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Operating Budgets

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Variance Analysis

With a good foundation of costs, we can use this information to perform variance analysis and utilize the budget as a tool to improve operating performance. There are three main components to variance analysis: the revenue variance, the cost variance, and the profit variance.

Revenue Variance

Let's begin with the revenue variance. The revenue variance is equal to actual revenues minus static or budgeted revenues. This variance consists of a volume component as well as a price component. The volume component (variance) equals the flexible revenue (revenue adjusted) for volume changes minus static or budgeted revenues. The price component (variance) equals the actual revenue minus flexible revenue. Subtracting the common factor in each (flexible revenue) will yield the revenue variance or actual revenues minus static or budgeted revenue.

 

 

Alternate Version of Variance Equations Diagram

Cost Variance

The cost variations also have two components: the volume variance and the management variance. The volume variance equals the static or budgeted costs minus the flexible costs, which are costs adjusted for volume changes. The management variance equals those flexible costs minus the actual costs. Subtracting the common factor (flexible costs) in each will yield the cost variance--which is static costs minus actual cost. The management variance may represent the most important variance, as management has the most ability to control this variance. Since volume is not a factor, the difference between flexible costs and actual costs represents the impact that management is having on cost behavior. For example, a positive management variance related to salaries indicates that holding volume is constant, and salaries are less than amount budgeted, which would indicate an improvement in productivity. Likewise, a positive management variance related to the supplies expense would indicate that cost savings have been achieved in the purchase of supplies. This supply expense reduction could be due to a renegotiation of payment rates or a more efficient use of supplies in the provision of the healthcare service or product. On the other hand, a negative management variance would indicate reduced productivity of staff resulting in increased salary expense. Decreased efficiency in the utilization of supplies or price increases would result in a negative management variance related to supply expense. Therefore, the management variance for each service line or department should be monitored closely to determine the impact that management is having (positive or negative) on cost behavior. The management variance then serves as a good measure of accountability for managers’ performance. It also represents an opportunity for improvement for the organization and may indicate changes that need to be made in operations in order to improve efficiency and better manage costs.

 

 

Alternate Version of Cost Variance Diagram

Profit Variance

A combination of revenue variance and the cost variance will yield a profit variance. Specifically, profit variance will equal the difference between the revenue variance (actual revenue minus static revenue as seen above) minus the cost variance (static costs minus actual costs as seen above) or, put another way, will equal actual profits minus static or budgeted profits. Therefore, the components of the revenue and cost variances are critical to determining what has contributed to changes in profit variances and profitability overall.

 

 

Alternate Version of Profit Variance Diagram

The healthcare organization can then analyze the changes in these components and determine what needs to be done to improve operations and profitability going forward. It is fair to say that healthcare organizations that closely monitor these variances and make appropriate changes in processes or operations in order to improve revenue or cost variances will likely yield positive operating results and uncover new opportunities to improve operational performance. These improvements may generate increased revenue or may improve cost efficiencies or hopefully both. The calculation and monitoring of these variances for each service or product line within a healthcare organization, as well as the implementation of operational changes, represents a strong internal consulting tool available to all managers and senior managers of a healthcare organization that can lead to both operational and financial improvements and overall success.

Variance Analysis Self Check

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Variance Analysis Self Check

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Sample Problem 8.2

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The sample problem provides an example of how to calculate the revenue, volume, and price variances for a hypothetical organization. This example will assist in the completion of the Chapter 8 problems assigned for this week.

 

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Lesson Two Learning Materials

 

Textbook Reading

 

Read the following in your Gapenski text:

1. Chapter 14: The Basics of Capital Budgeting

Due to the significant financial investment involved in the capital budgeting process, an accurate and thorough financial analysis is important to ensure resources are spent on the best projects available. Often, the management and staff involved in the area(s) impacted by the budget offer significant insight and information that is invaluable in ensuring the success of the selected projects.

Capital Budget Process

There are two steps in the capital budget process:

1. Select project(s)
2. Determine project financing

Opportunity Costs

 

 

An important concept of capital budgeting is known as opportunity cost. This represents the idea that the organization has multiple options for use of its financial resources at any point in time. It can invest these resources in one or more projects selected by the organization or it can choose to not pursue projects and maintain the funds in an investment portfolio for future opportunities. The "opportunity cost” is then the cost of the next best alternative(s) for the financial resources other than the option selected. For example, let's say an organization has the opportunity to invest in a project that will expand the capacity of its emergency room by adding more space and beds. The goal is to increase the volume in the emergency room which will lead to increased ER visits and perhaps increased ancillary services (laboratory, radiology, etc.) On the other hand, the organization could choose not to pursue the opportunity and save the resources for another project in the future. This assumes that the organization has a choice and is not required to, or does not feel compelled to, pursue the ER expansion as a result of the needs of the community. In this scenario, a financial analysis is required to determine if the project should be pursued or not based on the opportunity costs of the next best alternative—in this case, keeping the funds invested in the organization's investment portfolio.

Alternate Version of Opportunity Cost Diagram

Risk Analysis and Capital Budgeting

Due to the presence of opportunity costs, every capital budget proposal—whether it be a purchase of equipment, addition of a new service, or expansion of an existing service—carries with it certain risk. There is risk that the project itself will not meet the expectations set for it by management and will fail. There is also the risk that the project will negatively impact other aspects of an organization's operations in ways that were not intended.

Either way, the risk that the project will not produce the intended results heightens the opportunity risk inherent in the project itself. It is for this reason that the organization will need to spend as much time as necessary prior to the project implementation ensuring that as many possible outcomes (negative and positive) are considered and also try to build in various scenarios to illustrate the potential risk of the project. These scenarios can be weighted with probabilities, if necessary, to try to determine the likelihood of the various outcomes (sensitivity analysis). Three scenarios that plot most likely, worst case, and best-case scenario may be sufficient to identify the potential risks involved in the project and prepare senior management and the board of directors for possible variances from the anticipated outcome. This type of scenario analysis may help in the overall decision-making process, especially if more than one project is being considered. It may also prove useful at a later date after a project is selected. This type of analysis and supporting documentation will hopefully justify why the decision was made to pursue the particular project based on the information known at that time.

The table below shows a hypothetical scenario analysis.

	Most likely scenario	Probability	Worst case scenario	Probability	Best-case scenario	Probability
Option A	1 million	50%	($500,000)	30%	$2 million	20%
Option B	$750,000	33%	($1 million)	33%	$1.5 million	33%

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Pro Forma Analysis

 

 

In order to begin performing a financial analysis of a potential capital budget, a pro forma or "as if" statement of operations for the project is required. In essence, this entails creating an estimated operating budget for the project based on certain financial assumptions. In the case of the ER example, the gross and net revenue increase would need to be projected for the additional beds placed into service. This gross revenue would be estimated based upon the increase in volume (in this case, ER visits) multiplied by the average price charged for the visits. The gross revenue estimate would then be adjusted for contractual adjustments, bad debt, and charity (all estimated) to arrive at incremental estimated net revenue generated by the ER expansion (normally on an annual basis). The project term or lifespan will also need to be estimated. For equipment, the term is normally the estimated useful life of the equipment. In the case of a project like the ER, it would be the term set by management based on the best estimate, or, if another project exists, the term of that project for comparative purposes. For this example, let's assume it is five years. The net revenue will then need to be estimated for a five-year period.

In addition to revenues, the ongoing operating expenses related to the project must be estimated for the term of the project. These would include additional salaries, supplies, purchased services, and other cash costs associated with the operation of the expanded services. These expenses would be estimated on an annual basis to match the net revenue generated. The result is the creation of an estimated annual operating statement for each year of the project with a resulting income or loss for each period. The final step is to calculate the total initial or upfront expenses required for the project: In this case, all the costs necessary to build and equip the newly expanded emergency room beds and capacity.

Alternate Version of Pro Forma Analysis Diagram

Capital Project Assessment Methods

After the net revenues, expenses, and initial investment have been calculated, the information can be assessed to determine if the capital project should be pursued using three methodologies:

• Payback Period
• Internal Rate of Return (IRR)
• Net Present Value (NPV)

All three require an accumulation of all future revenues and costs that were previously forecasted.

Payback Period and IRR

These two methodologies are fairly simple to use and give a general idea as to whether the particular capital project merits consideration. Payback assesses the projects utilizing future dollar amounts rather than the discounted value of future dollar amounts like the IRR and NPV methods.

The payback method takes the initial investment amount of the project and divides it by the AVERAGE net profit (net revenues – expenses) or average operating income of the project.

Payback Period = Initial Cost / Average Annual Profit

If the project cost $1 million upfront, and generated an AVERAGE operating income of $100,000 (undiscounted), the payback period would be 10 years. In other words, it would take the organization 10 years to recover its initial investment before an overall net profit could then be realized.

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The IRR is a discounted cash flow calculation that compares the present value of a project’s projected cash inflows to the present value of a project’s projected cash outflows and measures project profitability in the form of a percentage (Gapenski, p. 512). The MIRR, or Modified Internal Rate of Return, represents an enhanced version of the IRR, which calculates the discount rate that forces the present value of the inflow terminal value to equal the present value of costs (Gapenski, p. 514).

Net Present Value

 

 

The Net Present Value (NPV) method utilizes the same input information as the two methods discussed previously; however, there is one important difference. Rather than calculating a project’s profitability in the form of a percentage like IRR, the NPV method measures profitability in the form of dollars and is normally the preferred method of assessment for a capital project.

In our previous example, the $100,000 net operating amount each year is discounted back to today's dollar using an interest rate compounded by the number of periods (years) away from today. Thus, the $100,000 generated five years from now is discounted back by an interest rate, compounded for five years. This interest rate or "hurdle rate" represents the rate of the next best alternative (in this case, that is the estimated interest rate expected to be earned by investing the money in the organization's investment portfolio). After each year's net operating income is discounted back to today's dollar, the sum of each of all these amounts is compared to the initial investment and the following occurs:

Sum of each year's operating income – initial investment = NPV

The following decisions on the project are then:

• If NPV > 0, the project should be undertaken as it exceeds the next best alternative or opportunity costs.
• If NPV < 0, the project should not be undertaken as it fails to exceed the next best alternative or opportunity costs.
• If NPV = 0, we are indifferent as to the two projects.

Based on the methodology above, any of the three methods can be undertaken. However, the NPV method is preferred as it more closely matches the initial investment amount to the discounted value of future net operating margin or cash flows.

Alternate Version of Net Present Value Diagram

Sample Problems

The sample problems provide an opportunity to walk through the various methods used to determine whether certain capital projects or which capital projects should be pursued from a financial or quantitative approach. These methods include the calculation of payback period, IRR, MIRR, and NPV. After reviewing the sample problems and reading the appropriate sections in Chapter 14, the student should have the information necessary to complete the problems assigned in this lesson.

Sample Problem 14.1

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Sample Problem 14.2

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Sample Problem 14.4

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Week 7 lesdson 2 material

 

1. Harris, J.M. & Hemnani, R. (2013). The transition to emerging revenue models. HFM Magazine. Retrieved from http://www.hfma.org/Content.aspx?id=16291
2. Redding, J. (2013). Achieving clinical integration. HFM Magazine. Retrieved from http://www.hfma.org/Content.aspx?id=20071

The readings for this lesson provide insight to the potential reimbursement changes facing health care organizations in the future. In addition, the resources and structures that will be needed by health care organizations to survive and succeed in this potential new reimbursement environment are also discussed.

Key Changes in Financing and Reimbursement of Health Care

 

 

We will spend this final week looking at some current and emerging trends in health care reimbursement as well as discuss some future potential changes in how health care is reimbursed in our country.

As before, we will begin and by discussing some significant changes that are currently underway and will likely continue into the future. You probably remember from Week Six that even though health care is reimbursed by most payors on a prospective payment system with predetermined rates, payments are made for services, assuming appropriate billing and coding is done accurately. However, outcomes are not really factored into this reimbursement. This is currently changing and will continue to change, likely significantly, in the near future. The best way to describe this change in paradigm is that payors are moving from a payor of health care services solely to more of a value purchaser of health care services for its beneficiaries. What this means in simple terms is that payors will begin to scrutinize outcomes, quality, customer service, and efficiency and begin to structure reimbursement based on these criteria rather than just the performance of services. This is currently underway through the quality indicators measured by payors for all hospitals. For example, certain quality measures have been identified by Medicare and on a quarterly basis, Medicare requests clinical data from hospitals and asks these hospitals to show evidence that the clinical criteria established by Medicare has been met in each selected case. Some of these measures include heart failure, acute MI, pneumonia, surgical infection rates, just to name a few. Currently, if hospitals submit these data on a timely basis, they will receive the full Market Basket update or increase in reimbursement each year. As an aside, historically, Medicare increases in patient reimbursement rates by a percentage each year to reflect increases in the costs of providing these services. So, as long as hospitals report these data regardless of score, this update increase is received. It is thought, though, that eventually, once enough data has been accumulated by Medicare for these clinical criteria, a benchmark will be established. Hospitals that meet or exceed the benchmark will be incentivized and those that fall below may see decreases in reimbursement in some form. Furthermore, the results of quarterly data submitted to Medicare are currently disclosed on the Internet for patients and physicians to see. Each individual hospital that reports data has its results posted on a quarterly basis. The disclosure of this information and future quality initiatives will only likely increase in future years. In addition, many other payors, including commercial and other governmental payors, are also in the process or already have transitioned to a value-based from a fee-for-service reimbursement structure.

Alternate Version of Key Changes in Medicare Diagram

Payment Reform

In the last five years or so, long discussed and awaited health care reform took its first formal steps to becoming reality. Although the changes that will occur and the impact it will have still certainly remains to be seen, there is no question that payment or reimbursement reform is already taking place and will likely accelerate in the future regardless of the other changes occurring as a result of health care reform. With quality outcomes and pay for performance as its foundation, the way providers will be reimbursed in the future is likely to change dramatically. It is clear that the current fee for service driven reimbursement mechanism is not likely sustainable and will need to be replaced with at least one and perhaps multiple new reimbursement mechanisms. We will discuss several potential mechanisms or forms that future reimbursement that may emerge as well as what will be required of health care organizations to be successful in the future reimbursement environment.

Bundled Payments

One potential future payment mechanism is the bundling of payments to providers, specifically facility and physician providers. As discussed previously, these providers are currently paid independently for the most part by payors for the services that they provide. An option for the future includes reimbursement to one provider (likely hospital or other facility) that covers both professional and facility services. The single payee would then, in turn, be responsible for reimbursing the physician provider out of the bundled payment. The idea would be that the single payment would be less going forward than the sum of the separate payments in the past. Both the physician and facility would work together to achieve efficiencies in the delivery of care that would result in collective cost savings that would more than offset (hopefully) the reduction in reimbursement. This collaboration would include a focus not only on cost savings but also improved quality outcomes. This could be supported through some form of incentive payment built into the mechanism. If achieved, the outcome could result in lower costs (and thus lower reimbursement required) and improved outcomes, or two main reasons for health care and payment reform in the first place. This method is not without its challenges, namely which entity would receive the payment and how this payment would be split equitably yet not raise any compliance issues related to incentives for physicians to refer more business in exchange for the reimbursement. In addition, any payment mechanism that reduces overall payment must be studied and monitored carefully to ensure that there is not an inappropriate reduction of care provided (underutilization).

Episodic Payments

Another potential reimbursement mechanism is the combination of payments to multiple or all providers involved in the delivery of care based on episodes of care, driven by a clinical condition. An example would be open heart surgery. One payment would be made to an entity (likely hospital) which would then be allocated to all providers involved in the entire episode of care, including physicians, rehab, hospital, etc. Similar to bundled payments, the single payment would be discounted from the current sum of all payments to encourage collaboration among all providers involved. The benefits of this collaboration seem clear, but so do some of the challenges of this mechanism, both of which are similar to that of bundled payments. These episodic payments are actually being piloted currently by CMS with certain providers and early results do seem to suggest there are improvements in outcomes along with reduced costs of delivery due in part to the collaboration amongst the parties. The question that is raised is to what scale this type of mechanism can be applied. Will it work for many episodes or be limited to certain ones in the delivery system?

Risk Sharing/Coordination

A third potential mechanism is a revised version of the risk sharing capitation model discussed earlier in the course. This mechanism involves multiple providers and requires at least some of these providers to accept risk in the form of set payments for a period of time (perhaps per member per month) in exchange for reimbursement. Since there have been and currently are challenges to making this type of reimbursement work effectively, more work will need to be done to implement such a mechanism. However, any mechanism that seeks to manage utilization (cost) and improve outcomes will certainly entertain a close review and consideration.

Accountable Care

Overall, health care organizations will be held more accountable for the health care services they provide under these various reimbursement structures that focus on value versus utilization. health care delivery structures known as Accountable Care Organizations (ACO) or Accountable Care Entities (ACE) will likely become more common as well. Many providers (Hospital and Physician) have established these entities to contract with Medicare, State Medicaid, and Commercial payors and this trend will likely continue well into the future. These ACOs and ACEs can take various forms, but essentially take responsibility for providing all health care services for a defined population in returned for reimbursement. However, these entities take on the risk that the overall cost (reimbursement) will not exceed certain cost and quality benchmarks or thresholds defined by the payor. If the entity can demonstrate that it provides an acceptable quality level of care and controls or reduces its costs, then incentive payment opportunities exist (ie earn more reimbursement). However, if costs are not managed well and they ultimately exceed the benchmarks in terms of reimbursement, these entities may be forced to repay or refund reimbursement received in the future. In some ways similar to HMOs, these entities will shift the risk from payor to provider and overall hold these entities more accountable for the care they provide.

Medical Homes

Another form of accountable care is known as the patient centered medical home.   This approach includes a team structure of providers led by a personal (likely primary care) physician who provides and oversees the coordination of all the patient’s healthcare needs. These include, but are not limited to wellness and preventative services, inpatient and outpatient acute care, chronic disease management, and end of life care coordination.  The providers (physicians and non-physicians such as pharmacists, therapists, allied health, and other providers work collaboratively to integrate and manage care appropriately and efficiently.  The focus, like ACO’s and others focuses on achieving the triple aim of improved patient experience (quality and satisfaction), improving population health, and reducing and managing costs of providing care.  The approach also seeks to improve access the appropriate services for the population served. This approach, like other models likely incorporates a value based reimbursement structure as opposed to a fee for service structure.  This value based methodology is likely utilized in the Medical Home approach as opposed to the more fragmented and less coordinated fee for service models seen more commonly in the current and past healthcare environment.  

Any of the above models or approaches, independently or some combination of these, are potential future or already are current reimbursement mechanisms. All demonstrate promise and all also pose challenges. Regardless, reimbursement will change and as it does, health care organizations and providers need to be preparing as soon as possible for these changes. There are various factors and strategies that health care providers will need to consider and focus on developing in order to cope with in the near future, including:

• Physician/facility integration.
• Cost standardization and utilization management.
• A strong IT system for gathering, reporting, and interpreting information (clinical and financial).
• Creative and adaptive strategies to manage change and produce desired results.
• Likely significant investments and capital for infrastructure and IT.
• Clinical integration among providers: employed and independent physicians, facility and hospital providers and health systems, and all other providers to ensure services meet quality standards yet are provided within appropriate cost thresholds.

Although the exact form of changes to reimbursement are unknown, it is clear that a movement away from the traditional fee for service to value based methodologies is already underway and health care providers must be ready to not only embrace these changes but plan accordingly and acquire resources not only to survive, but to succeed in this new reimbursement environment.

 

Group Assignment 6.3: Consultant Report Group Project

 

 

The Consultant Report provides an opportunity for the student (working in groups) to synthesize the topics learned in this course into a project. This project provides the group with a hypothetical organization with some financial, operational, and strategic assumptions and asks the group to prepare a report to the Organization’s Senior Management and Board of Directors with an assessment as to how the Organization is currently performing and what recommendations are important to implement in order for the Organization to succeed in the future.

This is a small group assignment (Group Assignment 6.3 Group X).

Before beginning this assignment, please listen to the podcast below, provided by Dr. Budd.

Click the link below to listen to the podcast. To download the podcast, right-click on the link, click Save Link As..., and save it to your computer.

 

Transcript of Creekside Community Case Podcast

For this assignment, you will need to refer to the following set of financial data:

• Creekside Community Hospital Data

Utilize the following information:

• Hospital Characteristics (see attached financials)
• • Competitive environment, declining market share to competitors
  • Moderate to substantial debt
  • Facility and equipment that is fairly current, but will have future investments in capital
  • Partial electronic medical record system
  • Mediocre quality and patient satisfaction scores
  • Few employed physicians/ no hospitalist program
  • Split payor mix between public and private
  • Overall not profitable from operations in most recent fiscal year
• Local Physician Practices Characteristics
• • Small primary care and specialty practices (mixture of solo and small groups)
  • Independent ownership
  • Loose affiliation with hospital
  • Combination of office and hospital practice

Both Hospital and Physician organizations have contract-only relationships with payors and suppliers and are currently not working with either in any strategic way financially.

Your group is hired as a financial consultant to prepare a financial strategy (or strategies) to the hospital as they transition from the current environment to the future environment that will be impacted by health care reform due to governmental intervention, as well as changes from within the industry itself.

Specifically, your strategy should consider more than one alternative (outcome). When formulating your response, consider addressing the following topics at a minimum (feel free to add other financial topics as well). This Consultant’s Report should include about one page for each topic:

1. Address how a strong operating and capital budget process would assist achieving future financial goals (what tools might you employ?). Explain why accurate cost allocation is important. What would be the priorities for capital budgets (in general, not specifically)? (Refer to your Week Four Learning Materials.)
2. Address how changes in patient quality and satisfaction could impact future reimbursement and operating performance. Also address ownership structures that both the hospital and physicians' organizations should consider going forward (maintain independent or consider joint venture, merger, etc) and why. (Refer to your Week Six Lesson Two and Week Seven Lesson Two readings.

 

 

)All sources, including course materials, must be cited in text in APA style. Remember that course materials need not be included in your references page, but all other references must be.