HCA 312: Health Care Finance- Capital Expenditure Budget

Planning and Budgeting 7 . mtcurado/iStock/Thinkstock Learning Outcomes By the end of this chapter, you will be able to:

• Explain the importance of planning and budgeting • Describe the planning process • Describe decisions made in the budgeting process • Develop volume forecasts, revenue forecasts, expense forecasts, and preliminary budgets • Prepare a capital budget • Conduct a budget variance analysis smi81240_07_c07_167-194.indd 167 3/7/14 9:45 AM 168 Section 7.1 Importance of Planning and Budgeting Introduction Bixby Hospital is a short-term acute care hospital that is part of a larger network of hospi - tals. They have 120 beds, 531 full-time equivalent employees providing more than 23,000 inpatient days of care, and more than 69,000 outpatient visits per year. Despite substantial decreases in patient volume since 2008, a favorable and generous payer mix and aggressively managed cost reductions have permitted Bixby to be highly profitable each of the past five years. This is a good position for management. It is also a challenge for management to sus - tain or improve upon prior years’ results. As they plan for 2013 and beyond, the board of directors has challenged management to earn an 8% operating margin and to avoid staff lay - offs like the one that happened in 2010.

Planning and budgeting don’t just happen in an organization. Planning and budgeting require a process that is designed to meet the organization’s needs and its capabilities for having persons spend time on the process. A budget for a healthcare organization typically involves preparing forecasts of the service that will be provided, how services will be paid, and how expenses are incurred. These forecasts are followed by forecasts for the numbers of services that will be provided and corresponding forecasts of the amounts of revenues and expenses incurred. To both assess financial performance and refine the budget process, analyses of the differences between budgeted and actual amounts are a final step in the budget process.

7.1 Importance of Planning and Budgeting Planning and budgeting are among the most important forward-looking activities for manag - ers of healthcare organizations. A common expression among managers is to “plan the work and work the plan.” Planning the work involves making a careful assessment of current opera - tions and making adjustments that will permit the organization to achieve future goals. For healthcare organizations, planning means establishing which services will be offered, pro - jecting how many patients are likely to require these services, and developing guidelines on the number of employees and other resources necessary to provide these services in an effec - tive and efficient manner. Working the plan involves adhering to the guidelines established in the budget and making changes only when the projections included in the budget process are found to need revision. Of course, no projections are perfect. Revisions are almost always required.

Budgeting is the action of placing dollar values on the items in an organization’s operational plan. Placing dollar values on the number of patients receiving services involves use of the information developed for charges and payments, as discussed in Chapter 5. Preliminary inpatient and outpatient payment amounts for Medicare are posted in the Federal Register three to six months before the start of the government’s fiscal year on October 1, though final amounts are posted only a few weeks in advance. For physician services, preliminary pay - ment amounts for Medicare are also posted in advance of the start of the calendar year, and last minute changes are common, leaving only a few days’ warning of annual adjustments in payment amounts. smi81240_07_c07_167-194.indd 168 3/7/14 9:45 AM 169 Section 7.1 Importance of Planning and Budgeting For private sector revenues, good budgeting goes hand in hand with insurance company and managed care plan negotiations. For many payers, the negotiation process occurs three months or more before the start of the contract year, permitting time to evaluate the manage - ment implications of changes in payments and the procedures required to receive appropri - ate payments. For some healthcare organizations, payment reductions may require curtailing the availability of services or redrawing guidelines to provide services more efficiently. Pay - ment increases and payments for new services may require planning for how the services are to be provided to more patients.

Note that three different years have been mentioned:

calendar year, fiscal year, and contract year. The calendar year is January 1 through December 31. The fiscal year of an organization can be any 12-month period. It is com - mon to select a fiscal year starting on January 1, March 1, June 1, or October 1, with January 1 being the most com - mon. Contract years with insurance companies can also be any 12-month period. Medicare uses the federal gov - ernment fiscal year of October 1 for hospital payments and January 1 for physician payments. Contract years with private sector insurance companies typically start January 1. For healthcare organizations, the selection of a fiscal year that corresponds to major contract years will make interpretation and analysis of financial results easier but make for very busy periods of time for finance professionals.

Placing dollar values on costs associated with treating a given number of patients receiving services involves use of the information developed for fixed and variable costs, as discussed in Chapter 6. Even though the two processes are generally kept separate, the development of practice guidelines and changes in service delivery are closely related to the budget process.

Once an organization has adopted a practice guideline, it has also implicitly adopted use of the personnel and other resources required to implement and follow the guideline. Developing practice guidelines without recognizing the cost implications may be wasted time and effort.

This chapter will present a planning process of delivery of healthcare services. Organizations must make a number of decisions, implicitly or explicitly, about the planning process, a few of which are highlighted in the following section. Planning contains budgeting, which has a forecasting component for the number of services, revenues, and expenses, and a mechanical component of placing forecasted dollar values on forecasted services. One of the products of a budget process is a projected income statement for the coming year. The finance term for a projected income statement is a pro forma income statement (alternatively termed a pro forma profit and loss statement or a pro forma statement of operations ). In addition to the pro forma income statement, budgets also include cash budgets . A cash budget is a document that provides a projection of the timing of cash receipts and cash expenditures. The goal of a cash budget is to have a clear plan for borrowing and other actions to be taken in the event of cash shortfalls, below some level greater than zero days’ cash on hand. Another goal of a cash budget is to have a clear plan for investing and other actions to be taken in the event of cash excesses, above some level. From the Front Lines “No arguments are needed these days to convince business of the advantages of the budget and its application to business problems. A budget is a common sense forecast or an advance statement of oper- ations for a specified period of time.” Source: Manager, Hinsdale Hospital (Rice, 1926). smi81240_07_c07_167-194.indd 169 3/7/14 9:45 AM 170 Section 7.2 The Planning Process Budgeting also has communication and enforcement actions during the budget year, and evaluation actions after the budget period is over. A good budget is widely disseminated, involving managers for developing projections and permitting staff throughout the organiza - tion to understand the plans for service delivery, the financial implications of the organiza - tion’s plan, and the constraints placed on actions in order to accomplish the plan’s objectives.

Budgets are often tied to management actions, such as in the area of human resources. The budget may permit the posting of open positions for new employees, or not permit addi - tional persons to be hired. For many organizations, the managerial reach of budget adminis - tration makes some components of it not just forecasts, but a clear plan of what will happen in the organization.

Total budgets are comprised of two components, the operating budget concerning the income statement and the capital budget concerning the balance sheet.

The final step in the budget process is the evaluation of results. The finance term for analy - ses of budgeted and actual values is variance analysis . A variance analysis seeks to pro - vide mathematical explanations regarding why actual results were above or below budgeted amounts. A good variance analysis is followed by verbal or written explanations to accom - pany the numbers, as well as enforcement actions by management. The results of the past year may have implications for salary changes and promotions of managers, as well as for the budgets established for future years.

For Review: 1. What are planning and budgeting and why are they important in healthcare organizations?

Planning means establishing which services will be offered, projecting how many patients are likely to require these services, and developing guidelines on the num - ber of employees and other resources necessary to provide these services in an effective and efficient manner. Budgeting is the action of placing dollar values on the items in an organization’s operational plan. Planning and budgeting are important in that they require decision making on the part of managers and statements of goals.

Plans and budgets permit clear communication about goals and a means for enforc - ing decisions. 7.2 The Planning Process The planning process for a healthcare organization starts with strategy . A strategy is a plan of action to achieve a specific aim. For many healthcare organizations, the aim is to achieve the mission statement. Recall the mission statement of Jersey Shore Hospital from Chapter 1:

The mission is to provide “quality health services with an efficient balance of outpatient care, acute and sub-acute inpatient care, primary care and outreach services.” This is a noble and broad mission that requires additional work to transform it into specific aims. Senior man - agement and the board of directors are charged with transforming the mission statement into specific aims that can be measured, monitored, and achieved. smi81240_07_c07_167-194.indd 170 3/7/14 9:45 AM 171 Section 7.2 The Planning Process Striving to provide “quality healthcare services” requires a definition of quality and a strategy to achieve results. For hospitals, Hospital Compare ( ht tp://w w w.medicare.gov/hospitalcom - pa re/ ) was created by the Centers for Medicare & Medicaid Services and the Hospital Quality Alliance, a public-private collaboration established to promote reporting on the quality of care. Selected quality measures from Hospital Compare are presented in Exhibit 7.1 for Bixby Hospital. For most of the selected measures, Bixby is providing services in a manner resulting in scores that are better than the national average.

The strategy for achieving good quality measures involves (1) policies for assuring quality, (2) training on quality initiatives, (3) leadership on quality initiatives, (4) measurement and reporting of quality outcomes, and (5) appropriate staffing for the number and medical needs of patients. The planning process and strategy are connected because the five components of the quality strategy require staff support and other resources. The plan must be specific about the inputs (staff and other resources) and output (quality measures) if it is to achieve its aims.

Exhibit 7.1 Selected quality measures, Bixby Hospital, 2012 Quality Measure Hospital Score National Average Timely emergency department care Average time patients spent in the emergency department before they were seen by a healthcare professional 14 minutes 28 minutes Average time patients who came to the emergency department with broken bones had to wait before receiving pain medication 32 minutes 60 minutes Timely surgical care Prophylactic antibiotic received within 1 hour prior to surgical incision 100% 98% Effective surgical care Patients having surgery who were actively warmed in the operating room or whose body temperature was near normal by the end of surgery 100% 100% Hospital acquired conditions Falls and trauma (rate per 1,000) 0.580 0.527 Vascular catheter-associated infection (rate per 1,000) 0.000 0.372 Serious complications and deaths Death from serious treatable complications after surgery 0.00% 11.34% Accidental cuts and tears from medical treatment 2.68% 2.05% Source: Author’s calculations based on Hospital Compare data ( http://www.medicare.gov/hospitalcompare/ ). Analyze This Are the hospital scores for Bixby adequate? Are there any areas in which Bixby needs to improve?

Please explain your reasoning. smi81240_07_c07_167-194.indd 171 3/7/14 9:45 AM 172 Section 7.2 The Planning Process Going back to our mission statement, providing an efficient balance of “outpatient care, acute and sub-acute inpatient care, primary care and outreach services” requires a measure for each service and a strategy to achieve results. Selected operating statistics for Bixby Hospital are presented in Exhibit 7.2. The number of nonemergency outpatient visits and emergency room visits are common measures for use of outpatient services. Counting the number of outpatient surgeries provides more specification to the use of outpatient services. Similarly, inpatient total discharges (the number of patients using inpatient services) and inpatient days are common measures for use of inpatient services. Counts of the numbers of inpatient surgeries and births provide more specification to the use of inpatient services. Further, the case-mix index is a measure of the severity of the conditions for which patients are being treated. A healthcare organization may implement its mission by specifying the availability of services that treat specific conditions or a combination of conditions.

The strategy for providing outpatient and inpatient services involves (1) making hospital sup - port for the services available, (2) having relationships with residents in the community who elect to use the hospital’s services, (3) having relationships with physicians in the community who refer patients to the hospital outpatient services and/or have privileges to admit patients to the hospital’s inpatient services, (4) measuring and reporting patient services, and (5) hav - ing appropriate staffing for the number and medical needs of patients. The connection to the planning process is that each of the five components of the patient services strategy requires staff support and other resources. The plan must be specific about the inputs (staff and other resources) and output (number of episodes of patient care) if it is to achieve its aims.

Exhibit 7.2 Selected operating statistics, Bixby Hospital, 2012 Operating Statistics 2008 2009 2010 2011 2012 Outpatient Outpatient visits 64,600 65,100 66,300 67,400 69,200 Emergency room visits 19,500 20,400 21,600 22,700 23,100 Outpatient surgeries 13,449 12,305 10,245 11,115 11,700 Inpatient Total discharges 6,921 6,248 5,666 4,875 4,963 Inpatient days 37,373 32,490 27,197 24,863 23,591 Inpatient surgeries 2,245 2,078 1,889 1,615 1,700 Births 2,067 2,003 1,945 1,842 1,912 Inpatient revenues (%) 48.1% 46.9% 45.1% 41.4% 41.2% Case mix index 1.3443 1.3085 1.2642 1.3829 1.3428 Average length of stay 5.40 5.20 4.80 5.10 4.75 Staffing Full-time equivalent positions 625 615 537 535 531 FTE 4Inpatient daily census 6.10 6.91 7.21 7.85 8.22 FTE 4 Total daily census 3.21 3.37 3.14 3.21 3.20 Source: Author’s calculations. smi81240_07_c07_167-194.indd 172 3/7/14 9:45 AM 173 Section 7.2 The Planning Process With a strategy in hand and specific aims for the quality, types of services, and quantity of services to be provided, the planning process continues on to forecast the quantity of services that might be provided in the future and the staff and other resources required for this quan - tity of services. The application of dollar amounts to the forecasts is the budgeting process.

Once a budget has been adopted, the organization moves toward implementing plans, as dis - played in Figure 7.1, the planning, managing, and controlling cycle.

It is important to have plans established before the start of the accounting period. Once a plan is created, the organiza - tion can implement it, knowing that it is being provided with the expected set of services and managing operations to assure compliance to the plan. Organi - zations that do not have plans available and communicated prior to the start of an account - ing period cannot readily expect results that follow the plan.

Without a map, it is difficult to know which way to travel.

During the accounting period, finance and information sys - tems are developed to collect data on services being provided to patients, revenues associ - ated with these services, and expenses associated with the staff employed and other resources used to deliver services and manage the organization. The data collected by the healthcare organization links the plan - ning, managing, and controlling cycle. It is the job of general managers to establish practices for collecting the data that are not routinely captured in financial accounting, such as patient satisfaction measures and quality measures. As noted in Chapter 2, it is the job of financial accountants to accurately capture relevant financial information, assure its accuracy, and report results. It is the job of general managers, and perhaps personnel in the finance office, to monitor revenues and expenses and to intervene if results are not following plans. The policies and procedures for intervention are part of the control function. Revise Plans Implement Plans Planning Collect Data Controlling Managing Figure 7.1: The planning, managing, and controlling cycle Analyze This Providing outreach services is a part of the mission of Bixby Hospital. Counts of outreach services are not routinely collected. How can Bixby measure fulfillment of its mission to provide outreach services? smi81240_07_c07_167-194.indd 173 3/7/14 9:45 AM 174 Section 7.3 Decisions in the Budgeting Process Based upon analysis of the data being collected and the interventions by managers, the plans may require revisions. For some healthcare organizations, revisions may occur during the year. For other healthcare organizations, plans remain in place for the entire year and analy - ses only influence future plans. For all organizations, the planning process is continuous, with one plan leading into the next.

For Review: 1. How are planning, managing, and controlling linked in healthcare organizations?

Can financial accounting manage the planning process alone?

Data on financial accounting and data on patient satisfaction and quality link plan - ning, managing, and controlling. Data on patient satisfaction, quality, and perhaps other measures included in plans come from outside financial accounting, meaning that financial accounting cannot manage the planning process alone. 7.3 Decisions in the Budgeting Process The budgeting process for an organization is, simply, the application of dollar values to the planning process. Of course, nothing is ever as simple as it may at first appear. Before con - sidering the mechanics of the budgeting process (the forecasting of plans and the application of dollar amounts to the plans), a series of structure and management decisions about the budgeting process are described. The structure and management of the budgeting process varies widely among healthcare organizations. Some organizations have very rigid processes.

Other organizations have very loose processes. There isn’t one correct budget process for all organizations. The budget process should be designed to fit the needs of the organization and be consistent with the other managerial processes employed. The following process elements serve to highlight decisions that must be made by managers, not to prescribe decisions.

Budget Input There are many persons who might contribute to the budget process. Managers must decide who has input into the process and how the cycle of input proceeds, from initial specification of aims to final approval of the budget. At one extreme, budgets can be completely top-down.

That is to say, the board of directors or senior management may decide upon the strategic plan and budget and simply pass it down to line managers to implement without any opportu - nity for discussion. Organizations that are in financially difficult circumstances will, at times, impose strict controls on the budget and use a very top-down process to affect quick change.

At the other extreme, budgets can be completely bottom-up. That is to say, line managers can prepare projections of services to be provided and indicate the staffing and other resources Analyze This Bixby Hospital has been working on making its birthing center more attractive. If during the mid - dle of 2013 a local, competing hospital implemented a plan that made its own birthing center even more convenient and attractive, should Bixby alter its budget forecast for births during the year? smi81240_07_c07_167-194.indd 174 3/7/14 9:45 AM 175 Section 7.3 Decisions in the Budgeting Process desired for providing these services. The budget for the organization as a whole may simply be the sum of all line managers’ projections.

Most healthcare organizations do not face circumstances that require a completely top-down process nor have they fostered the development of budgeting skills at the department level or have the financial flexibility to permit a completely bottom-up process. Instead, organizations that are not facing serious financial difficulties will employ a mixed input process. In a mixed input process, the board may set general targets, senior management may translate these into more specific targets, departments may prepare budgets that they envision being consistent with targets, senior management may review and adjust the departmental budgets to align with the general targets, and the board may approve the final budget. There may be more or fewer iterations of a budget proposal between department managers and senior manage - ment, depending on the established process and any disagreements on appropriate amounts.

In a mixed input process, a number of persons might be involved in budgeting.

The board of directors of the healthcare organization has important roles in the budget process. Most budget processes start with input from the board on overall aims for the organization. Some of the aims are derived from the mission statement and specified in the oper - ational planning process. Other aims may be unique to budgeting. For example, the board of directors at Bixby Hospital has challenged management to earn an 8% operating margin and to avoid staff layoffs. With - out conducting a serious analysis into what the board may have meant by “challenging” management to earn an 8% operating margin, a reasonable response by management would be to present a budget that includes an expected operating margin of 8% or more or to prepare an explanation for why an 8% operating margin is not feasible in the next year. Boards of directors vary dramatically in terms of how prescriptive they are to senior management about financial results.

Beyond the board of directors, many other persons might have a role in the budgeting pro - cess. Total quality management and similar initiatives highlight the importance of empower - ing line managers and listening to customers about services desired and satisfaction with services delivered. In fact, most organizations will have mechanisms for considering the input of customers in their service offerings. Along these same lines, the input of physicians for the budgeting of services may be critical. Physicians are the vehicle for patient referrals and the provision of services. Their insight into the medical needs of patients in the community and their preferences about the level of staffing and availability of resources for the provision of services is critical to effective budgeting. Physicians are involved in volume of services fore - casts and the budgeting of major purchases.

A challenge for management is that having more people involved in the budget process typi - cally implies a more time-consuming process and requires more formal mechanisms for presenting and evaluating budget requests. A benefit to having more people involved is an increase in information as it permits management to learn of information on new services that might be forthcoming, and patients’ and physicians’ attitudes about these services.

Involvement might also increase the likelihood that managers and staff will be aware of the budget and accept limitations. From the Front Lines At our organization, managers and physi- cians originate budget requests, which are then evaluated. “It’s a wish list that bubbles up.” Source: Hospital CFO (Smith, Wheeler, Rivenson, & Reiter, 2000a). smi81240_07_c07_167-194.indd 175 3/7/14 9:45 AM 176 Section 7.3 Decisions in the Budgeting Process Altogether, decisions on input present a trade-off between planning and control. A more bottom-up and open process permits a more informed plan. A more top-down or closed process permits tighter control. Healthcare organizations must evaluate their current finan - cial circumstances and other managerial processes employed to determine how much input to include in the budget process.

Budget Timing Time is money. Whether or not Benjamin Franklin was the first person to use this phrase in uncertain, but its wisdom is without question. Budgets can be assembled quickly, at the risk of being uninformed and error ridden. Budgets can also be painstakingly prepared over several months and be fully informed and very expensive. Just as there is a budget trade-off between planning and control, there is a trade-off between time spent planning, time spent managing, and time spent controlling. Most healthcare managers would prefer to spend their time man - aging operations rather than planning or conducting analyses of results. However, the time spent planning and analyzing is important.

How long should a budget process take from start to finish? The budget timeline for Bixby is presented in Exhibit 7.3. The operating budget includes elements on the income state - ment, namely the revenues and expenses of the organization. The operating budget process takes about four months. The capital budget includes elements on the balance sheet, with an emphasis on the fixed assets and how they are purchased with borrowed money or sav - ings. The capital budgeting process takes about three months. In both cases, the actual process likely takes more time than is listed in Exhibit 7.3 as clinical service departments, finance, and senior managers may be working on new strategies and plans for projects throughout the year.

Exhibit 7.3 The budget timeline, Bixby Hospital Date Budget Activity Operating Budget July 1 Department service projection meetings July 15 Finance proposes pricing and revenues August 15 Finance evaluation of department projections August 31 Department review of revenue and volume September 15 Board of directors budget targets (operating margin, other aims) September 30 Expense budget for fixed expenses (and capital expenses) September 30 Budget target for variable expenses October 15 Board of directors review/approval October 31 Distribution of budget to departments Capital Budget July 1 Funds available for capital presented to departments July 1 Distribute capital request forms July 15 Capital request forms due August 1 Senior management review and prioritize list August 31 Financial management drafts financial analysis for selected projects September 15 Board of directors capital committee reviews presentations and approves selected projects and allocates funds smi81240_07_c07_167-194.indd 176 3/7/14 9:45 AM 177 Section 7.3 Decisions in the Budgeting Process Using a mixed input model, the operating budget starts with department projections that move up to finance for review before making revisions and submitting results for approval.

Internally, finance and senior management complete reviews before making a presentation to the board of directors. For the capital budget, a subcommittee of the board, the capital com - mittee, receives the presentation for projects that have been given a high priority by finance and senior management. Given the high dollar amounts and the time required for careful review of presentations, the board delegates approval of capital projects to the committee.

The complete budget, including the operating budget and the capital budget, are approved by the full board of directors before distribution.

Budget Increments Within the policy of budget timing, there are also policies of the increments of the budget and how revisions can be made. Budget increments are the time periods within the year when actual results and budgets are compared. Increments could be weekly, monthly, quarterly, or just once per year. Once again, the budget process offers a trade-off between planning and controlling. For organizations facing difficult financial challenges, very short-range bud - get increments may be required. Healthcare organizations with 10 days’ cash on hand might not have the luxury of waiting three months before reviewing results. For organizations with fewer challenges, longer time periods permit a more flexible management of activities.

In practice, budget increments are often associated with the timing of meetings of the finance committee of the board of directors or a meeting of the full board. Finance and senior manag - ers have the ability to review interim results without a fully prepared analysis of actual and budgeted results. At the latest, full analyses are presented annually. Healthcare organizations rarely present operating budgets that encompass multiple years due to uncertainty in reve - nues. With Medicare and state Medicaid programs having annual payment rate determination processes, only single-year budgets can be reliably prepared.

Budget Revisions Revisions to budgets are made annually, at a minimum, during the routine budget process and potentially more frequently. Revisions that are made annually are often made incre - mentally, following a percentage adjustment for changes in revenues and expenses. As an alternative, organizations can use zero-based budgeting . A zero-based budgeting process requires the creation of new information on all of the values in the budget, rather than adopting prior values and assumptions about the revenues and expenses of the organiza - tion. Zero-based budgets can be helpful when substantial changes in the cost structure of an organization are required, as each item in the budget must be examined and justified (Cichocki, Kerr, Clare, & Koegel, 2012). At times when substantial changes in costs are not required, the time and effort to review all programs and all assumptions in a budget can be substantial. For most organizations, the time and effort of preparing a zero-based budget is Analyze This Is Bixby’s budget process too long? How could it be done faster? smi81240_07_c07_167-194.indd 177 3/7/14 9:45 AM 178 Section 7.3 Decisions in the Budgeting Process not worthwhile every year, but it may be worthwhile every few years. This is another case of a trade-off between time spent planning and time spent managing and controlling the organization.

Revisions may be made to a budget within the fiscal year if there is new information on vol - umes of services, revenues, or expenses that merit the change. Most healthcare organizations will conduct reforecasting of patient volumes but will not change the initial budget unless there is a dramatic change that affects a large part of the organization. The loss of an agree - ment with an insurance company covering a large percentage of patients or the loss of key medical staff might trigger a need to prepare a revised budget for approval. Minor changes in patient volume forecasts, revenues, or expenses do not require revised budgets. Instead, minor changes require analysis and explanation at the end of the year.

Fixed or Flexible Budgets Again, the key factors in a budget are the forecasts of patient volumes, expenses associated with treatment of patients, and revenues associated with treatment of patients. While pro - jections of patient volumes are an important activity for management, some organizations question whether projections of patient volumes are an important aspect of the budget. To hold managers accountable to volume projections, most healthcare organizations use fixed budgets . Fixed budgets establish dollar amounts for revenues, expenses, and net income that are expected to be earned during the budget period.

An alternative to a fixed budget is a flexible budget . A flexible budget establishes revenue and expense amounts per volume of activity. The budget is then presented as a number of patients multiplied by revenues and expenses. For managers that cannot be held accountable to projections of patient volumes, flexible budgets provide a more accurate assessment of the dollars to which the manager can be held accountable. The manager of the hospital pharmacy cannot have a substantial impact on the numbers of drugs that are provided to patients, as that will be determined by the volume and severity of patients and the treatment patterns of physicians (Edwards, 2011). The manager of the hospital pharmacy can control the number of pharmacists and technicians employed relative to patient volume and the expenses for the management of the pharmacy. It might make more sense to provide the hospital pharmacy with a budget per patient rather than a fixed dollar amount for the year.

The intuition behind flexible budgets is based on cost structures presented in Chapter 6. Costs may be generally categorized as fixed or variable. For fixed costs, fixed budgets make perfect sense. Even for organizations that use flexible budgeting, there are fixed components for clear fixed costs, like marketing expenses and capital expenditures. Do fixed budgets make sense for variable costs? Certainly using an understanding of fixed and variable costs is important in the mechanics of the budget development process. Whether fixed or flexible budgets make sense for an organization is less dependent upon the fixed or variable nature of costs and more dependent upon whether managers can be held accountable to forecasts of patient vol - ume. Further, organizations need a sophisticated and well-maintained cost accounting sys - tem to support flexible budgeting. The advantages of flexible budgeting may not justify the cost of an expensive accounting system. smi81240_07_c07_167-194.indd 178 3/7/14 9:45 AM 179 Section 7.3 Decisions in the Budgeting Process Budget Tightness and Legitimacy The process of soliciting input on budgets and the review by finance and senior management may reveal a range of views on what are reasonable amounts for volume, expenses, and rev - enues. Reconciling the range of views into a consensus on the budget is ideal but difficult to achieve. Included in department managers’ sense of reasonable amounts are the uncertain - ties associated with the volume of patients and the resources that will be required to treat them appropriately. Budgets that adhere to closely managed treatment guidelines and strict expense limits are termed tight budgets . Budgets that permit more flexibility of expenses within a department are termed loose budgets . Every department manager can envision ways to improve patient outcomes and the patient experience by adding more staff and other resources. If department managers are evaluated upon adherence to a budget, patient outcomes, and patient experiences, they will seek looser expense budgets. Senior managers understand the interests of department managers in hav - ing loose expenses budgets, as well as the needs of the organization to make optimal use of resources. If every department manager were permitted a loose budget and actually spent to the limit of budgeted expenses, overall expenses may exceed net revenues.

Rather than seeking consensus, organizations often seek legitimacy. Legitimacy of a budget is a process that has sufficient opportunities for input and amounts for patient volume, revenues, and expenses that permit managers at all levels to accept the use of the budget for purposes of individual performance evaluation. For department managers, controlling total expenses at or below the budget level may be a component of their annual perfor - mance evaluation. For senior managers, the adherence to the entire budget, as measured by net income, may be a component of their annual performance evaluation.

For Review: 1. If you were the manager of a clinic that anticipated 16,000 encounters, would you want a fixed budget of 16 persons, for the entire year, or a flexible budget that involves having a budget for the number of staff in a clinic being set at one full-time position for every 1,000 patient encounters in a year?

If the budget includes an accurate projection of the number of patient encounters, a fixed budget and a flexible budget yield the same number of positions, 16. With a fixed budget, you would be certain to have all 16 persons all year, and this may provide some stability in the roles of the workers. With a flexible budget, you would have the ability to hire more employees if actual patient encounters increased more than the budgeted level. You would also bear the responsibility to reduce the num - ber of positions if there were fewer patient encounters. From the Front Lines Senior managers at our organization have 20–30% of total compensation related to financial performance, mostly budget adherence. The budgets and financial performance are ver y important and are treated very seriously.

Source: Hospital CFO (Smith et al., 2000a). smi81240_07_c07_167-194.indd 179 3/7/14 9:45 AM 180 Section 7.4 Mechanics of Budgeting 7.4 Mechanics of Budgeting Once the planning process has been defined and the decisions in the budgeting process have been made, the organization can undertake the mechanics of budgeting. The key mechanics of budgeting include forecasting patient volumes and operating statistics, forecasting revenues, and forecasting expenses. The end product of the mechanical aspects of placing numbers on volumes and dollar amounts on revenues and expenses is a pro forma income statement.

There are many ways in which organizations can develop forecasts. As with the identification of fixed versus variable costs, having the knowledge and insights of an experienced manager is a great starting point. Persons who see the patient flow process, who communicate with physicians, who keep up with the activities of competitors, who keep up with insurance com - pany policies, and who keep up with clinical advances in the field can offer accurate assess - ments of likely patient volumes, revenues, and expenses. Finding and retaining such people can be difficult.

To supplement the insights of experienced managers, organizations can use trends in data from prior years to prepare forecasts. A host of advanced statistical techniques have been developed for forecasting (González-Rivera, 2012). When trend analysis or other statistical techniques are used for forecasting, having managerial review of results may be helpful for purposes of legitimacy.

Volume Forecasts The starting point for planning and budgeting is the forecast of patient volumes. Treating patients is the reason that healthcare organizations exist, so it is only fitting that identifica - tion of the number of patients would be the starting point. Depending on the sophistication of the budgeting process, the level of detail on patient volumes might be minimal, for example, only counting total patient visits. Alternatively, it could be a highly detailed count of patient visits by type of service. Consider the list of emergency department visits at Bixby Hospital presented in Exhibit 7.4. Analyze This What number of patient visits might Bixby Hospital expect to provide in 2013? Exhibit 7.4 Bixby Hospital, emergency department visits, 2012 APC Description Patient Visits Net Patient Revenue 0613 Level 2 Type A emergency visits 2,138 $404,809 0614 Level 3 Type A emergency visits 7,215 $2,151,374 0615 Level 4 Type A emergency visits 10,253 $4,897,349 0616 Level 5 Type A emergency visits 3,494 $2,471,101 Total 23,100 $9,924,633 Source: Author’s calculations. smi81240_07_c07_167-194.indd 180 3/7/14 9:45 AM 181 Section 7.4 Mechanics of Budgeting A naive forecast of the number of emergency department visits in 2013 would be 23,100 patient visits. This forecast would assume no change in the number of visits. Recalling Exhibit 7.2, the number of emergency department visits has not remained constant over time. In fact, the number of emergency department visits has increased each of the past four years. An alternative forecast might be to add the average increase over each of the past four years (900 emergency department visits) to the 2012 value. Yet another alternative would be to use the trend of increases over the past four years (1,210 emergency department visits). A view of an Excel spreadsheet calculation of these forecasts is presented in Exhibit 7.5. A forecast in the range of 24,000 to 24,310 emergency department visits would be more reasonable than 23,100 emergency department visits.

Exhibit 7.5 Forecasts of emergency department visits, Bixby Hospital, 2013 A B C D E F G H 1 Emergency Department Visits 2 Year 2008 2009 2010 2011 2012 2013 3 Visits 19,500 20,400 21,600 22,700 23,100 ? 4 Change 900 1,200 1,100 400 5 24,000 6 =AVERAGE(B4:E4)+F3 7 24,310 8 =TREND(B3:F3,B2:F2,G2) Source: Author’s calculations.

The AVERAGE function in Excel calculates the simple mean of the values listed. In Exhibit 7.5, the AVERAGE of the 2009–2012 changes in emergency department visits can be calculated manually and added to the number of visits in 2012 to yield the forecast for 2013: Avera ge c h ang e i n visi ts 5 9 00 1 1,2 00 1 1,1 00 1 400 4 y ears Av era ge c h ang e i n visi ts 5 900 p er y ear F ore ca st o f 2 013 v isi ts 5 Visi ts in 2012 1 Av era ge c h ang e i n visi ts F ore ca st o f 2 013 v isi ts 5 23,1 00 1 9 00 Fore ca st o f 2 013 v isi ts 5 24,0 00 The TREND analysis tool finds the line that best fits the relationship between two sets of numbers. In this case, the TREND analysis tool finds the best relationship between emer - gency department visits and time, as measured in years. The Microsoft Excel support files present a good explanation of the use of the trend analysis tool: ht tp://support.microsof t . c om/ k b/828 8 01 . From this example, it may be clear that forecasting patient volume is not a simple process or one that can be taken lightly. The forecasts of patient volume are the foundation upon smi81240_07_c07_167-194.indd 181 3/7/14 9:45 AM 182 Section 7.4 Mechanics of Budgeting which forecasting of net patient revenues and operating expenses is built. Initial forecasts of patient volume are carefully examined and often contested in discussions involving physi - cians, department managers, and senior management.

In Exhibit 7.6, forecasts for all of Bixby Hospital’s patient operating statistics for 2013 are pre - sented. These forecasts were developed using the trend analysis tool in Excel. The only items not forecasted were average length of stay and ratios involving the number of full-time equiv - alent (FTE) positions. The average length of stay was calculated as the ratio of the number of inpatient days divided by the number of discharges. FTE positions are calculated by taking the total number of hours worked by all employees and dividing by the number of work hours in a year for a full-time employee (2,080). Since healthcare organizations often employ many part-time workers, standardizing by full-time equivalent provides a consistent count of the number of employees. Inpatient daily census was calculated as inpatient days divided by 365 days. Total daily census was calculated as inpatient days divided by 365 days, plus outpatient visits and emergency department visits multiplied by 40%.

The calculation of total daily census includes the conversion of outpatient visits and emer - gency department visits to the equivalent of inpatient visits. The calculation involves mul - tiplying visits by 40% since outpatient and emergency department visits are, on average, 40% as costly as an inpatient day. Again, this is not a simple process. Reasonable people could disagree upon the best method for forecasting the number of patient visits for 2013.

Ideally, an organization not only would use statistical techniques, such as trend analysis, but would also seek out the view of experienced managers in each of the clinical service departments. Analyze This If you were the budget manager at Bixby Hospital, what number of emergency department patient visits would you want to use in the budget for 2013? If you only had data for 2011 and 2012, would your answer be different? Who might you ask to learn more about expected num - bers of emergency department volumes? smi81240_07_c07_167-194.indd 182 3/7/14 9:45 AM 183 Section 7.4 Mechanics of Budgeting Exhibit 7.6 Forecast of selected operating statistics, Bixby Hospital, 2013 Operating Statistics 2009 2010 2011 2012 2013 Outpatient Outpatient visits 65,100 66,300 67,400 69,200 69,970 Emergency room visits 20,400 21,600 22,700 23,100 24,310 Outpatient surgeries 12,305 10,245 11,115 11,700 10,356 Inpatient Total discharges 6,248 5,666 4,875 4,963 4,148 Inpatient days 32,490 27,197 24,863 23,591 18,545 Inpatient surgeries 2,078 1,889 1,615 1,700 1,440 Births 2,003 1,945 1,842 1,912 1,813 Inpatient revenues 46.9% 45.1% 41.4% 41.2% 38.7% Case mix index 1.3085 1.2642 1.3829 1.3428 1.3500 Average length of stay 5.20 4.80 5.10 4.75 4.47 Staffing Full-time equivalent positions 615 537 535 531 488 FTE 4 Inpatient daily census 6.91 7.21 7.85 8.22 9.61 FTE 4 Total daily census 3.37 3.14 3.21 3.20 3.17 Source: Author’s calculations.

With volume forecasts established, the next two steps in the budget process are to forecast the revenues and expenses associated with treating these patients. Once an organization sees the full implications of the volume, revenues, and expense forecasts, namely net income, it is not uncommon to revisit the forecasts for patient volumes.

It is important for managers of healthcare organizations to understand that patient volume is partly under their control. Certain aspects of patient volume are uncontrollable, as they relate to the overall health status of a population, the rate of accidents and illnesses that affect the population, the availability of insurance coverage, and other factors. What is under the control or influence of managers are the availability of services, the relationships with resi - dents in the community who elect to use the organization’s services, the relationships with physicians in the community who refer patients to outpatient services or have privileges to provide inpatient services, and the image of quality and caring promoted by the healthcare organization. Also somewhat outside of the control of management are the actions taken by competing healthcare organizations that have similar missions. Part of the job of managers of healthcare organizations is to assure that patient volume forecasts are realized, to the extent that they are under their control. Analyze This Do any of the volume forecasts for Bixby Hospital appear to be unreasonable? Please explain your reasoning. smi81240_07_c07_167-194.indd 183 3/7/14 9:45 AM 184 Section 7.4 Mechanics of Budgeting Revenue Forecasts Revenue forecasts are the product of volume of services forecasts and revenue per service forecasts. Revenue per service forecasts are partially known to the extent that the organiza - tion has negotiated contracts with insurance compa - nies and managed care organizations and provides services to Medicare and Medicaid enrollees. While the exact payment rates may not be known far in advance of the start of the fiscal year, indications of the likely payment rates are often provided some time in advance.

The 2013 revenue budget for Bixby Hospital is presented in Exhibit 7.7. Management expects a 2% increase in the number of Medicare and Medicaid patients and a 1% increase in the payment rates per patient, for an overall 3% increase in Medicare and Medicaid net patient revenues. Obviously, these values could change substantially depending on federal and state budget decisions. Management also expects a nearly 10% decrease in the number of patients covered by private health insurance. Negotiations with insurance compa - nies and changes in the mix of services provided to pri - vately insured patients have yielded a 9% increase in revenues per patient, which still leaves a 1% decrease in private health insurance net revenues. In total, net patient revenues in 2013 are projected to be nearly identical to net patient revenues in 2012. Exhibit 7.7 Revenue budget, Bixby Hospital, 2013 Actual 2012 Budget 2013 Medicare revenue $17,626,545 18,155,341 Medicaid revenue $11,817,508 12,172,033 Private insurance and other revenue $80,585,777 79,779,919 Net patient revenues $110,029,830 $110,107,293 Source: Author’s calculations.

Expense Forecasts Expense forecasts are also the product of volume of services forecasts and expense per ser - vice forecasts. However, unlike revenue forecasts, which are entirely variable, expense fore - casts must consider the fixed and variable nature of costs. As presented in Exhibit 7.8, each of the types of operating expenses can be generally designated as being fixed or variable.

Depreciation expense, lease expense, and interest expense may be related to patient volume in the long run, as the organization adjusts physical capacity and borrowing associated with different levels of patient volume. In the short run, these are treated as fixed expenses. From the Front Lines The budget tells the story of our priorities.

As a safety net hospital, our budget is full of risk and educated guesses. This year, we are estimating that graduate medical education payments won’t decrease, that the State won’t cut Medicaid any further, and that our add-on payments won’t be cut too severely. We also estimate volumes (inpatient, outpatient, emergency, etc.) based on last year’s volumes, market anal- ysis, and macro trends (such as decrease year-over-year in inpatient admissions).

In other words, we attempt to bring in known facts and evidence but, ultimately, there are a lot of estimates.

Source: Chief operating officer, county medical center. smi81240_07_c07_167-194.indd 184 3/7/14 9:45 AM 185 Section 7.4 Mechanics of Budgeting Salary and fringe benefits expenses have both a fixed and a variable component. With mini - mum numbers of employees for any level of patient volume, there is a fixed component to salary expenses. Fringe benefits costs (health insurance, life insurance, pension contribu - tions, Social Security, other payroll taxes, etc.) are related to the number of employees and therefore also have a fixed and a variable component. Most supplies expenses are variable, as more patient visits require more supplies. About half of the other operating expenses (approximately $10 million per year) are associated with building maintenance and other fixed expenses.

Exhibit 7.8 Fixed and variable operating expenses, Bixby Hospital, 2013 Operating Expenses 2012 Type of Expense Salary and fringe benefits expense $61,730,186 Variable / fixed Depreciation expense $5,849,240 Fixed Lease expense $1,674,723 Fixed Interest expense $840,479 Fixed Supplies and other operating expenses $31,300,668 Variable / fixed One unique challenge to Bixby Hospital is how to interpret the board of directors’ challenge to avoid staff layoffs like the one that happened in 2010. As presented in Exhibit 7.2, the number of full-time equivalent positions at Bixby decreased from 615 to 537 in 2010. The number has remained fairly constant over the past three years. With the assumption that the board is quite concerned with maintaining the number of positions, the forecasted operating expense budget for Bixby Hospital is presented in Exhibit 7.9.

Exhibit 7.9 Operating expense budget, Bixby Hospital, 2013 Operating Expenses Actual 2012 Budget 2013 Salary and fringe benefits expense $61,730,186 $60,495,582 Depreciation expense 5,849,240 6,321,974 Lease expense 1,674,723 1,794,355 Interest expense 840,479 848,884 Supplies and other operating expenses 31,300,668 35,315,691 Total operating expense $101,395,296 $104,776,486 Preliminary Budgets The next to last step in the mechanics of the budget process is to combine the revenue and expense budgets to yield budgeted operating income. Forecasts of miscellaneous nonpatient revenue and taxes (if applicable) are also prepared at the end of the budget process. The pre - liminary budget for Bixby Hospital is presented in Exhibit 7.10. Using the budgeting assump - tions provided in the previous sections, forecasted operating income is over $5.3 million, a 4.8% operating margin. With miscellaneous nonpatient revenue of $3.9 million, and no taxes, net income is forecasted to be $1.7 million less than in 2012, with a total profit margin of 8.1% for the year. smi81240_07_c07_167-194.indd 185 3/7/14 9:45 AM 186 Section 7.4 Mechanics of Budgeting Exhibit 7.10 Preliminary budget, Bixby Hospital, 2013 Actual 2012 Budget 2013 Net patient revenues $110,029,830 $110,107,294 Total operating expense $101,395,296 $104,776,486 Operating income $8,634,534 $5,330,808 Miscellaneous nonpatient revenue $2,260,304 $3,907,068 Net income or (loss) $10,894,838 $9,237,876 The example presented in Exhibit 7.10 is termed a preliminary budget, as it may be the sub - ject of much discussion and analysis before becoming the final budget. With the preliminary budget completed, the implications of the budgeting process can be assessed. In many organi - zations, an evaluation of financial performance, as discussed in Chapter 3, may be performed on the preliminary budget. Questions asked during the evaluation of the preliminary budget focus on profitability and operational measures: • Is the operating margin sufficient and consistent with the long-range financial plan? • Is the total margin sufficient and consistent with the long-range financial plan? • Is the outpatient revenue percentage consistent with current trends and the long- range plan? • Is the Medicare payment percentage consistent with current trends and the long- range plan? • At the forecasted volume of inpatient services, what is the planned occupancy rate? • What is the ratio of salaries to revenues? Is this consistent with other healthcare organizations? The evaluation of the preliminary budget may result in changes that are made before approval of the final budget. Once the final budget is approved, it is communicated as the financial plan for the upcoming year.

For Review: 1. A senior manager reviewed the expense budget and thought that it was too high.

What aspects of the mechanics of the budgeting process would need to change to reduce the budget?

The expense portion of a budget includes forecasts of fixed costs and forecasts of patient volumes multiplied by variable costs. Reducing expenses requires either reducing projected fixed costs or reducing projected variable costs. In a short period of time, it can be difficult to change fixed costs, such as leases. Salary expenses, supplies, and other operating expenses can be reduced by changing the treatment processes. Analyze This To realize the 8.1% operating margin, 43 fewer persons would be employed at Bixby Hospital.

The board of directors challenged senior management to avoid layoffs. Should senior manage - ment plan for an 8.1% operating margin or plan to spend $3.6 million to employ 43 persons and not have layoffs? smi81240_07_c07_167-194.indd 186 3/7/14 9:45 AM 187 Section 7.5 Capital Budget 7.5 Capital Budget The capital budget for a healthcare organization is the complete listing of the projects and expenditures approved in the current budget and the projects and expenditures approved in prior time periods for which the investment is ongoing. Large-scale construction projects can take three or more years to complete, requiring inclusion on capital budgets for each year.

Further, given the timing of when projects can start and be completed, even short-term proj - ects may extend beyond one budget year.

For investor-owned healthcare organizations, and even not-for-profit healthcare organiza - tions with access to capital markets for investment in new projects, a general decision rule would be to accept all projects with positive net present value. For a number of reasons, organizations create processes that place limits on capital budgets each year. Having limits on capital budgets is called capital rationing . Capital rationing may arise due to hard con - straints imposed by credit markets. Organizations with limits on borrowing associated with debt covenants may be required to limit capital budgets. More frequently, organizations set internal budget allocations, which are called soft constraints.

There are a number of ways in which organizations can establish internal budget allocations.

One common method of establishing capital budgets is to start with the operating budget to project depreciation expense, which indicates the amount that could be spent without impacting the balance sheet. Further net income provides an amount that may be available for capital expenditures, to the extent that plans for the debt ratio do not otherwise limit available funds. Beyond the sum of depreciation expense and net income, organizations need to examine how much of investments (marketable securities, assets limited as to use) could be used for capital expenditures or how much more could be borrowed.

The forecasted 2013 balance sheet for Bixby Hospital is presented in Exhibit 7.11, based on the depreciation expense and net income included in the income statement forecast. Without changing the use of debt, Bixby has forecasted additional fixed assets of $14 million, which is its capital budget for the year.

Exhibit 7.11 Forecasted balance sheet, Bixby Hospital, 2013 Assets Current assets $37,000,000 Fixed assets $104,681,305 Accumulated depreciation $27,000,000 Net fixed assets $77,681,305 Assets limited as to use $76,353,016 Total assets $191,034,321 Liabilities and Net Assets Current liabilities $9,000,000 Long-term liabilities $40,375,920 Total liabilities $49,375,920 Net assets $141,658,401 Total liabilities and net assets $191,034,321 smi81240_07_c07_167-194.indd 187 3/7/14 9:45 AM 188 Section 7.5 Capital Budget With a capital budget in hand, financial managers are asked to evaluate the financial aspects of capital budget requests to propose projects to approve and to allocate funds. With a variety- based positioning strategy, Bixby Hospital is attempting to focus its strategic capital expendi - tures on providing specific and unique services, with a focus on the quality and effectiveness of the service. The sleep lab project fits well within this strategy, more so than the waiting room project, which fits well with an access-based strategy. The fact that the net present value for the sleep lab project is positive, larger than alternative uses of the space, and a good stra - tegic fit, makes it a project that can be approved.

Strategic projects make up one portion of a capital budget. A typical capital budget will include routine maintenance, strategic projects, and carry forward of prior capital expenditure plans.

For the 2013 capital budget, Bixby Hospital conducted an assessment of its facilities, equip - ment, and technology to determine the priorities for replacement, repair, and any new acqui - sitions. The assessment and prioritization process addressed patient safety, obsolescence, new technology, building safety, and code compliance requirements. Routine maintenance and equipment replacements create capital expenditure needs of approximately $6 million per year.

With all of the uncertainty for 2013 and 2014, the strategic capital budget recommendation is being limited to $8 million in 2012. At the $8 million level, the budget is 120% of the prior year depreciation expense. The proposed 2013 capital budget is presented in Exhibit 7.12.

Exhibit 7.12 Proposed capital budget, Bixby Hospital, 2013 Routine Capital Budget Facility projects $2,300,000 Information technology projects $1,200,000 Medical equipment $2,500,000 Total routine $6,000,000 Phase I strategic capital projects Primary care clinic $1,400,000 Ambulatory care center projects $2,500,000 Total phase I $3,900,000 Phase II capital projects Hospital renovations $2,000,000 Ambulatory care center projects $900,000 Physical therapy center $1,200,000 Total phase II $4,100,000 Total capital budget $14,000,000 smi81240_07_c07_167-194.indd 188 3/7/14 9:45 AM 189 Section 7.6 Budget Performance Evaluation (Variance Analysis) The examination room project for the clinic is one of the types of projects that might be included in Bixby’s phase I (year one) ambulatory care center projects. Given the amount of time and effort required to assemble background information, prepare budget forecasts, and conduct decision making, capital budgeting is a substantial and time-consuming aspect of financial management.

For Review: 1. Why don’t organizations adopt all projects that have estimated net present values greater than zero?

Organizations limit their capital expenditures based upon their ability to borrow money, as well as internal limits on how many projects they want to attempt to com - plete within a given year. 7.6 Budget Performance Evaluation (Variance Analysis) At the end of a budget period, the final step in the process is to evaluate budget performance.

Organizations routinely present end-of-period performance reports that display the income statement for the period and the budgeted amounts for the period. Reports highlight variance, that is, the difference between actual and budgeted amounts. The level of formality of the report and the discussion that accompanies performance reports vary among organizations.

Organizations that have financial difficulties often have more formal reporting and require fuller discussions to accompany reports. For performance reports that display underperfor - mance, as defined by lower revenues, higher expenses, or lower net income, corrective action plans may also be required. Corrective action plans are proposals by managers for changes in operations to achieve results that are more consistent with the budget.

The budget performance report for the first quarter of 2012 at Bixby Hospital is presented in Exhibit 7.13. The first quarter budget at Bixby Hospital is 23% of the annual budget for patient visits, to be consistent with historical values. When an organization presents a first quarter budget of exactly 25% of the annual budget, it might indicate historical values for an industry that does not experience seasonal trends, or it might be an approximation that has no particular significance.

At Bixby Hospital, first quarter net patient revenues were higher than budgeted for all pay - ers, especially Medicaid, at 15% more than budgeted. Salaries and supply expenses were also higher than expected. Depreciation, lease expense, and interest expenses were precisely as expected, budgeted at 25% of annual amounts, since these values truly represent fixed costs for the year that are evenly divided by quarter. As a result of net patient revenues exceeding budget more than operating expenses, operating income exceeded its budgeted amount. Mis - cellaneous nonpatient revenue was below its budgeted amount, as was net income. smi81240_07_c07_167-194.indd 189 3/7/14 9:45 AM 190 Section 7.6 Budget Performance Evaluation (Variance Analysis) Exhibit 7.13 Budget performance report, Bixby Hospital, first quarter 2012 First Quarter Actual First Quarter Budget Variance Percentage Variance Medicare revenue $4,153,879 $4,054,105 $99,774 2.5% Medicaid revenue $3,125,897 $2,718,027 $407,870 15.0% Private insurance and other revenue $19,785,422 $18,534,729 $1,250,693 6.7% Net patient revenues $27,065,198 $25,306,861 $1,758,337 6.9% Operating expenses Salary and fringe benefits expense $15,426,789 $14,197,943 $1,228,846 8.7% Depreciation expense $1,462,310 $1,462,310 $0 0.0% Lease expense $418,681 $418,681 $0 0.0% Interest expense $210,120 $210,120 $0 0.0% Supplies, other operating expenses $7,564,125 $7,199,154 $364,971 5.1% Total operating expense $25,082,025 $23,488,207 $1,593,818 6.8% Operating income $1,983,174 $1,818,654 $164,520 9.0% Miscellaneous nonpatient revenue $350,000 $519,870 ($169,870) 232.7% Net income or (loss) $2,333,174 $2,338,524 ($5,350) 20.2% Total patient visits 13,124 12,939 185 1.4% With actual amounts differing from budgeted amounts, an explanation of variances may be required. For some organizations, informal explanations of variances may be required. For the first quarter of 2012 at Bixby Hospital, the higher than expected number of patient visits was associated with higher revenues and higher expenses, resulting in higher net income. The shortfall in miscellaneous nonpatient revenue led to an actual net income that was only 0.2% less than budgeted.

For other organizations, more formal explanations of variances may be required. Which vari - ances merit the time and attention required to provide more formal explanations? Variances greater than specified dollar amounts, such as $100,000, may require explanations. Variances greater than specified percentages, such as 5%, may require explanations. Or, variances of specified dollar amounts or percentages that persist for some time periods, such as three quarters, may require explana - tions. There is no common rule for when explanations are required. This is a decision for management.

Even without a common rule for when explanations are required, there is a common practice for developing more information for the explanation, which is called variance analysis. A variance analysis is a separation of total revenue or expense variances into component parts. The two main components of revenue are volume of services and revenues per service. Similarly, the two main components of expenses are volume of services From the Front Lines One CFO required an explanation of cause and a plan of action for variance of $5,000 or 5% of budget. Another CFO required explanation for monthly variances of 5% (cost per patient/unit, not related to vol- ume) and for variances of 2% that persist for 3 or more months—to avoid “ low f ly - ing” problems.

Source: Smith et al. (2000a). smi81240_07_c07_167-194.indd 190 3/7/14 9:45 AM 191 Section 7.6 Budget Performance Evaluation (Variance Analysis) and expenses per service, only for variable costs. For fixed costs, there is no separation of a variance into component parts. For example, if the actual expense for marketing at Bixby Hospital were $100,000 higher than the budgeted amount, there would be no reason that the higher amount was associated with providing services to more patients.

The equations for conducting variance analyses are straightforward. For revenue variances, the three components are Revenue variance 5 Actual revenue 2 Budgeted revenue Revenue volume variance 5 (Actual volume 2 Budgeted volume) 3 Budgeted revenue per service Revenue per service variance 5 (Actual revenue per service 2 Budgeted revenue per service) 3 Actual volume For Bixby Hospital in the first quarter of 2012, the revenue variance analysis is presented in Exhibit 7.14. The total revenue variance was $1,758,337, which is the amount to be explained by the analysis. The portion of the revenue variance explained by a higher than expected number of patient visits was $361,616. The portion of the revenue variance explained by a higher than expected revenue per patient visits was $1,396,721. For Bixby, volume explained 20% of the revenue variance, and revenues per patient explained 80% of the variance. The simple explanation of having more patients and therefore more revenues was only partially correct. The full story would not have been revealed without a variance analysis.

Exhibit 7.14 Revenue variance analysis, Bixby Hospital, first quarter 2012 Actual revenue 2 Budgeted revenue Variance Revenue variance 5 $27,065,198 – $25,306,861 $1,758,337 Revenue volume variance 5 (Actual volume 2 Budgeted volume) 3 Budgeted revenue per service (13,124 2 12,939) 3 $1,955.86 185 3 $1,955.86 $361,834 Revenue per service variance 5 (Actual revenue per service 2 Budgeted revenue per service) 3 Actual volume ($2,062.27 2 $1,955.86) 3 13,124 $106.42 3 13,124 $1,693,525 For expense variances, the three components are Expense variance 5 Actual expense 2 Budgeted expense Expense volume variance 5 (Actual volume 2 Budgeted volume) 3 Budgeted expense per service Expense per service variance 5 (Actual expense per service 2 Budgeted expense per service) 3 Actual volume smi81240_07_c07_167-194.indd 191 3/7/14 9:45 AM 192 Summary & Resources Variance analysis provides a more complete explanation for differences between actual val - ues and budgeted values than a simple examination of performance reports. The real expla - nations only begin to be explored when the components are separated. Still, variance analysis provides numerical results, not the underlying reasons. It is the start of the questioning pro - cess. For volume variances, why was the number of patient visits different than budgeted?

Were there external causes? Were there different levels of illness and injury in the commu - nity? Were there internal causes? Was there a successful marketing campaign that resulted in a higher number of physician referrals? Variance analysis permits the questions to be asked in a more structured format, guiding managers to important financial answers.

For Review: 1. What are the sources of differences between budgeted amount of revenues and expenses and actual amounts? Is it possible that volume variances could exist for a revenue budget and not an expense budget?

In simple variance analyses, the only two sources of variances are volumes of patients and revenue per patient or expense per patient. Since the first part of the calculation of volume variances is the same for revenues and expenses (Actual vol - ume 2 Budgeted volume), it is not possible that volume variances could exist for a revenue budget and not an expense budget. For a situation where actual volume is different from budgeted volume, the magnitude of the volume variances will dif - fer by the extent to which budgeted revenue per service is different from budgeted expense per service. Summary & Resources Chapter Summary Budgeting is among the more important forward-looking requirements for managers. Bud - gets require a careful examination of the aims of an organization, its strategy for achieving those aims, and very specific measures that translate broad statements about services into specific counts and dollar values. The mission statement may serve as the guiding star for a healthcare organization, while the budget serves as the road map.

Budgeting is part of the planning, managing, and controlling cycle used by organizations. At one level, planning involves making decisions about what services to offer and to whom they are sold. The end results of planning are forecasts of patient volume. Budgeting is the appli - cation of dollar amounts to the forecasts. Budgeting results in projected revenues associated with patient volume, projected expenses associated with patient volume (variable costs), and projected expenses associated with maintaining the organization (fixed costs).

Once a budget has been adopted, the organization moves toward implementing plans and managing revenues and expenses. A budget cannot control revenues, but it can help to control Analyze This For Bixby Hospital, prepare a variance analysis for operating expenses for the first quarter of 2012. smi81240_07_c07_167-194.indd 192 3/7/14 9:45 AM 193 Summary & Resources expenses. To the extent that the budget is linked with human resources and other areas of expense, it can serve as a tool that restricts unauthorized expenses.

At the end of the budget period, the last step in the process is to evaluate the differences between the actual financial results and budgeted results. Using performance reports and, when warranted, variance analysis, managers can assess reasons for financial results and be prepared to revise plans and establish the next budget.

Discussion Questions 1. A senior financial official has a preference for having a rigid budget process that involves only senior managers and the board of directors. The budget is completed within one month each year and presents quarterly projections of patient visits, revenues, and expenses. Budgets are not revised and are fixed for the year. The expense portion of the budget is based on the prior year’s actual expenses, with a 1% increase in expenses per patient visit. What are the pros and cons of such a bud - get process? 2. As presented in Exhibit 7.13, the actual salary and fringe benefits expense was 8.7% more than budgeted and the actual number of total patient visits was 1.4% more than budgeted. Without doing a variance analysis, can you estimate the propor - tion of the expense variance associated with volume and salary and fringe benefits expense per patient visit?

If salary and fringe benefits expense are 6% higher than the budgeted amount for one three-month period, what actions should managers take? Exercises 1. The portion of Exhibit 7.6 that provides forecasts for the number of births is given below. What would you forecast as the number of births for 2014? 2009 2010 2011 2012 2013 Births 2,003 1,945 1,842 1,912 1,813 2. A series of projections have been made for births in 2014. Net patient revenues asso - ciated with births are projected to increase from $12,446 to $12,757, fixed expenses are projected to increase from $14,000,000 to $15,500,000, and variable expenses are expected to increase from $650 to $700 per birth. What are the budgets for births for 2013 and 2014? 3. For 2012, the budget and actual values are presented in the following table. What were the sources of variances for revenues and expenses? 2012 Budget 2012 Actual Births 1,842 1,912 Net patient revenue per birth $12,263 $12,142 Total net patient revenue $22,588,446 $23,215,504 Fixed expenses $13,500,000 $13,500,000 Variable expenses per birth $650 $675 Total variable expenses $7,970,950 $8,195,850 Net income $1,117,496 $1,519,654 smi81240_07_c07_167-194.indd 193 3/7/14 9:45 AM 194 Summary & Resources Key Terms capital budget A document that provides a projection of elements on the balance sheet, with an emphasis on the fixed assets and how they are purchased through borrowing money or using savings.

capital rationing The application of internally or externally imposed limits on funds available for capital expenditures.

Under capital rationing, not all profitable projects may be approved, meaning that only the most profitable projects can be accepted.

cash budget A document that provides a projection of the timing of cash receipts and cash expenditures.

fixed budget A budget that establishes dollar amounts for revenues, expenses, and net income that are expected to be earned during the budget period, with a specific planned volume of services. flexible budget A budget that establishes dollar amounts for revenues, expenses, and net income on a per unit of service basis. As volume of services varies, so does the total amount of the budget.

operating budget A document that pro - vides a projection of the elements on the income statement, namely the revenues and expenses of the organization.

pro forma income statement A projected income statement (for the next period).

strategy A statement of actions that are designed to achieve a specific aim.

variance analysis A comparison of actual results and budgeted results with calcula - tions of differences associated with volumes of services and revenues or expenses per unit of service.

zero-based budgeting A budgeting pro - cess that requires new information on all of the assumptions in the budget, rather than adopted prior assumptions. Suggested Websites • For analyses of the survey results on hospital services, see Hospital Compare: ht tp://w w w.medicare.gov/hospitalcompare/ smi81240_07_c07_167-194.indd 194 3/7/14 9:45 AM