finance management

Breakeven Analysis Case Study

Sun City Community Hospital

Sun City Community Hospital (SCCH), an acute care hospital with 300 beds and 160 staff physicians, is one of 75 hospitals owned and operated by Health Services of America, a for-profit, publicly owned company. Although there are two other acute care hospitals serving the same general population, SCCH historically has been highly profitable because of its well-appointed facilities, fine medical staff, reputation for quality care, and the amount of individual attention it gives to its patients. In addition to inpatient services, SCCH operates an emergency room within the hospital complex and a stand-alone, walk-in clinic located across the street from the area's major shopping mall, about two miles from the hospital.

In spite of its overall financial soundness, Mike Reynolds, SCCH's CEO, is concerned about the hospital's walk-in clinic. About ten years ago, all three area hospitals jumped onto the walk-in clinic bandwagon, and within a short time, there were five clinics scattered around the city. Now, only three are left, and none of them appears to be a big money maker. Mike wonders if SCCH should continue to operate its clinic or close it down. The clinic is currently handling a patient load of 45 visits per day, but it has the physical capacity to handle many more visits—up to 85 a day. Mike's decision has been complicated by the fact that Rose Daniels, SCCH's marketing director, has been pushing to embark on a new marketing program for the clinic. She believes that an expanded marketing effort aimed at local businesses will bring in the number of new patients required to make the clinic a financial success.

Mike has asked Brent Williams, SCCH's chief financial officer (CFO), to look into the whole matter of the walk-in clinic. In their meeting, Mike states that he visualizes three potential outcomes for the clinic: the clinic may be closed; it may continue to operate without expanding its marketing program; or it may continue to operate with the expanded marketing effort. As a starting point for the analysis, Brent has collected the most recent historical financial and operating data for the clinic, which are summarized in Table 1. In assessing the historical data, Brent noted that one competing clinic had recently (December 2006) closed its doors. Furthermore, a review of several years of financial data revealed that the SCCH clinic does not have a pronounced seasonal utilization pattern.

Next, Brent met several times with the clinic's director. The primary purpose of the meetings was to estimate the additional costs that might have to be borne if clinic usage rose above the current January–February average level of 45 visits per day. Any incremental usage will require additional expenditures for administrative and medical supplies, estimated to be $5.00 per patient visit for medical supplies such as tongue blades and rubber gloves, and $2.00 per patient visit for administrative supplies, such as file folders and clinical record sheets.

Because of the relatively low utilization level, the clinic has purposely been staffed at the bare minimum. In fact, some clinic employees have started to grumble about not being able to do their jobs well because of overwork. Therefore, any increase in the number of patient visits will require immediate administrative and medical staff increases. In addition, at an increase of 11 visits, the clinic will have to replace a part-time receptionist and record keeper with a full-time employee. At an additional 21 visits per day, another part-time nurse and physician will have to be added to the clinic's staff, and another part-time clerk will have to be hired if patient visits increase by 31 per day. The incremental costs associated with increased utilization are summarized in Table 2.

Additionally, Brent learns that the building is leased on a long-term basis. SCCH might cancel the lease, but the contract calls for a cancellation penalty of three months’ rent, or $37,500, at the current lease rate. In addition, Brent is startled to read in the newspaper that Baptist Hospital, SCCH's major competitor, has recently bought the city's largest primary care group practice. Baptist's CEO was quoted as saying that more group practice acquisitions are planned. Brent wonders whether Baptist's actions will influence the decision regarding the clinic's fate.

Finally, Brent meets SCCH's marketing director, Rose Daniels, to learn more about the proposed expansion of the clinic's marketing program. The primary focus of the new marketing program is occupational health services (OHS). OHS requires providing medical care to local businesses, including physical examinations for managers and employees, treatment of illnesses that occur predominantly during working hours, and treatment of work-related injuries, especially those covered by workers' compensation. Although some of the clinic's current business is OHS-related, Rose believes that a strong marketing effort, coupled with specialized OHS record keeping, might bring additional patients to the clinic. The proposed marketing expansion requires a marketing assistant who will run the clinic's OHS program. Additionally, the new marketing program will incur advertising costs for newspaper, radio, and TV ads as well as for brochures and handouts. The incremental costs associated with the new marketing program are also summarized in Table 2.

With a blank spreadsheet on the screen, Brent begins to construct a model that will provide the information required to help the board make a rational, informed decision. At first, Brent plans to conduct a standard capital budgeting analysis that focuses on the profitability of the clinic as measured by net present value (NPV) or internal rate of return (IRR). Then, he realizes that the expanded marketing program requires no capital investment. He also realizes that no valid data are available on the incremental increase in visits that will be generated either by an increasing population base or by the expanded marketing program. Finally, he remembers that Mike has requested that the analysis consider the inherent profitability of the clinic without the expanded marketing program.

With these points in mind, Brent thinks that a breakeven analysis is useful in making the final decision. Specifically, he wants to develop answers to the following questions:

· What is the projected profitability of the walk-in clinic for the entire year if utilization continues at its current level?

· How many additional visits per day will be required to break even without the new marketing program?

· How many additional visits per day will be required to break even assuming that the new marketing program is undertaken?

· How many additional daily visits will the new program have to include to break even, regardless of the overall profitability of the clinic?

Finally, in earlier conversations, Mike also wonders if the clinic might inflate its way to profitability; that is, if utilization remains at its current level, can the clinic become profitable in, say, five years, solely because of inflationary increases in revenues? Overall, Brent must consider all relevant factors—both quantitative and qualitative—and come up with a reasonable recommendation regarding the future of the clinic. Assume that as Brent’s assistant it is your task to aid him with the analysis.

Table 1: Sun City Community Hospital: Financial and Operating Data
	CY2006	Jan 2007	Feb 2007	2006	Jan–Feb 2006	Total
Number of visits	14,522	1,365	1,335	1,210	1,350	1,230
Gross revenue	578,237	58,231	57,996	48,186	58,114	49,605
Allowance percentage	5.1%	5.5%	5.6%	5.1%	5.6%	5.2%
Net revenue	548,747	55,028	54,748	45,729	54,888	47,037
Salaries and wages	154,250	13,540	13,544	12,854	13,542	12,952
Physician fees	192,000	18,000	18,000	16,000	18,000	16,286
Malpractice insurance	31,440	3,215	3,215	2,620	3,215	2,705
Travel and education	5,365	538	665	447	602	469
General insurance	8,112	843	843	676	843	700
Subscriptions	189	0	0	16	0	14
Electricity	11,820	1,124	1,029	985	1,077	998
Water	1,260	135	142	105	139	110
Equipment rental	1,260	105	105	105	105	105
Building lease	155,745	12,500	12,500	12,979	12,500	12,910
Other operating expenses	103,779	8,152	7,923	8,648	8,038	8,561
Total operating expenses	665,220	58,152	57,966	55,435	58,061	55,810
Net profit (loss)	116,473	3,124	3,218	9,706	3,173	8,773
Gross margin (percent)	–21.2%	–5.7%	–5.9%	–21.2%	–5.8%	–18.7%

Table 2: Sun City Community Hospital: Walk-In Clinic: Monthly Incremental Cost Data
	Number of Additional Visits per Day
	0	1-10	11-20	21-30	31-40
Variable Costs
Medical supplies		5.00 per visit	5.00 per visit	5.00 per visit
Administrative supplies		2.00 per visit	2.00 per visit	2.00 per visit
Total variable costs per visit		7.00 per visit	7.00 per visit	7.00 per visit
Semi fixed Costs
Salaries and wages		2,000	3,000	4,000
Physician fees		8,000	8,000	16,000	16,000
Total monthly semi fixed costs	0	10,000	11,000	20,000	21,000
Fixed Costs
Marketing assistant's salary	3,000	3,000	3,000	3,000	3,000
Advertising expenses	2,000	2,000	2 000	2,000	2,000
Total monthly fixed costs	5,000	5,000	5,000	5,000	5,000