/payor payment
system, 478
HMO, see Health Maintenance
Organization
horizontal analysis, 108–9, 138, 487
formula, 108
hospitals
evolution of system, 448
flat fees for, 452
size and financial statements,
112–13, 116, 139
hurdle rate, see cost of capital; discount
rate; required rate of return
IDSs (integrated delivery systems),
463
included costs, in NPV analysis, 256–7
income statement, 37, 38
consolidated, 67
see also statement of operations
incremental approach, replacement
decisions, 270, 271, 272
incremental cash flows, 257–8, 487
incremental costs, 320, 321, 487
incremental/decremental approach,
242–3, 351–2, 353, 387, 487
indemnity insurance, 447, 448, 449,
487
indenture, 280
indirect costs, 314–16, 428, 487
inflation, 192
information management, 395, 466–7
information technology, 151–6,
470–1
infrastructure, 398, 450
insurance companies, 33, 286
intake process, 436
integrated delivery systems (IDSs),
463
interest, 33, 44, 52, 230, 487
the concept of, 192
methods to calculate, 192–4
interest expense
adjustment for, 261–2
recording, 84, 237
504 Index
interest rate
fixed, 279
if not annual, 205–6
for a loan with fixed loan payments,
209
variable, 279
internal claims processing, 166–8, 180
internal rate of return (IRR), 240, 247,
487
capital investments, 239–41
defined, 239–40
internal rate of return method, 487
decision rules, 241
equal cash flows, 240
strengths and weaknesses, 241, 242
unequal cash flows, 240–1
Internet, 469–70
inventory, see supplies
investment
decision, 226–73
evaluation of profit and return, 400
long-term, 31
restricted, 31
return on, 478
short-term, 28, 170–3, 182
see also capital investments
investment bankers
and debt service coverage ratio, 135
see also underwriter
investment centers, 400, 413
investment grade bonds, rating, 286
investor-owned organizations, see
for-profit organizations
joint costs, see common costs
journal, 77
junk bonds, 286
just-in-time (JIT) inventory methods,
412
Kaiser Health Plan, 448
labor budget, 374, 376–8, 488
laboratory costs, 423
laws and regulations for billing
compliance, 179–81
lease financing, 290–4, 295
capital leases, 290–1, 295, 482
operating leases, 290–1, 295, 489
reasons for, 290
versus purchase decision, 291–4
ledger, 77
lessee, 290, 488
lessor, 290, 488
letter of credit, 286, 287, 488
liabilities, 26, 32–4, 54, 90, 488
liability accounts, 82
life expectancy, average, 6
line-item budget, 355, 357, 387, 488
lines of credit, 160, 161, 178, 181
normal, 161
revolving, 161
liquidity, 26, 158, 488
liquidity ratios, 112, 140
acid test ratio, 119–20
average payment period, 122–3
current ratio, 117
days in accounts receivable, 120–1
days cash on hand, 121–2
formulas, 141
quick ratio, 117–19
litigation, 8–9
loan amortization, see amortization
loan covenant, 280
loan payments, calculation of periodic
(PMT function) with Excel, 206
loans, see debt
lockbox, 169, 488
long-term, see also non-current
long-term debt to equity ratio, 133,
141
long-term debt to net assets ratio,
133–4, 141
long-term financing, 278, 295
bonds, 278
term loans, 278, 279, 295, 493
long-term investments, 31
losses, changes in net unrealized, 45–6
mail float, 168
make-or-buy decisions, 328–30
managed care, 450, 455, 488
overview, 455–7
payment methods, 457–60
and risk sharing, 455–66
managed care organizations, 399
premium rate-setting methods,
461–3
management
evaluation, 285
manipulation of revenues and
expenses, 78–9
management information systems, 166
margin approaches to setting charges,
479–80
market value, 45, 285, 300, 301–2, 488
Medicaid, 4, 33, 449–50, 488
eligibility criteria, 9
factoring illegal, 178
Medical Group Management
Association, 369
medical records, 436
coding, 167
compliance issues, 166
computerization of, 15–16, 469–70
security and confidentiality, 180
medical savings accounts, 466, 488
Medicare, 4, 33, 449–50, 488
payment system, 11, 168, 179
rise in outpatient expenses, 452–3
Medicare Cost Report, 449
members, 458, 488
mergers and acquisitions, 16–17
mission statement, 346, 488
money, time value of, see time value of
money
money market mutual funds, 172–3
Moody’s, 285–6
mortgage bonds, 282
mortgages, 280
mortgages payable, 34
multi-year budget, 356, 387, 488
mutual funds, 172–3
name of the organization, 23–4
names, patients’, 166
negative pledge, 282
negotiable certificates of deposit
(CDs), 172
net assets, 26, 34–6, 54, 90, 488
permanently restricted, 35, 49
temporarily restricted, 35, 42–3,
48–9
unrestricted, 35, 46, 47, 48
see also statement of changes in net
assets
net assets to total assets ratio, 134, 141
net charges, 371, 488
net days in accounts receivable, 116
net income, 45, 314–16, 488
net patient service revenues, 39–41,
42, 72, 371–3
net present value method, 234–9, 489
strengths and weakness, 239, 243–7
net present value (NPV), 234, 237, 489
decision rules, 238
example of analysis, 235–7
technical concerns, 256–9
using analysis for a replacement
decision, 241–3
using spreadsheets to calculate,
238–9
Index 505
net proceeds from a bond issuance,
289, 489
net unrealized gains and losses on
other than trading securities,
change in, 45–6
net working capital, 156, 259–61
non-avoidable fixed costs, 326, 489
non-current, see also long-term
non-current assets, 29–32, 489
non-current liabilities, 34, 489
non-financial benefits, 229
non-financial criteria, in special
decisions, 306
non-negotiable certificates of deposit
(CDs), 172
non-operating income, 42
non-operating revenue ratio, 125–6,
141
non-patient revenues, 373–4, 375
non-regular cash flows, 258, 259, 489
normal line of credit, 161
not-for-profit organizations, 21–2
basic accounting equation, 55
bond issuance process, 284–9
bond rating, 287
business-oriented, 21
debt financing, 279–83, 295
financial statements for, 37, 64–74
net assets, 34
non-business-oriented, 21
replacement decisions, 265–7, 270,
271
return on net assets, 126–8
return on total assets, 126
sources of equity financing, 276, 295
Notes to Financial Statements, 37,
70–4, 489
NPV, see net present value
objectives of capital investment,
229–30
Official Statement (OS), 284, 289
operating budget, 361–5, 387, 489
budget variances and, 411–12
creating, 371–84
operating cash flows, 257–8, 489
operating costs, 477
operating expenses, 92–3
operating income, 42, 44, 93, 489
operating lease, 291, 295, 489
operating margin ratio, 124–5, 141
opportunity cost, 192, 256, 489
opportunity cost of capital, see
discount rate
ordinary annuity, 201, 210, 489
future value, 201–2, 211
present value, 203–4, 211
organizational approaches to
budgeting, 348–59, 387
authoritarian approach, 349, 387,
482
budget detail, 355–7
budget models, 351–5
budget modifications, 357–9
incremental/decremental, 351–3,
387, 487
participation, 349–51, 352, 387, 489
zero-based, 352, 354–5, 387, 494
OS, see Official Statement (OS)
outliers, 13, 14, 460
outpatient care, flat fees for, 452–4
outpatient services
categories of, 453
shift to, 14–15
outstanding bond issue, 287–8, 489
overhead costs, 436
owners’ (shareholders’) equity, 26, 34,
36, 93, 489, 492
par value, 281, 300, 489
participating provider, 457, 458, 489
participatory approach, 349, 352, 387,
489
patient accounts receivable, 27
net of estimated uncollectibles, 28,
29, 44
patients, effects of payment systems
on, 445
Patients’ Bill of Rights, debate on,
467–8
patients’ rights, 8–9, 467–8
payback method, 232–4, 243, 489
equation, 233, 248
payment systems, 4–5, 444–80
(1865–1983), 448–50
(1929–1965), 446–8
(1984 to the present), 450–66
effects on stakeholders, 445
evolution of, 5, 447, 466–72
flat fee, 4
historical/market/payor method,
478
history of, 446–66
inpatient, 4
managed care, 457–60
margin approaches, 479–80
mixed, 4
outpatient, 4, 452–4
prospective, 11, 13, 491
unit-based, 477
weighted-average method, 478–9
see also APCs; capitation; chargebased
payment; cost-based
payment systems; DRGs; global
payments
payors, 445, 490
effects of payment systems on, 445,
473
efforts to control costs, 10–14
multiple, in product margin
decision, 328, 329
types in statistics budget, 360–1
PCP, see Primary Care Provider
PDAs (personal digital assistants),
469–70
penalties, on HMO patients seeking
care outside, 12
per diem, 12, 458–9, 490
per member per month (PMPM), 13,
34, 168, 322, 461, 490
per member per year (PMPY), 461
percentage of managed care premium,
463
performance budget, 356, 387, 490
performance measures
budget variances, 402–12
financial and non-financial, 402
ratios, 412
responsibility centers, 402
perpetuity (annuity), 208, 490
formula, 208, 211
personal digital assistants (PDAs),
469–70
PHOs, see physician-hospital
organizations, 463
physician organizations (POs), 463
physician-hospital organizations
(PHOs), 463
see also super PHOs
physicians
evaluation, 285
flat fees for, 452
planning, 346–7, 490, 493
planning/control cycle, budgeting,
346–8, 386–7
plant and equipment
acquisitions, 46, 52
age of plant ratio, 131
PMPM, see per member per month
PMPY, see per member per year
point of care, 12
point of service (POS), 455, 457, 490
506 Index
pooled equipment financing, 280
POs, see physician organizations
POS, see point of service
PPO, see Preferred Provider
Organization
PPS, see prospective payment system
preadmissions screening, 11, 166, 167
precautionary purposes, 160
predetermined rates, 451, 490
Preferred Provider Organization
(PPO), 399, 455, 457, 490
premium, 301–2, 447, 448, 490
percentage of managed care, 463
rate-setting methods, 461–3
premium revenues, 41
prepaid assets, see prepaid expenses
prepaid expenses, as current assets,
28–9
prescription drug costs, 7
present value of an annuity, 203–4,
208, 490
Present Value of an Annuity Table,
203–4, 210, 224–5, 490
present value factor, 198, 199, 210, 490
present value factor of an annuity
(PVFA), 203–4, 490
present value (PV), 192, 197–200, 209,
237, 490
calculating in special situations,
205–9
comparison with future value, 193
defined, 197
discounting to find, 198
equation, 198, 211
formulas to calculate, 198–9, 211
relationship with future value, 199
tables to compute, 199
Present Value Table, 199, 210, 222–3,
490
price setter, 5, 448, 490
prices, 316
breakeven approach to determine,
307–8
Primary Care Provider (PCP), 458,
490
principal, 192
private sector, cost-shifting to, 5
pro forma financial statements and
ratios, 367, 388
processing float, 168
product margin, 325–8, 334, 335, 491
multiple payors, 328, 329
multiple services, 326–8
for special decisions, 328–33
product margin decision rule, 327,
328, 334, 490
profit, see net income
profit centers, 398–400, 413, 491
administrative, 399–400
capitated, 399
traditional, 398–9
profitability ratios, 112, 123–9, 130,
140
formulas, 141
non-operating revenue ratio, 125–6
operating margin, 124–5
return on total assets, 126
program budget, 355, 358, 359, 387,
491
promissory notes, see also bond;
commercial paper
properties and equipment
net, 31
net assets released for purchase of,
46
purchase of, 46, 52
prospective payment system (PPS), 11,
13, 451, 454, 491
provider sponsored networks (PSNs),
11, 463
providers, effects of payment systems
on, 445
PSNs (provider sponsored networks),
11, 463
PV, see present value
PVFA, see present value factor of an
annuity
quality, 468–9
balancing with cost and access,
445–6, 466–72
decentralization and, 395
quantity, see activity
quick ratio, 117–19, 120, 141
ratio, 112, 491
ratio analysis, 112–37, 140
pro forma financial statements, 367,
388
ratios
categories, 112–37
examples, 142–54
as financial performance indicators,
412
using and interpreting, 113–16
RBRVS (Resource Based Relative
Value System), 11, 452, 491
realized gains/losses, 45–6
reasonableness of cost, 476
recording financial transactions, 76,
80–9
process, 84–9
rules for, 82–4
red herring, 289, 491
reengineering/redesign, 17
regular cash flows, see operating cash
flows
regulations
for billing compliance, 179–81
for bond issuance, 288
regulators, effects of payment systems
on, 445
reimbursement, see payment systems
relative value units (RVUs), 369, 452,
491
relevant range, 310, 491
remote disbursement, 170
replacement decision, 227, 229, 242,
491
comparative approach, 243, 244–5,
265–9, 273
example, 242–3, 244–6
capital budget, 262–73
incremental approach, 242, 243,
246, 270–3
using a net present value (NPV)
analysis, 241–3, 273
required cash balance, 175
required market rate, 300, 491
required profit, 314–16
required rate of return, 241, 491
see also cost of capital
residual value, see salvage value
Resource Based Relative Value System
(RBRVS), 11, 452, 479, 491
responsibility, 401, 413, 491
responsibility accounting, 393–417
responsibility centers, 397, 412, 491
cost allocation, 419–20
measuring performance of, 400–2,
404
types, 397–400, 412–13
restricted net assets, 35, 42–3, 48–9
retained earnings, 230, 491
retrospective payment, 11, 450, 491
retrospective review, 11
return on assets, 126
return on equity, 126–8, 141
return on investment, 478
return on net assets ratio, 126–8, 141
return on total assets ratio, 126, 141
revenue attainment, 411, 491
Index 507
revenue budget, 361, 371–4, 491
net patient revenues, 371–3
non-patient revenues, 373–4
revenue enhancement, 412, 492
revenue rate variance, 406–7, 413, 414,
492
revenue variances, 403–7, 413
revenue volume variance, 406–7, 413,
414, 492
revenues, 39–42, 84
under accrual accounting, 84
revolving line of credit, 161
risk pools, 13, 14, 492
risk sharing, and managed care,
455–66
rolling budget, 356, 357, 387, 492
RUGs (skilled nursing home care), 11
RVUs, see relative value units
salaries, 33
sale/leaseback arrangement, 291, 292,
492
salvage value, 237, 258, 294, 492
scrap value, see salvage value
second party, 448, 492
secondary market, 282
securities, 31
Securities and Exchange Commission
(SEC), registration with, 284
serial bonds, 281
service centers, 397–8, 412–13, 492
service mix, 476
services
adding-or-dropping, 330–1, 332
bundling of, 14
expanding or reducing, 331–3
of integrated health care system,
464
multiple, and product margin
decision, 326–8, 334
shareholders’ (owners’) equity, 26, 34,
36, 93, 489, 492
short-term financing, 278, 295
sources of, 160–70
short-term investments, 28, 170–3,
182
characteristics, 171
instruments, 170–3
short-term plans, 347, 492
short-term thinking, 412
simple interest method, 192–4, 195,
209, 492
sinking fund, 278, 279, 282, 492
special decisions, 306
add/drop, 328, 330–1, 332
applying product margin paradigm,
328–33
expand/reduce, 328, 331–3
financial and non-financial criteria,
306
make/buy, 328–30
using cost information for, 305–44
speculative bonds, 286
speculative purposes, 160
spillover cash flows, 258
staff mix, 476
Staff Model HMO, 449, 457, 492
stakeholders, effects of payment
systems on, 445
Standard & Poor’s (S&P), 285–6
standards for comparison, 115–16
standards for data protection, 180
statement of cash flows, 49–54, 55,
93–4
cash and cash equivalents at the end
of the year, 52–4
consolidated, 69
from financing activities, 52
from investing activities, 52
for not-for-profit hospital, 51, 66
from operating activities, 50, 53
statement of changes in net assets,
47–9, 55, 65–6, 93
statement of operations, 37–47, 54,
90–3
below the line items, 45–7
excess of revenues, gains and other
support over expenses, 38, 41, 45,
93
expenses, 43–4, 92–3
increase in unrestricted net assets,
38, 46–7, 93
for not-for-profit hospital, 40, 65
operating income, 38, 44, 93
other income, 38, 44
see also income statement
static budget, 357, 387, 492
statistics budget, 360–1, 362, 387, 492
creating, 367–70
steerage, 12, 457–8
step fixed costs, 310–11, 492
step-down method, 419–24, 437, 492
stock financing, compared with debt
financing, 277
stock markets, 277
stockholders’ equity, see shareholders’
(owners’) equity
stop loss, 460, 493
straight-line depreciation, 242, 493
strategic decision, 227, 493
strategic planning, 346–7, 387, 493
subcapitation, 323, 464, 493
subordinated debenture, 281
substandard bonds, 286
sunk costs, 256, 493
super PHOs, 463
supplies
as assets, 28–9
distinguished from equipment, 29
just-in-time (JIT) methods, 412
supplies budget, 378–84
sweep accounts, 170
syndication, 289
talent, decentralization and
development of, 396, 397
target costing, 316, 493
tax
bonds and, 282–3
implications for for-profit
organizations in a capital
budgeting decision, 261–2
Tax Reform Act (1986), 277
tax shield, 292, 493
tax-exempt bonds, 282
tax-exempt revenue bonds, 282
taxable bonds, 282–3
technology
cost-effectiveness of, 469–70
rising costs of, 5, 450
telemedicine, 15
temporary cash, sources, 160–70, 181
term loan, 278, 279, 295, 493
amortization of, 303–4
terminal value, see salvage value
third party, 448, 449, 493
third party payors, 33, 166, 175, 493
time value of money, 191–225, 493
annuities, 200–5
defined, 192
future value, 192–7
present value, 197–200
special situations, 205–9
times interest earned ratio, 134–5, 141
top-down budgeting, see authoritarian
approach
top-down/bottom-up approach, see
participatory approach
total asset turnover ratio, 129–30, 141
total contribution margin, 321, 322,
335
total cost line, 320
508 Index
Index 509
total revenue
equation, 308
formula when price and quantity are
known, 307
total revenue line, 316–20
total variable cost, 312
trade credit, 162–5, 181
trade payables, 162–5, 170
traditional profit centers, 399, 493
transaction notes, 160, 161, 162, 181
transfer prices, 399
transfers to parent, 47, 52, 94, 122
transit float, 169–70, 182
Treasury bills (T-bills), 171, 172
trend analysis, 109–10, 138, 493
formula, 109–10
trustee, 290, 493
role in bond issuance process, 288,
289–90
UCR, see usual/customary and/or
reasonable (UCR) charges
unbundling, 179
uncollectibles expense, see bad debt
expense
underwriter, 283
role in bond issuance process,
288–90
uninsured, the, 9–10
unrealized gains/losses, 45–6
unrestricted net assets, 35, 46, 47, 48,
132
unsecured loans, 160–2
usual/customary, and/or reasonable
(UCR) charges, 476
utilities, allocating, 420–2
variable cost per unit, 309, 312
variable costs, 311, 333, 493
and activity, formula, 312
and changes in volume, 312
characteristics, 311–12
role in breakeven analysis,
311–14
variable interest rate debt, 279
variable labor budget, 374, 379–80
variable supplies budget, 381, 383
formula, 381, 388
vertical analysis, 110–12, 138, 493
formula, 110
visits
categories and relative resource
consumption, 369–70
converting projections to weighted
visits, 369, 370
developing projections of number,
367–9
percentage distribution by payor,
369–70
volume, see activity
wages payable, 33
web links
by source, 495–7
by type of information, 497–9
weighted visits, see relative value units
(RVUs)
weighted-average method of charge
setting, 478–9
wire transfers, 169–70
working capital, defined, 156, 181
working capital management, 155–90
accounts receivable management,
175–8
aggressive approach, 158, 160, 181
cash management, 160–75
conservative approach, 158, 160,
181
working capital cycle, 156–60, 181
working capital strategy, 156, 157–60,
493
yield to maturity, 300–1, 494
ZBB, see zero-based budgeting
zero coupon bonds, 281
zero-balance accounts, 170
zero-based budget (capitation), 465,
494
zero-based budgeting (ZBB), 352,
354–5, 356, 387, 494
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