Over the past few years, highly unstable prices in commodities markets have put financial pressure on many producers. Between 2003 and 2008, prices for many of the raw materials used for making industrial products (such as crude oil, steel and aluminum) and consumer packaged goods (such as paper, wheat and milk) rose at double-digit rates only to fall dramatically in the following year. Some sectors have recovered while others remain depressed, but the consensus is that more volatility and uncertainty can be expected going forward.
Many manufacturers lack the flexibility to quickly respond to market volatility. Traditional approaches often leave decisions in the hands of a single function at each step in the value chain: product development and R&D determine the required feedstocks and materials specifications to use for the given product; procurement determines supply availability, negotiates with suppliers and bears the most responsibility for acquiring materials; manufacturing determines the production process and requirements; finance provides hedging strategies; and the marketing and sales provide demand signals and sets the price for the finished product.
The failure to integrate these functions can lead to costly misalignment of efforts. A lack of coordination between supplier and customer sales contracts is a common example. If purchasing renegotiates a higher price for a particular raw material to ensure availability when prices are rising, but sales has already locked the company into non-negotiable customer contracts for the same time period, the higher prices cannot be passed on to customers. In effect, the company assumes the full cost of mitigating the supply risk, rather than being able to share some of that cost -- and risk -- with the customer.
In one case, an aluminum products manufacturer set price ceilings for customers without capping supplier contracts, and as a result, was unable to pass along raw materials price increases. When these prices rose to unprecedented levels, the company's financials collapsed, market capitalization dropped by approximately 35%, and the company lost $1.1 billion over four years.
Moreover, companies without departmental cooperation struggle to develop production methods that can respond to cost fluctuations. Deploying a new technology in the production process, for example, can allow a manufacturer to substitute alternative feedstocks as prices seesaw, freeing it from relying on a single feedstock or sole supplier. But at many companies, sales, purchasing, product development and manufacturing do not work together enough to exploit these opportunities.
Another pitfall is over-relying on hedging as the primary way to manage raw materials price volatility. Typically the exclusive domain of finance, hedging is often carried out with limited visibility into the terms of sales contracts being negotiated by marketing, sales or procurement. Companies that make the wrong bets can pay a heavy price, becoming locked into contracts while prices fall. When natural gas prices fell from a short-term high, for instance, one specialty chemicals company hedged using six-month forward contracts. As gas prices continued to drop, the company's cost disadvantage doubled.
As with any good risk management strategy, companies looking to mitigate raw materials price volatility must look up and down the value chain. Consider all the risks-from supply-chain concerns of transporting cheap raw materials from distant locations and storing large inventories to the capital-expenditure perils of refitting plants and altering production processes for different feedstocks.
After these risks are assessed, companies can then choose from among four categories of risk transfer and mitigation techniques:
1. Upstream Risk Transfer to Suppliers
Companies can employ sourcing and contracting techniques to limit suppliers' ability to pass on additional costs. For example, diversifying the supplier base for priority raw materials gives companies negotiation leverage and limits the power of individual suppliers when prices spike. In some circumstances, it is possible to partner with suppliers to share supply chain risk (such as using fixed, long-term contracts).
2. Downstream Risk
Transfer to Customers Companies can include terms and conditions in contracts to adjust the timing of contract expiration and the risk exposure, where both let them pass on additional costs to consumers. For example, when volumes are agreed to for the long term, pricing can be updated frequently as the market changes. Other approaches include using public indexes or developing synthetic indexes for prices (that is, trending prices to a market price for a particular class of commodities or underlying cost drivers), using "collars" to restrict price changes to a specified range, and matching the contract terms with those of supplier contracts.
3. Risk Transfer to Outside Entities
Although companies should not rely on them exclusively, hedging strategies that transfer risk to counterparties in the financial markets can be critical. But companies must have in-house finance departments that understand the sophisticated positions they need to take -- otherwise they may end up creating more risk for their organization. Companies can also transfer risk externally by collaborating with other companies in pursuit of shared goals. Such cooperation can create a win/win situation that reduces both cost and risk. For instance, a manufacturer can gain access to raw materials outside its home market by contracting to swap or share raw materials with another manufacturer, allowing both companies to reduce costs and giving them the flexibility to minimize supply chain risk.
4. Internal Risk Mitigation
For internal mitigation, the key is developing flexibility in product-development and manufacturing operations. This lets companies switch to cheaper raw materials when prices rise or shift production to different geographic locations that have cost advantages. Companies can also stockpile an inventory of raw materials when prices are low and draw on these when prices spike. While there are costs associated with maintaining high volumes of inventory, they may be justified by the benefits when prices for raw materials are highly volatile.
To mitigate risk through flexibility, one company developed an analysis tool to identify where it should buy a particular raw material and whether it should change the specifications (i.e., quality or grade). Balancing input costs, demand requirements and market prices enabled the company to approve multiple catalysts for its production process and choose which to use based on the regional prices of its product, thereby reducing cost and risk. When its supply costs rose, the company bought a higher-performing catalyst that created a higher yield. Although the company was paying more for its raw materials, the higher yield was large enough that it actually resulted in higher profits. When prices declined, it shifted back to a material that produced slightly lower yields but at a significantly lower cost.
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Indiscriminate Stat orders contribute significant costs. If you experience more than 15 per cent Stat work during the day shift and more than 35 per cent on the p.m. shift, you are in a high-cost mode. Stats limit your ability to batch and save on labor and reagent costs.Timed orders requiring special specimen-collection trips outside scheduled collection rounds have an impact similar to States on the laboratory. Inability to control at least 90 per cent of timed orders can add excessive costs.
Physician demands for lab work to be completed and on the charts by a specific early a.m. time are often unrealistic. Even if the laboratory wants to comply, logistics makes it impossible when too many physicians make the same request.
If 20 physicians want their chemistry panels completed by 7 a.m. and it takes one hour to run 20 unknowns (drawn at 6 a.m.) with appropriate standards and controls, then the first patient will be finished around 7 a.m. and the 20th at 8 a.m. Even drawing all the specimens at 5 a.m. and starting the tests at 6 a.m. may not be very helpful--physicians are likely to decide the panels should be completed at a 6 a.m., since each takes only three minutes.
Late presurgical admissions, requiring extensive testing and transfusion setups, add to the normal cost of operations. In addition, work quality may decline if the night shifts are staffed by generalists. Though capable of handling most problems, generalists are not as experienced as specialists when it comes to unusual blood banking problems or abnormal results in chemistry and hematology. They need more time to solve problems, and repeat testing is often necessary.
Under the guise of learning, residents and interns in teaching hospitals order inappropriate and unnecessary tests and make unreasonable demands on the laboratory staff. Documentation of these additional services can demonstrate the need for increased control over the test ordering patterns of residents and interns.
Physicians in the habit of ordering multi-test panels may just want one or two tests Stat and the rest later, but they will order the whole panel Stat. Then there are those who don't want all the tests but believe it costs the same for one as for 20. They do not know the difference between random access (discrete) and sequential analyzers.
If your laboratory has a random access analyzer and you run a panel of tests when only three are necessary, you are adding to the hospital's costs for DRG cases and reducing opportunities to retain prospective payment dollars. In this connection, costs also rise because of the reluctance of third-party payers to pay for screening panels.
These are but a few examples of hidden costs or variables that are not under the direct control of the laboratory. But laboratory management has a responsibility to document such costs, offer reasonable patient-oriented alternatives, and educate administration and the medical staff about the impact on hospital financial performance.
Evaluating costs from a quality assurance viewpoint. As hospitals move closer to the Joint Commission on Accreditation of Healthcare Organizations' 1990 agenda for outcome-oriented quality assurance, greater attention will be paid to physician behaviors that greatly affect ancillary services' costs. The laboratory should already be gathering data to show how physician ordering patterns influence test costs and case outcomes. Medical directors, in cooperation with clinicians, should be developing appropriate DRG ordering profiles and interpretive algorithms that not only reduce costs but also insure quality patient care.
It may not be too long before all third-party payers go on a prospective payment system. Attention to case mix of admissions (the number and types of cases based on DRGs or other determinants) and patient acuity levels (the degree of severity of illness in different types of cases) will be a major factor in establishment of laboratory test methods and delivery systems. Costs will be determined by case or DRG rather than individual tests. And revenue from billed tests will contribute very little to the laboratory's bottom line.
Understanding today's laboratory financial statement. For years, laboratories have received a monthly financial statement that looked something like the example in Table I. In the good old days when revenue meant actual income from billed charges (adjusted slightly for bad debt), the laboratory could estimate its hospital contribution by multiplying the gross margin figure by a known percentage for allocated expenses. After deducting that result, net income over expenses was usually a solid plus.
Today, however, the revenue entry has become a distraction, since there is no longer any direct relationship between billables (tests charged) and payables (revenue received). With prospective payment, it doesn't make any difference how much you charge or who gets billed. The hospital receives a lump sum out of which it must cover costs of service.
Many laboratory managers believe prospective payment exerts only minimal impact on their actual revenue since less than 50 per cent of patients in their hospitals are on Medicare or Medicaid or are in self-payer categories that generate the majority of contractual adjustments and bad debt. That 50 per cent level can be very misleading, however. I have found most laboratories draw a higher percentage of contractual payment than their hospitals. In larger institutions with laboratory sections as individual cost centers, chemistry, hematology, and the blood bank have very high levels of contractual payment. Table II illustrates the actual experience of one laboratory.
As the population gets older and ambulatory services increasingly take care of less critical cases, hospitals will be treating more over-65 acutely ill patients. These patients require extensive diagnostic and therapeutic testing, mostly not billable.
Prospective payment is also spreading, making the laboratory a major contributor to hospital costs and less a generator of revenue. The old financial statement is only of value as a reference to projected charges versus actual charges. It has little relationship to actual money received.
The key aspect of analyzing financial statements, therefore, is the evaluation of laboratory costs in relation to overall hospital costs. This will necessitate sophisticated cost analysis and a thorough understanding of all aspects of today's financial systems in health care.
Administrators will expect nothing less than effective laboratory management. The individual responsible for management of the laboratory must have knowledge and skills that range beyond medical technology and pathology educational programs. Technical and professional expertise alone will not do the job in a business-oriented organization.
More than 10 billion medical tests of all types are run annually in the U.S., costing $100 billion to $150 billion or as much as one-third of the nation's $450 billion health care bill.1 Laboratory diagnostic and thereapeutic procedures make up a major portion of this activity.
Studies in recent years have suggested that 20 to 30 per cent of all tests are unnecessary or inappropriate. Besides their cost, these may generate an additional $70 billion in medical expenses, including hospitalization and office visits.1
In the face of such figures, it is not surprising that administrators expect their department managers to keep a tight lid on costs. The question is, how can this best be accomplished in the laboratory? Should cost containment be achieved through management effectiveness or external controls? If management can't do the job, there are bound to be more and more imposed controls.
Laboratory administrative directors are evaluated on how they control quality, timeliness, appropriateness, and cost of services. Major variances in that last category raise the most red flags, but the other three factors have an impact on costs, so they must also be considered in any discussion of managing laboratory financial activities.
I have found varying levels of management sophistication in present-day laboratories--from individuals who lack even the most basic understanding of cost management principles and techniques to those who are highly skilled in these areas. Obviously, the latter will be able to survive continued financial contraints and pressures. But that still leaves a very large body of managers who have to expand their knowledge and skills if they do not want to be replaced. This article will focus on what such managers must master --the elements of successful financial management.
Establishing a management system. The first step requires strategic planning and establishment of objectives. Crisis management may result without a detailed operational plan, objectives that maintain realistic expenditures, and the flexibility to respond to change. Development of the budget--essential for finalizing objectives--is a critical part of the first stage of financial planning.
Planning accuracy depends upon extensive internal and external data. Laboratory input should include 1) direct and indirect cost data, 2) billed and actual revenue information, 3) productivity and personnel utilization statistics, and 4) information from ongoing monitoring of delivery systems. External data should include 1) the hospital's average daily census with breakdowns by case mix and acuity levels, 2) projected service expansion or service reduction plans, 3) contractual payment levels (Medicare, Medicaid, and self-pay), and 4) projections of government changes in reimbursement schedules.
When all the necessary data are collected, the laboratory can begin to develop a realistic, reliable budget. Prior to prospective payment, a fixed or static budget was the norm. This was logical since monthly variances were not important, as a high percentage of revenue was based on reimbursement of actual charges. Now, however, a flexible budget, representing a good cost system, will allow the laboratory to adjust expenditures to reflect actual services provided.
Analyzing the cost of operations. Cost analysis is just one part of cost information. Cost information also includes looking at the entire expense of doing business, not just identifying the obvious direct and indirect costs associated with a specific test result. In some laboratories, the difference is minimal. In a great many others, it is quite significant.
Financial officers and controllers speak of direct and indirect, fixed and variable costs; allocated expenses; minimum staffing levels; and controllable costs, to name a few terms. Understanding all of these terms will help you when interacting with administration, when analyzing laboratory costs, and when setting up cost accounting procedures.
Accounting definitions or applications have to be modified to fit the reality of a hospital clinical laboratory operation:
Direct costs are usually those costs connected with performing a test procedure, including labor, supplies, and reagents. They are considered under the control of the laboratory.
Indirect costs are incurred but not directly connected to any specific test procedure. These costs include standards and controls, instrument depreciation, specimen collection, supervisory and clerical help, and internal overhead costs.
Allocated indirect costs (also called allocated overhead) are the laboratory's portion of the expenses of nonrevenue-producing departments. The laboratory has no control over these allocations, and they are determined by specific formulas for each category.
Variable costs fluctuate proportionately with changes in the type and volume of services and usually represent nonsupervisory labor and supplies. These costs are often influenced by external policies and procedures beyond the control of the laboratory.
Fixed costs remain constant over a particular period of time and range of volume. The fixed cost per unit becomes progressively smaller as the volume increases. Supervisory salaries, heating and lighting bills, rental agreement, and depreciation are considered fixed costs. They are often called noncontrollable costs.
Minimum staffing levels reflect a predetermined amount of otherwise variable costs that is necessary for operational or accreditation /licensure reasons. Most laboratory managers believe their present staffing level is minimal and not variable. In reality, it is more likely to be an optimum or even maximum level.
Controllable costs represent discretionary variable and fixed costs. It is this category that causes laboratory managers the most grief. The costs may be controllable, but the control does not always rest with the laboratory. These would be better called noncontrollable variable costs.
Identifying noncontrollable variable costs. It is relatively simple to calculate the direct and indirect costs involved in producing a specific test result. The difficulty comes in determining those costs under a number of different circumstances, most of which are created by medical staff expectations and administrative policies.
These variables must be identified so administration becomes aware of their impact on the cost of laboratory operations. Besides those identified in the College of American Pathologists workload recording manual as workloaded activities, many major cost addons are related to physician ordering patterns. Among the more common:
I am a clinically oriented person. That's not surprising, since I'm a lab manager. I never realized how much I would have to know about finance! Rapidly changing outpatient reimbursement mechanisms have put me in a spin. Medicaid rules in our state (New York) and others are awfully complex. How much do I have to understand about the details of both state and Federal reimbursement regulations? How much can safely be left to others - and to whom? A More than ever before, says Ted Street, the proactive laboratory manager must be comfortable in finance, economics, and accounting. You can never learn too much about regulations, he asserts, particularly those related to reimbursement and licensure. A strong business background as an adjunct to clinical training prepares the laboratory manager for coping in today's changing environment.
At Marti Day's institution, the University of La Verne (Calif.), candidates for both bachelor's and master's degrees are required to take accounting and finance courses. Lab managers need to understand as much as it takes to manage an efficient and effective laboratory, says Day. Being clinically and technically expert no longer suffices for any supervisor or manager in today's health care environment, she believes. Take courses in school and through the professional societies. The presence or absence of such expertise often determines who will be hired - and fired. Marti Bailey wouldn't go quite that far. "It is not my impression that a lab manager needs more than a broad working knowledge of reimbursement rules," she says. "Leave this to your hospital's financial management department, who do need to be intimately aware of these rules to make sure that regulations are being met, that the hospital is receiving 100% of what is due, and to provide budget (revenue) analysis."
Lab managers need to know only what will affect the bottom line of the laboratory's financial reports, Bailey continues. This includes the percentage and approximate reimbursement level of lab tests reimbursed by Medicare/Medicaid, the percentage of lab charges being written off as bad debts, and similar aspects. Having this information is useful when predicting real versus actual lab revenue and pursuing outpatient markets. Being aware of the payment policies of all third-party payers for highly specialized services (such as transplants, trauma, and in vitro fertilization) helps the lab manager determine the potential impact on lab revenue if any of these services are being considered or about to be implemented. Panelist Lynne Garcia suggests that you need a grasp of at least the basics of the financial mechanisms that come into play when you consider new methods, instrumentation, use of personnel, and costing out of current and proposed procedures. She recommends that you thoroughly understand the DRG system, CAP workload recording, CPT codes, personnel salary structures, complete benefit costs, overhead, and direct versus indirect costs. You need to recognize how regulatory changes, such as CLIA '88, will affect your financial picture. You need to understand proficiency testing costs, including the cost to your lab of controls and repeat testing. "You may not need to make every decision or plug in every figure yourself," Garcia warns, "but you'd better have someone good providing you math comprehensible data that make sense and that can be tracked from month to month or even more often. Understand the audit system and how coding errors could prevent you from receiving your fair share of reimbursement.
Learn the ramifications of trying to cheat the system (not recommended). You must understand these issues even if you work with a large business office that regularly supplies data. You must see the whole picture in order to be able to interpret what's going on, particularly in this era of rapid change and serious financial disarray. In addition, you should serve as a reliable source of information for your staff; don't rely on someone else to do it. What you don't understand, you're liable to screw up!" Betty Martin states flatly that a laboratory manager "must know all there is to know about financial management." Avail yourself of all possible avenues of continuing education in the business aspects of laboratory management, she strongly urges. The Clinical Laboratory Management Association (CLMA), for example, of which Martin is president, has received a number of requests for such programs from its members and accordingly presents national videoconferences on financial management. Financial savvy will determine survival in the future, Martin concludes: "It is crucial to be able to forecast data and make appropriate trend analyses. This is one area that the manager does not want to delegate ... unless, of course, that individual is anxious to find employment elsewhere."
As mentioned previously, the budget is a plan. Managers are often required to make forecasts as part of the budgetary process. Forecasts are essentially projections of future scenarios and can be short or long range. Changes in payer mix and utilization patterns can affect forecasts and therefore must be considered when performing this task.
The first phase of the budgeting process is the planning phase. During planning, several essential factors should be considered in the formulation of the budget, including the establishment of goals, the evaluation of the resources needed to meet these goals (including personnel, supplies, and equipment), and an estimation of what these resources will cost. Other things to consider are special projects and their impact on the resources of the organization (for example, the installation of a new information system), as well as large renovation plans and the operational consequences associated with them. One of the most important considerations at this stage is accounting for personnel and related matters, as this usually accounts for the majority of the laboratory’s total budget. The second phase of the process is the formulation of the budget. Line items on the operating budget of a laboratory may include payroll expenses (for management, technical, and clerical staff), benefits expenses (including taxes, vacation pay, and insurance), professional fees, supplies, and equipment fees (including service contracts and repair costs). Other miscellaneous expenses such as dues, subscriptions, and training costs are also included. The next step is the allocation of the expenses to individual laboratory sections, followed by the actual implementation of the budget, known as budget execution. Finally, the budget is monitored for variances. A variance is the difference between the projected expenditure and the actual expenditure in a given category.11 Often, managers are required to explain variances beyond a certain level using variance report forms. These forms often have entries for the projected and actual expenditure level, the numeric value of the difference between them, and the reason for such a variance. Such reasons can include an increase in vendor price, increased workload, or even excess reagent usage by the technical staff. The monitoring phase of the budget process encourages managers to cast a critical eye to their operation and evaluate its financial performance on a routine basis (typically monthly).
Determining the costs associated with all testing performed in a laboratory and performing financial analyses to evaluate operational performance may appear overwhelming. Fortunately, computerized options are available that can lessen the burden of this task. For determining cost per test, the creation and use of a Microsoft Excel spreadsheet customized for the laboratory isa tool used by many institutions. Commercial software is also available for this purpose that can help manage financial information and provide a mechanism for comparing costs, for example, in central versus satellite labs or between 2 potential testing systems. Software is also available for evaluating capital expenditures. Washington G-2 Reports12 offers several publications in the financial arena including one on budgeting/capital analysis and another on cost-based pricing strategies. For physicians’ office laboratories, a spreadsheet program developed by the Center for a Competitive Advantage in conjunction with Venture Resources is available through the American College of Physicians—American Society of Internal Medicine Web site.13 Entitled “Office laboratory check up: Is your lab financially fit,” this program helps, among other things, evaluate a lab’s profitability and assists in determining the financial consequences of performing a test in the office or sending it to a reference lab. There are also numerous printed materials available, including the NCCLS publication GP11-A, Basic Cost Accounting for Clinical Services: Approved Guideline. These and other resources can assist the laboratory manager in cost analysis. It is worth noting that the first resource in this area should be the accounting or finance department in the organization. Most likely, they will have useful cost accounting software or can make useful recommendations. Besides possibly saving the laboratory manager time and money, the methods employed will be compatible with those used by the organization as a whole.
The importance of adequately defining costs and their behaviors cannot be overstated. Cost accounting, that is, defining, measuring, and analyzing the financial elements associated with producing a billable test, is a crucial step in the development of a relevant laboratory budget. The budget provides the framework from which the laboratory will operate for the stated time period. It allows the laboratory to define staffing needs, establish operational goals, forecast revenues and develop strategies for improving the bottom line—whether that be increasing revenue or workload volume or decreasing costs.
Laboratory managers must also have a solid understanding of how the laboratory fits into the organization financially. What is the payer mix? What reimbursement rates are achieved? What are the expectations of the organizational leadership for the laboratory? In a time of increasing uncertainty in the healthcare field because of managed care issues, hospital mergers and consolidations, and escalating regulatory compliance costs, a solid financial plan may be the difference between those organizations that survive and those that don’t. While laboratories typically account for just over 5% of total hospital costs,15 the potential for positive financial contribution to the organization through cost containment and/or revenue- generating outreach programs is a goal worth pursuing.
Another important concept pertaining to costs is the break-even point. This point is achieved when the total costs for a test are equal to the total revenue received for performing the test. When revenue received is greater than this value, you will see a profit. When revenue is less than the break-even point, you will experience a loss. The break-even point is diagrammed in given diagram. Using the previous example, where fixed costs are $300, variable costs are $1 per test, and assuming a revenue of $4 per test, the break-even point (assuming no profit or loss) can be determined using the following variables:
X = volume of tests at breakeven point
R = revenue per test
V = variable cost per test
F = fixed cost per test
C = net income.
The equation to find the break-even
point using these variables is as follows:
RX = F + VX +C
X = (F+C)/(R – V)
Now, input the values from the previous
X = ($300 + $0)/($4 – $1)
X = 100 tests
The break-even point for this example is 100 tests. A test volume of less than 100 will result in a financial loss, and a volume of greater than 100 tests will show a profit. Note that in this example, the income value used is zero because the exact volume of testing where the total costs equal total revenue is the desired figure. Another way to use this formula is in the determination of what volume would be required to obtain a defined income. If a minimum income level of $1200 were desired, the equation would look like this:
X = ($300 + $1200)/($4 – $1)
X = 500
To cover total costs and achieve a profit of $1200, a test volume of 500 is necessary. In addition to the applications described above, a break-even analysis can be used to determine what price must be charged when the volume of testing is fixed. The break-even analysis is a useful tool that can predict what effect a change in cost, volume, or revenue may have and can help the supervisor to predict the success or failure of introducing a new test system.
Budgets Once costs and their behaviors are defined, they can be applied to the planning process through the budget. The budget is a plan of operations expressed in quantitative terms.8 It is used to forecast anticipated revenues and expenditures over a given period of time, typically 1 year, to provide a reference for the evaluation of financial performance of a department or the organization, and to help control costs. The budget is also a measuring stick for financial accountability. Supervisors or managers are generally held responsible for operating within their approved budgets, plus or minus a small variance. It is important to remember that the budget should be driven by the organization’s strategic plan and not visa versa. It is for this reason that developing the budget should be a coordinated process between top organizational management and the department level manager.
Capital budgets: Often, organizations create separate budgets: the operating budget, which is for general operations; and the capital budget, which encompasses larger expenditures that cost more than a defined dollar amount and whose useful life is usually longer than 1 year. Examples of capital expenditures include safety issues (such as those needed to comply with governing agencies such as JCAHO or CAP), the replacement of old or obsolete equipment, and the addition of new equipment for use in cost reduction or revenue- generating projects. Producing a capital budget requires management to perform several tasks when designing such projects. An estimation of initial cash outlay, an estimation of the future revenues and expenses, and a risk analysis of the project are just some of the considerations required in the process. In the MLO survey of CFOs mentioned previously, participants were asked to describe the criteria used to assess laboratory capital spending.
In their answers, 31% cited need, 29% looked at return on income, 20% based their assessment on cost, and 16% evaluated revenue generation.
Many institutions perform capital budgeting at the organizational rather than the departmental level because of the strategic financial implications. Some organizations also produce a separate budget for personnel costs. It is critical that these budgets are tied together in some respect so that changes in one are reflected in the others. For example, if a large capital equipment purchase is planned, it is essential that increases in supplies needed are noted in the operating budget and that any necessary addition of staff is reflected in the personnel budget.
Budget Types: There are several kinds of budgets. An appropriation budget is one in which a fixed sum is applied to each department that has no relationship to volume. This type of budget is common in government organizations. In a fixed budget, an expected volume or workload is defined and the revenues and expenses are forecasted from this volume. If the volume varies during the course of the budget cycle, the forecasted revenues and expenses do not change. The flexible budget recognizes that certain expenses will remain fixed over a given range of activity while others will vary directly with that activity. This does, however, make the flexible budget more time-consuming to develop. Because this type of budget is based on a range of activity or volume, that range must first be defined and then the patterns of costs expected during that period must be analyzed and separated by behavior (fixed or variable).
Costs, as described above, are expenditures and are classified as either direct or indirect. Direct costs are those that are specifically associated with a particular service or process. In the laboratory setting, examples of direct costs include instruments, reagents, and technical personnel. Indirect costs, on the other hand, cannot be specifically associated with a certain service or process and must be paid even when a particular service is discontinued. Examples of indirect costs include clerical staff, inspection costs, and hospital overhead. These costs are shared among several departments or units and thus are allocated accordingly. For example, hospital utility costs may be allocated as indirect costs to departments based on the square footage of the particular unit. Costs are also categorized based on their behavior patterns in relation to changes in volume. Variable costs are those that change proportionately with a given change in volume. If the workload for a particular test or service increases by 10%, the variable costs of performing this test would be expected to increase accordingly. Fixed costs, on the other hand, do not vary as volume changes. In our example above, as the workload for the test increased by 10%, the cost of the department manager’s salary would remain constant. While many of the direct costs associated with a particular test would be considered variable costs (for example, supplies), other direct costs are considered fixed (see Table 1). Additional examples of fixed and variable costs in the laboratory can be found in Table 2.
Other costs have elements of both fixed and variable costs; that is, they vary with volume, but not in direct proportion. These costs are termed semivariable. Continuing with the example above, as the volume for a test system increases by 10%, the semivariable costs would increase, but not by 10%. Staffing requirements can fall into this category. For example, the test volume increase in our example could reach as high as 30% without additional supervisory staff becoming necessary. However, there could be a breaking point where the test volume increase (to say 40%) would necessitate another supervisory position, which forces an increase in the semivariable cost. The fixed and variable components of semivariable costs can be determined using cost behavior models.5,6 As shown in Figure 1, total costs, therefore, are the summations of the variable, fixed, and semivariable costs or the total variable and the total fixed costs.
Cost per test
Once it is determined what the relative costs are, the cost per test can be calculated. This value is important for a number of reasons. It can be used to compare analyzers being considered for use in the laboratory, to compare costs in central versus satellite laboratories, to evaluate the benefits of changing a batch size, or to decide whether to continue to perform the test in house or refer it out for testing. It is important to include the total costs including direct and indirect supplies, salaries, and allocated administrative expenses as well as equipment and maintenance expenses when determining this figure. Costs that may be overlooked but that must be considered include the cost of calibrators, repeat testing, quality assurance costs, education, and losses such as expired reagents and spillage. The cost per test can then be calculated by dividing the total costs by the number of reportable tests.
For example, a laboratory wants to evaluate how the cost per test will change based on 3 potential monthly
test volumes: 100, 250, and 500 tests performed. The laboratory supervisor has determined that the total fixed costs for this test system are $300 and the total variable costs are $1 per test.
In Table 3, the relationship of these costs to the total cost per test is presented. Note that as volume increases, total costs rise; however, the cost per test decreases because the fixed portion is spread over a larger number of tests. It is important to remember that this trend will continue until a certain volume limit is reached where additional fixed costs will be required (for example, the acquisition of an additional instrument to handle the increased volume).
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The chief pathologist has been questioned by several staff physicians about the availability of a new test or disease XYZ. The pathologist then asks you, the chemistry supervisor, to look into the feasibility of offering this test. In researching the possibilities, you must consider several questions. What level of volume can you expect? What are the associated costs of adding this test to the menu? Will this addition require new equipment? Will this equipment be a capital expenditure? What staffing adjustments will be necessary? How many tests will the lab need to perform before realizing a profit?
The ability to answer these questions requires a basic understanding of financial management and is essential for the laboratory manager at any level. Understanding the role the laboratory plays in an overall hospital strategic plan assists the laboratory manager in planning for the direction the laboratory should take, both short-term and long-term. Unfortunately, there is often no formal training in managerial accounting or basic finance for theentry-level manager. In addition, understanding the relationship between revenue and expenses is an essential element in the budgetary process because the result of that process is the laboratory budget— a plan that can guide the laboratory to operational and financial success. Every lab manager should acquire a basic understanding of the financial terms and principles critical to that process.
Revenue and cost centers
In financial terms, institutions are composed of two groups: revenue centers and cost centers. Revenue is the intake of funds received by an organization for services rendered. A revenue center, therefore, is an area of the organization, be it an entire department or simply a unit of a department, which is responsible for generating a percentage of the total revenues expected by the organization. Costs, on the other hand, are expenditures incurred by the organization in the course of providing a service. A cost center is a unit within the organization whose primary purpose is to provide a service at the least possible cost.
Examples of cost centers in the hospital setting include the departments of maintenance, dietary, and medical records. Other cost centers, such as nursing, radiology, and pharmacy are also revenue producers. The laboratory may be viewed as either a revenue center or a cost center, depending on how the organization is structured. In smaller institutions, the laboratory may be categorized as a single cost center; whereas in larger organizations, individual sections such as hematology and cytology are assigned as separate cost centers. However, the laboratory does produce revenue in the form of the billable test. In this case, the laboratory (or section of the laboratory) could be thought of as a revenue center.
Assigning the laboratory to one of these categories can be difficult. Even the chief financial officers of healthcare facilities differ on how they view the laboratory portion of their institutions. In MLO’s poll of these executives, published in the September 1999 issue, 64% considered their labs revenue centers, 33% thought of them as cost centers, and 3% considered them to be both. In one case, the laboratory was viewed as a cost center for inpatient and outpatient testing and as a revenue center for its outreach program. As an emphasis is placed on reducing expenses rather than creating new sources of revenue, the laboratory is viewed as more of a cost center than a revenue center.
To Be Continued
Whether you are a Lab Manager planning for a smooth implementation of a plan or a Team lead on whose decisions a project depends, you cannot escape from the fact that project estimation is essential to its success. In the first place, there are three basic requirements that a project must satisfy: schedule, budget, and quality. The need to work within these essential project boundaries poses a huge challenge to everyone in the central management team.