health care finance assignment week 3

Part III: Tools to Analyze Financial Operations

CHAPTER 7: COST BEHAVIOR AND

BREAK-EVEN ANALYSIS

Fixed, Variable and Semivariable Costs

• Distinguishing between fixed, variable and semivariable costs is important because this knowledge is a basic working tool in financial management.

Fixed, Variable and Semivariable Costs

• Fixed Costs are those costs that do not vary in total when activity levels (or volume) of operations change.

• Examine the examples in the chapter.

• Variable Costs are those costs that vary in direct proportion when activity levels (or volume) of operations change.

• Examine the examples in the chapter.

Fixed, Variable and Semivariable Costs

• Semivariable Costs vary when the activity levels (or volume) of operations change, but not in direct proportion

• The most frequent patters of semivariable costs is the step pattern.

• Examine the examples in the chapter.

Fixed, Variable and Semivariable Costs

Analyze Mixed Costs

• The Manager needs to know how to analyze mixed costs because they occur so often.

Analyze Mixed Costs by Two Simple Methods

• The Predominant Characteristics Method — The manager judges whether the cost is more fixed or more variable.

• The Step Method — The manager examines the “steps” in the step pattern of a fixed cost and decides whether the pattern appears to be more fixed or more variable.

• Both of these methods are judgmental.

• Cost is examined at its high level and its low level.

• Obtain the difference in cost between the high and low levels; divide the amount of change in the activity (or volume).

• Examine the examples in the chapter.

Analyze Mixed Costs Through The High-Low Method

• The Scatter Graph finds the Mixed Cost’s average rate of variability more accurately.

• Use a graph to plot all points of data; cost on vertical axis, volume on horizontal axis of the graph.

• Fit a regression line to the plotted points.

• The average fixed cost is found at the point where the regression line intersects with the cost axis.

• Examine the examples in the chapter.

Analyze Mixed Costs by the Scatter Graph Method

• The Contribution Margin equals Variable Cost deducted from net revenues.

• The answer is the Contribution Margin, so called because it contributes to fixed costs and profits.

• Examine the examples in the chapter.

Understand Computation Of the Contribution Margin

Contribution Margin: Example 7B

• Examine Table 7-1, which contains Operating Room Fixed and Variable Costs.

• We can see that the total costs are $,1,217,756.

• Of this amount, $600,822 is designated as variable cost and $616,934 is designated as fixed ($529,556 + $87,378 = $616,934).

• For purposes of our example, assume the Operating Room revenue amounts to $1,260,000.

Contribution Margin: Example 7B

• The contribution margin is computed as follows:

• Thus $659,178 is available to contribute to fixed costs and to profit.

• In this example, fixed costs are $616,934, so there is an amount left to contribute toward profit.

Contribution Margin: Practice Exercise 7-II

• Assumptions: Greenside Clinic has revenue totaling $3,500,000.

• Of this amount, 40 percent is variable cost and 60 percent is fixed cost.

• Step 1. Divide costs into variable and fixed.

• In this case $3,450,000 times 40 percent equals $1,380,000 variable cost and $3,450,000 times 60 percent equals $2,070,000 fixed cost.

Contribution Margin: Practice Exercise 7-II

• Step 2. Compute the contribution margin:

Contribution Margin: Assignment Exercise 7-2.1

• Assumptions: The Mental Health program for the Community Center has just completed its fiscal year end.

• The Program Director determines that his program has revenue for the year of $1,210,000.

• He believes his variable expense amounts to $205,000 and he knows his fixed expense amounts to $1,100,000.

Contribution Margin: Assignment Exercise 7-2.1

• Required: Compute the contribution margin for the Community Mental Health program.

______________

______________

______________

______________

______________

Revenue

Less Variable Cost

Contribution Margin

Less Fixed Cost

Operating Profit (Loss)

Computation:

$1,210,000

($205,000)

$1,005,000

($1,100,000)

($95,000)

Contribution Margin: Assignment Exercise 7-2.2

• What does the result tell us about the program?

1. The contribution margin of $1,005,000 does not cover the fixed costs of $1,100,000.

2. There is an overall loss in the program of $95,000.

3. The fixed cost is very high, making it imperative that sufficient revenue levels be achieved.

The Cost-Volume-Profit (CVP) Ratio or Breakeven Point

• The Breakeven Point is the point when the contribution margin equals the fixed costs.

• Loss equals a loss;

• More equals a profit.

• Thus, Breakeven Point.

• Examine the examples in the chapter.

Figure 7–6 Cost-Volume-Profit (CVP) Chart for a Wellness Clinic.

Courtesy of Resource Group, Ltd., Dallas, Texas.

Compute the Profit-Volume (PV) Ratio

• If the contribution margin is expressed as a percentage of net revenues, it is often called the Profit-Volume Ratio

• A PV chart needs only 2 lines to show the effect of changes in volume.

• See example and explanation in the chapter

Figure 7–7 Profit-

Volume (PV) Chart for a Wellness

Clinic. Courtesy of Resource

Group, Ltd., Dallas, Texas.

CPV – PV Practice Exercise 7-III

• Assumptions: The Mental Health program for the Community Center has just completed its fiscal year end.

• The Program Director determines that his program has revenue for the year of $1,210,000.

• He believes his variable expense amounts to $205,000 and he knows his fixed expense amounts to $1,100,000.

CPV – PV Practice Exercise 7-III

$100.00

16.94

$83.06

90.91

$7.85

=PV or CM Ratio

100.00%

16.94%

83.06%

90.91%

7.85%

$1,210,000

(205,000)

$1,005,000

(1,100,000)

$95,000

Revenue

Less variable cost

Contribution margin

Less fixed cost

Operating (loss)

Per-VisitPercentAmount

CPV – PV Assignment Exercise 7-3

• Assumptions: Greenside Clinic has revenue totaling $3,500,000.

• Of this amount, 40 percent is variable cost and 60 percent is fixed cost. The clinic had 35,000 visits.

$100.00

-39.43

$60.57

-59.14

$1.43

=PV or CM Ratio

100.00%

-39.43%

60.57%

-59.14%

1.43%

$3,510,000

(1,380,000)

$2,120,000

(2, 070,000)

$50,000

Revenue

Less variable cost

Contribution margin

Less fixed cost

Operating profit (loss)

Per-VisitPercentAmount

Understand Further Use of The Contribution Margin

• Contribution Margins are also useful in showing measures of profitability in a simple, easy-to-understand manner.

• (For example, see the DRG matrix in Figure 7- 8.)