SOONER HEALTH NETWORK (the Network), which consists of five
medical group practices, is a subsidiary of not-for-profit Sooner
Health System (the System). The Network includes both primary care
and specialty physicians, with an emphasis on
obstetrics/gynecology, eldercare, and pediatrics. Prior to the
founding of the Network, the five practices operated
independently.
The Network has three practice locations, each staffed with a
mix of primary care and specialist physicians. Although the Network
itself is only marginally profitable, it is an important
contributor to the profitability of the System because it generates
a large amount of revenues from referrals for both inpatient
admissions and inpatient and outpatient ancillary services. In
fact, each $1 of revenue generated within the Network is estimated
to lead to $8 of inpatient and ancillary revenues to the System. By
limiting the amount of ancillary services provided at the three
Network locations, patients are forced (or at least encouraged) to
use other System facilities for such services.
Still, some ancillary services are best performed at the Network
locations for one or more of the following reasons: lower costs,
increased physician efficiency, and improved patient convenience
and hence better CAHPS (Consumer Assessment of Healthcare Providers
and Systems) scores. For example, one of the practice locations now
has a diagnostic imaging capability. When the scanner was moved
from another facility to the Network location, volume increased,
costs decreased, and both physician and patient satisfaction
improved. (For more information on the CAHPS program, see www. ahrq
.gov/ cahps/ about-cahps/index.html)
The proposal currently being considered by the Network is to
provide ultrasound services at the Network locations. Preliminary
analysis indicates that two approaches are most suitable.
Alternative 1 involves the purchase of one ultrasound machine
for each of the Network's three locations. Patients would schedule
appointments, generally at the clinic they are using, during preset
times on specified days of the week. Then, the full-time ultrasound
technician would travel from one location to another to administer
the tests as scheduled. Alternative 2, on the other hand, involves
the purchase of only one ultrasound machine, but patient scheduling
would be the same. The machine would be mounted in a van that the
technician would drive to each of the three Network locations. Most
of the operating costs of the two alternatives are identical, but
Alternative 2 has the added cost of operating the van and setting
up the machine after each move.
The two alternatives differ substantially in capital investment
costs because Alternative 1 requires three ultrasound machines, at
a cost of $100,000 each, whereas Alternative 2 requires only one
machine. However, Alternative 2 requires a van, which with
necessary modifications would cost $40,000. Thus, the capital costs
for Alternative 1 total 3 x $100,000 = $300,000, whereas the costs
for Alternative 2 amount to only $100,000 + $40,000 = $140,000.
Because the two alternatives have different operating costs, a
proper cost analysis of the two alternatives must include both
capital investment and operating costs. The Network financial
staff, which is the System financial staff, considered several
methods for estimating the operating costs of each alternative.
After much discussion, the chief financial officer (CFO) decided
that the activity-based costing (ABC) method would be best.
Furthermore, an ad hoc task force was assigned to perform the cost
analysis.
To begin the ABC analysis, the task force had to develop the
activities involved in the two alternatives. This task was
accomplished by conducting walkthroughs of the entire process from
the standpoint of the patient, the ultrasound technician, and the
billing and collections department. The results are shown in
exhibit 8.1. A review of the activities confirms that all except
one - consisting of transportation, setup, and breakdown - are
applicable to both alternatives.
The next step in the ABC process is to detail the costs
associated with each activity. This step uses financial,
operational, and volume data, along with the appropriate cost
driver for each activity, to estimate resource consumption. Note
that traditional costing, which often focuses on department-level
costs, typically first deals with direct costs then allocates
indirect (overhead) costs proportionally according to a
predetermined allocation rate. In ABC costing, the activities
required to produce some service, including both direct and
indirect, are estimated simultaneously. For example, exhibit 8.1
contains activities that entail direct costs (such as technician
time) and activities that entail indirect costs (such as billing
and collection). Although the ABC method is more complex and hence
costlier than the traditional method, it is the only way to
accurately (more or less) estimate the costs of individual
services.
Activity cost detail on a per procedure basis is contained in
exhibit 8.2. Each activity is assigned a cost driver that is most
highly correlated with the actual utilization of resources. Then,
the number of driver units, along with the cost per unit, is
estimated for each activity. The product of the number of units and
the cost per unit gives the cost of each activity. Finally, the
activity costs are summed to obtain the total per procedure
cost.
Many of the activity costs cannot be calculated without an
estimate of the number of ultrasounds that will be performed. The
best estimate is that
50 procedures would be done each
week, regardless of which alternative is chosen. Assuming the
technician works 48 weeks per year, the annual volume estimate is
2,400 procedures. Of course, one factor that complicates the
analysis is that a much greater total volume can be accommodated
under Alternative 1 (with three machines) than with Alternative 2
(with only one machine). However, to keep the initial analysis
manageable, the decision was made to assume the same annual volume
regardless of the alternative chosen.
Other costs are thought to be relevant to the decision. First,
in addition to the purchasing and operating (primarily consisting
of fuel expenses) costs of the van, the estimated annual vehicle
maintenance costs are $1,000. Furthermore, annual maintenance costs
on each of the three ultrasound machines under Alternative 1 are
estimated at $1,000, whereas the annual maintenance costs for the
single machine under Alternative 2 are estimated higher, at $1,500,
because of added wear and tear. The manufacturer of the ultrasound
machines has indicated that a discount may be available if three
machines, as opposed to only one, are purchased. The amount of the
discount is somewhat uncertain, although
5 percent has
been mentioned.
Finally, to get a rough estimate of the total annual costs over
the life of the equipment, assumptions about the useful life of the
ultrasound machines and the van must be made. Although somewhat
controversial, the decision was made to assume a five-year life for
both the ultrasound machines and the van and that the value of
these assets would be negligible at the end of five years.
Instructions
You are the chair of the Network's ad hoc task force. Your
charge is to evaluate the two alternatives and to make a
recommendation on which one to accept, if revenues would be
identical for the two alternatives, and hence the decision can be
made solely on the basis of costs. As part of the analysis, the
costs of the two alternatives must be estimated on a per procedure
basis and an annual basis. In addition, any relevant qualitative
factors must be considered before the recommendation is made.
To keep the base case analysis manageable, the task force was
instructed to assume that the operating costs remain constant over
the useful life of the equipment. For comparative purposes, this
assumption is not too egregious because the activities are roughly
the same for both alternatives and, hence, inflation would have a
somewhat neutral impact on the cost comparison.
In addition, the System CFO has asked the task force to perform
some sensitivity (scenario) analyses. He is concerned about the
accuracy of the cost detail inputs. Although he is confident about
many of the estimates, he thinks others are more arbitrary. Those
activity cost inputs considered to be most uncertain are supplies
cost per unit; billing and collection cost per unit; general
administration cost per unit; and transportation, setup, and
breakdown cost per unit.
Thus, first, the task force must redo the analysis assuming that
these inputs are higher than the base case values by 10 and 20
percent. Activity cost inputs less than the base case values could
also be examined, but the critical issue here is not to
underestimate the total costs involved in the two alternatives.
Second, the task force must determine what would happen to the cost
estimates if the useful life of the capital equipment were as short
as three years or as long as seven years. Another concern was that
the useful life of the equipment depended on the alternative
chosen; that is, there would be less wear and tear under
Alternative 1 than under Alternative 2. Finally, the task force
must assess the impact of a purchase discount: Would the discount
amount influence the ultimate decision?
You believe that performing a sensitivity analysis on the number
of procedures would be helpful, but you realize this task would
require recalculation of the per unit cost inputs, an effort
thought to be too time-consuming to undertake at this point in the
analysis.
Case 2 Questions
Question 1
Estimate the base case cost of Alternatives 1 and 2 regarding
the provision of ultrasound services.
Question 2
Which alternative has the lower total cost?
Question 3
Redo the analysis assuming that the per unit supplies cost;
billing and collection cost; general administration cost; and
transportation, setup, and breakdown costs are higher than the base
case values by 10 percent. Redo the analysis again assuming these
costs are 20 percent higher than the base case values.
Question 4
Return to the base case. What value for transportation and
set-up costs would make the costs of the two alternatives the
same?
Question 5
Again, use all base case data but assume that a 5 percent
discount is available if three machines are purchased. What effect
does this have on the decision? What discount amount would make the
two alternatives equal in costs?
Redo the base case analysis assuming a useful life of 3 years.
Now assume a life of 7 years.
Question 6
Do the analyses conducted for Questions 3 through 6 affect your
decision as to which alternative has the lowest cost?
Question 7
What subjective factors would influence the decision as to which
alternative to choose?
Question 8
What is your final decision?
Questions 9
In your opinion, what are the three key learning points from
this case
Remarks: