Cartwright Financial Management1 Managerial Accounting: Pricing and Service Decisions

Cartwright Financial Management 1

Managerial Accounting: Pricing and Service Decisions


Managers must set prices and/or determine services

• Price takers– no market power– take it or leave it offers from MCO and

Government– concentrate on cost structure

• Price setters– market power and size.– Differentiated service


Full-cost pricing

• In the long run must set a price to cover all costs in the firm.

• Direct variable costs of service

• Direct fixed costs

• Appropriate share of overhead


Marginal-Cost Pricing

• The cost of providing one more additional unit of output

• Medicare and Medicaid argue that providers should be payed marginal cost, not full costs. How will they cover fixed and overhead? and Who will pay?

• Actually this is more like an incremental cost calculation, rather than the economic concept of marginal cost.


Cost Classification Review

• Direct – inputs into service• Indirect (overhead) – shared inputs of

organization. (insurance, director salary)• Variable – activity, utilization, volume

impact on costs. (supplies)• Fixed – Pre-determined, no variation with

activity, utilization, and volume. (short-run staffing level)


Marginal-Cost Pricing

• Cross subsidization or price shifting is used to cover additional costs imposed for service units that are not full cost priced.

• Payers no longer are accepting price shifting.

• Affecting emergency care, teaching and research and indigent care.


Direct Cost Pricing

• Prices are set to cover the direct costs of providing services

• These are both variable and fixed costs.

• Indirect or overhead costs not covered.

• Usually higher price than marginal cost


Competitive Pricing

• Cost structure is not relevant to pricing

• A high cost structure as compared to to the revenues under competitive pricing results in low or negative profits or net earnings

• High costs may result in going out of business


Economics

• Price = Marginal cost

• Costs– Short run rising marginal cost– Long run u shaped average cost curve

• In equilibrium , Price = average cost – Sufficient profit to stay.– Lowest point of average cost curve.


Target Costing

• Take the price given for a service

• Subtract the desired profit on that service

• Now have target cost level

• Reduce the full cost to the target level and continue to push costs down


Setting Prices on Individual Services

• Use the revenue, cost, profit equation

• Solving for price given a profit ( economic breakeven) and pricing assumption


Example 1: Windsor Clinic Pricing: Breakeven

AssumptionsVariable cost per visit 10$ Annual direct fixed costs 100,000$ Annual overhead allocation 25,000$ Volume 5,000Profit 0

Total Revenues - Total Cost = $0

Total Revenue 5000*PriceTotal costs + profit 175,000$

Price= 35.00$


Example 1: Windsor Clinic Pricing: Profit

AssumptionsVariable cost per visit 10$ Annual direct fixed costs 100,000$ Annual overhead allocation 25,000$ Volume 5,000Profit 100,000$

Total Revenues - Total Cost = Profit

Total Revenue 5000*PriceTotal costs + profit 275,000$

Price= 55.00$


Example 1: Windsor Clinic Marginal Cost Pricing

AssumptionsVariable cost per visit 10$ Annual direct fixed costs 100,000$ Annual overhead allocation 25,000$ volume 5,000profit 100,000$


Total Revenue 5000*PriceTotal variable costs 275,000$ Profit (125,000)$ Price= 10.00$


Example 1: Windsor Clinic Direct Pricing

AssumptionsVariable cost per visit 10$ Annual direct fixed costs 100,000$ Annual overhead allocation 25,000$ volume 5,000profit -$


Total Revenue 5000*PriceTotal direct costs + profit 150,000$

Price= 30.00$


Hospital Price Setting Under Capitation

• Offer a capitated plan for inpatient services

• What is the new price for the plan?

• 13% conversion of patient base

• Number of admissions under plan stay the same as selected groups.

• Capitated price must provide same net income.


Table 7.1 Montana Medical Center (MMC): Pro-Forma Worksheet and P&L Statement for 2005 FFSAverage Variable Total

Number of Revenue per Revenues Cost per Variable ContribtuionPayor Admissions Admission by Payor Admission Costs MarginMedicare 4,268 7,327$ 31,271,636$ 2,529$ 10,793,772$ 20,477,864$ Medicaid 5,895 5,448 32,115,960 1,575 9,284,625 22,831,335 Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544 Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140 Commercial 1,408 11,770 16,572,160 2,969 4,180,352 12,391,808 Self-Pay 1,289 2,053 2,646,317 1,489 1,919,321 726,996 Other 1,149 11,539 13,258,311 3,085 3,544,665 9,713,646 Total 17,054 108,583,746$ 35,174,873$ 73,408,873$

Weighted average 6,367$ 2,063$

P&L StatementTotal Revenues 108,583,746$ Variable Costs 35,174,873$ Contribution margin 73,408,873$ Fixed costs 71,746,561Net income 1,662,312$


Capitation Assumptions

• Enrollment: Medicaid (20%), Commercial (40%), Self Pay (40%)

• Adjust admissions accordingly

• Enrollees in new plan will be 25,000

• Total Fixed Costs Stay Same


Net Income “hold harmless”

• Capitated plan must bring in $108,583,746 - $94,473,163 = $14,110,583


MMC Capitation Assumptions for Pricing New PlanPercent Capitated PreviousLoss Admissions Admissions Var Cost Var Cost

Medicaid 20 5,897 1,179 1,575 1,856,925 Commercal 40 1,408 563 2,969 1,671,547 Self-Pay 40 1,289 516 1,489 768,324

2,258 4,296,796

Variable cost per admission 1903

Note rounded off capitated admissions

Capitated Total Revenues are 14,110,583$ Total Enrollees 25,000Annual revenue per enrollee is 564.42$ Per Member Per Month 47.04$

903 admissions per 10,000


Table 7.3 Montana Medical Center (MMC): Pro-Forma Worksheet and P&L Statement for 2005 with CapitationAverage Variable Total

Number of Revenue per Revenues Cost per Variable ContribtuionPayor Admissions Admission by Payor Admission Costs MarginCapitated 2,258 6,250$ 14,112,500$ 1,903$ 4,296,796$ 9,815,704$ Medicare 4,268 7,327 31,271,636 2,529 10,793,772 20,477,864 Medicaid 4,716 5,448 25,692,768 1,575 7,427,700 18,265,068 Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544 Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140 Commercial 845 11,770 9,945,650 2,969 2,508,805 7,436,845 Self-Pay 773 2,053 1,586,969 1,489 1,150,997 435,972 Other 1,149 11,539 13,258,311 3,085 3,544,665 9,713,646 Total 17,054 108,587,196$ 35,174,873$ 73,412,323$


annual capitated requirments for 25,000 564.50$ Monthly capitated revenue reequirments 47.04$


22Cartwright Financial Management

Sensitivity Analysis

• As managers, you need to assess the impact of changes in the key variables from the base case scenario

• Scenario 1 – only 15,000 enrollees, not 25,000

• Scenario 2 – Additional 10,000 enrollees added to plan. (35,000)

• Scenario 3 – Lower premium to $40


Capitation with 15,000 enrollees at 47.04 PMPM

• 60% shortfall in enrollees – For Medicaid, 0.60 X 20% = 12%

• Need distribution of the type of enrollees in the shortfall. Smaller numbers coming out of other plans.

• Medicaid (12%, ): (1-.12) x 5895 = 5188• Commercial (24%): (1-.24) x 1,408 = 1070• and Self-Pay (12%): (1-.24) x 1,289 = 980


Capitation with 15,000 enrollees at $47.04 premium

• Note premium has been fixed and therefore the sensitivity analysis is looking at the net income generated.

• Net income is the same, since the reduction in the capitated plan enrollment means that admissions remained in the other plans.


Table Montana Medical Center (MMC): Assuming 15,000 with CapitationAverage Variable Total

Number of Revenue per Revenues Cost per Variable ContribtuionPayor Admissions Admission by Payor Admission Costs MarginCapitated 1,355 6,250$ 8,468,750$ 1,903$ 2,578,565$ 5,890,185$ Medicare 4,268 7,327 31,271,636 2,529 10,793,772 20,477,864 Medicaid 5,188 5,448 28,264,224 1,575 8,171,100 20,093,124 Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544 Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140 Commercial 1,070 11,770 12,593,900 2,969 3,176,830 9,417,070 Self-Pay 980 2,053 2,011,940 1,489 1,459,220 552,720 Other 1,149 11,539 13,258,311 3,085 3,544,665 9,713,646 Total 17,055 108,588,123$ 35,176,290$ 73,411,833$




What if 10,000 additional enrollees in the capitated plan

• Increase enrollment to 35,000 @ $47.04 PMPM• Utilization rate of 903 per 10,000 constant• Variable cost per admission constant• Additional enrollees are brand new and do not

cannibalize other plans• Each additional enrollee brings in $47.04 PMPM

in additional revenue.• Where would MMC get these additions?


What if 10,000 additional enrollees in the capitated plan?

• Marginal (incremental) revenue– 114,227,979 –108,583,746 =5,664,233

• Marginal (incremental) cost– 36,893,591 – 35,174,873 = 1,718,718

• Total contribution margin 3,925,515– added to the bottom line.


Table 7.4 Montana Medical Center (MMC): Assuming 35,000 with CapitationAverage Variable Total




Numbers in red vary from Gapenski


Capitation Assuming 35,000, but $40 PMPM

• Expansion requires a concession on price to be attractive in the market place

• Loss of revenue is – 35,000 x 7.04 x 12 = $2,956,800

• Adjust Revenues by Payor– 19,754,816 – 2,956,800 = 16,798,016– Which is rounded to $16,800,000 in Table 7.6


Capitation Assuming 35,000, but $40 PMPM

• Net income is $2,633,012 which falls $2,954,815 from $5,587,827 (@$47.04)

• No offsetting reduction in cost• Therefore, entire $7.04 PMPM decrease

falls on net income.• Premium can fall to $37.69 to achieve

original net income without capitation of $1,662,312


Table 7.5 Montana Medical Center (MMC): Assuming 35,000 and PMPM $40Average Variable Total




Numbers in red vary from Gapenski


Utilization and Cost Reduction Effects on Net Income

• Assume 25,000 and $47.04 PMPM

• Utilization rate falls from 903 per 10,000 to 800 per 10,000

• Revision of clinical guidelines result in a variable cost per admission reduction from $1903 to $1800


Utilization and Cost Reduction Effects on Net Income

• 25,000 x .08 = 2000 admissions

• 103/1903 = 5.4% reduction in costs

• Insert changes in Capitated row.

• Variable costs fall by $696,794

• Net income increases by same

1,662,312 + 696,794 = $2,359,106

• Should these be applied to all groups?


Table 7.6 Montana Medical Center (MMC): Assuming 25,000 and PMPM $47.04,Utilization and Cost Improvements

Average Variable TotalNumber of Revenue per Revenues Cost per Variable Contribtuion

Payor Admissions Admission by Payor Admission Costs MarginCapitated 2,000 7,055$ 14,110,000$ 1,800$ 3,600,000$ 10,510,000$ Medicare 4,268 7,327 31,271,636 2,529 10,793,772 20,477,864 Medicaid 4,716 5,448 25,692,768 1,575 7,427,700 18,265,068 Montana Care 828 4,305 3,564,540 1,907 1,578,996 1,985,544 Managed Care 1,885 3,842 7,242,170 1,638 3,087,630 4,154,540 Blue Cross 332 5,761 1,912,652 2,366 785,512 1,127,140 Commercial 845 11,770 9,945,650 2,969 2,508,805 7,436,845 Self-Pay 773 2,053 1,586,969 1,489 1,150,997 435,972 Other 1,149 11,539 13,258,311 3,085 3,544,665 9,713,646 Total 16,796 108,584,696$ 34,478,077$ 74,106,619$




Developing a Premium Ratefor Managed Care Plan

• Institutional rates - fee-for-service equivalent method (set charge)

• Budgetary or Cost rates – usage and costs– Demand,FTE,average cost per FTE, support

• Demographic base rates – Utilization by age and sex, costs PMPM


Institutional RatesInpatient cost PMPM

• Per member utilization rate x Fee-for-service rate 12

• 350 inpatient days for 1,000 members = .350 days per member

• $938 per day charge

• (.350 * $938)/12 = $27.35 PMPM


Institutional Rates Out of Area Use

Annual Usage per Fee-for-service CapitationService 1,000 Members Rate Rate PMPM

Out-of-area inpatient days 25 1,495 3.11Outpatient surgeries 50 1,082 4.51Emergenciy room visits 125 138 1.44Skilled nursing home days 5 150 0.06

9.12


Budgetary or Cost Approach

• Based on usage or underlying costs

• Expected patient demand

• FTE physicians

• Physician cost: base compensation, fringe benefits, malpractice premiums

• Costs for staffing x FTEs


Example for BetterCare

• Each enrollee makes 3.0 visits to primary care physician per year (3 per 1,000 rate)

• FTE handles 4,000 patient per year

• Total Compensation is $175,000 per year


BetterCare PMPM for Primary Physician Compensation

• Each enrollee requires 3/4,000 Physiciansor .00075 physicians

• Annual Cost = .00075 x $175,000 = $131.25 per year

• Cost PMPM = 131.25/12 =$10.94


BetterCare Physician Specialist Care

• 1.2 visits to specialist per enrollee• 1000 enrollees have 1,200 visits• Each Specialist sees 2,000 patients per year• Total compensation is $284,000 per year• 1,000 enrollees require $1,200/$2000 x FTE• Cost is 0.60 x $284,000 = $170,400 per 1,000• Cost PMPM is $170.40/12 = $14.20


BetterCare Premium Rate CalculationPrimary Care 10.94 PMPMSpecialist Care 14.20 Support Staff 6.67 Supplies 3.50 Overhead 6.00 Subtotal 41.31 PMPMProfit (10%) 4.13 In-area total 45.44 PMPMOutside referrals 3.40 Total 48.84 PMPM


Demographic Approach

• Age/sex distribution of enrollees is specified and specific cost data is applied to estimate the capitation rate.

• Total service cost (PMPM) is a weighted average of age and sex.


Cost Per Member Per Month Demographics Primary Care Specialist/Referral Hospital/Other

Age Male Female Male Female Male Female Male Female

0-1 1.9 1.9 47.00$ 47.00$ 31.42$ 31.42$ 29.93$ 29.93$ 2-4 2.8 2.8 20.25 20.25 11.19 11.19 16.29 16.29 5-19 12.4 12.4 11.04 11.04 11.19 11.19 15.35 15.35 20-29 11.4 15.4 10.53 15.92 18.44 49.30 11.58 55.65 30-39 9.6 10.0 13.04 17.56 23.26 44.51 24.95 58.97 40-49 5.3 5.7 16.40 19.56 32.64 41.05 53.74 52.31 50-59 3.6 3.6 20.74 22.74 47.13 47.74 80.60 66.91 60+ 0.7 0.5 24.93 25.60 73.43 58.91 121.54 87.60 Total 47.70 52.3

Male/Female Cost 7.07 9.10 10.57 18.69 13.24 23.22

Total Service Cost 16.17$ 29.27$ 36.47$


Getting to Final Cost

• Need a capitation rate to pay all providers in –area or outside-of-area services

• Some services will be carved out like pharmacy and durable medical equipment

• Carve-out of behavioral health benefit

• Carve-outs may be in the offer and costs or out.


BetterCare, Inc HMO Bid

Hospital inpatient 27.35$ PMPMOther Instituional 9.12Pharmacy and DME Benefits 7Physician care 48.84 Total medical care costs 92.31$ PMPM

HMO ccosts Administration 13.85$ Contribtuion to reserves/profits 2.05Total HMO Costs 15.90$ PMPMTotal Premium 108.21$ PMPM


Management Decisions

• What is the market like?

• Does this bid look too low given current prices?

• Does this bid look to high?

• What is the competition?

• Is the right quality in the bid?


Using Relative Value Units (RVUs) to set prices

• Resources consumed to provide service• Establish RVUs for each of type of lab test• Multiply number of tests x RVUs to get

total RVUs• Divide Total costs/total RVUs to get dollar

per RVU $250,000/165,000=$1.52• Adding markup of 25%• 1.25 x $1.52 = $1.90


7.8 Clinical Laboratory RVU AnalysisNumber of Tests

Test Number of RVUs Performed Annually Total RVUsUrinalysis 5 5,000 25000Blood Typing 10 4,000 40000Blood Cell Account 50 1,000 50000Tissue analysis 200 250 50000

165000

7.9 Clinical Laboratory Price ListTest Number of RVUs Price per RVU Test Price

Urinalysis 5 $1.90 $9.50Blood Typing 10 1.90 $19.00Blood Cell Account 50 1.90 $95.00Tissue analysis 200 1.90 $380.00


Service Decision

• Accept or reject a new proposal or contract

• Is the offered PMPM sufficient to do business?

• Should I make a counter offer? Maybe we are not too far apart.

• Any contingencies to negotiate


Loosely Managed UtilizationAverage Cost

Inpatient Days Average Cost Per MemberService Categroy Per 1,000 Enrollees Per Day Per Month

General 157 1,500$ 19.62$ Surgical 132 1,800 19.8Psychiatric 71 700 4.14Acohol/Drug abuse 38 500 1.58Maternity 42 1,500 5.25 Total medical costs 440 1,375$ 50.39$

Administrative Costs 2.80 Risk (Profit) Margin 2.80

Total 55.99$


Tightly Managed UtilizationAverage Cost

Inpatient Days Average Cost Per MemberService Category Per 1,000 Enrollees Per Day Per Month

General 79 1,600$ 10.53$ Surgical 58 1,900 9.18Psychiatric 13 800 0.87Acohol/Drug abuse 4 600 0.2Maternity 26 1,600 3.47 Total medical costs 180 1,617$ 24.25$

Administrative Costs 1.35 Risk (Profit) Margin 1.35

Total 26.95$


Pro-Forma Cost Worksheet: Loosely Managed Utilization

Inpatient Days Average Cost TotalService Category Per 40,000 Enrollees Per Day Annual Cost

General 6,280 1,500$ 9,420,000.00$ Surgical 5,280 1,800 9,504,000.00$ Psychiatric 2,840 700 1,988,000.00$ Acohol/Drug abuse 1,520 500 760,000.00$ Maternity 1,680 1,500 2,520,000.00$ Total medical costs 17,600 1,375$ 24,192,000.00$

Administrative Costs 1,344,000.00 Risk (Profit) Margin 1,344,000.00

Total 26,880,000.00$


Pro-Forma Cost Workheet: Tightly Managed Utilization

Inpatient Days Average Cost TotalService Category Per 40,000 Enrollees Per Day Annual Cost

General 3,160 1,600$ 5,056,000.00$ Surgical 2,320 1,900 4,408,000.00$ Psychiatric 520 800 416,000.00$ Acohol/Drug abuse 160 600 96,000.00$ Maternity 1040 1,600 1,664,000.00$ Total medical costs 7200 1,617$ 11,640,000.00$

Administrative Costs 648,000.00 Risk (Profit) Margin 648,000.00

Total 12,936,000.00$


CHP/Baptist Memorial Profit and Loss Statement

Loosely Managed Utilization:Total revenues 16,800,000$ Total costs 26,880,000 Net income (10,080,000)$

Tightly Managed Utilization:Total revenues 16,800,000$ Total costs 12,936,000 Net income 3,864,000$


What is the decision?

• Accept if the hospital can tightly manage the contract

• Reject the contract if it cannot tightly manage the contract

• Conduct more sensitivity analyses


What if?

• Utilization management may improve over time• Five year or six year horizon

– May be profitable in sixth year

• Can the hospital afford to loose market share?• Can variable costs be covered?• Can Baptist capture more market share and raise

prices (or lower costs with economies of scale)?• Is the market stable or is there great turmoil?

Documents

Cartwright Financial Management1 Managerial Accounting: Pricing and Service Decisions