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CHAPTER 5 Pricing Decisions and Profit Analysis

Pricing

Decisions

Strategies

Profit analysis

Fee for service (FFS)

Capitation

Impact of cost structure on risk

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Introduction

Some uses of managerial accounting information in health services organizations:

Set the prices (and discounts) on services offered under charge-based reimbursement

Determine the financial impact of services offered when prices are dictated

Identify the lowest feasible price when prices are negotiated

In addition, cost and price information can be combined to conduct profit analyses.

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Price Setters Versus Takers

When a provider has market dominance, and, hence, can set its own prices (within reason), it is said to be a price setter.

In other situations, providers are price takers:

Perfectly competitive markets

Payer dominance

Government programs

However, in many situations, providers are neither pure price takers nor price setters, and room for negotiation exists.

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Price-Setting Strategies

When a provider is a price setter (or when negotiation is possible), there are several theoretical bases on which prices can be set.

The two most common are

full cost pricing, and

marginal cost pricing.

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Price-Setting Strategies (cont.)

Under full cost pricing, prices for a service are set to cover all costs:

Direct costs (fixed and variable)

Overhead (indirect) costs

Economic costs (profit)

Under marginal cost pricing, prices for a service are set to cover incremental, or marginal, costs. Generally, this means recovering only direct variable costs.

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Discussion Items

Can a provider survive if all services are priced at marginal cost?

What is cross-subsidization, or price shifting?

Should marginal cost pricing ever be used?

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Target Costing

Target costing is a management strategy used by price takers.

Under target costing,

revenues are projected, assuming prices as given in the marketplace;

required profits are subtracted from revenues; and

the remainder is the target cost level.

What is the primary benefit of target costing?

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Profit (CVP) Analysis

Profit analysis, also called cost-volume-profit (CVP) analysis, is a technique used to assess the effects of alternative volume assumptions on costs and profits.

Why is such information valuable to health services managers?

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Profit Analysis Example

Atlanta Clinic has forecasted the following cost data on the basis of 75,000 expected visits:

Fixed costs

Total variable costs 2,113,500

Total costs

$7,080,962

$4,967,462

Note that the “best guess” volume forecast defines the base case. Also, Atlanta’s relevant range is 70,000 to 80,000 visits.

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Profit Analysis Example (cont.)

What is the variable cost rate?

Variable cost rate

Total variable costs

Volume

$2,113,500

75,000

$28.18 per visit

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Profit Analysis Example (cont.)

What is Atlanta’s cost behavior model?

Total costs = Fixed costs + Total variable costs

= $4,967,462 + ($28.18 × Volume)

For example, at 70,000 visits:

Total costs

= $4,967,462 + ($28.18 × 70,000)

= $4,967,462 + $1,972,600

= $6,940,062

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Profit Analysis Example (cont.)

Cost/volume summary:

Volume = 70,000

TC = $4,967,462 + $1,972,600 = $6,940,062

Volume = 75,000 (base case)

TC = $4,967,462 + $2,113,500 = $7,080,962

Volume = 80,000

TC = $4,967,462 + $2,254,400 = $7,221,862

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Profit Analysis Example (cont.)

Now, suppose that the average revenue per visit is expected to be $100. What does the clinic’s cost and revenue structure look like graphically?

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Graph of Clinic’s Cost and Revenue Structure

Revenues and costs

($)

Volume

(number of visits)

Total costs

Fixed costs

Total revenues

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Forecasted Profit and Loss (P&L) Statement

The forecasted P&L statement uses cost structure information along with the revenue forecast and projected volume to forecast profitability.

Because it is a forecast, it can be influenced by managerial actions.

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Base Case P&L Statement

Total revenues ($100 × 75,000) $7,500,000

Total VC ($28.18 × 75,000) 2,113,500

Total CM ($71.82 × 75,000) $5,386,500

Fixed costs 4,967,462

Profit $ 419,038

VC = Variable costs

CM = Contribution margin

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Contribution Margin

The contribution margin is defined as the difference between per visit (unit) revenue and the variable cost rate.

It is the amount of each visit’s revenue that is available to

first cover fixed costs, and then

flow to profit.

In this illustration, the contribution margin is $100 − $28.18 = $71.82.

What is the total contribution margin?

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Breakeven Analysis

Breakeven analysis is performed in many different finance contexts.

Here, it is used to determine the breakeven volume, defined as the volume needed for an organization (or service or program) to be financially self-sufficient.

There are two types of breakeven:

Accounting breakeven (zero profit)

Economic breakeven (with profit)

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Breakeven Analysis (cont.)

What is the accounting breakeven for Atlanta Clinic? The easiest way to answer this question is to convert the P&L statement into an equation.

Total revenues − Total VC − Fixed costs = Profit

($100 × V) − ($28.18 × V) − $4,967,462 = $0

$71.82 × V = $4,967,462

V = $4,967,462 ÷ $71.82 = 69,165 visits

P&L Equation (Standard Format)

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Breakeven Analysis (cont.)

Note that the P&L equation can be recast in a contribution margin format.

CM × V = Fixed costs

$71.82 × V = $4,967,462

V = $4,967,462 ÷ $71.82 = 69,165 visits

P&L Equation (Contribution Margin Format)

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Marginal (Incremental) Analysis

Suppose Atlanta Clinic is approached by a new insurer.

This payer is expected to contribute 5,000 additional visits.

However, it wants a 40 percent discount, resulting in a revenue of $60 per visit.

At a volume of 80,000, the clinic’s average cost per visit is $7,221,862 ÷ 80,000 = $90.27, so Atlanta’s managers might be tempted to refuse.

However, more analysis is required.

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Base Case P&L Statement

Total revenues ($100 × 75,000) $7,500,000

Total VC ($28.18 × 75,000) 2,113,500

Total CM ($71.82 × 75,000) $5,386,500

Fixed costs 4,967,462

Profit $ 419,038

VC = Variable costs

CM = Contribution margin

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P&L Statement with Added Volume

Undiscounted revenue ($100 × 75,000) $7,500,000

Discounted revenue ($60 × 5,000) 300,000

Total revenues ($97.50 × 80,000) $7,800,000

Total VC ($28.18 × 80,000) 2,254,400

Total CM ($69.32 × 80,000) $5,545,600

Fixed costs 4,967,462

Profit $ 578,138

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Marginal (Incremental) Analysis (cont.)

The marginal cost of each visit is the variable cost rate of $28.18 per visit.

The marginal revenue on the new contract is $60 per visit, so the contribution margin is $60 − $28.18 = $31.82.

Thus, 5,000 incremental visits would add 5,000 × $31.82 = $159,100 to the bottom line: $419,038 + $159,100 = $578,138.

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How would the analysis change if the incremental volume was 10,000 visits, for a total of 85,000, which is outside the relevant range?

At this point, the numerical analysis indicates that the offer should be accepted. Considering all the factors relevant to the decision, what should Atlanta Clinic’s managers do?

Discussion Items

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Profit Analysis Under Capitation

Capitation changes the way in which profit analysis is conducted

Perhaps the best way to see the effects of capitation is by graphical analysis.

We will examine two approaches to graphical analysis:

In terms of utilization (number of visits)

In terms of membership (covered lives)

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Analysis Based on Visits

Revenues and costs

($)

Volume

(number of visits)

Total costs

Fixed costs

Total revenues

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Analysis Based on Visits (cont.)

On this graph, the P&L areas are the reverse of those on the FFS graph.

This “perverse” result occurs because the contribution margin on a per visit basis is negative.

$0 − $28.18 = −$28.18.

Each additional visit increases costs with no increase in revenues.

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Analysis Based on Members

Revenues and costs

($)

Volume

(number of members)

Total costs

Fixed costs

Total revenues

Note: Average utilization is assumed, regardless of volume.

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Analysis Based on Members (cont.)

Now, the P&L areas are the same as those on the FFS graph.

On a per member basis, the contribution margin is positive.

Each additional member contributes positively to profits.

If per member annual revenue is $400 per member and variable costs (based on 4 visits) are 4 × $28.18 = $112.72 per year, the contribution margin is $400 − $112.72 = $287.28.

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Discussion Items

What do the graphs tell managers about the importance of utilization management:

Under FFS reimbursement?

Under capitation?

What do the graphs tell about the importance of the number of members under capitation?

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The Impact of Cost Structure on Risk

If reimbursement is tied exclusively to volume (FFS), the provider’s financial risk is minimized if all costs are variable.

If reimbursement is exclusively capitated, the provider’s financial risk is minimized if all costs are fixed.

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Graphical Analysis Under FFS

Revenues and costs

($)

Volume

(number of visits)

Total costs

Total revenues

Total VCs

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Graphical Analysis Under Capitation

Revenues and costs

($)

Volume

(number of visits)

Total costs

Fixed costs

Total revenues

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What are the implications of the previous two slides for managerial decision making?

Discussion Item

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This concludes our discussion of Chapter 5 (Pricing Decisions and Profit Analysis).

Although not all concepts were discussed, you are responsible for all of the material in the text.

Do you have any questions?

Conclusion

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