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Using transfer pricing in decision making. (Nuts and Bolts of Business).

Imagine this problem. A clinical specialty within an academic, multi-specialty group practice is going to leave the group and join a new department created for its specialty. This specialty provides the largest billings and collections to the group.

The school of medicine has agreed to the formation of the new department. While there is no argument that the departure will have significant financial impact to the multi-specialty group, there is disagreement about what the financial impact will be.

The question is how to fairly compensate the group for the departure of this specialty. How do we solve the dilemma?

One way to approach the problem is to use the concepts of transfer pricing. Traditionally, transfer pricing is used when one division of a company provides goods or services to another division of the same company. It is a means of preventing the division that sells the final 'product" from reaping all of the profits, despite the contributions of the other divisions in producing that product.

If you think of each of the clinical specialties as divisions of the same company, and the care of the patient as the final product, then the principles of transfer pricing may be applied to this problem.

Some form of competitive market price generally is regarded as the best approach to solving a transfer-pricing problem. By using market prices to control transfer pricing, every division is able to show profits, not just the final division in the chain of transfers. Obviously, this model assumes that each division behaves as an independent profit center.

A general formula exists to calculate market based transfer pricing between divisions or segments in a multidivisional company. The transfer price should be equal to the variable costs of the goods or services, plus the contribution margin per unit that is lost. It is expressed as:

Transfer Price = Variable costs per unit + Lost contribution margin per unit

Variable costs increase or decrease in direct proportion to changes in the level of activity that produce the cost. Fixed costs remain constant, even if the level of activity changes. Contribution margin is the difference between revenue and variable expenses. It is so named because it "contributes" toward covering fixed expenses and then towards profits (for a detailed discussion on cost, please see the January-February 2002, Nuts and Bolts of Business in The Physician Executive).

Assume the following data was made available for the multi-specialty practice as a whole and the division that plans to leave.

The practice as a whole sees 6,000 patient admissions per year. The departing division sees 2,500 admissions per year. For our calculations, patient admissions will be our unit of transfer.

Total group revenue (collections) is $11 million per year, while the departing division's revenue is $3 million per year. The group's total variable costs are $1 million per year, while the division's variable costs are $500,000 per year.

Therefore, the variable cost per unit for the group, as a whole, equals the variable cost for the group divided by the number of admissions ($1,000,000/6,000) or $166.67 per admission.

The physicians in the departing division are paid a total of $2.1 million in salaries each year. The division's contribution margin will be the difference between their revenue and the sum of their variable cost and salaries.

We assume salary to behave like a variable cost when the division leaves the group, since the group will no longer be paying this as a fixed cost. So, the division's lost contribution margin equals $400,000 {$3,000,00 on revenue -- ($500,000 lost variable cost + $2,100,000 lost salary)l. The lost contribution margin per admission is $400,000 divided by 2,500 admissions per year or $160 per admission.

To calculate the transfer price, we add the variable cost of $166.67 per admission and the lost contribution margin per admission of $160 to obtain a total of $326.67 per admission. Multiplying by 2,500 lost patient admissions yields a financial impact of $816,675 per year.

Knowing this number is important for several reasons:

* It sets the groundwork for negotiations regarding control of the accounts receivable balance of the departing division.

* It allows the group that is losing this division to better understand the measures it will need to implement as a result of the loss.

* It will allow the medical school to understand the amount of additional or new support it may need to provide to the multispecialty group as a result of the transfer.

While transfer pricing generally is thought of as an important management accounting tool in manufacturing companies, as can be seen from this example, transfer pricing can play an important role in understanding the profitability impact of the transfer of goods or services between divisions in health care, too.

RELATED ARTICLE: Calculating the Transfer Price

Transfer Price = Variable cost/unit + Lost contribution margin/unit

* Group total collections = $11 million/year

* Division collections = $3 million/year

* Group variable costs = $1 million/year

* Division variable costs = $500,000/year

* Division salaries = $2.1 million/year

* Total Group admissions = 6,000/year

* Total Division admissions = 2,500/year

Group Variable Cost/Unit = $1,000,000/6,000 = $166.67/unit

Division Lost Contribution Margin = $3,000,000 - (500,000 + 2,100,000) = $400,000

Division Lost Contribution Margin/Unit = $400,000/2,500 = $160/unit

Transfer Price = $166.67/unit + $160.00/unit = $326.67/unit

Transfer Price = $326.67/unit x 2,500 admissions = $816,675

David P. Tarantino, MD, MBA, is the executive medical director of Shock Trauma Associates, PA., 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. Tarantino can be reached by phone at (410)328-3198 or by e-mail at
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Article Details
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Author:Tarantino, David
Publication:Physician Executive
Date:Mar 1, 2003
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