Breakeven point in revenue

Breakeven point in revenue

C h a p t e r ➤ 8 : ➤ C o s t ➤ A c c o u n t i n g 1 7 5

toward assuming more risk for utilization through value-based purchasing, such as bundled payments and accountable care organizations. According to a study by the Agency for Healthcare Research and Quality (Bush 2012), 1 percent of the patients consumed 20 percent of all healthcare spending in 2009, or more than $90,000 per person that year. The same study found that 5 percent of the patients accounted for more than 50 percent of all healthcare spending. Data usage in the past has been on volume and profit, while data usage in the future will be on finding best practices and comparing costs between treatment options (Selivanoff 2011). Also, costing methods in the past have included ratio of costs to charges and job-order costing, while costing methods in the future should be on activity-based costing in an attempt to identify and reduce both direct and indirect costs.

relAtIonsHIP of costs to volume And revenue For purposes of determining profit or loss, managers must review costs in relation to associated volumes and revenues (sometimes referred to as cost-volume-profit analysis). The profit equation is

Profit = Revenues – Expenses

Therefore, the manager first must understand the relationship between costs and expenses. Within this context, cost is the amount spent to acquire an asset, and expense is the amount spent consuming the asset. Therefore, expense is an expired asset. As referenced earlier in this chapter, costs can be classified as fixed costs or variable costs. When classifying these costs in relation to an accounting period, fixed costs remain constant and variable costs change in relation to volume, as demonstrated in exhibit 8.5.

exHIbIt 8.5 Costs per Period

Fixed cost

Profit

Volume

Ch ar

ge /C

os t

Loss

Breakeven point

Total revenue (Charge × volume)

Total cost (Unit cost × volume)

Variable cost

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I n t r o d u c t i o n ➤ t o ➤ t h e ➤ F i n a n c i a l ➤ M a n a g e m e n t ➤ o f ➤ H e a l t h c a r e ➤ O r g a n i z a t i o n s1 7 6

Related to costs per period, the breakeven point is the volume in units at which the total revenue line intersects the total cost line, or where total costs equal total revenues, as expressed by the equation

= −

Breakeven quantity Total fixed costs

Charge Variable costs per unit

When classifying these costs in relation to a unit of product or service, fixed costs change in relation to volume, and variable costs remain constant per unit, as shown in exhibit 8.6.

Exhibit 8.6 is somewhat unorthodox, but it is important to understand the relationship in this way to understand breakeven analysis. At any point on the volume axis, total costs equal variable costs per unit, which remain constant, plus fixed costs per unit, which decline as volume increases. Using costs per unit, the breakeven point in units or revenues is the point at which fixed costs have been covered. Before the breakeven point, each unit sold not only has covered its variable costs but also has contributed something to fixed costs. After the breakeven point, each unit sold has covered its variable costs and its fixed costs and is contributing to profit. This concept is called the contribution margin and can be expressed in dollars with the formula

Contribution margin $ = Charge – Variable costs per unit

It also can be expressed as a percentage:

= −Contribution margin percent Charge Variable costs per unit Charge

exHIbIt 8.6 Costs per Unit

Fixed costs per unit

Volume

Ch ar

ge /C

os t

Breakeven point in revenue

Breakeven point in units

Variable costs per unit

Total revenue

Total costs

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C h a p t e r ➤ 8 : ➤ C o s t ➤ A c c o u n t i n g 1 7 7

and the breakeven point in dollars can be expressed with the formula

=Breakeven Point $ Total fixed costs Contribution margin percentage

After the breakeven point has been reached and fixed costs have been covered, each subsequent unit produced contributes to profit, rather than to fixed costs. Problem 8.4 demonstrates breakeven analysis per period, where the objective is to deter- mine the quantity necessary to cover fixed costs and where additional quantity will increase profit.

To understand breakeven analysis in a capi- tated revenue environment, a more detailed profit equation is needed. (This equation is also useful in determining profit at various levels of volume and determining profit if variable costs per unit can be reduced.) Problem 8.5 demonstrates breakeven analysis in a capitated environment where the objective is to determine the quantity necessary to cover fixed costs and where additional quantity will decrease profit.

PROBLEM 8.4 Breakeven Analysis

ABC’s➤home➤health➤care➤agency➤is➤considering➤a➤new➤product➤with➤a➤fixed➤cost➤of➤$1,000,➤

a➤charge➤of➤$10➤per➤unit,➤and➤a➤variable➤cost➤of➤$5.

What➤is➤the➤breakeven➤point➤in➤quantity➤and➤in➤dollars?

What➤is➤the➤contribution➤margin➤in➤dollars➤and➤in➤a➤percentage?

− Breakeven point quantity =

1,000 10 5

= 200 units

Contribution➤margin➤$➤=➤10➤–➤5➤=➤$5

− Contribution margin percent =

10 5 10

= 50 percent

Breakeven point $ = 1,000

0.5 = $2,000

*

MINI-CASE STUDY✓

Suppose➤that➤you➤are➤the➤administrator➤of➤a➤physician’s➤of-

fice➤practice,➤and➤the➤physician➤owners➤have➤asked➤you➤for➤a➤

presentation➤on➤improving➤profitability➤without➤raising➤rates.➤

Using➤both➤exhibits➤8.5➤and➤8.6,➤explain➤how➤profit➤can➤be➤

increased.

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I n t r o d u c t i o n ➤ t o ➤ t h e ➤ F i n a n c i a l ➤ M a n a g e m e n t ➤ o f ➤ H e a l t h c a r e ➤ O r g a n i z a t i o n s1 7 8

Profit = Revenues – Expenses where Revenues = (Charge × Volume)

and where Expenses = (Fixed costs) + (Variable cost per unit × Volume)

In a capitated revenue environment, revenue is fixed, and what becomes important is controlling volume and variable costs. Exhibit 8.7 gives a graphic representation of the breakeven point in a capitated revenue environment.

PROBLEM 8.5 Breakeven Analysis for Capitated Revenue

ABC➤Outpatient➤Clinic➤is➤considering➤a➤capitated➤agreement➤with➤an➤insurance➤company➤

whereby➤the➤clinic➤would➤provide➤outpatient➤coverage➤to➤a➤1,000-member➤plan➤at➤$100➤

per➤member➤per➤month.➤Variable➤costs➤are➤projected➤at➤$150➤per➤clinic➤visit,➤and➤fixed➤

costs➤allocated➤to➤the➤agreement➤are➤$600,000➤per➤year.➤What➤is➤the➤breakeven➤point➤

in➤volume➤of➤clinic➤visits?

Profit➤=➤Revenue➤–➤(Fixed➤costs➤+➤[Variable➤cost➤per➤unit➤×➤Volume]➤)

$0➤=➤$1,200,000➤–➤($600,000➤+➤[$150➤×➤Volume])

Volume➤=➤4,000➤clinic➤visits➤(more➤than➤4,000➤clinic➤visits➤would➤result➤in➤a➤loss)

*

exHIbIt 8.7 Breakeven Point

for Capitated Revenue

Fixed cost

Profit

Volume

Ch ar

ge /C

os t

Loss

Variable cost

Revenue

Total costBreakeven point

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C h a p t e r ➤ 8 : ➤ C o s t ➤ A c c o u n t i n g 1 7 9

➤➤ Understanding➤the➤various➤methods➤of➤classifying➤costs➤is➤necessary➤in➤a➤cost-

containment➤environment.

➤➤ Knowing➤how➤indirect➤costs➤are➤allocated➤to➤direct➤costs➤and➤ultimately➤to➤the➤charge➤

is➤crucial➤to➤an➤understanding➤of➤the➤cost➤structure➤of➤a➤department.

➤➤ A➤manager➤who➤wants➤to➤improve➤department➤efficiency➤and/or➤profit➤must➤

understand➤the➤relationship➤of➤costs➤to➤both➤volumes➤and➤revenues.

➤➤ Knowing➤how➤to➤isolate➤relevant➤costs➤in➤differential➤cost➤analysis➤improves➤decision➤

making.

➤➤ Allocating➤costs➤using➤activity-based➤costs➤better➤reflects➤costs➤and➤in➤turn➤will➤

enable➤more➤accurate➤rate➤setting.

➤➤ Identifying➤new➤costing➤methods➤is➤necessary➤under➤the➤ACA.

1.➤ Why➤is➤it➤important➤for➤the➤healthcare➤manager➤to➤be➤able➤to➤classify➤costs➤in➤a➤variety➤ of➤ways?

2.➤ What➤is➤the➤point➤of➤allocating➤costs?➤After➤allocation,➤how➤is➤the➤resulting➤ information➤used?

3.➤ Cost➤information➤can➤be➤assembled➤in➤a➤variety➤of➤ways➤for➤a➤variety➤of➤reasons.➤What➤ are➤three➤ways➤that➤cost➤information➤is➤assembled,➤and➤what➤is➤the➤reason➤for➤the➤ assembly?

4.➤ How➤might➤differential➤cost➤analysis➤be➤used➤in➤the➤following➤nonroutine➤decisions:➤ expanding➤an➤existing➤service,➤decreasing➤an➤existing➤service,➤starting➤a➤new➤service,➤ and➤closing➤an➤existing➤service?

5.➤ How➤was➤the➤ACA➤expected➤to➤change➤how➤providers➤look➤at➤costs?

6.➤ What➤are➤the➤similarities➤and➤differences➤between➤breakeven➤points➤per➤period➤and➤ breakeven➤points➤per➤unit➤of➤service?

cHAPter key PoInts

dIscussIon QuestIons

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I n t r o d u c t i o n ➤ t o ➤ t h e ➤ F i n a n c i a l ➤ M a n a g e m e n t ➤ o f ➤ H e a l t h c a r e ➤ O r g a n i z a t i o n s1 8 0

P R

AC TI

CE P

R O

B LE

M S

A N

D S

EL F-

Q U

IZ ZE

S

Differential Cost Analysis 7

Differential Cost Analysis

Differential Cost Analysis Practice Problem

Beta Managed Care Corporation has approached XYZ Hospital for inpatient labor and delivery coverage for Beta’s subscribers. Beta will pay $5,000 per delivery. XYZ’s fixed costs per delivery are $3,000, and variable costs are $3,000. Using differential cost analysis, should XYZ Hospital accept Beta’s offer?

Study Guide:Layout 1 12/27/07 2:33 PM Page 7

8 Practice Problems and Case Study

Differential Cost Analysis Practice Problem Solution

Step 1: Gather all costs and revenues associated with each alternative.

Accept Reject Revenue $ 5,000 $ 0 Fixed Cost 3,000 3,000 Variable Costs 3,000 0 Full Cost Gain/(Loss) ($1,000) ($3,000)

Step 2: Identify and drop all sunk costs (drop $3,000 fixed cost for each alternative).

Accept Reject Revenue $5,000 $0 Fixed Cost 0 0 Variable Costs 3,000 0

Step 3: Identify and drop all costs and revenues that do not differ between the alternatives.

Accept Reject Revenue $5,000 $0 Fixed Cost 0 0 Variable Costs 3,000 0

Step 4: Select the best alternative based on the remaining cost and revenue information.

Accept Reject Revenue $5,000 $0 Fixed Cost 0 0 Variable Costs 3,000 0 Differential Cost Gain/(Loss) $2,000 $0

Conclusion: Using differential cost analysis, XYZ should accept the offer because it has a higher differential gain ($2,000) than rejecting the offer ($0).

Study Guide:Layout 1 12/27/07 2:33 PM Page 8

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