Download Problem Set #5 Answers

HSMP 587 - Health Care Fin. Mngmt
Winter 2017
2/27/17
Dr. Neal Wallace
Problem Set # 5 Answers
1) Why is it important to estimate your profitability for each type of service you provide?
Why might you want to also assess profitability using “non-sunk” costs only? Is it ever
OK to maintain a product line that is not profitable?
Estimating the profitability of each of the specific products you produce is critical
in considering pricing strategies and the overall financial viability of your current
production choices (e.g. whether you should be producing all the things you do, or
which you might need to produce more efficiently). You may often want to consider
doing this analysis using only “non-sunk” costs as these more limited costs tend to
be more stable over time. Sunk costs often reflect more highly variable capital costs
so that one year’s estimates may not fully reflect future profitability. Since non-sunk
costs are also minimum operating costs, we may want to know if a service line is at
least covering the basic costs of producing it. There is nothing wrong with holding
on to “non-profitable” services if they fit the organizations mission and/or they
provide some form of “quality” that substantially enhances demand for your other
product lines.
2) What is a break-even analysis and why would you want to do it?
A break even analysis identifies the minimum number of visits you need to produce
to “breakeven” or generate just enough revenue to meet you essential or minimum
operating costs. Your minimum operating costs are your “non-sunk” costs. In our
case these are our costs excluding depreciation and principal payments on our debt,
as these are “optional” expenses to pay back for sunk capital costs. Dividing our
minimum operating costs by our average revenue per visit gives us our overall
breakeven number of visits. Note that since we have a cost allocation, we could
determine our minimum operating costs for each final product and come up with a
breakeven visit rate for each product line.
3) Suppose we decide to keep our clinic open in the evening. Would our cost per visit
(overall or by type) likely be the same/higher/lower than before? Why?
Our cost per visit would likely be lower due to economies of scale. We will have
more variable costs, such as lab supplies and higher labor costs, but we don’t need
to rent more space and probably don’t need to have more administration. Thus the
incremental costs for opening in the evening will only reflect our additional variable
costs, while our fixed costs will be spread over more visits produced, lowering our
overall cost per visit.
HSMP 587 - Health Care Fin. Mngmt
Winter 2017
2/27/17
Dr. Neal Wallace
Problem Set # 5 Answers
4) What is a transfer price, what is it used for, and how do you determine what it is?
A transfer price is the internal cost of producing an intermediate product (e.g. our
lab services). It is used as a benchmark for contracting out as we would not want to
contract for lab services at a price higher than our own transfer price. Transfer
prices come from step-down cost allocation. In the case of lab services, it would be
the fully allocated cost of lab divided by the number of lab visits produced.
5) How does quality relate to your decision to contract out for services, and how might
you estimate its importance?
Price and quality are critical variables in any economic transaction. In the decision
to contact out (the “make or buy” decision), you want to make sure that a
contractor can provide you with a service with a combination of price and quality
that is better than what you could do yourself. In our lab example, timeliness and
accuracy of lab tests is critical. Cheaper externally produced lab visits are no good if
they can’t provide the timeliness and accuracy we need. We can use various parts of
our financial model to estimate the cost of quality. In the lab example we know that
lab visits only go to initial and high/low risk visits (from stats or cost-allocation setup). Using our revenue stats we can estimate the average revenue from these types
of visits and recognize that a “bad” lab test can result in a “lost” visit that goes
unreimbursed at the average revenue rate for those visits. This is the basis for any
“cost of lab quality” analysis.