HMGT 322 (3)
BYSTANDER
PPTFORNUMBER2.pptxUMUC HMGT 322
Week 4: Income Statement and Cost-Volume-Profit (CVP) Analysis
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Cost Management
Fixed and Variable Costs
Methods to Allocate Costs
Income Statement and Profit Loss Analysis
Contribution Margin
Volume Needed to Breakeven
Volume Needed to Reach Profit Targets
Degree of Operating Leverage
Overview
Process of collecting, analyzing, evaluating and reporting of cost information relative to revenues received is important for budgeting, forecasting, pricing, profitability analysis and performance reporting.
Cost Management
Firms that minimize costs can maximize profits
Three Categories of Costs:
Fixed Costs – do not vary by volume of services.
Examples: expenditures on facilities and diagnostic equipment, salaries of full-time staff
Variable Costs – vary by the volume of services provided.
Example: medical supplies which varies by number of patients treated (volume)
Semi-Fixed Costs – costs that are fixed within ranges of volume (also called step-variable costs).
Example: Annual workforce of a laboratory can only handle 10,000 tests a year, so an additional technician would have to be hired if tests exceeds 10,000.
Cost Categories
Direct vs. Indirect Costs
Direct costs – Can be traced directly to a service, easy to identify
Indirect or overhead costs – tied to shared resources (administrative staff)
Cost object - an item for which a business need to separately estimate cost.
It can be allocated by department or a product(procedure).
Cost pool – a grouping of costs that must be allocated
Cost driver – the criterion used for cost allocation
Cost Allocation Basics
Three basic types to allocate by department
Direct method
Reciprocal method
Step-down method
A top-down approach.
It begins with aggregate costs that are then allocated downstream
Some would say it is a “traditional” approach
Cost Allocation Methods by Department
Direct method
Costs of each cost center are allocated directly to, and only to, the producing departments.
Easy to do.
Does not consider the inter-relationship between two supporting departments.
Cost Allocation Methods (Cont.)
Accounting
Human Resource
Routine Care
Radiology
Housekeeping
Supporting Dept.
Producing Dept.
Reciprocal method
Recognize all of the inter-relationship between supporting departments.
Most accurate among the 3 methods.
Very complex, and the calculation is difficult.
Cost Allocation Methods (Cont.)
Accounting
Human Resource
Routine Care
Radiology
Housekeeping
Supporting Dept.
Producing Dept.
Step-down method
After the 1st supporting department allocates the costs to all, the 2nd supporting department allocates costs to all but the first one.
Recognize some of the inter-relationship among supporting departments, but not all.
More complex than direct method but easier to calculate than reciprocal method
Cost Allocation Methods (Cont.)
Accounting
Human Resource
Routine Care
Radiology
Housekeeping
Supporting Dept.
Producing Dept.
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Ratio of Costs to Charges (RCC)
Assumes costs are proportional to charges
Easier to calculate
Relative Value Units (RVU)
RVU is a measure of resources consumed by each product (procedure).
Assume costs are proportional to the volume of RVUs.
Healthcare providers may develop their own RVUs of each procedure, or use the RVUs developed by CMS for Medicare physician fee schedule (RBRVS).
The components of RVUs from RBRVS include physician work, practice (overhead), and malpractice (insurance) expense with adjustment for geographical variation.
Activity-Based Costing
Cost Allocation Methods By Procedure
Bottom-up approach; begins with identifying individual activities that comprise the services provided.
Rather than top-down approach, which begins with aggregate costs that are then allocated downstream to departments or individual events.
Use the basic activity that causes costs to be incurred as the cost driver.
More precise to allocate indirect costs.
Require more information and resource to establish it.
Activity-Based Costing
Estimate profits from income statement
Net Income (Profits) = Revenues - Costs
Both revenues and costs vary by quantity (e.g. volume of services) provided
Revenues = Price of service x Quantity(Q)
Costs = Fixed + Variable Costs
Variable costs vary by volume = VC x Q of services provided
Profit Loss Statement
Assume the following for a Radiology center:
Price per xray/report = $200
Total Fixed costs = $200,000
Variable cost = $100
Assume annual quantity (also called volume) of 4,000 tests a year
| See-Thru-U Radiology Center | |
| Total revenues ($200 x 4,000) | $800,000 |
| Total Variable Costs ($100 x 4,000) | $400,000 |
| Total Fixed Costs | $200,000 |
| Net Income (Profit)= (TR – TC) | $200,000 |
Base Case Profit Loss Statement
Contribution Margin is the dollar amount (per unit/visit) needed to cover fixed costs
= Per unit revenue - per unit variable cost
= P - VC
Contribution Margin important for determining:
Break even point where profits are zero
Estimate volume needed to reach a profit target
Operating Leverage
Contribution Margin
| Laparoscopic Center (Assumes 1,000 procedures a year) | |
| Total Revenues ($30,000 x 1,000) | $30,000,000 |
| Total Variable Cost ($20,000 x 1,000) | $20,000,000 |
| Total Contribution Margin ($10,000 x 1,000) | $10,000,000 |
| Fixed Costs | $6,000,000 |
| Profit | $4,000,000 |
Example from Week 3 article by Choudury et. al, 2013
Revenue and cost assumptions for Laparoscopic surgery center:
Price (P) per procedure = $30,000
Variable cost (VC) per procedure = $20,000
Total Fixed Cost (TFC) for Facility = $6 million
Contribution Margin(CM) =
P – VC = $30,000 - $20,000 = $10,000
Need at least $10,000 per visit to cover fixed costs
Contribution Margin Example
Important question: At what quantity level(Q) will profits be zero
Total revenue(TR) – Total costs(TC) = 0
Break even occurs when TR = TC
TR = Price(P) x Quantity(Q)
TC = Fixed Cost (FC) + Variable Costs(VC x Q)
Assume Profit = 0 : P x Q = FC + (VC x Q)
This can be solved for Q (breakeven quantity)
Break Even Q = FC/(P – VC)
Denominator is the contribution margin
Break-Even Quantity Calculation
Using Laparoscopic example earlier:
Price (P) per procedure = $30,000
Variable cost (VC) per procedure = $20,000
Total Fixed Cost (TFC) for Facility = $6 million
Contribution Margin (CM) = P – VC = $30,000 - $20,000 = $10,000
Break even quantity = FC/(P – VC) = FC/CM= $6 million/$10,000 = 600
So surgery center would have to conduct 600 procedures to break-even and cover their costs
Example of Break Even Quantity
Using contribution margin(CM), can estimate what quantity or volume is needed to generate a given profit level
Assume profit target $1 million
CM for Laparoscopic Surgery Center Example = $10,000
CM x Q = Fixed Costs + Profit Target
Solve for Q= (FC + Targeted Profit)/CM
Q = ($6 million + $1 million)/$10,000 = 700
Need 700 procedures to make a profit of $1 million
Quantity Needed to Reach Profit Target
Degree of Operating Leverage (DOL): Relationship between fixed and variable costs
High operating leverage
Low percentage of VC to TC or higher percentage fixed costs
Must generate larger volume to cover fixed costs
Low operating leverage
High percentage of VC to TC or lower percentage fixed costs
Lower volume required to cover fixed costs
Degree of Operating Leverage (DOL) =
Total Contribution Margin (CM)/ Earnings before interest and taxes (EBIT)
Operating Leverage
Laparoscopic Surgery Center
DOL = TCM/EBIT = TCM/(TCM-FC)
TCM = 10,000 x 1,000 = 10,000,000
EBIT = 10,000,000 – 6,000,000 = 4,000,000
DOL = 10,000,000/4,000,000 = 2.5
A DOL indicates how much profit will change with 1% change in volume
DOL = 2.5 = Each 1% change in volume produces 2.5% change in profit
Calculating Degree of Operating Leverage (DOL)
In a fee-for-service system, revenue continues to increase past the break even point with each additional laparoscopic procedure provided
A capitated environment, however, does not reward volume, but rather provides a fixed reimbursement per member per month (per enrollee).
Total revenue curve is flat as volume increases
Additional procedures beyond breakeven point will result in loss of revenue.
Optimal profit is where fixed revenues exceed fixed costs
See full discussion with graphics in: Roller, Mark; “The Effect of Fee-For-Service and Capitation Reimbursement Models on Healthcare Providers” (January 28, 2016) in this week’s readings.
Break-Even Analysis Varies Between Fee for Service vs. Capitated Payments
