Cost, volume and profitability analysis. (Nuts and Bolts of Business).

Physician practices often make business decisions without understanding the impact of that decision on profitability.

In order to determine whether a business decision will improve profitability, you first must understand how costs are defined, as well as the relationship between cost, volume, and profitability.

Costs

Costs are defined by behavior.

* Variable costs increase or decrease in direct proportion to changes in the level of activity, which produce the cost. One example of a variable cost for a pediatric practice is vaccines. The cost of the vaccines is in direct proportion to the amount of vaccines ordered and given.

* Fixed costs, on the other hand, remain constant even if the activity level changes. A good example is office rent. The practice will pay a fixed amount of rent each month, regardless of the volume of patients seen.

The second way to define cost is based upon how costs are assigned.

* Direct costs are those that can be traced to a particular individual or department. They may be variable or fixed costs. For example, salary and vaccines may both be direct costs, since they may be assigned to a particular individual or department. Salary, however, is usually classified as a fixed cost, while vaccines are a variable cost.

* Common or indirect costs must be allocated to an individual or department. In other words, there is no direct connection between the individual and the cost. An example of a common cost is utilities. It is not practical to attempt to measure each individual's use of utilities in a practice. This common cost is allocated among all the individuals in the practice.

Profit

Once we understand the definitions of cost, we can begin to analyze profitability.

One method is to look at the contribution income statement.

With the financial income statement, cost is organized by function and listed as operating expenses. Even if these operating expenses were further broken down into categories, they still would not describe the behavior of those expenses.

First, variable expenses are subtracted from revenue, producing what is referred to as the contribution margin. It "contributes" toward covering fixed expenses and then towards profits.

Compare that with a contribution income statement.

Fixed expenses are then subtracted to determine the net income. Just like cost, our analysis of cost and profitability also may be organized by behavior. This is the role of the contribution income statement.

The contribution income statement is important because it allows you to analyze and find the most profitable combination of variable costs, fixed costs and volume. This is referred to as cost-volume-profit or CVP analysis.

The two most common analysis equations are the contribution margin ratio and the break-even analysis.

The contribution margin ratio is also referred to as the profit-volume ratio. It is the ratio of the contribution margin to total revenue. Why is this ratio important? Once calculated, the contribution margin ratio will allow you to quickly determine the impact of increased revenue on your total contribution margin. If fixed expenses do not change, then net income also will increase by the same amount.

For example, if the contribution margin is $40,000 and the total revenue is $100,000, then the contribution margin ratio is 40 percent. So, for each $1.00 increase in total revenue, the contribution margin will increase by 40 cents. If fixed expenses do not change, then for every $1.00 increase in total revenue, net income will increase by 40 cents.

Imagine that you want to increase your net income by spending more time in your office seeing patients. You estimate that this increased time will allow you to have 500 more visits each year.

One half of these visits are new patients (CPT 99203) for which you collect $70 per visit. The other half are established patients (CPT 99213), for which you collect $45 per visit. You calculate your contribution margin to be 50 percent. The increased time in the office will not raise fixed expenses.

Given these assumptions, what will your increase be in net income?

First, calculate the increase in new revenue.

With half of the additional patients new and the other half established, expect to collect additional revenue of $28,750. The increase in contribution margin will be 50% x $28,750 or $14,375. Since there is no change in fixed expenses, net income also will increase by the same amount as the contribution margin, $14,375.

The question you must ask yourself is whether increasing your time is worth an additional $14,375 to you.

Likewise, you can use CVP analysis to determine the number of patients required to reach a target net profit.

Let's say you want to increase your net profit by $30,000 per year. How many new patient visits (CPT 99203) will you need to see to achieve this target?

First, calculate the contribution margin per new patient visit, which is $70 per new patient multiplied by the contribution margin ratio of 50 percent or $35 per new patient visit. If fixed expenses do not change, then you will need to see 857 new patients ($30,000/$35 per new patient) to achieve your target net profit.

The second analysis the contribution margin ratio allows is the break-even analysis. The break-even point is when total contribution margin equals total fixed expenses. At break-even, net income is zero. The breakeven point is calculated as the ratio of the fixed expenses to the contribution margin ratio.

In our example where the contribution margin ratio was 40 percent, fixed expenses equaled $30,000, then the breakeven point in revenue equaled $30,000/0.40 or $75,000.

This is valuable, since if fixed expenses were to increase, you could easily calculate the additional revenue required to at least break-even from your investment.

For example, if you hired an additional employee at a cost of $25,000 per year, you would have to generate revenue of $137,500 ($55,000/0.40) to break even on this additional investment.

As you can see, use of the contribution income statement and CVP analysis are powerful tools since they allow you to understand the interrelationships among cost, volume and profit. This knowledge can be used as a key factor in many business decisions within your practice.

David P. Tarnatino, MD, MBA, is the executive medical director of Shock Trauma Associates, P.A., a 50+ physician, multispecialty practice associated with the University of Maryland School of Medicine. In addition, he is the chief executive officer of The MD Consulting Group, LLC, a health care management consulting firm in Baltimore, Md.

Figure 1

Financial vs. Contribution Income Statement

Financial Income Statement

Cost by Function     Cost by Behavior

Revenue                       $12,000
Operating Expenses            $11,000
Net Income                    $ 1,000


Contribution Income Statement

Cost by Function     Cost by Behavior

Revenue                      $12,000
Variable Expenses            $(3,000)
Contribution Margin          $ 9,000
Fixed Expenses               $(8,000)
Net Income                   $ 1,000

Figure 2: Using CVP Analysis

More income by increasing your time in the office

500 more office visits per year

One half will be new patients = $70/visit.

One half will be established patients = $45/visit.

No increase in fixed expenses.

Contribution margin ratio is 50%.

New revenue = (250 x $70) + (250 x $45) = $28,750

Increase in Net Income = 50% x $28,750 = $14,375

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If you want to increase your income by seeing more patients, it's important to figure out the financial impact such a move could have on your practice. Learn how to run a cost, volume and profitability analysis to determine how business decisions can change your financial picture.