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Understanding cost behavior in the lab: the key to financial success.

TODAY NO ONE in laboratory management can escape the trials and tribulations associated with financial assessment. Everywhere you turn, managers are being asked to justify all they plan to do and substantiate what's already being done. Laboratorians who don't understand how different costs behave run the risk of making inaccurate budgetary decisions that can have a serious impact on their operations.

Because most laboratory testing takes place in a hospital setting, many of the laboratory's financial decisions are influenced by the hospital's finance department. Traditionally, hospitals have allocated certain hospital-wide expenses to the laboratory, for instance, costs associated with the cafeteria, administrative support, and admissions. While this practice is acceptable, it can burden a lab's outreach program with "unearned" costs that make the program uncompetitive. Additionally, some hospital-based accountants are accustomed to a relatively stable, or slightly declining, hospital lab test volume. As a result, it appears to them that most lab costs are fixed, yet these costs are at least 50% variable.

Here's just one example of cost behavior that could affect pricing and budgetary decisions in your laboratory: Assume your total laboratory costs are $100,000 per year and that your staff performs 10,000 tests annually. If the $100,000 is treated as fixed, each test costs $10.00 ($100,000/ 10,000 tests). If, on the other hand, half of the $100,000 cost is considered variable (see box, "What are fixed and variable costs?'", the incremental cost of each test is $5.00, or $50,000 (half the total of $100,000) divided by 10,000 tests. If your lab had put in a bid to do tests for a customer based on the first scenario, it probably would lose out to a facility that better recognizes and understands cost behavior. This article explains how to differentiate fixed from variable costs and reviews the dynamics of how the two costs behave with changing test volumes.

Fixed costs

Fixed costs do not fluctuate with test volume. Fixed costs in the laboratory include hospital allocations, rent for space, and salaries and benefits for managers. The fixed cost does not change with volume; however, the fixed cost per test fluctuates as volume changes. If volume increases, the fixed cost per test will decline. Likewise, if volume decreases, the fixed cost per test will increase (see box, "Fired versus variable cost behavior"). Laboratorians who run successful outreach programs recognize that increasing test volume reduces the fixed cost for all tests. These facilities also leverage fixed-cost behavior when bidding for large contracts or attracting new customers. By bringing in more tests, all tests (even those priced with no contribution to fixed costs) will realize reduced fixed cost per test. When pricing tests, however, you always should try to recover some fixed costs. Ignoring fixed costs as your operation continues to grow could result in your coming up short when the time comes to expand.

Variable costs

Laboratory variable costs include things such as salaries and benefits for various testing personnel, costs for testing supplies and reagents, even telephone expenses.

Variable costs fluctuate with test volume. When test volume rises, so do variable costs. Similarly, when test volume declines, variable costs go down; however, variable cost per test usually remains constant, regardless of volume. This is in sharp contrast to fixed cost per test, which does rise and fall with volume. As shown in the table, the total amount of fixed costs remains constant. Variable costs are based on volume, so total variable costs do change.

It may seem as if some variable costs ought to be considered fixed costs; however, they usually appear to be fixed in the short run, but prove to be variable over the long haul. For example, assume each of your medical technologists produces 1,000 tests per month. If you pay your technologists $3,000 per month, this would mean you should add $3.00 for each new test ($3,000.00 / 1,000 tests). If, however, you add only 100 new tests in a given month, you probably will not hire a new technologist. In this case, the normally variable cost of medical technologist labor appears fixed. If, in the long run, your volume increases by 1,000 tests per month, you probably will have to expand your staff, and therefore increase the cost for labor.

With the exception of consumable items, most variable costs in the laboratory behave much like medical technologist labor, as described. These costs tend to react incrementally to fluctuations in volume. In the scenario just described, the variable cost of technologist labor increases in increments of $3,000 for each new technologist added to the staff.

Be mindful of such long-term, incremental cost increases when classifying your costs as fixed or variable. It's a good idea to include a portion of all variable costs with each new or lost test (i.e., the $3.00 cost included per test for technologist labor in the abovementioned example). The question to ask yourself is this: Will a sustained change in volume cause an incremental rise or fall in this cost? If the answer is yes, the expense is variable.

Information is not everything

The late Dr. W. Edwards Deming asserted that "Information is not knowledge. Let's not confuse the two." No one will argue all labs have costs--this is information; understanding cost behavior is knowledge.

Laboratory managers must possess this knowledge to supervise their lab's financial processes effectively. To gain meaningful knowledge from observing the cost behavior in your clinical laboratory, remember the following points: 1) Costs that do not fluctuate with volume are fixed; 2) Costs that do fluctuate with volume are variable; 3) You must account for 100% of your variable costs per test on changing volumes; 4) In certain situations, you can ignore most of your fixed costs per test on changing volumes; however, always factor in a small contribution to fixed costs for the unknown impact of sustained growth or decline; 5) Look out for the costs that look fixed but vary in the long run. These rules can help you lead your department to financial success.

RELATED ARTICLE: What are fixed and variable laboratory costs?

Fixed costs

* Salaries and benefits for management, sales staff (excluding commissions), and administrative support staff

* Allocations from the hospital

* Rent for laboratory space and the patient service center

* Sales and marketing promotional expenses

* Amortization of leasehold improvements

* Depreciation on laboratory information systems

* Depreciation on laboratory testing equipment

* Legal and accounting fees

* Equipment repair and maintenance

Variable costs

* Salaries and benefits for medical technologists, cytotechnologists, histotechnologists, etc.; processing personnel; courier services; data entry staff; billing department staff; customer service staff

* Testing supplies and reagents

* Specimen collection supplies

* Forms (reports, requisitions, invoices)

* Office supplies

* Telephone expenses

* Postage

* Remote printers

* Insurance tied to revenue

* Bad-debt expenses

* Courier vehicle expenses

* Sales commissions

* Utilities

RELATED ARTICLE: Fixed versus variable cost behavior
 Total costs Cost per test
Test
Volume Fixed Variable Fixed Variable Total

500 $5,000.00 $2,000.00 $10.00 $4.00 $14.00
1,000 5,000.00 4,000.00 5.00 4.00 9.00
2,000 5,000.00 8,000.00 2.50 4.00 6.50


Increasing test volume reduces the fixed cost per test. Conversely, decreasing test volume increases the fixed cost per test. Because variable costs are proportional to volume, you must account for them accurately, particularly when pricing for bids or developing a budget. Variable costs must be recovered to avoid a negative margin.

James Fantus is president and chief executive officer of Franciscan Shared Laboratory and Medical Science Laboratories in Milwaukee, Wis.
COPYRIGHT 1997 Nelson Publishing
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1997 Gale, Cengage Learning. All rights reserved.

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Author:Fantus, James
Publication:Medical Laboratory Observer
Date:Jul 1, 1997
Words:1268
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