Overview of Financial Statements2©Ingram Publishing.docx

Overview of Financial
Statements
2
©Ingram Publishing/Thinkstock
Learning Outcomes
By the end of this chapter, you will be able to:
• Describe the role of financial accounting in healthcare
organizations
• Discuss financial accounting principles
• Explain the information contained in a balance sheet
• Discuss the components of an income statement
• Identify the information contained in a statement of cash flows
• Explain the purpose of activity measures and community
benefit statements
smi81240_02_c02_025-058.indd 25 3/7/14 9:25 AM
26
Section 2.1The Role of Financial Accounting

Introduction
Chamberlin Skilled Nursing, Inc. is a 54-bed nursing home
providing skilled nursing care,
mostly to persons with Medicare coverage. Most residents
receive care for two to three weeks
after a hospitalization or other major medical event. With
Medicare as its major payer, Cham-
berlin is subject to the government’s annual process of payment
determination. More than
half of their expenses are associated with payroll and benefits
of its nursing staff. Substantial
revenues and expenses are also attributable to physical therapy,
occupational therapy, and
medications provided to recovering residents. To maintain even
a slim amount of profit, the
financial accountant at Chamberlin tracks the dollars coming in
and the dollars going out very
closely.
The process of tracking the dollars at Chamberlin Skilled
Nursing, and all organizations, is the
responsibility of financial accounting. Their formal reports are
financial statements, which
provide information on the current status of the organization
and its recent financial perfor-
mance. With a good understanding of the process that leads to
the preparation of financial
statements, and a good understanding of the content of the
statements, managers can use
the information to lead the organization. Financial statements
also permit persons outside of
the organization to understand its financial position and
performance and to make their own
assessments of the organization.
2.1 The Role of Financial Accounting

Financial accounting is responsible for recording and compiling
business and financial trans-
actions, assuring the accuracy of transactions, and preparing
reports of the results. To com-
prehensively record all transactions, financial accounting must
be involved in almost every
aspect of managing an organization. Its role is highly visible
when it is actively involved in the
recording of large transactions, such as the purchase of a new
building or medical equipment.
Financial accounting is less visible, but no less important, as it
passively captures each service
that is provided to patients through the billing system.
Cycle of Activity
Financial accounting follows a cycle of activity that continues
throughout the year. A view of
this cycle is presented in Figure 2.1. It all starts with a system
to record transactions. All orga-
nizations maintain a chart of accounts, or a listing of accounts
that they envision using to
record transactions. Organizations maintain a chart of accounts
as a means of standardizing
the classification of entries and permitting computerization of
accounting.
smi81240_02_c02_025-058.indd 26 3/7/14 9:25 AM
27
Figure 2.1: The accounting cycle

Prepare/Assess
Chart of Accounts
Document
Transaction
Prepare Financial
Statements/Close
Books
Journal Entry
Adjusting
Entries
Post to a
Ledger
Pre-Adjusted
Trial Balance
The Office of Statewide Health Planning and Development,
State of California (2012) provides
a sample chart of accounts for use by California hospitals, a
small portion of which is pre-
sented in Exhibit 2.1. In the complete version of this chart of
accounts, there are more than 200
accounts of assets, liabilities, and fund balances and nearly 600
accounts for revenues and
expenses. Beyond the general categories there are details for
specific purposes. For example,
under category 1001 “General Checking Accounts,” there might
be an account 1001.01 for a
checking account at Bank of America and an account 1001.02
for a checking account at Wells

Fargo. Thus, a full hospital chart of accounts can include
thousands of specific accounts.
Exhibit 2.1 A portion of a hospital chart of accounts
Assets
Current Assets
1000–1009 CASH
1001 General Checking Accounts
1002 Payroll Checking Accounts
1003 Other Checking Accounts
1004 Minor Expense Cash Funds
1005 Savings Accounts
1006 Certificates of Deposit
1007 Treasury Bills and Treasury Notes
1009 Other Cash Accounts
Source: Office of Statewide Health Planning and Development,
State of California (2012)
smi81240_02_c02_025-058.indd 27 3/7/14 9:25 AM
28
The active aspect of financial accounting starts with initial data
capture. Based upon formal
documents or substantial evidence that a financial transaction
has occurred, it is the role of
financial accounting to analyze and record the transaction in a
consistent manner. For routine
transactions, documentation may be standardized and already
prepared by the accounting
information system. Records of the number of hours worked by
nurses and other staff are

an example of routine transactions. For nonroutine transactions,
such as the purchase of a
new piece of equipment, the receipt and other documentation of
the purchase and installa-
tion may be required. Each transaction is analyzed to assure that
its inclusion in the financial
accounting system is appropriate and to determine which
accounts are involved.
The initial recording is called a journal entry—as accountants
often use the term journal to
reflect the transactions involving an account. Again, for many
routine transactions, documen-
tation may be presented and directly entered through the
information systems of the orga-
nization. Recording of the hours worked by a nurse may be
routinely performed by a clerk
who enters the hours into the information system. In larger
organizations, recording of hours
worked may require approval by a supervisor. The direct
payment of employees’ paychecks
into their bank accounts represents a routine transaction that
may be performed automati-
cally by the accounting information system. Nonroutine
transactions, such as the purchase of
a new piece of equipment, may be manually entered into the
accounting system, with refer-
ences to the equipment and the method of payment.
An important aspect of accounting practice is the double-entry
nature of recording trans-
actions. Every transaction involves two entries into the
accounting system, affecting one or
more journals or accounts. For example, a hospital might
redeem certificates of deposit at
a bank if it needs more funds in payroll checking accounts.

Thus, the transaction involves
decreasing the account of certificates of deposit and increasing
the payroll checking account
by the same amount. The general process of increasing and
decreasing amounts in accounts
is termed crediting and debiting, terminology that we will not
belabor in this textbook, but
which are commonly used in accounting practice.
After transactions have been initially recorded, they are also
recorded in a summary listing
of accounts. This second step of recording is termed posting to
a ledger. A ledger is a sum-
mary of the transactions for a particular account. In the case of
account 1001.01 for a check-
ing account at Bank of America, the ledger would provide a
listing of all deposits and checks
written on this account. All organizations maintain a general
ledger that includes all accounts.
Further, many organizations maintain subsidiary ledgers that
maintain the accounts of indi-
viduals and companies with which they conduct business.
Hospitals regularly maintain a sub-
sidiary ledger for every patient and insurance company. The
general ledger for amounts owed
by patients is termed the control account for all of the
individual patients’ accounts. With
the control account, the hospital knows at every point in time
how much it is owed from all
patients, without having to look at each individual patient.
Periodically, a preadjusted trial balance of all accounts is
prepared to assure that all
transactions have been properly reported. Since every
transaction involves two entries in
the accounting system, the preadjusted trial balance serves as a

check that the sum of all
increases and decreases are balanced. It is still possible that
errors were made in the entries
of particular accounts, but it provides some assurance that there
were not simple math errors
smi81240_02_c02_025-058.indd 28 3/7/14 9:25 AM
29
or failures to properly record transactions. For example, if
$10,000 were transferred from a
savings account to a checking account, the dollar amount of the
entries should be the same
for both accounts. If there was a $10 fee by the bank for this
transfer, and it was not recorded,
then the $10,000 decrease in the savings account would not
balance the $9,990 addition to
the checking account. The preadjusted trial balance permits
periodic checking of transac-
tions. With good information technology, the need for
preadjusted trial balances has been
reduced. Still, because entries can be done manually, there is
always the chance of an error.
Analyze This
If financial accounting made a journal entry of an increase in a
checking account without report-
ing on another account, what information would be missing
from the accounting system?
At the end of accounting periods (monthly, quarterly, or

annually), a series of adjusting entries
are recorded. Adjusting entries are required to acknowledge that
the values in a number of
meaningful accounts have changed, even when an explicit
transaction has not occurred at
the same time. For example, at the beginning of a year, an
organization may make a payment
for the purchase of property insurance. This purchase would be
recorded as a decrease in a
general checking account and an increase in a prepaid expense:
insurance account. As each
month passes, the value of the protection made available
through the insurance coverage is
recognized as an expense, and this recognition comes in the
form of an adjusting entry. Finan-
cial accounting is responsible for noting when transactions,
such as the purchase of insur-
ance, will involve future adjusting entries and for reporting
those adjusting entries.
Financial statements can be prepared after trial balances have
been verified as being correct
and all adjusting entries have been made. The key financial
statements include the balance
sheet, the income statement, and the statement of cash flows,
which will be detailed later in
this chapter. Each of these statements summarizes selected
accounts from the accounting sys-
tem. The balance sheet summarizes the amounts in asset,
liability, and net asset accounts. The
income statement summarizes the revenue and expense
accounts, as well as gains and losses
from changes in asset and liability accounts. The statement of
cash flows provides details on
the cash account from the balance sheet and highlights
transactions that yield changes in cash

balances associated with operating, investing, and financing
activities.
Finally, after the financial statements have been prepared,
organizations close the books,
meaning that they stop making changes to accounts for the time
period covered by the finan-
cial statements and make entries that mark the end of the time
period. The closing process
also involves preparation of a closing balance, which, like the
trial balance, provides some
assurance of no math errors. This closing balance then becomes
the opening balance for the
next time period. Before the first transactions are made in the
next period, there may be a
review of the chart of accounts and changes made if new
accounts are required or if unused
accounts can be deleted.
smi81240_02_c02_025-058.indd 29 3/7/14 9:25 AM
30
In following the cycle of activities prescribed for financial
accounting, it is clear that financial
accounting is involved in all of an organization’s transactions
and keeps accounts on all per-
sons and corporations with which the organization conducts
business. At a minimum, the role
of financial accounting includes recording and compiling
transactions, assuring the accuracy
of transactions, and preparing reports of the results. Due to the

intimate role of accounting
in the recording and reporting processes, accounting may also
be involved with the transac-
tion itself. In small organizations, the accounting clerk may
work closely with supervisors for
recording payroll and with individuals responsible for ordering
supplies. In larger organiza-
tions, the jobs become more specialized. By being involved in
transactions directly, account-
ing can assure that transactions yield accurate and consistent
recordings and assure that
reporting of results is correct.
The Users and Regulators of Financial Accounting Information
With financial accounting information including summaries of
all transactions that occur
for an organization, there are a number of persons who use this
information and a number
of parties that regulate the information. The list of users of
financial accounting informa-
tion begins with the management of the organization itself.
Financial information provides
one set of measures on organizational performance. Managers
and others care about qual-
ity of care, access to services and community benefits, and also
financial performance. Man-
agers will look to the financial reports to see the levels of assets
and liabilities held by the
organization as well as the revenue, expenses, and net income
earned in recent accounting
periods. These reports help to guide decision making on asset
management, debt manage-
ment, and the resources devoted to services that yield the
earning of net income. Along
the same lines as managers, boards of directors and others
involved with the governance

of organizations rely upon financial statements as their source
of information on financial
aspects of performance.
Many individuals and businesses with an interest in an
organization use the organization’s
financial statements. Individuals or companies to whom an
organization owes money will
carefully examine that organization’s financial statements. In
addition to the financial state-
ments as a whole, debt holders may require presentation of
selected values from financial
statements in special reports to meet their information needs.
For example, many companies
representing debt holders require presentation of selected
information related to a hospital’s
ability to make required debt payments. Based upon the
information from financial state-
ments, they may require special reports on how much debt is
owed, how much the organiza-
tion is earning each year, and how much money is available for
making debt payments.
Various government agencies including Medicare, the federal
program that provides insur-
ance for the aged and disabled, and Medicaid, the state-federal
program that provides insur-
ance for the poor require the submission of annual financial
statements. Medicare and
Medicaid rely upon financial statements for analysis of the
adequacy of insurance payments.
Another government agency, the Internal Revenue Service
(IRS), requires submission of tax
returns, which are based on financial statements. Even
organizations that are exempt from

income tax, including most not-for-profit healthcare
organizations, must file tax returns:
smi81240_02_c02_025-058.indd 30 3/7/14 9:25 AM
31
Form 990, Return of Organization Exempt From Income Tax
(http://www.irs.gov/uac/
Form-990,-Return-of-Organization-Exempt-From-Income-Tax-).
Schedule H of the Form 990
(http://www.irs.gov/pub/irs-pdf/f990sh.pdf ) requires detailed
information on the financial
assistance and community benefits provided by not-for-profit
organizations. The IRS uses this
information to assess whether not-for-profit organizations
deserve their tax-exempt status.
Because these tax returns are publicly available, boards of
directors and other interested par-
ties may also use this information to assess whether the
organization is meeting its mission.
Regulation of Financial Accounting
To assure users of financial statements that the information is
recorded and presented appro-
priately, there are a variety of bodies that regulate or provide
input into the regulation or
setting of standards for financial accounting. Legally, the IRS
and Securities and Exchange Com-
mission (SEC) have the authority to define accounting practices
that meet their requirements.

As a practical matter, the starting point for standard setting is
the Financial Accounting Stan-
dards Board (FASB) for investor-owned and community not-for-
profit organizations, and the
Governmental Accounting Standards Board (GASB) for
governmental organizations. Using a
process that involves widespread discussion, deliberation, and
dissemination, FASB provides
the standards that are accepted by the IRS and SEC for
reporting financial information. The
end product of FASB’s work is a set of generally accepted
accounting principles that guide
recording and reporting (Larking & DiTommaso, 2012).
Two related parties provide additional details that assist
healthcare organizations’ financial
accounting. The American Institute of Certified Public
Accountants’ (AICPA) Committee on
Healthcare and the Healthcare Financial Management
Association’s (HFMA) Principles and
Practices Board exist to provide guidance to FASB on standards
affecting healthcare organiza-
tions and to provide guidance to healthcare organizations on
practices that are too detailed
for inclusion in FASB standards.
For Review:
1. Why do organizations maintain a chart of accounts?
A chart of accounts is required to provide consistent recording
of financial transac-
tions. It is desired because it permits identification of all details
of an organization
upon which they may report results.
2. What are the seven steps in the account cycle?

The accounting cycle starts with the preparation or assessment
of the chart of
accounts. Transactions are documented, journal entries are
made, and results are
posted to a ledger. To assure that the double-entry system has
been followed, a
preadjusted trial balance is prepared. At the end of an
accounting period, adjusting
entries are recorded, financial statements are prepared, and the
books are closed for
the period.
smi81240_02_c02_025-058.indd 31 3/7/14 9:25 AM
http://www.irs.gov/uac/Form-990%2C-Return-of-Organization-
Exempt-From-Income-Tax-
http://www.irs.gov/pub/irs-pdf/f990sh.pdf
32
Section 2.2Financial Accounting Principles
2.2 Financial Accounting Principles
There are several assumptions about organizations and
principles of accounting practice that
guide the recording and reporting of financial information, as
indicated in GAAP. Each of the
assumptions and principles is necessary to prepare financial
statements that can be under-
stood by persons who might not be familiar with an
organization. Additional explanations are
required only when specific assumptions are not met or
principles are not applied.

Assumptions
A set of assumptions that form the basis for the application of
GAAP starts with the definition
of the entity. Financial accounting is assumed to be concerned
with information on a specific
entity—be it a clinic, hospital, or health system. Understanding
the specific entity to which
the financial information applies is important and yet sometimes
difficult to know without
a clear indication. It is important to be clear on the ownership
of an asset among entities,
as well as the recipient of revenues and obligations of expenses.
Since it is not uncommon
for one accounting entity (e.g., a skilled nursing facility) to
exist within a larger entity (e.g., a
health system that includes multiple hospitals or other
organizations), the definition of the
entity is often included as the first of many footnotes of
financial statements.
Another assumption is that of treating the organization as a
going concern. A going concern
is an organization that is expected to be in existence for the
foreseeable future. The principles
of accounting, particularly for the assets of an organization, are
very different if one considers
it to be a going concern as opposed to an organization that
might close in the coming year. If
a clinic is treated as a going concern, you can measure the value
of its equipment by its pur-
chase price. If a clinic may go out of business, you may need to
measure the value of its equip-
ment by what it might sell for at an auction, which is a much
more difficult task.

All financial transactions are assumed to be recorded in
monetary units (i.e., dollars), with
clear notes if transactions are converted among different
currencies. This assumption implies
that there can be clear documentation of the dollar value of all
purchases and sales. In most
instances, this assumption easily holds. When a patient
purchases a prescription drug from
the hospital pharmacy, the amount paid will be clearly
indicated, and documentation of the
transaction will be created. On the other hand, when a donor
provides a hospital with a piece
of land for construction of a new clinic, formal appraisals must
be obtained to know the value
of the transaction.
The final assumption is that there is a formal and explicit
definition of the accounting period
being represented by a financial statement. Applying a financial
statement to the first month
of one year, as opposed to the full year, could result in a
different interpretation of the finan-
cial results, such as the revenues or expenses.
Principles
In terms of principles, the starting point is objectivity.
Recording of transactions are expected
to be based upon evidence that can be verified and would be
accepted by persons outside of
the organization. Even though financial accountants may be
employed by a hospital, their
work should be performed such that any similarly educated
person would record transac-
tions in the same way and produce reports with the same results.
smi81240_02_c02_025-058.indd 32 3/7/14 9:25 AM

33
For purposes of objectivity and the related principle of
reliability, which requires that trans-
actions be accurate and complete, most assets held by
organizations are reported at their
purchase price, which is also called its historical cost.
Historical costs do not change and can
be verified. Along with the principle of going concern, assets
can be presented at historical
cost and not using assessment of current market value or cost of
replacement. Along these
same lines, revenues are not counted until they have been
earned. Revenues are considered
to be earned after a service has been provided and the amount
that is likely to be paid for that
service has been analyzed. A principle that is embedded within
reliability is that of conserva-
tism, which cautions against overstating assets or net income.
Transactions and reports are also expected to contain
information that is relevant to the
organization. Relevance refers to the information being
associated with the entity and the
information potentially making a difference to users. A
challenge with the determination of
relevance is that there may be many individuals, banks, and
other organizations that use the
financial statements of a healthcare organization. Different
users may have differing needs
for detail provided in financial statements. The principle of

relevance requires that transac-
tions are recorded on a timely basis and reflect true values. The
principles of reliability and
relevance can sometimes be at odds with one another. In fact,
there is a movement toward
reporting monetary assets (e.g., stock and bonds) at market
value, which is more relevant,
rather than at historical cost, which is more reliable.
A principle of comparability, or matching, requires that
expenses should be recorded in the
same period as the revenues that caused the expenses to be
generated. As a result of this
principle, organizations following GAAP use accrual accounting
rather than cash account-
ing. For healthcare organizations, accrual accounting means that
expenses and revenues are
recorded when services are provided to patients. The actual cash
expenditure associated with
an expense (e.g., bandages) will likely occur well before the
service is provided. The actual
cash receipt of payment will likely occur well after the service
is provided, particularly if the
service is covered by insurance. By matching expenses and
revenues, we obtain an accurate
picture of the important events that happened in a time period
(the provision of services
to a patient). The potential mismatch between when
expenditures occur and expenses are
recorded and when revenues are earned and payments are
received is the reason for the
preparation of a statement of cash flows. For personal
accounting practices and that of many
small companies, cash accounting is employed for its
simplicity.

A final principle is that of full disclosure. Organizations are
expected to record all trans-
actions, yet only report those account balances that are of
sufficient magnitude and impor-
tance to decision making to justify presentation on financial
statements. Within this principle
is a test of materiality, which asks whether an error in recording
or reporting results is a
significant misinterpretation of the financial status of an
organization. For purposes of full
disclosure, the amount of cash held is sufficiently important to
be reported on financial state-
ments, regardless of the amount. In fact, having a very small
amount of cash might make this
reporting especially important. Similarly, the total value of
patient accounts receivable—the
amounts owed to the organization by patients and insurance
companies—is important to
report on financial statements, though the source of the amounts
owed by specific payers,
like Medicare and Medicaid, may only be reported in footnotes
of financial statements, if at all.
A healthcare organization may have contracts with dozens of
insurance companies and the
amounts owed by each may not be sufficiently important to
disclose. Weighing the materiality
smi81240_02_c02_025-058.indd 33 3/7/14 9:25 AM
34
of reporting items on the financial statements or in its footnotes

is an important task of finan-
cial accounting and is tested by external auditors.
An important constraint on adherence to accounting principles
is that of cost. The value of
recording and reporting financial information must be weighed
against the cost associated
with the recording and reporting process. Organizations are
expected to use the same record-
ing and reporting methods in each accounting period
(consistency) unless the costs of doing
so or the circumstances of an organization have changed such
that different methods are
more appropriate. Full disclosure requires the reporting of any
changes in accounting meth-
ods. The cost principle or constraint on principles is difficult to
employ, as the value of unreli-
ability, mismatching, and failure to fully disclose information
may not be well understood as
accounting systems are being developed. The excuse of “I didn’t
think that it was worth the
cost of recording all bank loans” may not be accepted upon the
default on a loan.
Each of the principles is necessary as a foundation for how
transactions are recorded and
reported. For organizations that follow all accounting principles
in standard ways, the finan-
cial statements may be easily read and interpreted by managers
and other interested per-
sons. For organizations that do not follow all accounting
principles, additional explanations
may be required.
Internal Controls
Following GAAP requires discipline on the financial accounting

for an organization. The disci-
pline employed in financial accounting is characterized by the
internal controls put in place
to provide reasonable assurance that assets are safe and that the
accounting records are reli-
able. The ultimate responsibility for internal control rests with
the key executives and boards
of directors. Internal controls are implemented by senior
financial personnel. Auditors regu-
larly verify the use of internal controls and their effectiveness.
Good internal controls start
with an environment where the organization recognizes the
importance of accurate and
timely financial information and there is respect for following
GAAP. If there is insufficient
recognition of importance, sufficient resources may not be
provided for conducting financial
accounting according to GAAP. If there is insufficient respect
for the process, individuals may
not be motivated or held accountable to high standards of
objectivity and reliability.
Establishing a process of good internal controls requires an
assessment of risks to following
GAAP and the associated recording of transactions and
reporting of results. Risk assessment
is the process of envisioning risks to good accounting practices
and developing probabilities
and monetary consequences when these practices are not
followed. Clearly identified and
measured risk can be managed through the application of
information and communication
systems and specific risk control strategies.
Accurate reporting and verification of information related to
potential financial transactions

requires systems, processes, and procedures to manage the flow
of the immense amount of
data generated in healthcare organizations. Hendrickson
Memorial Hospital, with financial
statements included in Appendix A, had 116,459 inpatient
admissions, 120,240 outpatient
visits, and 36,360 emergency department visits in 2012. These
visits generated an immense
amount of data that is potentially related to financial
transactions. In fact, merely accounting
for the time-keeping, payroll, employee benefits, and associated
taxes for 3,000 employees
generates data that requires good systems, processes, and
procedures to manage.
smi81240_02_c02_025-058.indd 34 3/7/14 9:25 AM
35
Effective control relies upon not just the written policies and
procedures but also well-
trained, competent personnel to follow and interpret the policies
and procedures. Ideally,
duties among personnel would be separated so that different
people record and verify finan-
cial information and these employees are rotated among the
different assignments. It is not
ideal to have the employee who operates the cash register in a
clinic also count the money
at the end of the day and also reconcile patients’ billing
accounts with cash paid. This would
provide too many opportunities for cash to be misreported or,

worse, missing. In practice,
there are trade-offs between the advantages of specialized
knowledge associated with having
long-term relationships and responsibilities for operations and
the verifiable integrity of a
control system. Errors in judgment or lack of integrity can be
hidden for long periods of time
without clearly defined responsibilities and rotation of duties.
Finally, good internal controls require monitoring to assure that
the climate is maintained
and that policies, procedures, and action are followed. Annual
audits now routinely assess
internal controls and may offer recommendations for
improvement. The importance of good
internal controls has gained visibility and attracted more
monitoring and reporting after the
financial scandals that led to the passage of the Sarbanes–Oxley
Act of 2002. This act requires
greater disclosure of accounting practices than were previously
employed by some compa-
nies (Securities and Exchange Commission, 2013).
Analyze This
Melissa Hanks Bordelon, former chief financial officer of
Acadian Medical Center in Eunice,
Louisiana, was sentenced to 18 months in prison and ordered to
pay restitution for embezzling
$192,000. Ms. Bordelon had the hospital issue checks for its
student loan repayment program in
excess of the amount of the loans. She used the excess amounts
for personal expenses.
Where did internal controls fail at Acadian Medical Center?
Source: Becker’s Hospital Review (2010).

For Review:
1. What are the three key assumptions about healthcare
organizations used to apply
generally accepted accounting principles?
The three assumptions are that the organization is a clearly
defined entity, that it is a
going concern, and that transactions apply to a specified time
period.
2. What are seven key principles applied in financial
accounting?
Key principles include objectivity, reliability, conservatism,
relevance, comparability,
full disclosure, and consistency.
3. Why are internal controls important? Who is responsible for
assuring good internal
controls over financial information?
Internal controls permit an organization to follow generally
accepted accounting prin-
ciples and produce financial statements that fairly depict the
organization. The senior
executives (CEO and CFO) and the board of directors are
ultimately responsible for the
financial statements and assuring good internal controls around
their preparation.
smi81240_02_c02_025-058.indd 35 3/7/14 9:25 AM
36
Section 2.3Balance Sheet Basics

2.3 Balance Sheet Basics
A balance sheet is a presentation of the assets, liabilities, and
the net assets of an organiza-
tion at a point in time. In essence, a balance sheet is a snapshot
of an organization’s financial
standing. It captures what the organization possesses to engage
in its activity (assets), how
much it owes to other organizations and individuals (liabilities),
and therefore how much
of the organization it owns outright (net assets). The name
balance sheet comes from the
requirement that the two sides of the basic accounting equation
are equal:
Assets 5 Liabilities 1 Net assets
The observation that a balance sheet actually balances is an
outcome of the double entry
nature of financial accounting. The addition of an asset (e.g.,
purchase of equipment) gen-
erally comes from either the substitution of another asset (e.g.,
cash) or the addition of a
liability (e.g., a loan). Careful financial accounting assures that
the balance sheet always bal-
ances. The balance sheet for Chamberlin Skilled Nursing is
presented in Exhibit 2.2. A more
complicated balance sheet, Hendrickson Memorial Hospital, is
presented as the first financial
statement in Appendix A.
Exhibit 2.2 Balance sheet, Chamberlin Skilled Nursing
2012 2011
Assets
Cash and cash equivalents $731,690 $615,397
Resident accounts receivable (net of allowance for Doubtful

accounts of $18,000 in 2012 and $20,000 in 2011)
1,145,073 1,183,457
Inventories 93,909 116,688
Prepaid items 21,470 26,541
Total current assets $1,992,142 $1,942,083
Assets limited as to use $462,734 $493,798
Property, plant, and equipment $960,431 932,357
(Accumulated depreciation) (348,960) (219,347)
Net property, plant, and equipment 611,471 713,010
Other long-term assets 79,025 64,323
Total long-term assets 690,496 777,333
Total assets $3,145,372 $3,213,214
Liabilities
Accounts payable $187,818 $233,376
Accrued payroll-related liabilities $331,227 $352,081
Other accrued liabilities $29,706 $2,730
Total current liabilities $548,751 $588,187
(continued)
smi81240_02_c02_025-058.indd 36 3/7/14 9:25 AM
37
Exhibit 2.2 Balance sheet, Chamberlin Skilled Nursing
(continued)
Long-term liabilities

Mortgages $1,426,660 $1,457,356
Notes payable $534,699 $599,671
Total long-term liabilities $1,961,359 $2,057,027
Total liabilities $2,510,110 $2,645,214
Net assets $635,262 $568,000
Total liabilities and net assets $3,145,372 $3,213,214
Source: Author’s calculations.
Assets
Assets are physical or financial items that can be owned and
facilitate the operations of an
organization. Many assets have physical forms, like buildings,
that are clearly identifiable
and can be verified and have their value assessed. Other assets
may not be in direct physical
form, such as cash in a checking account, but they are still
identifiable and can be verified and
assessed for value. There are still other items that organizations
refer to as assets because
they facilitate operations, but they are not assets in a financial
accounting sense because they
cannot be owned. For example, having a reputation for quality
and patient satisfaction may be
beneficial to the hospital, but it does not appear on the balance
sheet.
Assets are presented on the balance sheet in three general
categories: current assets, assets
whose use is limited, and long-term assets.
Current Assets
Current assets are either in the form of cash at a point in time or
are expected to be translated
into cash within a short period of time—typically one year.
Current assets are generally listed

on the balance sheet in terms of liquidity, or how quickly they
can be translated into cash.
Cash and cash equivalents are the most liquid current assets.
Cash includes not just the physi-
cal money that is held in cash registers but also funds held in
checking and savings accounts.
Cash equivalents are generally defined as funds held in debt
instruments (e.g., government
treasury notes) with original maturities of three months or less.
Patient accounts receivable are the amounts owed to the
organization by patients or their
insurance companies. Balance sheets of healthcare organizations
list the total amount of
patient accounts receivable as well as the estimated allowance
for doubtful accounts. Doubt-
ful accounts are those accounts one does not expect to be paid;
they do not, on average, neces-
sarily concern specific patients or insurance companies. In
industries other than healthcare,
doubtful accounts are called bad debts. Some patients will lose
their ability to pay due to
illness or injury, loss of a job with insurance, or other
circumstances. Some insurance compa-
nies will not pay bills submitted due to lack of coverage for the
patient who claimed coverage,
lack of coverage for the specific service provided, or other
circumstances. Financial account-
ing in healthcare organizations often devotes substantial
resources toward assuring that bills
submitted to patients or insurance companies are accurate and
complete. Still, there are sub-
stantial sums that will not be collected, and therefore an
estimate is provided on the balance
sheet as an act of full disclosure. In addition to amounts owed

for patient services, other indi-
viduals or organizations may owe amounts that are summarized
as other receivables.
smi81240_02_c02_025-058.indd 37 3/7/14 9:25 AM
38
Inventories are the dollar value of drugs, medical supplies, and
other products that are pur-
chased for use in the provision of services to patients. Even
though not all drugs and medical
supplies may be used within the same year that they are
purchased, they are potentially avail-
able for use and are therefore considered to be current assets.
The final category of current assets is prepaid expenses. As
noted previously, an example
of prepaid expenses is insurance. When insurance premiums are
paid, an organization holds
the asset of protection against a loss. Similarly, when an
organization pays rent on property
or equipment, it holds the asset of the property or equipment
until the rental period is over.
Because most insurance covers a single year, as do many rental
agreements, prepaid amounts
are generally current assets.
Balance sheets will often also include a category of other
current assets to reflect assets that
don’t fit into one of the specific categories and are not of
sufficient value to warrant creation

of a new category. Examples of other current assets include
equipment that is not currently
being used for patient care and is being prepared for sale and
cash advances paid to employ-
ees for travel to continuing education programs.
Assets Limited as to Use
Assets limited as to use defines assets that have restrictions on
their use that were imposed
by the organization itself or, more frequently, by an outside
party. Assets limited as to use are
often held in the form of financial assets (stock and bonds) or
holdings in other companies.
They include assets that are temporarily or permanently
restricted, with restrictions that are
internally or externally imposed. Temporarily restricted assets
may be used when a specific
need or purpose arises. When assets limited as to use are
released from their restriction, they
can be used by the organization and may be listed as current
assets until they are used. For
example, a healthcare organization may have assets set aside for
new buildings. Once the new
buildings are under construction, a portion of the assets may be
transferred to current assets
as payments are required.
Permanently restricted assets are those that cannot be used,
although some portion of the
investment earnings, interest and dividends, can be used. For
example, if a clinic is provided
with an endowment of $100,000 in order to train nurses, this
principal amount cannot be used.
Investment earnings on the $100,000, perhaps $10,000 in a year,
may be used to pay for train-
ing programs or left in the endowment to provide for larger

investment earnings in the future.
Larger healthcare organizations often hold some funds in cash
and cash equivalents for trans-
actions purposes, such as paying employees and suppliers, and
they may also hold substantial
amounts of financial investments in accounts designated as
assets limited as to use for pre-
cautionary and speculative purposes (Rivenson, Reiter,
Wheeler, & Smith, 2011). Precaution-
ary amounts are those held to protect the organization’s ability
to pay its bills in the event
Analyze This
Chamberlin Skilled Nursing estimated an allowance for doubtful
accounts of $18,000 in 2012 and
$20,000 in 2011. What might explain the differences in the
allowances between these two years?
smi81240_02_c02_025-058.indd 38 3/7/14 9:25 AM
39
of changing payment systems or other risks. They are held to
protect the organization and
to protect individuals or firms that loan money to the
organization. Organizations that hold
substantial amounts for precautionary purposes may be
rewarded with lower interest rates
from lenders who recognize lower risks for loan repayment.
Speculative amounts held as assets limited as to use are

investments that are designed to increase in value for
the future benefit of the organization. Investments in
financial assets and direct investments in other compa-
nies may provide earnings that can subsidize unprofit-
able services that are important for the fulfillment of
a healthcare organization’s mission as well as provide
resources for future plant replacement and expansion.
The reasons for the limited use of assets may come
from decisions that are made internally to the organi-
zation or externally by donors or investors. Internally,
the board of directors can restrict funds for specific
purposes, be it for plant replacement and expansion or
for undesignated precautionary or speculative pur-
poses. Such restrictions can place financial discipline
on the management of an organization, but it can be
changed by the board at their discretion. Externally,
donors often place restrictions on the use of their dona-
tions. The use of endowments to create permanent pro-
grams or services is quite common.
Long-Term Assets
Long-term assets are not expected to be converted into cash or
cash equivalents within a year.
Generally, long-term assets, sometimes called fixed assets,
represent the physical assets that
permit the provision of healthcare services. Separately or
combined as one line, the amount of
property, plant (buildings), and equipment purchased by an
organization is usually its largest
long-term asset. Other fixed assets may include patents,
copyright, and other assets that are not
used in the delivery of health services. All assets are initially
recorded at their purchase price.
A unique feature of long-term assets is that they are used over

time. Even though the details of
how accounting recognizes that they are used over time are
provided later in this chapter, the
general concept is that, to follow the matching principle, the
cost of buildings and equipment
should be recognized over the course of their useful life. Thus,
the balance sheet includes the
initial value of property, plant, and equipment, the amount of
depreciation expense that has
been accumulated since the assets were purchased, and the
difference being the net property,
plant, and equipment.
Liabilities
Liabilities are the amounts the organization owes to other
businesses or individuals. They are
presented on the balance sheet in two general categories:
current liabilities and long-term
liabilities.
From the Front Lines
We just increased our board-designated
assets limited as to use for precaution-
ary purposes in order to plan ahead. We
are changing our payment model with
commercial insurance companies later
this year, and we know that, as a result,
our utilization of inpatient services will
decline. We also know that we must con-
tinually invest in information technology
to support changes to the care delivery
model. Therefore, we are being cautious
with our finances and are restricting how
we use our money.
Source: Health system vice president.

smi81240_02_c02_025-058.indd 39 3/7/14 9:25 AM
40
Current Liabilities
Current liabilities are obligations that are expected to be paid
within the year. For debts that
extend beyond one year, like mortgages, leases, and pensions,
the payments that must be paid
within a year are listed as current liabilities. They are presented
separately to highlight an
organization’s need for resources to pay liabilities due within a
year and to permit a compari-
son with available resources, namely current assets.
Many obligations are explicitly expected to be paid within a
year. For many purchases of medi-
cal products and supplies, the payment is not made at the time
of the receipt of the goods.
Instead, an accounts payable is created with the bill being due
within 30 days, sometimes
with a discount if it is paid sooner.
Salaries, wages, and payroll-related expenses (medical
insurance, payroll taxes, etc.) are
accrued each day as employees work for the organization, but
are paid at the end of the week
or month and certainly are paid within a year. When balance
sheets are prepared on a day
that doesn’t match payday, there are obligations for accrued
salary, wages, and payroll-related
expenses.

At the time a balance sheet is prepared, there may also be
accrued interest payable on short-
term obligations and other current liabilities. There is also often
recognition that the amounts
paid to the organization by insurance companies might not be
exactly what should have been
paid, though a final determination of the correct amount may
take months to resolve. Depend-
ing on the nature of the estimates, there may be short-term
liabilities if they have potentially
been overpaid (or short-term assets if they have been underpaid)
of estimated third-party
payer settlements.
Analyze This
Chamberlin Skilled Nursing’s total current liabilities were
$548,751 in 2012. Should they be con-
cerned about their ability to pay this debt in the current year?
What information should you have
to assess their ability to pay this debt?
Long-Term Liabilities
For larger organizations, the amount of long-term mortgages,
bonds, or other forms of long-
term debt will be the largest long-term liability. Other long-
term liabilities include notes
and loans payable to banks and other lenders, long-term lease
obligations (also called capi-
tal leases), estimated liabilities for any self-insurance claims,
and accrued pension and post-
retirement healthcare costs. In each type of long-term liability,
there may also be a current
liability portion that is due within the year.
Net Assets

Net assets represent the value of the organization’s assets after
subtracting the value of
the liabilities. In some presentations of balance sheets of not-
for-profit organizations, net
assets may be presented as the fund balance or a set of funds. In
smaller organizations and in
smi81240_02_c02_025-058.indd 40 3/7/14 9:25 AM
41
organizations that do not have donor restrictions on assets
limited as to use, there will only be
one fund and no special accounting techniques are required. For
investor-owned companies,
also called for-profit companies, net assets are called equity,
owners’ equity or shareholders’
equity. In all cases, net assets can be considered as what the
organization owns after all the
bills have been paid. Within not-for-profit organizations, the
owners are the community as
a whole, which can be difficult to define. For investor-owned
organizations, the owners are
those who hold the stock of the company.
Fund Accounting
Not-for-profit organizations are unique in that they may present
net assets as a set of funds
reflecting the restrictions placed upon certain assets, a practice
called fund accounting. As
noted with assets limited as to use, there may be restrictions
upon the use of resources avail-

able to the organization, and these restrictions are reflected on
the net assets side of the
balance sheet. Three types of funds may be used to represent the
types of restrictions placed
upon the use of resources: unrestricted, temporarily restricted,
and permanently restricted.
There is only one unrestricted fund, often called the general
fund, and it represents the net
assets associated with the operations of the organization. In
fact, if there are no changes in the
structure of an organization other than carrying on operations,
the net income (net loss) will
be reflected in the increase (decrease) in the balance of the
general fund. If someone gives an
unrestricted donation of cash to a not-for-profit healthcare
organization, the donation will be
recorded as nonoperating revenue and subsequently, through an
increase in net income, be
reflected as an unrestricted net asset.
Restrictions on net assets can arise from internal or external
sources. The board of directors
can internally restrict funds that would otherwise be in the
general fund; these funds are
termed board-restricted or board designated funds. Donors,
grant agencies, lenders, and oth-
ers can impose external restrictions on funds. In some cases,
there may be legal obligations
to designate funds associated with external restrictions. In
addition to the designation of the
funds as being temporarily or permanently restricted, there may
be other designations asso-
ciated with the expected use of the funds. Common uses of
restricted funds include building
projects, provision of charity care, and endowments for specific

purposes.
One common type of temporarily restricted fund is a plant
replacement and expansion fund.
Donations or monies set aside for building projects may be
designated as being temporarily
restricted in the plant fund. When the building project has been
completed, the restriction
is removed, and the amount in the plant fund is transferred to
the general fund. (For these
same building projects the investments being made in assets are
designated as construction-
in-progress, which is a type of asset limited as to use. When the
building is completed, it is
transferred to property, plant, and equipment, which is a long-
term asset.)
Another common type of temporarily restricted fund is
associated with charity care or other
special services being supported by a donor or grant funding
agency. When assets are used to
pay for the services associated with the gift or grant, the
amounts in the temporarily restricted
funds are reduced.
A final type of fund is a permanent fund, often also termed an
endowment fund. The essence
of a permanent fund is that the assets associated with the fund—
typically held as financial
smi81240_02_c02_025-058.indd 41 3/7/14 9:25 AM
42

Section 2.4Income Statement Basics
investments—are not to be used for the purpose of the fund.
Only the investment earnings on
the financial investments may be used by the organization.
Depending on the purpose of the
endowment, it may be that all earnings are used every year, or
that only some of the earnings
are used and the endowment fund may grow over time.
As you have seen, the balance sheet provides a complete listing
of the assets, obligations, and
net assets of an organization at a specific point in time. As
such, it provides an indication of
many events that have occurred in an organization’s history.
The balance sheet lists all of the
items the organization has purchased that are still held, and all
the amounts that it has bor-
rowed that it still owes. Balance sheets are conventionally
reported in a comparative manner,
presenting value for both this year and last year. The
transactions that occur during the year
that lead from one balance sheet to the next are summarized in
the income statement and the
statement of cash flows.
For Review:
1. What is the basic accounting equation?
Assets 5 Liabilities 1 Net assets
2. What is the difference between current and long-term assets?
Current assets are either cash or can be expected to be
converted into cash within a
year. Long-term assets will remain in their current form (e.g.,
buildings and equip-

ment) for more than one year.
3. What is the difference between current and long-term
liabilities?
Current liabilities are obligations that are expected to be paid
within a year. Long-
term liabilities will remain obligations that will not be paid for
at least one year.
4. What is the difference between assets and net assets?
Assets are the physical and financial items that an organization
has under its control.
Net assets represent that portion of the value of the assets that
are owned by the
organization. Net assets are the value of the assets, less the total
amounts owed to
other parties (which are the liabilities).
2.4 Income Statement Basics
An income statement is a presentation of the revenues,
expenses, and net income of an orga-
nization over an accounting period. The income statement may
also be called the statement
of operations or the statement of revenues and expenses, which
are common labels in not-for-
profit healthcare organizations. The income statement captures
how much the organization
expects to be paid for the provision of services (its operating
revenues), how much it expects
to spend to provide those services (its operating expenses), and
its earnings from invest-
ments and other nonoperating activities. Organizations may also
yield gains or losses from
the sales of assets not related to patient services, such as the
sale of an old X-ray machine. The
general equation for the income statement is

Net income 5 Revenues 2 Expenses 1 Gains 2 Losses
smi81240_02_c02_025-058.indd 42 3/7/14 9:25 AM
43
The income statement for Chamberlin Skilled Nursing is
presented in Exhibit 2.3. A more
complicated income statement, Hendrickson Memorial Hospital,
is presented as the second
financial statement in Appendix A.
Exhibit 2.3 Income statement, Chamberlin Skilled Nursing
2012 2011
Revenues
Skilled Medicare revenue $3,754,548 $4,252,005
Private patient revenue 52,892 38,680
Ancillary services revenue 6,005,460 5,975,758
Other revenue 305,816 274,151
Gross patient services revenue $10,118,716 $10,540,594
(less provision for doubtful accounts) (22,956) (31,007)
Net Revenues $10,095,760 $10,509,587
Expenses
Salaries and wages $4,799,108 $4,960,685
Fringe benefits 864,934 897,288
Contract/registry labor 104,102 174,273
Physical therapy 899,920 836,363
Occupational therapy 821,152 781,753
Speech therapy 219,323 201,182

Pharmacy 555,302 800,304
Laboratory and other ancillary 278,708 294,999
Building and equipment rental 1,357,141 1,319,746
Depreciation expense 129,613 120,936
Interest expense 61,886 70,585
Total operating expenses $10,091,189 $10,458,114
Net operating income (loss) $4,571 $51,473
Net Nonoperating revenues 16,024 15,789
Net Income $20,595 $67,262
Revenues
Patient services revenues are earned by the healthcare
organization through the provision
of services and products related directly to patients. The level
of detail of revenues pre-
sented on income statements varies among organizations. For
Chamberlin, it was deemed
material to present skilled Medicare revenue, private patient
revenue, and ancillary services
revenue separately. For larger organizations, it is common to
present only the total of patient
services revenue on the income statement and then to present
the breakdown by payer, such
as Medicare and Medicaid, or by type of service provided in the
footnotes of the financial
statements.
smi81240_02_c02_025-058.indd 43 3/7/14 9:25 AM
44

Contractual Allowances, Charity Care, and Doubtful Accounts
Internally to the accounting system, revenues may be recorded
at the organization’s full price
listed on the chargemaster. However, two deductions from
revenue occur behind the scenes.
First, the billing system will include the expected payments of
services corresponding to
agreed charges, or agreed upon discounts from usual charges.
Only the expected payments
are counted as revenues. The differences between an
organization’s listed charges and the
expected payments are called contractual allowances. If the
chargemaster lists $150 as the
price for a service, and the contract with an insurance company
lists $100 as the payment for
a service, the contractual allowance is $100. Contractual
allowances do not appear on audited
(GAAP) financial statements, although they do appear on
reports provided to Medicare.
Second, the revenues associated with patients qualifying for
charity care are deducted from
total revenues. Healthcare organizations are expected to have a
charity care policy and seek
to identify patients who might qualify for charity care. When a
patient qualifies, the health-
care organization does not send the patient a bill, and there is
no expectation of revenue. An
outline of the charity care policy as well as the amount of
charity care based upon the esti-
mated cost of providing the care are reported in a footnote of
financial statements.
An annual total of uncollectable accounts, or doubtful accounts,
is a third deduction from
revenue that appears directly on the income statement. As with

the estimated provision for
uncollectable accounts that appears on the balance sheet, a
portion of the estimate is based
on historical patterns of payments. Uncollectable accounts also
include a patient-by-patient
accounting of whether or not the organization was paid.
Nonoperating Revenue
In addition to revenues earned from provision of services to
patients, healthcare organiza-
tions may earn revenue from a number of services related to the
patient experience. These
other operating revenues include cafeteria sales, parking lot
fees, and research revenues.
Further, healthcare organizations may earn revenue from
services unrelated to the patient
services experience. Earnings associated with nonoperating
services are often presented as
nonoperating income (nonoperating revenue less nonoperating
expenses) as the details are
not generally important. Sources of nonoperating income
include earning on financial invest-
ments, interest income, and restricted gifts and donations.
Analyze This
St. Francis Hospital, The Heart Center., has the following
section in its charity care policy: Patients
without sufficient non-exempt assets qualify for 100% charity
care if their family income is at or
below 300% of the Federal poverty guidelines. Patients are
responsible for 20 to 80% of their bill
if their family income is between 300 and 400% of the Federal
poverty guidelines. Please refer to
the current charity care income guidelines for sliding scale
eligibility percentages. Documenta-

tion and verification of income and assets will be requested
during the application process.
Does this charity care policy seem fair to you?
Source: Catholic Health Services of Long Island (2013).
smi81240_02_c02_025-058.indd 44 3/7/14 9:25 AM
45
Expenses
Expenses include the cost of services and goods used in the
provision of patient care and
administrative activity. Expenses are typically presented by the
type of service that is involved,
such as salaries and wages, and fringe benefits. For some
organizations, either on the income
statement or in the footnotes, expenses are presented by the area
of business for the organi-
zation, including inpatient and outpatient expenses. The latter is
particularly true for complex
healthcare organizations that include many different areas of
business like hospital services,
nursing home services, and home health services.
The reporting of expenses for most services and goods
represents an accounting of when ser-
vices and goods are provided. Again, with accrual accounting,
expenses represent the value
of the services and goods used during an accounting period, not
necessarily the expendi-
tures that occurred during that same time period. For salaries,

wages, and related expenses,
accounting must recognize when employees are working, which
can be complicated given the
various types of overtime pay or differences in pay associated
with working nights or week-
ends. For temporary workers provided through an agency and
professional medical services
provided by nonemployees (e.g., physical therapy, speech
therapy), invoices for payment
must include the dates of work.
Reporting of expenses for pharmacy, laboratory, and other
ancillary services may be tied to
the process that tracks use of services for billing purposes. The
reporting of expenses associ-
ated with the general use of the facility and equipment requires
additional analysis associated
with the expenses. For building and equipment rental expenses,
as well as interest expenses,
the expense itself is typically associated with a specific time
period. Even though attributing
the expense of the building and equipment rental to particular
patients can be a challenge,
attributing the expense to a time period for purposes of
preparing the income statement is
not a challenge. For buildings and equipment that are
purchased, recognition of the expenses
over time comes from depreciation.
Depreciation Expense
The term depreciation as used by accountants refers to the
recognition of the expense of using
buildings and equipment over time. Long-term assets may be
purchased with one payment
or by payments on a loan or mortgage over time; in either case,
the goal of accounting is to

match the use of assets to the provision of services. There are
several methods of depreciation
Because not-for-profit organizations have limited sources of net
assets as compared to inves-
tor-owned organizations, it is often observed that large not-for-
profit organizations generate
substantial earnings from nonoperating sources. As presented on
Chamberlin Skilled Nurs-
ing’s Income Statement (Exhibit 2.3), nonoperating income
comprises a substantial portion
of net income.
Analyze This
Is it a concern that most of the net income earned by
Chamberlin Skilled Nursing in 2012 was
derived from nonoperating income? Explain your reasoning.
smi81240_02_c02_025-058.indd 45 3/7/14 9:25 AM
46
available for businesses. Healthcare organizations
predominantly use the straight-line
method of depreciation. The straight-line method divides the
purchase price by the number
of years that an asset will typically be used, or its useful lives.
To facilitate the accounting pro-
cess for hospitals, nursing homes, and physician offices, the
American Hospital Association
(2013a) prepares an annual guide to the depreciation lives for
medical and administrative

assets, including desks and chairs. An example of types of
useful lives is presented in Exhibit
2.4. A demonstration of the process of recording depreciation
expenses for the income state-
ment and the resulting values for the balance sheet is presented
in Exhibit 2.5.
Exhibit 2.4 Useful lives of selected medical assets
Anatomical model 10 years
Arthroscopy instrumentation 3 years
Arthroscope 5 years
Apnea monitor 7 years
Audiometer 10 years
Biofeedback machine 8 years
Bronchoscope 3 years
Exhibit 2.5 Depreciation schedule for an apnea monitor
Year Depreciation Expense Accumulated Depreciation Book
Value
Year 0—Purchase $0 $0 $4,025
Year 1—Use $575 $575 $3,450
Year 2—Use $575 $1,150 $2,875
Year 3—Use $575 $1,725 $2,300
Year 4—Use $575 $2,300 $1,725
Year 5—Use $575 $2,875 $1,150
Year 6—Use $575 $3,450 $575
Year 7—Use $575 $4,025 $0
Gains and Losses
Gains and losses are earned from the sales of assets (or
repayment of liabilities) at amounts
that differ from those presented on the balance sheet. For
example, say a healthcare orga-
nization purchased a new apnea monitor for a clinic in 2010 for

$4,025. After two years, it
had accumulated depreciation of $1,150 and had a net value on
the balance sheet of $2,875.
Analyze This
Chamberlin Skilled Nursing recorded depreciation expenses of
$129,613 in 2012 and $120,936
in 2011. Why did the depreciation expense increase?
smi81240_02_c02_025-058.indd 46 3/7/14 9:25 AM
47
The organization conducted a complete renovation and
concluded that it no longer needed
that particular machine. When the apnea monitor was sold, the
organization received $2,000.
Thus, the organization experienced a loss of $875 on the sale.
Since the total of gains and
losses is often not substantial, the net amount (gains minus
losses) may be presented as a
single line on financial statements. For Chamberlin Skilled
Nursing, there were no gains or
losses in the two years presented in Exhibit 2.3. For
Hendrickson, there was a gain for paying
off debt early, and gains and losses on disposal of equipment, as
presented in Appendix A.
Provision for Taxes
It is perhaps well known that for-profit companies are expected
to report the payment of
income taxes, property taxes, and other nonpayroll taxes on the

income statement. Perhaps
less well known is that not-for-profit organizations may have
income related to services that
are not a regular part of the organization’s activities. For
example, a hospital may own a build-
ing that is primarily used for medical offices, but when they
have an excess number of offices,
they may lease them to nonmedical companies. The income
earned from the nonmedical
company leases is viewed as unrelated business income and is
subject to taxes.
The income statement provides a summary of the transactions
that occur during the account-
ing period. This information leads to the calculation of net
income, which is the sum of the
revenues and gains minus the expenses and losses. By focusing
on revenues and expenses,
the income statement focuses on the organization’s operations.
By following GAAP, it is pos-
sible to compare organizations in terms of their net income to
assess profitability. Due to the
nature of accrual accounting practices, the income statement
might not provide all users with
the information that they would like to have to assess the
financial activity of an organization.
Therefore a statement of cash flows is also provided.
For Review:
1. What is the general equation for the income statement?
Net income 5 Revenues 2 Expenses 1 Gains 2 Losses
2. What are contractual allowances?
Contractual allowances are the differences between an
organization’s listed charges

and the expected payments from health insurance companies and
other payers.
3. What is depreciation expense?
Depreciation expense is recognition of the use of an asset over
its life. By spreading
out the expense associated with purchasing an asset over the
number of years it can
be used, organizations can better match revenues earned each
year with expenses.
4. What is the difference between contractual allowances,
charity care, and doubtful
accounts?
Contractual allowances reflect differences between charges and
expected payments
based upon contracts with insurance companies. Charity care
represents care for
which no charges are expected, which is measured at the cost of
providing the ser-
vice. Doubtful accounts represent care for which charges are
made and for which an
estimate of the amount that will not fully be collected is
prepared.
smi81240_02_c02_025-058.indd 47 3/7/14 9:25 AM
48
Section 2.5Statement of Cash Flows
2.5 Statement of Cash Flows
The statement of cash flows is a presentation of the sources and
uses of cash balances of

an organization over the time of an accounting period. The
purpose of the statement of cash
flows is to provide an explanation for the changes in cash
(actually cash and cash equivalents)
between two accounting periods. In providing this explanation,
the statement of cash flows
also reconciles the difference between the accrual account and
cash accounting measures of
financial performance.
The statement of cash flows for Chamberlin Skilled Nursing is
presented in Exhibit 2.6. A
more complicated statement of cash flows from Hendrickson
Memorial Hospital is presented
as the third financial statement in Appendix A.
Exhibit 2.6 Statement of cash flows, Chamberlin Skilled
Nursing
2012 2011
Net income $20,595 $67,262
Change in:
Depreciation 129,613 120,936
Prepaid items 5,071 1,089
Resident accounts receivable 38,384 64,891
Inventories 22,779 (15,236)
Accounts payable (45,558) (152,256)
Accrued payroll/related liabilities (20,854) 165,827
Other accrued liabilities 26,976 (106,064)
Net cash provided (used) by operations $177,006 $146,449
Cash flows from investing
Purchase of depreciable assets

Building $23,243 $67,263
Equipment 28,074 (67,886)
Other fixed assets 14,702 0
Other noncurrent assets (31,064) 5,177
Net cash provided (used) by investing $34,955 $4,554
Cash flows from financing
Mortgage notes ($30,696) ($343,839)
Notes payable (64,972) (78,079)
Net cash provided (used) by financing ($95,668) ($421,918)
Net increase (decrease) in cash $116,293 ($270,915)
Cash at beginning of period $615,397 $912,856
Cash at end of period $731,690 $615,397
smi81240_02_c02_025-058.indd 48 3/7/14 9:25 AM
49
Section 2.5Statement of Cash Flows
Cash Flow from Operations
The statement of cash flows is separated into three parts: cash
flow from operating activi-
ties, cash flow from investing activities, and cash flow from
financing activities. Cash flow
from operations starts with net income from the income
statement. Adjustments for non-
cash expenses are added back to net income next, with the major
adjustment typically being
the depreciation expense. When long-term assets are purchased,

an outflow of cash occurs
(an investment activity as described in the next section). When
expenses associated with
the depreciation of long-term assets are recorded each year,
they do not involve any use of
cash, which is why depreciation is added back to net income. To
fully reconcile the difference
between accrual and cash accounting, changes in balance sheet
items related to operating
activities, primarily current assets and current liabilities, are
also presented.
For example, at Chamberlin Skilled Nursing, resident accounts
receivable (net of allowance for
doubtful accounts of $18,000 in 2012 and $20,000 in 2011)
decreased to $1,145,073 in 2012
from $1,183,457 in 2011. This decrease of $38,384 represents
additional cash that must have
flowed into the organization from patients and their insurance
companies. In total, Chamber-
lin experienced positive cash inflows from operations far in
excess of net income alone.
Cash Flow from Investing Activities
Cash flow from investing activities reflects purchases of
physical plant assets (property, plant,
and equipment) and sales of financial securities that are held as
assets limited as to use or
for other long-term purposes. For Chamberlin, the sale of
equipment in 2012 was associated
with cash inflows, and the purchase of equipment in 2011 was
associated with cash outflows.
Cash Flow from Financing Activities
Cash flow from financing activities reflects obtaining funding
and the repayment of funding

from noncurrent sources. Bonds, mortgages, notes, or leases are
sources of cash inflows when
they are acquired and sources of cash outflows when they are
repaid. It is valuable to observe
that the payment of interest is recorded on the income statement
and the repayment of prin-
cipal balances is recorded on the statement of cash flows.
Net Income Versus Cash Flow
Again, one purpose of the statement of cash flows is to
reconcile the difference between
accrual account and cash accounting measures of financial
performance. In other words, the
income statement reflects accrual accounting methods and
provides the value of net income
earned. The statement of cash flows adds the inference of cash
transactions to the income
statement and balance sheet to provide the value of cash flow
realized.
In the case of Chamberlin Skilled Nursing, operating, investing,
and financing activities dem-
onstrated positive net cash flows in excess of net income in
2012. However, in 2011, the effects
of purchasing equipment and repaying mortgages and notes
result in negative net cash flows
that more than offset net income. Earning positive income is
looked upon as a favorable mea-
sure of organizational performance. Net cash flows can be
positive or negative depending on
the range of activities without a clear indication of
performance.
smi81240_02_c02_025-058.indd 49 3/7/14 9:25 AM

50
Section 2.6Activity Measures and Community Benefit Statement
For Review:
1. What are the three sections of a statement of cash flows?
The three sections of the statement of cash flows are cash flow
from operating activi-
ties, cash flow from investing activities, and cash flow from
financing activities.
2. What is the difference between net income and net cash flow?
Net income is the amount that an organization has earned from
providing services
and other activities during the year. Net cash flow is the change
in cash held by the
organization over the year. Depending on the level of investing
and financing activi-
ties in the current year and prior years, net income and net cash
flow can be very
different, and both are important.
2.6 Activity Measures and Community Benefit Statement
The dollar values presented on formal financial statements can
be useful to those involved
with the management and governance of an organization and to
lenders and other interested
persons outside the organization. Still, the dollar values may
not provide a complete picture
of a healthcare organization. For this reason, activity measures
and community benefit state-
ments are prepared and made available to the public.
Activity Measures

Activity measures provide a more complete presentation of the
transactions that occur during
an accounting period. Since activity measures are not required
by financial accounting prin-
ciples, there are not definitions of which activity measures to
present, nor are there uniform
ways in which they are presented. The selection and
presentation of activity measures is left
to the judgment of management. The value of activity measures
is that they enable users of
financial statements to place the values on the balance sheet and
income statement in context.
Selected key activity measures for Chamberlin Skilled Nursing
are presented in Exhibit 2.7.
Exhibit 2.7 Key activity measures, Chamberlin Skilled Nursing
2012 2011
Licensed bed capacity 54 54
Total admissions 984 868
Total discharges 892 841
Medicare resident days 17,008 17,378
Private resident days 133 79
Other resident days 1,341 1,267
Total resident days 18,482 18,724
Occupancy rate 93.8% 95.0%
Registered nurses 18 24
Turnover rate 48% 57%
Licensed practical nurses 8 12
Nurse aides 129 133

smi81240_02_c02_025-058.indd 50 3/7/14 9:25 AM
51
Section 2.6Activity Measures and Community Benefit Statement
Community Benefit Statement
The IRS, and many states, now requires certain not-for-profit
healthcare organizations to pro-
vide a community benefit statement. This statement is a listing
of the activities that ben-
efit the community and the costs and any offsetting revenues
associated with these services.
Under the Patient Protection and Affordable Care Act, there are
new standards for not-for-
profit hospitals to meet to maintain tax-exempt status. IRS Form
990, Schedule H lists specific
categories of community benefits for reporting. However, even
before the Affordable Care Act,
some states had gone further to require community benefit
statements (Somerville, Nelson,
& Mueller, 2013).
There has not been a standard format for public presentation of
these statements as there
is for financial statements. However, with the revisions to the
IRS Form 990, Schedule H, its
format now appears to be broadly adopted for public
presentation. To prepare a community
benefit statement, it is first necessary to define and describe the
community served by the
healthcare organization. Second, it is expected that a
community benefit planning process
will occur, including a community health needs assessment.

Third, measurable objectives and
timelines must be prepared to assure consistent and accurate
reports. Finally, a report can be
prepared that includes financial measures of community benefits
as well as unquantifiable
measures. The key figure from Bixby Health System’s
Community Benefit Statement for 2012
is presented in Exhibit 2.8.
For the management of a skilled nursing facility, key activity
measures include the number
of residents, the number of resident days, and the number and
turnover rates of key nursing
personnel. Chamberlin experienced an increase in the number of
admissions and discharges
in 2012 as compared to 2011 and a slight reduction in the
number of patient days of care. This
means that there were slightly shorter lengths of stay for
patients in 2012. The numbers of
nurses in each category were lower at the end of 2012 as
compared to 2011. Also of note, the
turnover rate (the percentage of nurses who left the organization
during the year) was lower
for every category of nurse, and markedly lower for nurse aides.
Analyze This
Does Chamberlin Skilled Nursing employ enough nurses to
provide good quality patient care?
What information would you need to possess to provide a good
answer to this question?
smi81240_02_c02_025-058.indd 51 3/7/14 9:25 AM
52

Summary & Resources
Exhibit 2.8 Community benefit statement, Bixby Health System,
2012
Expense Offsetting Revenue Net Benefit
Direct individual benefits
Financial assistance for persons in poverty $4,966,936 $0
$4,966,936
Medicaid services 90,843,186 91,402,850 (559,664)
Medicare services 65,413,256 60,197,727 5,215,529
Community services
Community benefit operations 401,910 0 401,910
Community building activities 22,145 0 22,145
Community health improvement services 548,879 71,221
477,658
Financial and in-kind contributions 1,521,854 40,661 1,481,193
Subsidized health services 3,024,357 0 3,024,357
Total community benefit $166,742,523 $151,712,459
$15,030,064
In Bixby’s statement, benefits are provided to individuals in
need, as defined as persons in
poverty, persons qualified for Medicaid and Medicare coverage,
and the community as a
whole. All direct and community services are measured at costs,
not charges. It is informa-
tive to managers and other interested parties that Bixby may be
losing money on Medicaid
services and earning a profit on Medicare services. This
information may be used to examine
the efficiency in the provision of services to all patients.

Further, it may be useful to boards of
directors and others who assess whether an organization is
meeting its mission by providing
medical services to specific populations and other services to
the community.
For Review:
1. Who benefits from healthcare organizations’ community
benefits?
For certain community benefits, specific individuals benefit by
receiving financial
assistance or services covered by Medicaid or Medicare. For
other community
benefits it is the community broadly defined, not clearly defined
individuals, that
benefits.
Summary & Resources
Chapter Summary
This chapter has covered a substantial amount of material on the
role and function of finan-
cial accounting in healthcare organizations. Preparation of
complete and accurate financial
accounting reports requires involvement in almost every aspect
of the operations of a health-
care organization. Financial statements are used for managerial
purposes by people within
the organization and for evaluation purposes by outside the
organization. Given the wide-
spread use of financial statements and the public interest in
accuracy, the preparation and
presentation of financial statements is tightly regulated.
smi81240_02_c02_025-058.indd 52 3/7/14 9:25 AM

53
Summary & Resources
The three main financial statements include the balance sheet,
the income statement, and the
statement of cash flows. The balance sheet presents a listing of
the assets held by an orga-
nization, the liabilities (debts) owed to others, and the net of the
assets minus the liabilities
at a specific point in time. It presents physical assets at their
purchase price, which is not
necessarily a perfect measure of value, but it can be consistently
and accurately reported.
Financial assets are reported at their current market value. Both
current assets and current
liabilities are highlighted to provide information on the short-
term status of the organization.
Also highlighted for not-for-profit organizations are restrictions
that may be placed on assets
due to decisions by the board of directors or donors. These
restrictions may lead to keeping
track of assets and net assets by the fund upon which it is based.
The income statement lists the revenues earned by the
organization, the expenses incurred,
and the net income that remains. In many not-for-profit
healthcare organizations, the income
statement is alternatively called a statement of operations or a
statement of revenues and
expenses. This statement is the key source of information on the
sources and level of profit-
ability for the organization.

In addition to the measurement of profitability on the basis of
the income statement, the
statement of cash flows measures where actual dollars flowed in
and out of the organization.
Three types of cash flows are presented in the statement of cash
flows: operating activities,
investing activities, and financing activities. Net income is the
starting point for the statement
of cash flows, which then presents the reasons for the change in
the level of cash available for
the organization being different from net income, with each
reason involving how account-
ing is conducted under accrual rules that match revenues and
expenses, rather than a simple
calculation of receipts of money and expenditures.
Discussion Questions
1. Healthcare organizations generally follow the steps in the
accounting cycle and
adhere to accepted accounting principles. Are persons in the
community really con-
cerned with healthcare organizations’ financial accounting
practices, or do they just
want to receive good quality medical services? Is consistency
all that important?
2. Many small physician offices have only one person who
submits bills to insurance
companies and records and deposits the checks when bills are
paid. It doesn’t make
sense to hire more persons to comply with good practices for
internal controls. If
you don’t trust the finance person, can’t you just fire them?

3. How can a healthcare organization have a positive net
income, yet have no money?
What can be done to remedy this situation?
4. How can healthcare organizations earn revenues, other than
providing services
to patients? From Exhibit 2.3, it appears that in 2012
Chamberlin Skilled Nursing
earned $4,571 from operations and $16,024 from other sources.
Should Chamberlin
cease operations to focus on earning money from other sources?
smi81240_02_c02_025-058.indd 53 3/7/14 9:25 AM
54
Summary & Resources
Exercises
1. The balance sheet for 2012 at Sheldon Clinic is presented in
Exhibit 2.9. Unfortu-
nately, the elements are presented in alphabetical order instead
of the appropriate
accounting format. Rearrange the rows to put them in the
correct order.
Exhibit 2.9 Balance sheet for Sheldon Clinic, December 31,
2012
Accounts payable $588,899
Accounts receivable $2,516,631
Accrued expenses $372,561
Accumulated depreciation $4,422,702
Allowances for uncollectible accounts $298,740

Assets limited as to use $4,440,081
Cash and cash equivalents $1,473,975
Fixed assets $10,061,440
Loans and notes payable $1,567,857
Long-term liabilities $3,351,761
Net accounts receivable $2,217,891
Net fixed assets $5,638,738
Other current assets $100,014
Pharmaceutical inventories $696,615
Restricted net assets $4,588,430
Short-term investments $1,038,172
Total assets $15,605,486
Total current assets $5,526,667
Total current liabilities $2,529,316
Total liabilities $5,881,077
Total liabilities and net assets $15,605,486
Total net assets $9,724,408
Unrestricted net assets $5,135,979
smi81240_02_c02_025-058.indd 54 3/7/14 9:25 AM
55
Summary & Resources
2. The Income statement for 2012 at Sheldon Clinic is presented
in Exhibit 2.10. Unfor-
tunately, the elements are presented in alphabetical order
instead of the appropriate
accounting format. Rearrange the rows to put them in the
correct order.
Exhibit 2.10 Income statement for Sheldon Clinic, December
31, 2012

Medicaid revenue $8,362,905
Depreciation expense $567,040
Interest expense $1,073,674
Lease expense $449,582
Miscellaneous nonpatient revenue $567,633
Net income or (loss) $1,938,226
Net patient revenues $22,422,749
Operating income $1,370,593
Other government revenue $5,555,873
Private insurance revenue $8,503,972
Professional services $3,154,713
Salary and fringe benefits expense $14,335,919
Supplies and other operating expense $1,471,228
Total operating expense $21,052,156
3. Following the amounts set in the chargemaster at Sheldon
Clinic, $140,000 in bills
were processed for private insurance patients in December
2012. Of these bills,
$20,000 is associated with patients who qualify for 100%
charity care. For the
remaining patients, if the usual rate of contractual allowances is
25%, how much
would Sheldon Clinic list as revenues for the month of
December 2012?
4. Continuing with Exercise 2, if 10% of patient bills are
expected to be uncollectable,
how much would Sheldon Clinic list at revenues for the month
of December 2012?
5. Sheldon Clinic purchased new equipment for an examination
room. The cost of the
equipment is $24,000 and has a useful life of eight years. Using
the straight-line
deprecation method, what is the annual depreciation expense for

the equipment?
Prepare a depreciation schedule of the equipment for the clinic.
Key Terms
accounting period The time period cov-
ered by a financial statement, usually being
a month, quarter, or year.
accrual accounting The practice of record-
ing expenses and revenues when services
are provided to patients rather than when
cash transactions occur.
adjusting entries Transactions that are
entered into the accounting process to rec-
ognize changes in values that are not due to
specific events.
assets Physical or financial items that can
be owned and facilitate the operations of
an organization. Current assets are those
assets that are in the form of cash or cash
equivalents or that are expected to be in the
form of cash within one year.
assets limited as to use Assets that have
restrictions on their use that were imposed
by the organization itself or by an outside
lender or donor. Assets limited as to use are
often held in the form of financial assets.
smi81240_02_c02_025-058.indd 55 3/7/14 9:25 AM
56

Summary & Resources
balance sheet A presentation of the assets,
liabilities, and net assets of an organization
at a point in time.
basic accounting equation
Assets 5 Liabilities 1 Net assets.
cash accounting The practice of record-
ing revenues when payments are received
and recording expenses when supplies and
resources are purchased.
chart of accounts A listing of accounts that
organizations use to record transactions.
Each type of transaction must be recorded
in an account, with subaccounts made avail-
able to record the details associated with
transactions.
close the books The process of stopping
changes to accounts for the time period
covered by the financial statements and
then making entries that mark the end of
the time period.
community benefit statement A state-
ment that lists the services provided by
the organization that furnish a benefit to
the community, either through provision of
healthcare services to defined populations
or services that benefit the community as
a whole. Community benefits are valued at
costs, not charges.

comparability An accounting principle
that expenses should be recorded in the
same time period as the revenues that
caused the expenses to be generated. For
assets that are used over several time peri-
ods, depreciation is required.
conservatism An accounting principle
that if there is any doubt or possible bias in
transactions, the organization should not
overstate assets or net income.
consistency An accounting principle that
organizations are expected to use the same
recording and reporting methods in each
accounting period.
contractual allowances The differences
between an organization’s listed charges
and the expected payments from health
insurance companies and other payers.
cost The sum of the expenses associated
with a service; also, a constraint on adher-
ence to accounting principles, whereby the
value of recording and reporting financial
information must be weighed against the
resources associated with the recording and
reporting process.
current assets Assets that are cash or are
expected to be converted into cash within a
year.
current liabilities Liabilities that are

expected to be paid within a year.
depreciation Recognition of the expense
of using buildings and equipment over time
to match when they are used to provide
services to patients.
doubtful accounts The dollar value of
uncollected bills from patients and third-
party payers, also called bad debts.
entity The company or organization that is
the subject of a financial statement.
equity The term for net assets used by
investor-owned organizations; what the
organization owns after all the bills have
been paid.
expenses The costs of services and goods
used in the provision of patient care and
administrative services during an account-
ing period.
smi81240_02_c02_025-058.indd 56 3/7/14 9:25 AM
57
Summary & Resources
full disclosure An accounting principle
that all transactions are reflected in finan-
cial statements.

fund accounting Not-for-profit organiza-
tions are unique in that they may present
net assets as a set of funds reflecting the
restrictions placed upon certain assets.
fund balance The value of the organiza-
tion’s assets after subtracting the value of
the liabilities. The more commonly accepted
term for fund balance on balance sheets of
not-for-profit organizations is net assets.
gains Amounts earned by selling assets
for more than the purchase price less any
depreciation.
going concern An assumption in finan-
cial accounting that the organization being
reported upon in the financial statements is
expected to be in existence for the foresee-
able future.
income statement A presentation of the
revenues, expenses, and net income of an
organization over the time of an accounting
period. The income statement may also be
called the statement of operations or the
statement of revenues and expenses.
internal controls The process by which
an organization assures the accurate and
consistent recording of transactions and
reporting of results.
journal entry The initial recording of a
transaction in an account, with journal
being another term for an account.

liabilities The amounts owed by the orga-
nization to other businesses or individuals.
long-term assets Assets that are not in the
form of cash and are not expected to be sold
during the current year.
long-term liabilities The amounts owed
by the organization to other businesses or
individuals that do not have to be paid in
the current year.
losses Amounts lost by selling assets
for less than the purchase price less any
depreciation.
materiality A test of whether an error in
recording or reporting results in a signifi-
cant misinterpretation of an organization’s
financial status.
net assets The value of the organization’s
assets after subtracting the value of the
liabilities. In some presentations of balance
sheets of not-for-profit organizations, net
assets may be presented as fund balance. In
presentations of balance sheets of for-profit
organizations, net assets may be presented
as owner’s equity.
nonoperating revenue Revenue earned
from activities not directly related to the
main purpose of the organization.
objectivity An accounting principle of

recording transactions based upon evidence
and independent of bias.
posting to a ledger The step of record-
ing transactions to accounts in a summary
manner.
preadjusted trial balance An interme-
diate step in the accounting process that
checks that transactions have been properly
recorded.
prepaid expenses Current assets that
represent advance payment of amounts that
will be treated as expenses.
relevant An accounting principle of report-
ing summaries of transactions that are
meaningful to users.
smi81240_02_c02_025-058.indd 57 3/7/14 9:25 AM
58
Summary & Resources
reliability An accounting principle of
recording transactions in an accurate and
complete manner.
revenues The amounts earned through
the provision of services and products, with
the amounts being recorded at the level of
payment agreed upon from a third-party

payer or the level expected from individuals
or companies.
statement of cash flows A presentation of
the sources and uses of cash balances of an
organization over the time of an account-
ing period; it is divided into sections for
operating activities, investing activities, and
financing activities.
straight-line method of deprecia-
tion Recording the expense associated
with use of a long-term asset by dividing the
purchase price by the number of years the
asset will be used.
unrestricted fund (general fund) Net
assets associated with the operations of the
organization.
useful lives The number of years that
assets are expected to be available and func-
tioning. This number is used for recording
depreciation expense.
Suggested Websites
• For an example of a full chart of accounts for hospitals, see
California’s Office of
Statewide Health Planning and Development:
http://www.oshpd.ca.gov/hid/Products/Hospitals/AnnFinanData/
Manuals/
index.html
• For information on financial accounting standards and the
public accounting profes-

sion, see American Institute of Certified Public Accountants
(AICPA):
http://www.aicpa.org
• For information on financial accounting standards, see
Financial Accounting Stan-
dards Board (FASB): http://www.fasb.org
• For information on accounting practices and the healthcare
financial management
profession, see Healthcare Financial Management Association
(HFMA):
http://www.hfma.org
• Internal Revenue Service: Form 990, Return of Organization
Exempt From Income Tax,
http://www.irs.gov/uac/Form-990,-Return-of-Organization-
Exempt-From
-Income-Tax-, Schedule H, http://www.irs.gov/pub/irs-
pdf/f990sh.pdf
smi81240_02_c02_025-058.indd 58 3/7/14 9:25 AM
Manuals/index.html
Manuals/index.html
http://www.aicpa.org
http://www.fasb.org
http://www.hfma.org
http://www.irs.gov/pub/irs-pdf/f990sh.pdf

Module Ten Discussion Board (200 words)
1. In an agreement between a supplier and a customer, the
supplier must ensure that all parts are within tolerance before
shipment to the customer. What would be the effect on the cost
of quality to the customer? What would be the effect on the cost
of quality to the supplier?
Module Eleven Discussion Board(200 words)
Distinguish between dependent and independent demand in a
McDonald’s, in an integrated manufacturer of personal copiers,
and in a pharmaceutical supply house.
Module Twelve Discussion Board(200 words)
1. Is it possible to achieve zero inventories? Why or why
not?
2. Stopping waste is a vital part of lean. Identify some
sources of waste in your home or dorm and discuss how they
may be eliminated.
Module Thirteen Discussion Board(200 words)
1. With so much productive capacity and room for expansion
in the United States, why would a company based in the United
States choose to purchase items from foreign firm? Discuss the
pros and cons.
2. As a supplier, which factors would you consider about a
buyer (your potential customer) to be important in setting up a
long-term relationship?
Module Fourteen Discussion Board(200 words)
1. List five major reasons why a new electronic components
manufacturing firm should move into your city or town?

2. What are the pro and cons of relocating a small or
midsized manufacturing firm (that makes mature products) from
the United States to China?
3. If you could locate your new software development
company anywhere in the world, which place would you choose,
and why?
Prices and Payment
Systems
5
Ingram Publishing/Thinkstock
Learning Outcomes
• Describe the importance of prices in the healthcare industry
• Explain traditional methods for paying healthcare
organizations
• Calculate payment amounts under modern methods for paying
healthcare organizations
smi81240_05_c05_117-142.indd 117 3/7/14 9:41 AM
118

Section 5.1Prices in the Healthcare Industry
Introduction
Having inpatient hospital services, outpatient hospital services,
nursing facilities, and three
health centers, Hendrickson Memorial is having a difficult time
with pricing services and rec-
onciling how much they charge and how much they are paid.
With good cost determination
processes, they calculated inpatient costs to be $2,636 per day,
outpatient costs to be $703
per patient visit, skilled nursing costs to be $241 per day, and
health center costs of $233 per
patient visit. Like any other business, each service must have a
standard set of prices, which
are called charges in healthcare organizations. Also like any
other business, each customer
wants to pay a different amount. Half of Hendrickson’s net
patient services revenue was paid
by government payers (Medicare, Medicaid, and other), with
some payment amounts lower
than costs. Negotiations with other major customers, insurance
companies, and managed
care organizations have generally resulted in payments slightly
in excess of costs, leaving
them with a small profit level. A small percentage of customers
are insurance companies or
patients without insurance who pay changes. Some patients
without insurance pay nothing.
Prices set by healthcare organizations, and the resulting
payments actually received, are half
of the basic accounting equation. Recall that operating net
income equals revenues minus
expenses. It is important for healthcare organizations to realize
revenues that are sufficient

to cover expenses as well as to generate a level of net income
that permits investment in new
property, plant, and equipment to keep pace with the
advancement of medical care. Effec-
tive financial management requires an understanding of how
healthcare organizations are
paid by government, insurance, and individual patients and how
they manage the process to
assure they are collecting appropriate amounts.
5.1 Prices in the Healthcare Industry
Prices and payment systems are among the most complicated
and controversial aspects of
the business of healthcare. To some observers, the amounts
listed in hospital chargemasters
and prices for physician services, nursing homes, and other
healthcare organizations do not
appear reasonable or related to the cost of providing services
(Brill, 2013). One can argue
about whether prices are reasonable or related to costs, but
there’s no arguing the compli-
cated nature of prices and payment systems.
To begin an analysis of prices and payment systems, it is useful
to consider the sources of
financing for healthcare services. Many not-for-profit
healthcare organizations owe their ori-
gin to community-based philanthropy, contributions by religious
orders and other not-for-
profit entities, and government appropriations, grants, and
programs to support construction
and operations of facilities. Investor-owned organizations are
founded with investments
from individuals, venture capital funds, and other private
sources of funds. To augment the
sources of net assets and owner’s equity, healthcare

organizations may also borrow funds in
order to purchase the assets required to provide patient services.
These sources of financ-
ing, net assets and owner’s equity, and debt, cover the costs of
establishing and maintain-
ing assets—the balance sheet of the organization. Separately,
the organization needs to find
funds to cover the costs of providing services—the income
statement of the organization. To
cover the operating costs associated with providing services,
healthcare organizations must
largely rely upon the revenues received from patients and third-
party payers.
smi81240_05_c05_117-142.indd 118 3/7/14 9:41 AM
119
Not-for-profit healthcare organizations may subsidize operating
costs with earnings from
investments and designated donations. Investment earnings and
donations covered less
than 1% of operating expenses for Hendrickson Memorial in
2012 (financial statement
presented in the Appendix A) and 7% of operating expenses for
Middaugh United in 2012
(financial statements presented in Chapter 3). These funds are
valuable to health services
that are supported. However, relying upon earnings from
investments and donations is
risky for healthcare organizations, as it places their ability to
provide services at the vari-

able returns in investment markets. Some years may be good
and some years may be bad
(Song, Smith & Wheeler, 2008). For-profit healthcare
organizations do not have investment
earnings and don’t receive donations, so they must earn all
revenues from the provision of
medical services.
Revenues received from patients and third-party pay-
ers may come in varying amounts based upon the
prices set by the healthcare organization, the ability of
patients to pay their portion of prices, and prices dic-
tated or negotiated with third-party payers. It is clear
that there are differences in the levels of payments to
healthcare organizations among payers (Baker, Bun-
dorf, & Royalty, 2013). As will be discussed more exten-
sively later in this chapter, the prices set by healthcare
organizations are often dependent on the prices dictated
or negotiated with third-party payers. Not-for-profit
organizations that desire to cover the costs of opera-
tions through revenues from operating activities may
set higher prices when confronted with payments from
some payers that do not fully cover costs. This concept
is called cost-shifting. However, just because a health-
care organization sets prices at a given level does not assure
that payments at that level will
be received (Worth, 2013). As an example of cost-shifting, it
has been suggested that when
Medicaid programs lower payments, healthcare organizations
take extra efforts to negoti-
ate higher payments from insurance companies. In practice, it is
hard to determine if cost-
shifting results in higher payments over time. To the extent that
cost-shifting is attempted, the
dollar value is likely to be small relative to the total revenues of
the healthcare organization.

Working with Insurance Companies
The percentages of net patient services revenues received at
Hendrickson Memorial Health
System’s three major locations are presented in Exhibit 5.1. For
the system as a whole, Medi-
care and Medicaid account for 51% of net patient services
revenues. Medicare is the federal
insurance program for elderly and disabled U.S. citizens. At age
65, qualifying citizens become
eligible for enrollment in Medicare. Medicare has four parts:
Part A for hospital services, Part
B for physician and other services, Part C for all services in a
combined managed care plan
(Medicare Advantage Plans), and Part D for prescription drugs.
Another Part C, designed to
cover long-term nursing home services, was approved and then
repealed before it was fully
implemented (Aaronson, Zinn, & Rosko, 1994). Part A is fully
paid by the federal government,
while Parts B, C, and D require monthly payments from
enrollees.
We apply the earnings made from our
investments to half of the capital expen-
ditures on new buildings and equipment
each year. Our Board approves of our
plan of holding substantial investments in
order to have days cash on hand for our
credit rating, and these investment earn-
ings make our plan even more beneficial
to the system.
Source: Health system chief financial officer.
smi81240_05_c05_117-142.indd 119 3/7/14 9:41 AM

120
Analyze This
Should the Hendrickson Memorial Health system be concerned
that over half of their net patient
services revenue comes from governmental sources? Explain
your reasoning.
Exhibit 5.1 Hendrickson Memorial Health System, sources of
net patient
services revenues, 2012
Revenue Source Hospital Skilled Nursing Clinics Total
Medicare 37.4% 24.1% 30.4% 36.7%
Medicaid 14.3% 34.6% 8.3% 14.3%
Other federal programs 2.0% 0.0% 2.4% 2.0%
Other state and local programs 2.5% 1.9% 0.6% 2.4%
Private health insurance 38.8% 12.7% 46.5% 38.8%
Workers’ compensation and other private 1.6% 0.0% 2.1% 1.6%
Patient out-of-pocket 3.4% 26.7% 9.7% 4.2%
Total sources: 100.0% 100.0% 100.0% 100.0%
Medicaid is a federal-state partnership to provide health
insurance to persons with low
incomes. In addition to a low income, persons must also have
certain characteristics (e.g.,
children, pregnant women, parents of Medicaid-eligible
children, disabled). The specific char-
acteristics that enable enrollment in Medicaid vary by state.
With the Patient Protection and
Affordable Care Act, states have the option of increasing the

number of persons who qualify
for Medicaid to all persons with income up to 133% of the
federal poverty line. As of Janu-
ary 1, 2014, 24 states have opted to expand Medicaid eligibility,
while 26 have opted not to
expand Medicaid eligibility (Families USA, 2013).
Other federal programs include contracting with the Department
of Defense and other agen-
cies. At the state level, the State Children’s Health Insurance
Program (SCHIP) is the major
payment source. Private health insurance represents a
combination of a number of private
traditional health insurance companies, preferred provider
organizations, and health main-
tenance organizations, each of which may have a unique
contract with Hendrickson for each
location of service.
Medicare, Medicaid, other federal programs, and other state and
local programs are not
generally sources of net patient services revenues with which a
healthcare organization has
an opportunity to negotiate payment amounts. Governmental
programs generally have the
authority to dictate payment amounts. Healthcare organizations
can elect to participate in
these programs—though nonparticipation is not really an option
when a payer represents
half of their revenues. To the extent that negotiation occurs, it
is the collective negotiations
and lobbying conducted by trade associations and others to
benefit healthcare organiza-
tions collectively.
smi81240_05_c05_117-142.indd 120 3/7/14 9:41 AM

121
Although there may not be explicit negotiations that occur
between governmental programs
and individual healthcare organizations, the organizations may
still work closely with the
governmental program to assure that all proper payments are
made on a timely basis. It can
be helpful for healthcare organizations to employ persons with a
good understanding of the
payment processes of governmental programs. Even if all of the
larger dollar amount items
are paid according to established procedures, understanding the
detailed nuances of any
payment system may yield additional payments that make the
difference between earning a
profit and incurring a loss.
In addition to the fee-for-service programs of Medicare and
Medicaid, there are managed
care components as well. Under fee-for-service programs,
insurance provides a payment
for each medical service separately, and there are no
requirements for coordination of care.
Under managed care programs, there are requirements that
patients use selected healthcare
providers and rules about payment for providers that encourage
coordination of care. Since
managed care programs involve some limitation of choice
among providers, there are often
more services covered, and the potential for coordinated care

among providers that encour-
ages enrollment in managed care plans. Approximately one
quarter of Medicare enrollees are
in managed care plans (Medicare Payment Advisory
Commission, 2013). Unlike the fee-for-
service program, health plans bid to participate in Medicare
Advantage and receive payments
determined by a combination of the bid amount, a benchmark
payment amount, and a plan’s
quality ratings. Selected health plans, in turn, negotiate
payment arrangements with health-
care organizations. Similarly, Medicaid managed care programs
operate in many states and
replace the payment processes used in the fee-for-service
Medicaid program with payment
arrangements with healthcare organizations. Even though a
healthcare organization may
group all Medicare and Medicare Advantage revenues in one
line on a financial statement, the
payment amounts associated with various Medicare patients
may vary.
Healthcare organizations may contract with a number of private
health insurance plans, each
of which may have a different method of payment and a
different payment amount associ-
ated with each method. Hendrickson Memorial Health System is
not unusual in having over
two dozen contracts with health plans for the hospital side of
their operations alone. Three
major insurance companies pay for over half of the privately
insured patients; nevertheless,
the contract with every health plan is important to the financial
viability of the organization.
It is important for healthcare organizations to employ persons
with good understandings of

the payment processes of private insurance programs to assure
that appropriate payment
arrangements and amounts are negotiated at the start of a
contracting period and that actual
payments follow the contracts.
As with any negotiation between two companies, the results of a
negotiation process between
a healthcare organization and an insurance company will
heavily depend on the relative mar-
ket power of the two companies. Healthcare providers that have
large percentages of the
patients in a service area and have good quality scores and high
levels of patient satisfaction
will generally obtain higher payments than organizations that do
not enjoy these conditions
(Berenson, Ginsburg, & Kemper, 2010). In several states, there
are health insurance compa-
nies with high percentages of the individual coverage insurance
market, such as North Dakota,
Noridian Mutual Insurance Co., 97%; South Carolina,
BlueCross BlueShield of South Carolina,
93%; and Alabama, Blue Cross and Blue Shield of Alabama,
92%. On average, the leading indi-
vidual coverage insurer has a 58% market share (Kaiser Family
Foundation, 2012).
smi81240_05_c05_117-142.indd 121 3/7/14 9:41 AM
122
Healthcare Charges

Charges, or prices, are the amounts that healthcare
organizations expect to be paid by
patients or insurance companies that do not have prior
contractual arrangements. These are
the amounts that are put in the chargemaster. A common
complaint against the process of
developing charges is that they do not bear a close relationship
between the amount an orga-
nization is typically paid for services and the costs of an
organization. The former issue is
often true. Typical payments may be very different from charges
and vary among payers. The
latter issue is not generally true. Many healthcare organizations
develop their charges based
upon covering their full costs.
A brief depiction of the concept of cost-based charges is
developed in Exhibit 5.2. Total patient
charges are the amounts that stem from the prices set by the
hospital and are included in the
chargemaster. For patients covered by Medicare, Medicaid, or
another government programs,
$465,045,055 were posted as charges. Also included in the
chargemaster is the arrangement
with each payer. For government payers, the payment amounts
were $349,235,616 lower than
charges. This amount is termed a contractual allowance or, more
commonly, a discount. The net
patient revenue for patients covered by the government was
only 25% of the amount charged
($465,045,055 2 $349,235,616 5 $115,809,439). The net patient
revenue for all other patients
was 37% of the amount charged ($339,531,165 2 $213,231,151
5 $126,300,013).
Exhibit 5.2 Hendrickson Memorial Hospital, net patient

revenues
per patient, 2012
Government Programs Other Patients Total
Patient days 52,290 38,177 90,467
Total patient charges $465,045,055 $339,531,165 $804,576,220
Charges per patient $8,894 $8,894 $8,894
(Less allowances and discounts) ($349,235,616) ($213,231,151)
($562,466,767)
Net patient revenues $115,809,439 $126,300,014 $242,109,453
Net patient revenues per patient $2,215 $3,308 $2,676
Based on all patients at Hendrickson Memorial Hospital, net
patient revenues are close
to total patient costs. The average payment amount of $2,676
per day just covers the
average cost per day of $2,636. Of course, not all payment
amounts are equal. Medi-
care payments at Hendrickson (43.5% of total payments) are
92% of average costs
($2,435 4 $2,636 5 0.92), Medicaid payments at Hendrickson
(14.3% of total payments) are
60% of average costs ($1,582 4 $2,636 5 0.60), and other
government payments (2.0% of
total payments) are very close to average costs ($2,620 4 $2,636
5 0.99). On average, gov-
ernment payments are $421 below costs per patient ($2,636 2
$2,215 5 $421).
If government payments are close to costs, why are charges so
high? Part of the reason is
because of how charges are calculated. Patients with private
insurance and patients with-
out insurance who pay for services directly are expected to
cover their own costs, plus the

costs that are not covered by government patients and the costs
of patients who do not pay
at all. Contracts with many private insurance companies include
contractual allowances, or
discounts, that may be 50% to 75% of charges.
smi81240_05_c05_117-142.indd 122 3/7/14 9:41 AM
123
A calculation of charges for Hendrickson Memorial Hospital is
presented in Exhibit 5.3.
The pricing process begins with an estimation of total patient
expenses and the number of
patients. In this example, total patient expenses divided by the
number of patients yields the
cost per patient:
$2,636 expenses per patient 5
$238,471,012 total patient expenses
90,467 patients
Expected payments from insurance companies with
predetermined payment amounts
are subtracted from total patient expenses to yield the required
patient revenues from all
other patients. In this example, if only government programs
have predetermined payment
amounts, then the remaining costs must be covered by
nongovernment patients:

$238,471,012 (total patient expenses) 2 $115,809,439
(government programs) 5 $122,661,573.
In addition to covering patient costs, nongovernment patients
may also be charged an amount
that will permit an operating profit for the hospital. If the goal
for profit amount is set at a
modest 1.5% of total patient expenses, the total amount of
expected payments per patient
will be $126,300,013 ($122,661,573 1 $3,638,440 5
$126,300,013). On a per patient basis,
required patient revenues from nongovernment patients are
$3,213, plus $95 in additional
revenues for profit, for a total of $3,308 in expected patient
revenues.
Exhibit 5.3 Hendrickson Memorial Hospital, charges per
patient, 2012
Total Amount Per Patient
Total Patient Expenses $238,471,012 $2,636
Net patient revenues, Medicare $88,677,803 $2,435
Net patient revenues, Medicaid $22,028,599 $1,582
Net patient revenues, other government $5,103,037 $2,620
Less net patient revenues, government programs $115,809,439
$2,215
Required patient revenues, nongovernment $122,661,573 $3,213
Additional revenues for profit (1.5%) $3,638,440 $95
Expected patient revenues, nongovernment $126,300,013 $3,308
Required charges at 37.197% collection $339,543,547 $8,894
Up to this point, the calculations and costs per patient appear to
be very reasonable. What
happens next changes everything. To realize $126,300,013 in
patient revenues, this amount

is divided by the average percentage collection (1 2 percentage
discount) to yield the amount
that must be charged:
Percent collection 5 1 2 62.803% discount
Percent collection 5 37.197% collection
Amount charged 5
$126,300,013 net patient revenues
37.197% collection
5 $339,543,547
smi81240_05_c05_117-142.indd 123 3/7/14 9:41 AM
124
Analyze This
A clinic has negotiated with 80% of the insurance companies
covering its patients for an aver-
age payment amount of $100. The clinic currently sees 200
patients per week and has an average
expense per patient of $110. Insurance companies for the other
20% of patients have an average dis-
count of 50%. What amount will the clinic need to charge other
insurance companies to cover
their costs?
On a per patient basis:
Charge per patient 5

$3,308 net patient revenues
37.197% collection
Charge per patient 5 $8,894 per patient
It is correct to observe that $8,894 per patient day
is not what the organization is typically paid for ser-
vices, but it is based upon the organization’s costs. If
contracts with insurance companies were negotiated
at lower percentage discounts, for all payers, charge-
master amounts could be lowered to amounts that
more closely resemble payment amounts and costs.
Many leading health systems are attempting to make
their prices more transparent for consumers and are
renegotiating contracts and recalculating chargemas-
ter amounts (Jacobs & Eggbeer, 2012). Further, some
states are working on legislation that would not permit
healthcare organizations to have high charges for indi-
viduals without insurance (Melnick & Fonkych, 2013).
Due to the move toward more individual
insurance coverage and more choices by
patients, we have increased the transpar-
ency of our pricing and are trying to be
more patient friendly. While we previously
sent bills for services and expected patients
to pay us without question, we now list
the expected payments for a number of
common services on our website, so that
patients will know what to expect ahead of
time. We also have a financial assistance
number that patients can call to obtain an
estimate of payments before admission.

Source: Health system chief financial officer.
For Review:
1. Why do healthcare organizations establish charges that are so
different from costs?
Organizations seek to set charges that cover both costs and
profits. Some organiza-
tions set charges that are higher than costs to earn higher
profits. All organizations
set charges that enable healthcare payments that exceed costs in
a complex payment
environment. If government contracts and other insurance
companies negotiate
prices that are below costs, these amounts will be reflected in
overall charges and
may be much higher than costs.
smi81240_05_c05_117-142.indd 124 3/7/14 9:41 AM
125
Section 5.2Traditional Healthcare Payments
5.2 Traditional Healthcare Payments
Payments and payment methods for healthcare services are as
varied as the services them-
selves. As presented in Exhibit 5.4, health insurance companies
typically have 15 or more pay-
ment systems in place to cover the major types of healthcare
organizations and services. This
chapter focuses on the methods that Medicare and other large
insurance companies use to
pay healthcare organizations. Specific details of each payment

method for each type of health-
care organization would cover an entire book (Casto &
Forrestal, 2013). Therefore, only the
main aspects of interest to a manager are highlighted.
Exhibit 5.4 Healthcare organizations with separate payment
systems
Ambulatory surgical centers Ambulance services
Anesthesiologists Clinical labs
Critical access hospitals Durable medical equipment
Federally qualified health centers Home health agency
Hospice Inpatient hospital
Outpatient hospital Pharmacy
Physician Rural health clinics
Skilled nursing facility . . . and many more
Source: Author.
Methods for paying healthcare organizations include traditional
and more modern methods.
Traditional payment methods include:
• Charges
• Negotiated amounts
• Negotiated charge discounts
• Retrospective costs
Some modern payment methods include:
• Prospective amounts
• Per visit amounts
• Per episode amounts
• Per time period amounts
The first four methods are long-standing, traditional ways in
which healthcare organizations
have been paid. The last four methods are relatively new ways

in which healthcare organiza-
tions are being paid. The future of payment methods will build
on the last four methods, at
least in the near term. Even though some of these payment
methods are more common for
certain types of healthcare organizations than other payment
methods, every type of health-
care organization is confronted with multiple payment methods.
Each payment method is
briefly described, with examples that highlight common use of
the method.
smi81240_05_c05_117-142.indd 125 3/7/14 9:41 AM
126
Charges
For each type of healthcare organization, development of a list
of charges for services is
required if they are paid on the basis of charges. Payment of the
full amount charged may not
be common for healthcare organizations, though it is the method
of payment of most goods
and services in the economy. Payment for healthcare goods and
services is different due to the
myriad of third-party payers and government involvement.
Rather than pay the amounts charged by healthcare
organizations, many insurance com-
panies negotiate payment amounts. For physician services,
payments based upon fee
schedules or fee screens are quite common. Fee schedules are

payment amounts for
services that are fixed amounts. When an insurance company
receives a bill for a specific
service, it uses the fee schedule for the payment amount.
Fee screens place limits on payments that are based on charges.
Screens may be developed
based upon usual, customary, or reasonable charges (UCR).
Usual amounts are often
defined as the lowest amounts that a healthcare organization has
listed as charges on bills
submitted within the prior contract period, usually one calendar
year. The use of a usual
charge screen limits the rate of increase in healthcare payments
as there will be a one-year
lag between an increase in the charge by an organization and an
increase in the payment by
an insurance company.
Customary amounts are calculated by insurance companies for
healthcare organizations in
a particular region of the country or state. Customary amounts
are sometimes also called
the prevailing amount. To determine the customary amount,
insurance companies first com-
pute the distribution of charges that are included on patient
bills. Insurance companies then
select the median (half of the bills include charges that are
higher and half of the bills include
charges that are lower), the 75th percentile (75% of bills
include charges lower than a specific
amount), or the 90th percentile (90% of bills include charges
lower than a specific amount)
as the customary amount. For a midlevel, routine office visit for
an established patient, the
median charge might be $100, the 75th percentile might be

$125, and the 90th percentile
might be $150. The customary amount would be $100, $125, or
$150, depending on the cri-
teria established by the insurance company.
A charge is included on every bill a healthcare organization
presents to an insurance com-
pany for having provided a patient with a service. If the charge
on the bill is lower than the
fee screen, then the full charge is paid. If the charge on the bill
is higher than the fee screen
amount, only the fee screen amount will be paid. Payments of
full charges that are less than
fee screen amounts are called “reasonable” amounts. These
three definitions of charges are
often combined such that an insurance company will have a
policy of paying the lowest among
usual, customary, or reasonable charges.
Negotiated Payments
Payment amounts for healthcare organizations are often the
result of a negotiation process.
An organization’s owner, financial manager, or designated
representative will negotiate with
a provider contracting representative at an insurance company.
At times, the negotiation
process involves a fee schedule or a fee screen created by the
insurance company. At other
times, the chargemaster of the healthcare organization is the
foundation upon which a fee
schedule is based. It is quite common for health insurance
companies to negotiate healthcare
smi81240_05_c05_117-142.indd 126 3/7/14 9:41 AM

127
organization charges, less a specific percentage discount (e.g.,
25% or 50%). Referring back
to Hendrickson Memorial Hospital (Exhibit 5.2), charges to
private insurance companies
were $339,531,165 in 2012 and contractual adjustments and
discounts were $213,231,151,
a 63% reduction. For Hendrickson, some of the negotiated
private insurance payments were
based on charges, so there are contracts that state “charges
minus 50%.” Other contracts
simply state payment amounts without reference to charges.
Still, substantial discounts from
charges are common when payments are made on the basis of
negotiated payments.
An important consideration with negotiated payments is whether
or not balance-billing
is permitted. Balance-billing is the process of billing the patient
for the difference between
charges and the payments from insurance companies. Most
negotiated payment contracts
and all government payment systems prohibit balance-billing. If
a provider does not accept
the payment amount offered by an insurance company, and
balance-billing is not permitted,
they can elect not to see patients covered by that insurance
company.
Retrospective Costs
Retrospective costs is the method of payment upon which the
term reimbursement is based.

Under a payment method using retrospective costs, the
healthcare organization would be paid
based upon actual expenses incurred in the prior year. The
Medicare Cost Report, discussed
in Chapter 4 as a means to calculate costs on a department
basis, was originally developed
for hospital payments and used by Medicare and many insurance
companies. The condensed
version of the retrospective cost process is that a hospital
completes a cost report, which is
reviewed or audited, and then receives a payment for whatever
percentage of total costs is
associated with their enrollees. In this manner, an insurance
company would pay its propor-
tional share of total hospital costs. If one insurance company’s
patients accounted for 25% of
a hospital’s total number of patients, the insurance company
would pay 25% of the hospital’s
total costs. One important detail of actual payment policy is that
insurance companies would
pay hospitals monthly, a periodic interim payment, to assure a
steady cash flow, and then have
an end-of-year adjustment associated with the review of the cost
report.
The advantage of retrospective costs is that they are a clear
indication of the amounts that
have been spent in treating patients. There is no need to develop
a geographic practice cost
indicator if each organization is reimbursed for its actual
expenses. Some insurance com-
panies continue to use cost reports and retrospective costs as the
basis for payments, even
though most have abandoned cost-based reimbursement methods
and moved to prospective
payment methods.

For Review:
1. Healthcare organizations sometimes have difficulty in
responding to the question of
how much they are paid for providing a day of care. Why would
healthcare organiza-
tions have difficulty answering this question?
Healthcare organizations may be paid on the basis of one of
several different meth-
ods, each of which may have contract terms that are unique.
Traditional methods
include charges, negotiated amounts, negotiated charge
discounts, and retrospective
costs. More modern methods include prospective amounts, per
visit amounts, per
episode amounts, and per time period amounts. With many
insurance companies
paying with one or more of these methods, there may be a wide
range in the amount
that is being paid.
smi81240_05_c05_117-142.indd 127 3/7/14 9:41 AM
128
Section 5.3Modern Healthcare Payments
5.3 Modern Healthcare Payments
Payment on the basis of charges or some variant of charges is
the typical way in which most
goods and services in society are purchased. The downsides of
payment based upon charges
are that the method used to develop charges is not often clear,

and with markets where peo-
ple cannot easily shop for services, charges may be increased
over time to very high levels.
Payment on the basis of historical costs may be associated with
greater clarity of the costs
of services and yet is still associated with increasing payments.
Organizations that are paid
whatever costs they incur have little motivation to constrain
cost growth. In attempts both to
provide clarity or transparency to the payment process and to
constrain payment increases,
several modern methods have been developed to pay healthcare
providers. A few of these
methods are considered under the headings of prospective
payment and specific strategies
for prospective payment.
Prospective Payment
Prospective payment is a term used to distinguish modern
payment methods from retro-
spective costs. Prospective payment means that the payment
amount is known in advance of
a service being provided. With this meaning, almost all other
methods of payment, includ-
ing charges and negotiated payments, are prospective payments.
The distinguishing feature
of many prospective payment systems is their use of some form
of historical cost informa-
tion as the basis for establishing the prospective payment
amounts and the transparency of
the method.
Physician Service Payment
Common methods for implementing prospective payment
methods is to select the basis upon
which payments will be made, ideally on a basis that provides

incentives for cost contain-
ment. A commonly used method for paying physicians is
through the use of a relative value
unit (RVU) system. The essence of an RVU system is that
physicians’ time and costs associated
with providing services are compiled for all services, and the
relative amount of time and
costs for each service is measured against the average of all
services.
For physician payments, the basic service defined for an RVU is
based on common procedural
terminology—version 4 (CPT-4) codes. CPT- is a registered
trademark of the American Med-
ical Association. For each CPT-4 code provided, a
corresponding International Classification
of Diseases and Related Health Problems 10th Revision (ICD-
10) must also be provided. The
ICD-10 code describes the diagnosis; the CPT-4 code describes
the treatment. An example of
an ICD-10 code and CPT-4 code combination that may be used
for a physician’s services is
ICD-10 code L08.9: local infection of skin and subcutaneous
tissue, and CPT-4 code 11000:
debride infected skin. Debridement is the medical term for
removal of infected tissue.
Including all of the healthcare common procedure coding
system (HCPCS) codes that extend
the list of physician services beyond CPT-4 codes, there are
over 15,000 billing codes for phy-
sician services. An example of a HCPCS code that is not a CPT-
4 code is G0444, an annual
depression screening. Given the new procedures that are being
developed, many changes to
the list of HCPCS and CPT-4 codes are introduced every year

and are available on the American
Medical Association’s website: http://www.ama-
assn.org/ama/pub/physician-resources
/solutions-managing-your-practice/coding-billing-
insurance/cpt.page.
smi81240_05_c05_117-142.indd 128 3/7/14 9:41 AM
http://www.ama-assn.org/ama/pub/physician-
resources/solutions-managing-your-practice/coding-billing-
insurance/cpt.page
http://www.ama-assn.org/ama/pub/physician-
resources/solutions-managing-your-practice/coding-billing-
insurance/cpt.page
129
Medicare and many insurance companies use a resource-based
relative value unit system
(RBRVS) system, where the resources measured are physician
work time, office practice
costs, and malpractice insurance costs. Medicare calculates
RVUs for each component and
also calculates a geographic practice cost indicator (GPCI) for
each area of the country to
adjust for local cost differences. The total regulated payment
for Medicare physician service
payments is written as:
RBRVS payment 5 [(RVU work time 3 GPCI work time)
1 (RVU practice costs 3 GPCI practice costs)

1 (RVU malpractice 3 GPCI malpractice)]
3 Conversion factor
The final item in RBRVS payment calculations, as well as other
calculations described in the
following sections, is the conversion factor. The conversion
factor is a dollar amount paid
per RVU under each system. The Medicare RBRVS conversion
factor is regulated to change
annually by the percentage change in an inflation factor.
However, additional rules are imple-
mented almost every year to change the conversion factors.
Each year, the value of the con-
version factor for Medicare payment systems is proposed by the
Center for Medicare and
Medicaid Services (CMS), approved by Congress in a spending
bill, and finally signed by the
President of the United States. The estimated number of patient
visits multiplied by the num-
ber of RVUs for each visit multiplied by the conversion factor
yields the total Medicare budget
for physician services. When CMS, Congress, and the President
change the Medicare budget
for physician services, the primary means of doing so is to
change the conversion factor. As
demonstrated in Figure 5.1, the conversion factor of Medicare’s
RBRVS system has varied
within a narrow range over the past 15 years.
Figure 5.1: Medicare RBRVS conversion factors, 1998–2013
Source: Author’s calculations based on Centers for Medicare
and Medicaid Services data (Retrieved from
http://www.cms.gov
/Medicare/Medicare-Fee-for-Service-

Payment/PhysicianFeeSched/index.html?redirect=/physicianfees
ched/)
Year
$0
20082004200220001998 2013201220102006 2007
201120092005200320011999
$45
$40
$35
$30
$25
$20
$15
$10
$5
C
o
n
v
e
rs
io

n
f
a
c
to
r
(i
n
d
o
ll
a
rs
)
smi81240_05_c05_117-142.indd 129 3/7/14 9:41 AM
http://www.cms.gov/Medicare/Medicare-Fee-for-Service-
ched/
ched/
130
Analyze This
A physician practice is considering moving from Alabama to

Massachusetts where the GPCIs are
higher than the national average (GPCI work time 5 1.051,
GPCI practice costs 5 1.222, and
GPCI malpractice 5 1.023). For the same service, RVU 11100,
what would be the new payment
amount?
An example of payment under RBRVS is provided in Exhibit
5.5. A physician in Birmingham,
Alabama, performed a debridement of infected skin (HCPCS
11100) in 2012. The work time
involved is the same as that for an average procedure (a value
of 1.000). The practice expense
when performed in the physician office (as opposed to an
outpatient hospital facility) is
slightly less than the average procedure (0.878). The
malpractice expense is less than half of
the average procedure (0.474). The geographic price indices for
expenses in Alabama are all
lower than the national average. The national average GCPI is
1.000, by definition.
Exhibit 5.5 RBRVS payment, 2012
Work Time Practice Expense Malpractice Expense Total
RVU 11000 1.000 0.878 0.474
GPCI—Alabama 0.60 0.94 0.05
Product 0.600 0.825 0.024 1.449
Conversion factor $34.0376
Payment $49.32
Source: Author’s calculation.
Following the RBRVS equation,
RVU 11100 payment 5 [(1.000 3 0.60) 1 (0.878 3 0.94) 1 (0.474
3 0.05)] 3 $34.0376

5 (0.600 1 0.825 1 0.024) 3 $34.0376
5 $49.32
Charges and negotiated charge methods also use HCPCS or
CPT-4 codes to determine pay-
ments. Further, many other payment systems also use RVU-
based methods, though not
always with the same RBRVS amounts as Medicare and
frequently with different conversion
factors. A survey of Medicaid plans found that, on average,
Medicaid plans paid 66% of the
amounts paid by Medicare in 2012 (Zuckerman & Goin, 2012).
For the most common CPT-4
code, 99213, Office Visit with an Established Patient for 15
Minutes, representing one quarter
of all primary care physician claims, the mean Medicaid
payment was $38.20 and the range
was a low of $20.64 (Rhode Island) to a high of $111.22 (North
Dakota) (Zuckerman & Goin,
2012). The differences in these payment amounts are not
differences in the CPT-4 code or
differences in the RVUs associated with the service. The
differences are primarily in the con-
version factors.
smi81240_05_c05_117-142.indd 130 3/7/14 9:41 AM
131
Payment amounts from one particular payer may be low or high

relative to charges, nego-
tiation payments, and even amounts paid by other government
programs. With prospective
payments amounts that are regulated by government entities,
there is no opportunity for
individual healthcare organizations to negotiate different
amounts. Groups of providers and
organizations that represent providers, such as the American
Medical Association and the
American Hospital Association, may seek to provide input on
the regulation process. The key
to management of regulated payment amounts is to understand
the rules upon which pay-
ments are determined and to be attentive to changes in the rules
to assure compliance with
billing procedures.
Per Visit Amounts
Paying a fixed amount for all services provided within a visit to
a healthcare organization
is one way to limit the costs associated with providing services.
Paying a per visit amount
requires a system for, first, defining a visit. Since a visit to a
hospital outpatient department
can vary from receiving photochemotherapy to having a repair
of cardioverter-defibrillator
leads, some form of adjustment to payment amounts is required.
Medicare adopted the
method of payment based upon ambulatory payment
classification (APC). The APC clas-
sification involves bundling groups of services that are involved
with treating a patient into
one payment amount. Although there can be several bundles of
services provided in a given
outpatient visit, the APC system does provide incentives for
controlling the services provided

with a specific APC bundle.
APC payments are similar to RBRVS payments in that they
require a code (APC versus a HCPCS
or a CPT-4 code) with a unique RVU, have an adjustment for
geographic differences in wages
and other expenses, and have a conversion factor. For APCs
under Medicare, the APC weight
is the RVU, based on historical cost differences between
services. Also under Medicare, the
wage index only applies to 60% of the APC weight, as only 60%
of expenses are expected to
be labor related. The nonlabor expenses that account for 40% of
costs incurred by outpatient
facilities are expected to be set at the national level and do not
require a local nonwage index
adjustment.
APC payment 5 [(APC weight 3 60% 3 Wage index)
1 (APC weight 3 40%)]
3 Conversion factor
Consider the case of a hospital outpatient facility in
Washington, D.C., depicted in Exhibit 5.6.
From these two examples, it is clear that there can be
tremendous differences in the amounts
paid for services under per visit amounts.
smi81240_05_c05_117-142.indd 131 3/7/14 9:41 AM
132

Analyze This
For APC 0108, confirm that the total payment is $30,716.76.
Exhibit 5.6 APC payments, 2012
APC Description
APC
Weight
Wage
Index
Conversion
Factor
Total
Payment
0001 Photochemotherapy 0.5037 1.0546 $70.02 $36.42
0108 Insertion/replacement/repair of
cardioverter-defibrillator leads 424.77 1.0546 $70.02
$30,716.76
Following the APC equation,
APC 0001 payment 5 [(0.5037 3 60% 3 1.0546)
1 (05037 3 40%)]
3 $70.02
5 $36.42

At Hendrickson Memorial Hospital, financial results for the
most frequent outpatient visits
are regularly evaluated, as depicted in Exhibit 5.7. For the six
most frequent outpatient vis-
its, average payments are less than average charges. For all 12
services combined, revenues
exceed costs by a total of $382,927.
Exhibit 5.7 Hendrickson Memorial Hospital, top 12 outpatient
visits, 2012
Outpatient Visit Description (APC Code Numbers)
Patient
Claims
Average
Charge
Average
Payment
Average
Cost
Level 2 hospital clinic visits (0605) 8,184 $124 $69 $70
Level I X-ray plain film except teeth (0260) 6,647 $203 $40 $51
Level 4 Type A emergency visits (0615) 3,862 $899 $203 $232
Level 3 hospital clinic visits (0606) 3,451 $183 $91 $103
Level 3 Type A emergency visits (0614) 2,931 $635 $127 $163
Extended individual psychotherapy (0323) 2,802 $183 $94 $103
Computed tomography without contrast (0332) 1,702 $875 $174
$59
Level IV debridement & destruction (0016) 1,028 $429 $149
$132
Lower GI endoscopy (0143) 578 $2,638 $544 $550

Level I upper GI procedures (0141) 453 $2,291 $522 $472
Cataract procedures with IOL insert (0246) 430 $4,888 $1,550
$1,224
Diagnostic cardiac catheterization (0080) 292 $8,181 $2,256
$969
smi81240_05_c05_117-142.indd 132 3/7/14 9:41 AM
133
There are many other types of services that have per visit or per
service prospective payment
amounts. For example, ambulance services are paid on a per trip
basis, with adjustments for
geographic cost differences and distances traveled. For skilled
nursing facilities, payment is
made on a per day basis, with adjustments for geographic cost
differences and the condition
of the patient, based on resource utilization groups (RUGS).
There are 66 RUGS, with patients
classified on the basis of the Resident Assessment Instrument,
which is centered on the Mini-
mum Data Set for nursing home patients. The range of Medicare
payments for nursing home
care is $190.61 per day for patients with minimal needs to
$760.89 per day for patients with
extensive needs (Centers for Medicare and Medicaid Services,
2012a). Each system has a
number of unique aspects to its formation of patient groups,
calculation of geographic adjust-
ments, and calculation of conversion factors.

Per Episode Payment Amounts
To avoid the incentives associated with per visit payment
amounts, namely, to provide more
types of services at each visit, third-party payers have created
payment systems based upon
a bundle of services provided during an entire episode of patient
care. The clearest example
of this method of payment is the system most frequently used to
pay for inpatient hospital
services. Since 1983, Medicare has been paying hospitals a
single payment amount for all
services provided during an entire hospital stay on the basis of
diagnosis-related groups
(DRGs). DRGs are RVUs based on the cost of providing
services during a hospital stay for a
specific diagnosis. DRGs are different from the RBRVS and
APC RVUs, as they are based on the
diagnosis of the patients, rather than the services provided.
There have been a host of changes over time in the Medicare
DRG system, from incorporat-
ing capital costs along with operating costs in 1993 to
expanding the number of DRGs to
account for medical severity within diagnoses in 2008. Many
government payment programs
and private insurance companies also use DRG systems, though
sometimes with different
diagnosis groups, sometimes with different geographic
adjustments, and often with different
conversion factors. Consider the list of DRGs in the Michigan
Medicaid program for selected
services presented in Exhibit 5.8. Since childbirth is a much
more common condition for Med-
icaid enrollees than Medicare enrollees, selected DRGs are
refined under Medicaid programs.

The DRG weights and average lengths of stay in the hospital
have low and high values for the
detailed DRGs under Medicaid that are similar to the average
amounts for the single DRGs
under Medicare.
Analyze This
For Hendrickson Memorial Hospital, confirm that revenues
exceed costs by a total of $382,927
for the most frequent outpatient visits.
smi81240_05_c05_117-142.indd 133 3/7/14 9:41 AM
134
Exhibit 5.8 Selected diagnosis-related groups for Medicaid and
Medicare patients
DRG Description
Medicaid
DRG Weight
Medicaid
Average
Length of
Stay
Medicare
DRG Weight

Medicare
Average
Length
of Stay
791 Prematurity with major problems 1.1158 9.4 3.4363 13.3
791.1 Prematurity with major problems 3.9420 21.7
792 Prematurity without major problems 0.3985 4.5 2.0734 8.6
792.1 Prematurity without major problems 2.0846 13.2
Sources: Medicaid: Michigan Department of Community Health:
http://www.michigan.gov/documents/mdch/MSA_11-52
_370063_7.pdf; and Medicare: Center for Medicare and
Medicaid Services: http://www.cms.gov/Medicare/Medicare-
Fee-for
-Service-Payment/AcuteinpatientPPS/index.html.
The diagnosis for DRGs is a complex assignment for one of 956
clinical reasons for hospi-
tal admission based upon the principal diagnosis and additional
diagnosis codes, proce-
dure codes, patient age, gender, and discharge status (alive,
dead, home, or another facility).
There are annual changes to update diagnosis and procedure
codes as well as the other
factors in the calculation of payments. (For Medicare’s
processes, see http://www.cms.gov
/Medicare/Medicare-Fee-for-Service-
Payment/AcuteInpatientPPS/index.html?redirect
=/acuteinpatientpps/.)
Similar to the calculation of APC payments, the DRG payment
is based upon the DRG weight,
which is the RVU for hospital costs, and adjusted by a wage
index. The conversion factor for
inpatient hospital payments is separated for the labor and

nonlabor portions of operating
costs. Over time there have been several adjustments to the
DRG payment formula. There
have been adjustments for indirect medical education costs to
recognize the additional costs
associated with teaching residents and interns, adjustments for
treating a disproportionate
share of low income and uninsured patients, and adjustments for
cases deemed to be outli-
ers (with high lengths of stay and costs). The most recent
adjustment, introduced in 2011, is
a penalty for not providing quality of services information. Not
providing quality of services
information results in a reduction of 2% of the total payment.
The following calculation is the formula for DRG payments:
DRG payment 5 (DRG weight 3 Wage index 3 Labor standard
amount)
1 (DRG weight 3 Nonlabor standard amount)
1 (DRG weight 3 Adjusted wage index 3 Capital amount)
1 Additional adjustments
Exhibit 5.9 presents the calculations for payment to a hospital
treating a Medicare patient
with DRG 072 in Washington, D.C. in 2012. This is the total
payment for the facility, inde-
pendent of the length of stay and costs, unless costs are
extremely high (in excess of
$22,385) and several other criteria are met. Further, this is the
total payment for the facil-
ity, even if the patient is readmitted to the hospital within 10
days of discharge for the same

principal diagnosis.
smi81240_05_c05_117-142.indd 134 3/7/14 9:41 AM
http://www.michigan.gov/documents/mdch/MSA_11-
52_370063_7.pdf
http://www.michigan.gov/documents/mdch/MSA_11-
52_370063_7.pdf
Payment/AcuteinpatientPPS/index.html
Payment/AcuteinpatientPPS/index.html
Payment/AcuteInpatientPPS/index.html?redirect=/acuteinpatient
pps/
pps/
pps/
135
Exhibit 5.9 Payments for DRG 072, nonspecific cerebrovascular
disorders,
without complicating conditions (CC) or major complicating
conditions
(MCC), 2012
DRG Component
DRG

Weight
Conversion
Factor
Wage
Index
Total
Payment
072 Labor-related operating costs 0.7237 $3,584.30 1.0546
$2,735.59
Nonlabor-related operating costs 0.7237 $1,624.44 $1,175.61
Capital costs 0.7237 $421.42 1.0371 $316.30
Total payment (before any other adjustments) $4,227.50
Using the DRG equation,
DRG 072 payment 5 (0.7237 3 1.0546 3 $3,584.30)
1 (0.7237 3 $1,624.44)
1 (0.7237 3 1.0371 3 $421.42)
1 0 additional adjustments
5 $4,227.50
At Hendrickson Memorial Hospital, financial results for the
most frequent inpatient hospital-
izations are regularly evaluated, as depicted in Exhibit 5.10. For
the top 11 groups combined,
costs exceeded revenues by a total of $1,193,814.

Exhibit 5.10 Hendrickson Memorial Hospital, top 11 inpatient
hospitalizations, 2012
Inpatient Description (DRGs) Cases
Average
Charge
Average
Payment
Average
Cost
Heart failure & shock (293-292-291) 342 $21,707 $6,446
$6,513
Psychoses (885) 299 $24,765 $5,381 $8,433
Simple pneumonia & pleurisy (195-194-193) 212 $23,582
$6,718 $6,970
Major joint replacement or reattachment of lower
extremity (470-469) 205 $57,395 $12,768 $14,258
Intracranial hemorrhage or cerebral infarction
(066-065-064) 187 $25,208 $7,000 $7,426
Renal failure (684-683-682) 173 $24,515 $7,023 $7,621
Acute myocardial infarction, discharged alive
(282-281-280) 158 $27,251 $8,193 $7,665
Cardiac arrhythmia & conduction disorders (310-309-308) 151
$14,713 $4,927 $4,192
Esophagitis, gastroenteritis, & miscellaneous digestive
disorders (392-391) 135 $15,239 $4,508 $4,523
Chronic obstructive pulmonary disease (192-191-190) 134
$18,678 $5,944 $5,263
smi81240_05_c05_117-142.indd 135 3/7/14 9:41 AM

136
Analyze This
For Hendrickson Memorial Hospital, can you confirm that for
the most frequent inpatient hospi-
talizations, costs exceeded revenues by a total of $1,193,814?
Payment on the basis of DRGs is the most common method of
payment for hospitals at 38.9%
of net patient revenues in 2011. Hospitals also received
payment on the basis of charges,
with a negotiated percentage discount (19.8% of net patient
revenues), negotiated fee sched-
ules (19.0%), per day amounts (4.3%), capitation arrangements
(2.5%), and other methods,
including retrospective payments (8%) (Moody’s Investors
Service, 2013).
Per Time Period Payment Amounts (Capitation)
To avoid the incentives associated with per visit payment
amounts and the incentives associ-
ated with numbers of visits, third-party payers have developed
payment systems based upon
a bundle of services provided during an entire period of time.
Such payment systems are
called capitations. A capitation is a single payment that
provides for a defined set of ser-
vices for a defined period of time, typically one month.
Capitations can be narrow or broad.
A narrow capitation would be a payment to a primary care
physician for coordinating the
care associated with a patient assigned to the physician. The
physician may be paid a fee for
any visits plus a small amount to cover the administrative

aspects of coordinating care. This
amount may be as low as a dollar or two.
A broader capitation may be a partial, primary care capitation
paid to a medical group. In
exchange for providing all primary care services to a panel of
patients (all services associated
within a limited number of CPT-4 codes), a monthly payment
would be made at the beginning
of the month to the group. To the extent that the cost per visit
and the number of visits to the
physician group can be controlled by effective care
management, there may be additional
profit potential for the group.
An example of a partial, primary care capitation for routine
visits for established patients is
presented in Exhibit 5.11. Level 1 visits, with CPT-4 code
99211, are brief visits with patients
that have previously been seen at the physician’s office. If the
usual payment amount is $27.14
per visit, and, on average, only one tenth (10%) of patients have
this type of visit in a given
year, then the expected payment amount would be $2.71 ($27.10
3 0.10 5 $2.71). Using the
same calculation for each of the five levels of primary care
visits, the total expected payment
amount is $236.14 per year, or $19.68 per month. If the group
can manage the medical needs
of the patients for less than $19.68, per member, per month
(PMPM), the group will earn a
profit as compared to the expected payments.
smi81240_05_c05_117-142.indd 136 3/7/14 9:41 AM

137
Exhibit 5.11 Primary care capitation for an established panel of
patients
Covered Visit Type—
CPT-4 Code
Usual Payment
Amount per Visit
Expected
Visits per Year
Expected
Payment Amounts
Level 1—99211 $27.14 0.10 $2.71
Level 2—99212 $59.08 0.40 $23.63
Level 3—99213 $98.18 1.00 $98.18
Level 4—99214 $145.14 0.50 $72.57
Level 5—99215 $195.22 0.20 $39.04
Annual total 2.20 $236.14
Monthly total $19.68
The broadest form of capitation is a full, total service capitation
paid to an integrated health
system. In exchange for providing all services to a panel of
patients, a monthly payment
would be paid to the organization. In effect, the organization
would accept the full medical
responsibility normally taken by the insurance company. To the
extent that the cost per visit
and the number of visits to the health system can be controlled,

the health system may earn
more profits. In Exhibit 5.12, a financial analysis of a full, total
service capitation agreement
is presented. The expectation under this agreement is that there
would be various payment
arrangements made between the health system and the member
hospitals, physician groups,
and other providers. There is also an amount included for
administration of the agreement,
as it would be a significant administrative challenge for the
health system.
Exhibit 5.12 Full capitation for panel of patients
Cumulative Patients Months for Year 29,423
Service Annual Amount
Per Member, per
Month Amounts
Medical and Hospital Services
Inpatient Services—Capitated $334,749
Inpatient Services—Per diem $1,133,235
Inpatient Services—Fee-for-service/Case rate $2,036,252
Subtotal inpatient services $3,504,236 $119
Total patient days incurred 898
Average cost per patient day $3,902
Primary professional services—Capitated $1,120,970
Primary professional services—Noncapitated $1,069,336
Other medical professional services—Capitated $18,298
Other medical professional services—Noncapitated $412,978
Subtotal professional services $2,621,582 $89,100
Total member ambulatory encounters for period 26,298
Average cost per ambulatory encounter $100
Noncontracted emergency room $474,448
Pharmacy expense—Fee-for-service $1,109,490
Subtotal other services $1,583,938 $54

Total medical services $7,709,756 $262
Administration (’000) $836,600 $28
Total contract $8,546,356 $290
smi81240_05_c05_117-142.indd 137 3/7/14 9:41 AM
138
Summary & Resources
One current healthcare reform initiative is to create accountable
care organizations (ACOs),
or groups of physicians, hospitals, and other providers who
work together to coordinate care
for a panel of patients. A financial incentive for ACO
development is the ability to negotiate
capitation contracts. If quality care can be provided under a
capitation arrangement, and care
can be coordinated to reduce costs, ACOs may be able to earn
additional profits. At the level
of the ACO, there may be a single capitation payment from the
insurance company. Within
the ACO, individual providers may be paid a capitation or use
any other payment method.
Currently, more than 90% of ACOs use payment methods other
than capitation for individual
providers (Muhlestein, Croshaw, & Merrill, 2013).
There are a host of considerations of particular importance in
health insurance contracts
that include capitation. The benefit design of the contract is
particularly important. What ser-
vices are covered by the contract? Which other physicians are
also participating in the health

insurance plan? Is it easy to refer patients to other physicians,
or do the capitated physicians
have to provide more than routine primary care? How many
patients are in the panel? What
are the characteristics of the patients in the panel? Are the
values in the table for frequency
of expected visits per year adjusted for the age, gender, and
health status of the patients in
the panel? Analysis of these considerations is important to the
financial management of the
healthcare organization considering capitation payment
methods.
For Review:
1. Modern payment methods largely rely upon relative value
units. What are the com-
mon RVUs for physician services, outpatient services, and
inpatient services? Why
are different RVUs required for each type of service?
Physician RVUs are resource-based relative value services with
amounts of physician
work, practice expense, and malpractice insurance. Outpatient
RVUs are ambula-
tory patient classifications. Inpatient RVUs are diagnosis-
related groups. One reason
for the different RVUs is that they involve different bundles of
services. RBRVS are
unique for every physician service. APCs bundle services
provided as a group. DRGs
bundle services provided during a hospital stay.
Summary & Resources
Chapter Summary
This chapter has presented the wide range of methods used in

the healthcare system to pay
for services. It is important that all healthcare organizations
establish a list of charges for
services. Some patients and insurance companies pay on the
basis of charges. For most other
insurance companies, there are a number of methods used to pay
healthcare organizations,
many designed only for specific types of providers.
The payment methods used and the payment amounts associated
with each method are some-
times dictated to the healthcare organization. Government
programs use regulatory authority
to determine payment methods and amounts. Similarly, large
insurance companies may indi-
rectly dictate payment methods and amounts by right of their
market power. An insurance
company with a 90% market share of insured patients can
dictate many payment decisions
smi81240_05_c05_117-142.indd 138 3/7/14 9:41 AM
139
Summary & Resources
to healthcare organizations. Few healthcare organizations can
avoid government programs
or dominant payers, other than to limit patients treated or
services offered. Of course, health-
care organizations with dominant market positions may be able
to dictate terms to insurance
companies. In all other market conditions, the end results come
from a process of negotiation.

For many years, payment systems were termed reimbursement
because they paid back
healthcare organizations for expenses that were incurred.
Retrospective reimbursement
arrangements still exist in limited numbers. Most payments
systems are now based on pro-
spective methods. At the beginning of a contract year, the
amounts that will be paid for ser-
vices are set. Actual payments may be made using a number of
possible methods, from a
percentage discount on charges to methods that employ
precisely defining a service (using a
procedure code or a diagnosis code), making cost adjustments,
and applying a standard pay-
ment amount, often called a conversion factor. There are a
number of ways that healthcare
organizations require numerous financial management skills to
understand and verify that
correct payments are received.
1. Healthcare organizations are widely criticized for posting
high prices for services. Is
there an alternative to current pricing policies? Explain your
reasoning.
2. Charges and payments can vary widely in healthcare
organizations. Account-
ing rules dictate that expected payments be used to represent the
revenues of an
organization. Why aren’t expected charges used to represent the
revenues of an
organization?

3. The payment environment in healthcare has moved from
retrospective costs to pro-
spective prices. Why have third-party payers made this change
in payment policy?
Do you think that there will be a return to retrospective costs as
a dominant method
of payment? Explain your reasoning.
Exercises
1. A clinic receives an average of $150 per patient visit from
Medicare patients, which
represent 40% of the 1,000 patient visits per month.
a. If clinic expenses are $155,000 per month, how much does
the clinic need
to receive per patient from the insurance companies covering
the remaining
patients?
b. If the clinic seeks to earn a profit of $15,000 per month, how
does that affect the
amount the clinic needs to receive per patient from the
insurance companies?
2. Some physician payment systems are much simpler than
Medicare’s RBRVS payment
system. A physician payment system in one location may have
only one RVU measure
per procedure and one conversion factor. For a clinic
specializing in ear, nose, and
throat services, a list of its 10 most common ear services is
provided in Exhibit 5.13.
a. If the clinic receives payment on the basis of full charges,
what will be the total

revenue?
b. If the clinic receives prospective payment on a RVU basis,
and the conversion
factor is $35, what will be the total revenue?
c. How do the answers to 2.a and 2.b differ?
smi81240_05_c05_117-142.indd 139 3/7/14 9:41 AM
140
Summary & Resources
Exhibit 5.13 Common ear services
Ear Services Code RVU Patients Charge
Drain external ear lesion 69005 2.16 20 $130
Drain outer ear canal lesion 69020 1.53 120 $70
Biopsy of external ear 69100 0.81 120 $80
Biopsy of external ear canal 69105 0.85 90 $270
Remove external ear, partial 69110 3.53 20 $320
Removal of external ear 69120 4.14 10 $800
Remove ear canal lesion(s) 69145 2.70 30 $450
Extensive ear canal surgery 69150 13.61 20 $1,500
Clear outer ear canal 69205 1.21 360 $200
Remove impacted ear wax 69210 0.61 380 $50
3. An orthopedic unit in a hospital provides a large number of
level 1 (low complexity)
services and is paid on the basis of prospective prices for the
complete procedure
using APC methods. The five procedures most often provided to
Medicare patients
are given in Exhibit 5.14.
a. For the five procedures, what is the expected revenue from

Medicare?
b. If patients are required to pay 20% of the payment amount,
how much would
the hospital expect to receive from patients, and how much
would they expect to
receive from Medicare?
Exhibit 5.14 Five most common orthopedic procedures
APC Description Patients Payment Amount
0041 Level I arthroscopy 88 $2,074.62
0053 Level I hand musculoskeletal procedures 140 $1,202.64
0055 Level I foot musculoskeletal procedures 138 $1,546.28
0058 Level I strapping and cast application 146 $78.88
0062 Level I treatment fracture/dislocation 51 $1,830.69
4. A 100-bed skilled nursing facility provides services to
residents primarily within 10
RUG categories and is paid on a prospective basis using RUGs.
A list of the services
used is provided in Exhibit 5.15.
a. For the 33,274 resident days of care per year, what is the
expected revenue?
b. If the skilled nursing facility could increase its occupancy
rate from 91.2%
(33,274 resident days divided by 36,500 resident days at full
capacity) to 93.9%
by adding 1,000 resident days of care per year, which types of
resident days
should they attempt to increase?
c. What would be the change in revenue associated with adding
1,000 resident days
of care per year according to your response to 4.b?

smi81240_05_c05_117-142.indd 140 3/7/14 9:41 AM
141
Summary & Resources
Exhibit 5.15 Utilization of nursing home services
Resource Utilization Group Resident Days of Care Payment per
Day
RHA 5,407 $341.68
RMA 4,143 $292.60
RVA 4,082 $426.88
RVB 3,398 $428.54
RHB 3,363 $388.10
RMB 3,244 $355.61
RHC 3,004 $431.21
RVC 2,602 $494.86
RMC 2,345 $378.82
RUC 1,686 $576.84
Total 33,274
Key Terms
accountable care organization (ACO)
Groups of physicians, hospitals, and other
healthcare providers that provide coordi-
nated care to designated patients.
ambulatory payment classification (APC)
A system of classifying outpatient services
in a consistent manner that permits pay-
ment for a bundle of services on a relative
value unit basis.
balance-billing The process of a health-

care organization billing the patient for the
difference between charges and the pay-
ments from insurance companies.
capitation Payment of an amount for med-
ical services based upon the time period
of enrollment of a patient, not the services
used. Partial capitations cover the use of a
limited number of services. Full capitations
cover the use of a broad set of services.
charges Prices that a healthcare organiza-
tion lists for products or services.
conversion factor A dollar amount paid
per relative value unit under a payment
system.
cost-shifting The act of charging higher
prices when confronted with payments
from some payers that do not fully cover
costs.
diagnosis-related group (DRG) A sys-
tem of classifying patients using inpatient
services based on diagnoses (not actual
services used) in a consistent manner that
permits payment for services on a relative
value unit basis.
fee schedule A list of prices to be paid for
medical services.
fee screen A limit on the payments that
may be paid for medical services, to the
extent that charges are higher than screen

amounts.
prospective payment Use of a method for
setting payments to healthcare organiza-
tions before services are provided.
resource-based relative value unit
system (RBRVS) The system used by
Medicare and other insurance companies
to pay physicians. The RVUs are based on
resources used by physicians: physician
work time, office practice costs, and mal-
practice insurance costs.
smi81240_05_c05_117-142.indd 141 3/7/14 9:41 AM
142
Summary & Resources
retrospective cost Use of a method for
paying healthcare organizations their actual
costs after services have been provided.
usual, customary, or reasonable charges
(UCR) A method of paying healthcare orga-
nizations the lesser of previously charged
amounts, a percentile level of charges paid
by other healthcare organizations in a mar-
ket, the amount actually charged, or another
predetermined amount.
Suggested Websites

• The Social Security Administration provides a good
description of the parts of Medi-
care coverage: http://www.socialsecurity.gov/pubs/EN-05-
10043.pdf
• The Center for Medicare and Medicaid Services’
reimbursement sections (http://
www.CMS.gov) provide up-to-date information on
governmental reimbursement
methods. For outpatient services, see
http://www.cms.gov/Medicare/Medicare
-Fee-for-Service-
Payment/HospitalOutpatientPPS/index.html?redirect=/hospital
outpatientpps/
• The Center for Medicare and Medicaid Services has a
convenient source of informa-
tion on each state’s Medicaid program:
http://www.medicaid.gov/
smi81240_05_c05_117-142.indd 142 3/7/14 9:41 AM
http://www.socialsecurity.gov/pubs/EN-05-10043.pdf
http://www.CMS.gov
http://www.CMS.gov
Payment/HospitalOutpatientPPS/index.html?redirect=/hospitalo
utpatientpps/
utpatientpps/
utpatientpps/
http://www.medicaid.gov/

Planning and Budgeting 7
. mtcurado/iStock/Thinkstock
Learning Outcomes
• 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 7.1Importance 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 7.1Importance 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.
“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 7.2The 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
Striving to provide “quality healthcare services” requires a
definition of quality and a strategy
to achieve results. For hospitals, Hospital Compare
(http://www.medicare.gov/hospitalcom-
pare/) 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
http://www.medicare.gov/hospitalcompare/
172

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
smi81240_07_c07_167-194.indd 172 3/7/14 9:45 AM
173

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 7.3Decisions 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
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.

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
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
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

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
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.
Senior managers at our organization have
20–30% of total compensation related
to financial performance, mostly budget
adherence. The budgets and financial
performance are very 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 7.4Mechanics 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
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
Total 23,100 $9,924,633
smi81240_07_c07_167-194.indd 180 3/7/14 9:45 AM
181
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)
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:
Average change in visits 5
900 1 1,200 1 1,100 1 400
4 years
Average change in visits 5 900 per year
Forecast of 2013 visits 5 Visits in 2012 1 Average change in
visits
Forecast of 2013 visits 5 23,100 1 900
Forecast of 2013 visits 5 24,000
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:
http://support.microsoft
.com/kb/828801.
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
http://support.microsoft.com/kb/828801

http://support.microsoft.com/kb/828801
182
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
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
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
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
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.
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
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
Exhibit 7.10 Preliminary budget, Bixby Hospital, 2013

Actual 2012 Budget 2013
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 7.5Capital 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 7.5Capital 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
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 7.6Budget 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
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
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
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.
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:
smi81240_07_c07_167-194.indd 194 3/7/14 9:45 AM

Risk and Return 9
.XIANGYANG ZHANG/iStock/Thinkstock
Learning Outcomes
• Explain the importance of uncertainty and risk in the
determination of expected returns
• Calculate stand-alone risk for projects or organizations
• Understand financial risk and use the capital asset pricing
model to estimate the cost of
equity capital
• Calculate the weighted average cost of capital
smi81240_09_c09_221-244.indd 221 3/10/14 2:23 PM
222
Section 9.1Risk and Return
Introduction
Over the past four years financial assets at Bixby Hospital have
increased by $26.5 million due
to returns in the stock market on their portfolio of investments.
The average annual return on
investments has been 10.6% and very chaotic. In 2009 returns
were 0.7%, in 2010 they were
36.8%, in 2011 they were 27.4%, and in 2012 they were 12.1%.
The standard deviation of
investment returns over the past four years has been 19.1%. If

Bixby had held its portfolio
of investments solely in federal government bonds, it would
have earned an average annual
return of 1.0% with a standard deviation of 1.0% (U.S.
Department of Treasury, 2014). Bixby
earned a higher average annual return by accepting a higher
level of risk, as measured by the
standard deviation of returns.
Among the most central concepts in finance is the relationship
between risk and return. As
will be discussed in this chapter, earning a higher level of
return, as Bixby did by investing
in the stock market rather than government bonds, involves
taking more risk. The material
presented in this chapter is a bit more conceptually challenging
than the material in the other
chapters of this book. And yet, students who master the material
in this chapter will have a
greater appreciation of financial management and be prepared
for more advanced studies.
9.1 Risk and Return
As stated throughout this book, financial management involves
trade-offs. Profitability of
healthcare organizations, and the investments they make,
involves trade-offs between risk
and return. Quite simply, to earn higher expected profits
(returns), organizations must take
more risks. Higher expected risks on investments in financial
assets are quite systematically
linked to higher returns (Conrad, Dittmar, & Ghysels, 2013). To
persuade investors to pur-
chase the debt (loans and bonds) in high-risk firms, those firms
issuing debt must promise
a higher expected return, which comes in the form of higher

interest rates. Similarly, to per-
suade investors to purchase stock (equity) in high-risk firms,
those firms issuing stock must
promise a higher expected return, which comes in the form of
profits (net income). Since prof-
its are more difficult to promise than interest payments, the
expected returns on stocks must
be substantially more than the expected returns on bonds for the
same level of business risk.
The term returns appears six times in the preceding paragraph.
Returns to debt holders, in the
form of interest payments, are costs to the organization. Returns
to the owners of the orga-
nization are the profits earned after interest expenses and taxes.
For the owners of investor-
owned firms, returns are reflected in dividends or stock price
appreciation. For the owners of
not-for-profit organizations, returns are somewhat less clear.
Profits enable the not-for-profit
organization to continue to exist and provide funds for future
charitable activities. Owners of
not-for-profit organizations may want something different than
profits. The community that
owns a not-for-profit healthcare organization may want it to
provide effective, high-quality
services in an efficient manner and to provide charity care and
other services. The issue of
returns to not-for-profit organizations will be considered more
fully in Chapter 10.
The term risk also appears six times in the preceding paragraph,
and not by coincidence.
Three types of risk are considered in this chapter: firm-specific
risk, market risk, and
portfolio risk. Firm-specific risk is the risk associated with the

operations and management
smi81240_09_c09_221-244.indd 222 3/10/14 2:23 PM
223
of one particular organization. Market risk is the risk associated
with the industry that a firm
is in and the overall economy. Portfolio risk is the risk
associated with a number of invest-
ments, potentially several firms, in several industries, in several
economies.
This chapter more fully develops the definition of risk and
presents tools required for mea-
suring and adjusting analyses when risk is involved. The end
product of this chapter is a way
to define the returns associated with risks for use in long-term
financial decision making.
Tools and measures discussed will rely upon information
provided on financial statements as
well as information about the debt and equity markets more
generally.
Uncertainty and Risk
Uncertainty is defined as not having perfect knowledge of
future outcomes. In the business
of providing healthcare services, there are many sources of
uncertainty. It is not known how
many people will become ill or injured, or, more generally,
what anyone’s health status will be
on any given day. For persons who suffer ill health, it is not

known how, where, or if they will
seek medical services for treatment. And if persons suffering ill
health seek medical services
at a particular organization, it is not known what services they
will be provided or how they
will pay for these services. All of the uncertainty with regards
to patients’ health status and
care-seeking behavior translates to uncertainty for healthcare
providers. It is unknown how
many healthcare providers and other employees should be at
work on a given day. And it is
unknown what supplies and other resources they will
require to perform well on the job. All of the unknown
elements result in a high level of uncertainty for man-
agers of healthcare organizations.
Uncertainty translates directly into risk. From a finance
perspective, risk is the monetary impact of uncertainty.
An organization that does not know specifically how
many patients will visit the emergency department in
a given evening displays uncertainty. If there will be the
same number of nurses and other personnel staffing
the emergency department, irrespective of the number
of patients, then there is no risk in terms of costs. All
risk is associated with uncertainty. Not all uncertainty
is associated with risk.
Risk is measured by the variation in possible outcomes. From
the financial perspective of
a healthcare organization, risk is measured by the variation in
cost, revenues, and profits
(returns). A common measure of profit risk is the standard
deviation in returns, written as
the following equation:
Standard deviation 1s2 5 Å a

N
i 5 1
1Pi 3 1ri 2 E 3r 4 2 2 2
where the Greek symbol sigma (s) is conventionally used to
represent the standard deviation.
The summation function (∑) is taken from the first observation
(1) until the last time period
(N ). Since the calculation for the standard deviation may be
among several observations of
The department managers and finance
department are always in a state of ten-
sion with one another. It is hard to main-
tain reserve capacity when finances are
tight, and unfortunately, we regularly
exceed our target ratio of personnel per
occupied bed, which occurs when things
are slow and we can least afford it.
Source: Health system chief operating officer.
smi81240_09_c09_221-244.indd 223 3/10/14 2:23 PM
224
returns during the same period, as well as among several
observations over time, the sub-
script i represents the observation and N indicates the total
number of observations. New

terminology includes the probability (Pi ) of a return on a
specific observation (ri ) and the
expected return among all observations (E[r]). When the
probabilities and all expected
returns are equal, Pi can be omitted. The standard deviation is
calculated as the square root of
the sum of the differences between actual returns and the
expected return. The average value
among available observations of returns is often used as the
measure of the expected return.
If the distribution of the set of possible returns follows a normal
distribution, then 68% of
the observations will be within one standard deviation, plus or
minus, of the average return,
and 95% of the observations will be within two standard
deviations, plus or minus, of the aver-
age return. Consider the normal distribution of returns depicted
in Figure 9.1. The expected
return is 9% with a standard deviation of 3%. Two thirds of all
returns occur within the range
of 6% to 12%. Ninety-five percent of all returns occur within
the range of 3% to 15%.
Figure 9.1: Normal distribution of returns
For any organization, the risk of its returns may be measured by
the standard deviation of
returns in prior years, with the expected return being the
average return over the same time
period. The investment returns of Bixby Hospital and the
Standard & Poor’s 500 Index, an
index of the returns of the 500 largest investor-owned
corporations in the United States, are
presented in Figure 9.2. Note that these are not the profits of
Bixby Hospital (the total returns

to its owners), only the returns that the hospital has earned on
its financial investments. Bixby
experienced both a lower average return (10.6% versus 14.9%)
and a higher risk (standard
deviation of 19.1% versus 10.0%) than the Standard & Poor’s
500 index.
0
–3 211812 1593 60
0.14
0.12
0.08
0.04
0.10
0.06
0.02
P
ro
b
a
b
il
it
y

D
e
n
s
it
y
smi81240_09_c09_221-244.indd 224 3/10/14 2:23 PM
225
Figure 9.2: Normal distribution of returns for Bixby Hospital
and the Standard
& Poor’s 500 index, 200922012
Source: Author’s calculations and Standard & Poor’s
(http://us.spindices.com/indices/equity/sp-500).
Calculation of Averages and Standard Deviations
The calculation of averages and standard deviations of
observations can be performed by
hand or with a calculator. To ease the task when there are a
number of analyses that must
be performed, or when there are many observations, electronic
spreadsheets may be used
instead. Many popular calculators have a function key for
square root, and even for average
and standard deviation. Electronic spreadsheets permit
calculations based on the use of pre-

specified statistical functions. A calculation of the average
return and standard deviation of
returns for Bixby Hospital is presented in Exhibit 9.1.
Exhibit 9.1 Spreadsheet calculations of average and standard
deviation of
returns, Bixby Hospital
A B C D E
1 Year
Assets Limited
as to Use
Investment
Returns
Percentage
Return
2 2009 $30,429,437 $221,544 0.7% =(C2/B2)
3 2010 $57,263,543 $21,075,240 36.8% =(C3/B3)
4 2011 $63,042,673 ($4,655,574) –7.4% =(C4/B4)
5 2010 $81,577,433 $9,900,226 12.1% =(C5/B5)
6 Average 10.6% =average(D2:D5)
7
Standard
deviation 19.2% =stdev(D2:D5)
8
0
–100 8040 6020–60 –20–40 0–80

0.025
0.020
0.010
0.015
0.005
P
ro
b
a
b
il
it
y
D
e
n
s
it
y
Bixby Hospital Standard & Poor’s 500 Index
0

–100 80100 10040 6020–40 0–80 –20–60
0.045
0.040
0.030
0.020
0.035
0.025
0.005
0.015
0.010
P
ro
b
a
b
il
it
y
D
e
n

s
it
y
smi81240_09_c09_221-244.indd 225 3/10/14 2:23 PM
http://us.spindices.com/indices/equity/sp-500
226
Section 9.2Stand-Alone Risk
Analyze This
The operating margins at Bixby Hospital for 200822010 are
presented here. What is the aver-
age operating margin over this time period, and what is the
standard deviation of the operating
margin?
2008 2009 2010 2011 2012
17.8% 12.5% 5.2% 9.4% 7.8%
For Review:
1. What is the expected relationship between risk and expected
returns from a finance
perspective?
Risks and returns are expected to have a positive relationship. If
one is asked to
take on more risk, there should be a higher expected return to
make the investment
worthwhile.
2. Why is the standard deviation a measure of risk?

Risk is measured by the variation in possible outcomes, and the
standard deviation
is a measure of variation.
9.2 Stand-Alone Risk
Every business organization is associated with some level of
risk. The term for the risk associ-
ated with a single organization, or a single project within an
organization, is stand-alone risk.
Stand-alone risk is also called business risk when referring to
profitability. The stand-alone
risk for an organization can be separated into the risks faced by
the two sources of financial
support: debt and equity. The stand-alone risk for debt holders
is the likelihood that the orga-
nization will not earn enough revenue to cover the interest
expense and ultimately repay the
amount borrowed. The stand-alone risk for equity holders, or
business risk, is the standard
deviation of net income or stock returns.
Risk for Debt Holders
For debt holders, risk is taken into consideration in the setting
of interest rates. Organiza-
tions with higher expected levels of risk face higher interest
rates on debt than organizations
with lower expected levels of debt. For short-term loans,
interest rates are charged by banks.
For long-term debt, interest rates are informed by credit ratings
provided by one or more
agencies. As presented in Figure 9.3, credit ratings are typically
higher for hospitals that have
higher operating margins. Operating margins are one of many
considerations in the determi-
nation of credit ratings.

smi81240_09_c09_221-244.indd 226 3/10/14 2:23 PM
227
Figure 9.3: Stand-alone hospital credit ratings and operating
margins, 2012
Source: Author’s calculations based on data contained in:
Standard & Poor’s. (2013). U.S. Not-for-Profit Health Care
Stand-Alone
Ratios: Operating Pressures Led to Mixed Results in 2012. New
York, NY: Standard & Poor’s
(http://www.standardandpoors.com).
Debt holders for UnitedHealth Group (UNH on the New York
Stock Exchange), one of the larg-
est managed healthcare organizations in the United States with
over $110 billion in revenues
in 2012, are informed of its credit rating by four agencies:
Standard & Poor’s (A3 negative),
Moody’s (A stable), Fitch (A2 stable), and A.M. Best (BBB1
stable) (UnitedHealth Group,
2012). As displayed in Exhibit 9.2, the interest rates on large
amounts of long-term debt are
5.80% to 6.88%. Financial statements and other required filings
to the U.S. Securities and
Exchange Commission, the source of information on the cost of
debt to investor-owned orga-
nizations, are available for free on the SEC website
(http://www.SEC.gov).
Exhibit 9.2 UnitedHealth Group, senior unsecured notes due

203622038
Due Date Amount Interest Rate
March 2036 $850,000,000 5.80%
June 2037 $500,000,000 6.50%
November 2037 $650,000,000 6.63%
February 2038 $1,100,000,000 6.88%
Source: Author’s calculations, based on UnitedHealth Group,
2012.
Credit Rating
0%
1%
AA–AA BBBBBB+A A– LowerBBB–A+
6%
5%
4%
3%
2%O
p
e
ra
ti
n
g
M

a
rg
in
smi81240_09_c09_221-244.indd 227 3/10/14 2:23 PM
http://www.standardandpoors.com
http://www.SEC.gov
228
To provide debt holders with some protection against further
risk, debt agreements often
include debt covenants. Debt covenants dictate operating or
financial conditions that the
organization must meet or face immediate debt repayment or
other penalties. For United-
Health Group, one covenant is to maintain a debt ratio
(liabilities divided by total assets) of
not more than 50% (UnitedHealth Group, 2012). The debt
covenant involving the debt ratio
limits how much UnitedHealth Group can borrow and, therefore,
limits the risk that there will
not be sufficient funds available to pay the interest owed to
current debt holders.
Risk for Equity Holders
Equity holders do not have the same rating guidance as debt
holders or protections like debt
covenants. Equity holders own the net income of the
organization, after debt and taxes. The

true business risks for an organization, the risks associated with
profitability, are borne by
the equity holders. For investor-owned organizations,
presentations of risks are required by
the SEC. For example, UnitedHealth Group lists a number of
risks that could materially and
adversely affect the results of their operations, their financial
position, and cash flows. These
risks include
• Failure to effectively manage medical costs
• New laws or regulations
• Government healthcare program funding and enrollment
• Failure to compete effectively to maintain or increase market
share, including main-
taining or increasing enrollments in businesses providing health
benefits
(UnitedHealth Group, 2012)
Reflecting the relative risk between debt and equity, returns on
equity are expected to exceed
returns on debt. For UnitedHealth Group, as well as firms
generally (as measured by a com-
posite of the 50 largest firms in the United States and the S&P
500), equity returns are much
more volatile and, on average, higher than debt returns. As
displayed in Exhibit 9.3, at the
same time that debt for UnitedHealth Group has been issued at
5.80% to 6.88%, their equity
returns (as measured by dividends and stock price appreciation)
have varied from 8.6%
to 42.2%.
Exhibit 9.3 UnitedHealth Group, Fortune 50, and S&P 500
returns, 200922012

2009 2010 2011 2012
UnitedHealth Group 14.8% 19.9% 42.2% 8.6%
Fortune 50 11.8% 18.2% 0.0% 18.5%
S&P 500 Index 26.5% 15.1% 2.1% 16.0%
Source: UnitedHealth Group, 2012.
Stand-alone risks exist for both the debt and equity of every
organization. The essence of the
stand-alone risk for debt holders is the potential that the
organization will be unable to make
its required debt payments. The essence of the stand-alone risk
for equity holders is the vari-
ability in the net income that remains after debt payments and
taxes. If there is a risk of being
unable to make debt payments, then clearly there is a risk that
net income will be very low or
negative, which is the connection between risk for debt holders
and risk for equity holders.
smi81240_09_c09_221-244.indd 228 3/10/14 2:23 PM
229
Section 9.3Financial Risk
For Review:
1. Why are equity risks greater than debt risks?
Equity risks are associated with overall organization
profitability. Debt risks are
associated with the ability to make debt payments. The variation
in overall organiza-
tion profitability are generally greater than whether or not

organizations can pay for
their debt. Further debt payments are an expense and profits are
the amounts left
over after all expenses have been paid.
2. Can you think of any other equity risks for a healthcare
organization, beyond those
listed for UnitedHealth Group?
There are many possible equity risks. Some risks include
litigation actions, which
could damage reputation and result in substantial penalties;
losses in investment
portfolios; failure to properly maintain the integrity or
availability of data or to stra-
tegically implement new or upgrade or consolidate existing
information systems; or
technology products that do not operate as intended.
9.3 Financial Risk
In addition to the business risk associated with the profitability
of the operations of an organiza-
tion, another risk incurred by organizations when debt is issued
is financial risk. Financial risk
has two components: debt requirements and equity return
enhancement. This risk is the cost
of the uncertainty associated with revenues that may not cover
all expenses, especially interest
and principal payment on debt. Organizations without debt that
face shortfalls in net income
suffer from the reduction in net assets. Owners of the
organization, or the community-at-large
in the case of a not-for-profit organization, may seek changes in
management or activities to
achieve positive levels of net income in the future.
Organizations with debt that face shortfalls
in net income may additionally suffer from the actions of debt

holders. Debt requirements in
the form of covenants related to net income may involve
additional scrutiny from debt holders
or other costs. Further, under conditions of serious net income
shortfalls and the ability to pay
interest and principal, the viability of the organization may be
at stake.
The second, and perhaps more important, aspect of financial
risk is the enhancing effect that
debt has upon equity returns. The use of debt to facilitate the
purchase of assets serves as
leverage on the equity (net assets for not-for-profit
organizations) of the healthcare organi-
zation. With a limited amount of equity, the organization can
obtain more assets and provide
more services when debt is used. Of course, the use of debt has
a cost. Organizations must
pay interest for the use of funds provided by others as well as
pay back the debt at some point
in time. A subtle though important financial implication of
leverage is that the cost of debt
is fixed for any time period (interest expense), and the net
income associated with services
provided by the assets purchased using debt are variable. If the
percentage rate of return on
services (net income) is greater than the interest rate paid on
debt, leverage will increase the
percentage rate of return to the equity holders of the
organization.
The effect of financial risk is subtle, so an example is needed to
explain it fully. Consider the
financial statements of Bixby Hospital, which are presented in
an abbreviated manner in
Exhibit 9.4. In 2012 the balance sheet of Bixby included $49.6

million in total liabilities (debt)
and $132.2 million in net assets. The debt ratio, or the ratio of
total liabilities to total assets,
is 27.3%.
smi81240_09_c09_221-244.indd 229 3/10/14 2:23 PM
230
Debt ratio 5
Total liabilities
Total assets
3 100%
5
$49,611,000
$181,836,031
3 100%
5 27.3%
Another measure of profitability, beyond the four presented in
Chapter 3, is the return on net
assets (also called the return on equity), as defined by the
following equation:
Return on net assets 5
Net income
Net assets

3 100%
5
$10,894,838
$132,225,031
3 100%
5 8.2%
For Bixby Hospital in 2012, the return on net assets is 8.2%.
This is larger than the cost of
debt, which is around 3%. Therefore, at Bixby Hospital, we
expect leverage to increase the
return on net assets.
Exhibit 9.4 Financial statements and leverage, Bixby Hospital,
2012
Balance Sheet 2012 Alternative 2012
Total assets $181,836,031 $181,836,031
Net assets $132,225,031 $32,225,031
Total liabilities and net assets $181,836,031 $181,836,031
Income Statement
Interest expense $840,479 $4,488,330
Operating Income $8,634,534 $4,147,044
Miscellaneous nonpatient revenue $2,260,304 $2,260,305
Net Income or (Loss) $10,894,838 $6,407,349
Debt ratio (Total liabilities/Total assets) 27.3% 82.3%
Return on net assets 8.2% 19.9%
The effects of leverage on the return on net assets is
demonstrated by the suggested alterna-

tive financial statement for 2012, also presented in Exhibit 9.4.
For purposes of discussion,
suppose that there were $100 million more in long-term debt at
Bixby, and correspondingly
$100 million less in net assets. That is, suppose that the balance
sheet of Bixby included
$149,611,000 in total liabilities and $32,225,031 in net assets.
The resulting debt ratio is
82.3%. Also note that the resulting interest expense is much
higher, and therefore operating
income and net income are lower. Now here is the important
result, the return on net assets is
smi81240_09_c09_221-244.indd 230 3/10/14 2:23 PM
231
19.9%. As long as the initial return on net assets is greater than
the interest rate, higher debt
ratios will result in higher resulting returns on net assets.
Debt ratio 5
Total liabilities
Total assets
3 100%
5
$149,611,000
$181,836,031
3 100%

5 82.3%
Net income
Net assets
3 100%
5
$6,407,349
$32,225,031
3 100%
5 19.9%
With those results on the effects of leverage on returns on net
assets, why don’t organiza-
tions borrow as much as possible? Why aren’t debt ratios close
to 100%? Again, the use of
debt involves financial risk, which has two components: debt
repayment requirements and
equity return enhancement. With higher levels of debt, the
required payments associated
with debt (interest and principal payments) are higher. With
higher required payments, there
is a greater likelihood of experiencing revenue shortfalls that
impact debt holders. For this
reason, organizations with higher debt ratios, on average, have
lower credit ratings and pay
higher interest rates. At very high levels of debt, interest rates
become very high. Further, as
a protection for their risks, debt holders may place covenants on
organizations that limit the
use of debt. The debt ratio, the long-term debt to capitalization

ratio, or the debt-service cov-
erage ratio may be placed in a covenant.
The effect of leverage on equity return enhancement is the other
source of financial risk that
limits the amount of debt that organizations will use to support
the balance sheet. Just as
leverage increases the return on net assets when net income is
high, it decreases the return
on net assets when net income is low. Suppose for Bixby
Hospital that net patient revenues
had been $10 million lower in 2012, and that all other factors
had remained the same. At their
existing debt ratio of 27.3%, the result of the lower level of net
patient revenues would have
been net income of only $894,838 ($10,894,838 2 $10,000,000)
and a return on equity of
only 0.7%.
Net income
Net assets
3 100%
5
$894,838
$132,225,031
3 100%
5 0.7%
smi81240_09_c09_221-244.indd 231 3/10/14 2:23 PM

232
Under the alternative 2012 financial statements, with a debt
ratio at the higher 82.3% level,
the lower net patient services revenue would be associated with
a net loss of $3,592,651
($6,407,349 2 $10,000,000) and a return on equity of 211.1%.
Net income
Net assets
3 100%
5
2$3,592,651
$32,225,031
3 100%
5 211.1%
Leverage works both ways; it magnifies returns when profits are
positive and magnifies losses
when profits are negative.
Analyze This
If miscellaneous nonpatient revenue at Bixby Hospital had been
zero in 2012, what would have
been the return on net assets under the actual results and under
the alternative provided in
Exhibit 9.4?

Portfolio Risk
With the potentially substantial business risk inherent to every
organization, as well as the
added financial risk associated in organizations that use debt,
investors may seek ways in
which to reduce the risk of their holdings by spreading their
money across many organi-
zations. The general term for the process of spreading
investments across different assets
is diversification. The general term for the group of assets
pooled together for investment
purposes is a portfolio. The first finance principle associated
with diversification is that the
return on a portfolio is merely the weighted average of the
returns on the individual invest-
ments within the portfolio. Having a portfolio of assets, by
itself, rather than any single invest-
ment, does not change expected returns. For an investor who
owns many stocks, the expected
return on the portfolio is the weighted average of the returns on
the individual stocks. For
a healthcare organization that owns many separate businesses,
the expected return (net
income) is the sum of the expected returns from each business.
An important and intuitive second finance principle associated
with diversification is that the
risk of a portfolio of assets is generally less than the risk
associated with a single asset. As a
demonstration of the principles of diversification, consider
investments in some of the largest
U.S. healthcare organizations. As shown in Figure 9.4, the risks
and returns are highly variable
for five large healthcare insurance and managed care companies
(UnitedHealth Group, Well-
Point, Humana, Aetna, and Cigna) and five large healthcare

facility companies (Community
Health Systems, Tenet Healthcare, DaVita HealthCare Partners,
Universal Health Services, and
Health Management Associates).
smi81240_09_c09_221-244.indd 232 3/10/14 2:23 PM
233
Figure 9.4: Risk and returns for large healthcare organizations,
201022012
Source: Author’s calculation, based on individual company
Annual Reports (Form 10-K) (http://www.SEC.gov).
The average among the average returns for each company
displayed in Figure 9.4 is 16.5%
per year. The range of average returns is 3.1% to 24.4%. A
portfolio that contains equal dol-
lars invested in each company (that is, the portfolio value is
10% for each of the 10 compa-
nies) would yield a return of 16.5%.
The standard deviation of the returns for these 10 companies
ranges from 13.2% to 65.6%.
The average standard deviation of the returns among these
companies is 28.8%. The inter-
esting aspect of risks is what happens with a portfolio of assets.
As predicted by the finance
principle associated with diversification, the risk of the
portfolio is less than the average risk
among assets within the portfolio. In this case, the standard

deviation of returns for each
company is greater than the 8.9% risk associated with the
portfolio. Holding a portfolio of
assets, risk is reduced.
The degree to which risk is reduced with a portfolio is
dependent upon the relationships
among the returns on the assets of the individual investments. If
the risks and returns among
assets in a portfolio are very similar (very high correlation with
one another), the risk reduc-
tion is minimal. If the risks and returns among assets in a
portfolio are very different (very
low correlation with one another), the risk reduction is
substantial. For investors, finding the
portfolio of assets that achieves desired rates of returns, with
acceptable risks, can be a con-
tinuous process of searching and adjusting holdings.
Average Returns
0%
10%
5%0%
Community Health Systems
Tenet Healthcare
Universal Health Services
DaVita HealthCare Partners
Health Management Associates

Wellpoint
Aetna
Cigna
Total Portfolio
UnitedHealth Group
Humana
30%25%15% 20%10%
70%
60%
50%
40%
30%
20%
S
ta
n
d
a
rd

D
e
v
ia
ti
o
n
o
f
R
e
tu
rn
s
smi81240_09_c09_221-244.indd 233 3/10/14 2:23 PM
234
Just as a portfolio of assets can reduce risk for an investor, a
portfolio of services within a
healthcare organization can reduce risks as compared to having
only one service. There is
an ongoing debate within many companies about the extent to
which diversification should

occur. On the one hand, the finance principle of diversification
suggests greater diversifica-
tion to reduce risks. Having a broad portfolio of services will
reduce risk and perhaps help
to assure the viability of an organization. If the profitability of
one particular service should
suffer, the organization can continue operations.
On the other hand, diversification takes the time and attention
of senior managers and may
detract the focus from the most important, and perhaps narrowly
defined, services. Health-
care organizations that focus their time and attention on a
limited number of services may be
able to achieve great expertise and efficiency in the delivery of
those services at the expense
of risk. The debate about the optimal degree of diversification is
a good one to have within a
healthcare organization.
Cost of Equity: The Capital Asset Pricing Model
For the use of debt, organizations can rely upon banks and
markets, as influenced by credit
ratings, to establish the cost of debt. To determine the cost of
equity to an organization, there
are no simple ways of approaching investors for capital
investments, as we can do with banks
for loans. Instead, organizations may propose offers of
ownership in an organization to indi-
vidual investors or the open market for investors and see what
prices they are willing and
able to pay for ownership shares. This is, in fact, how values of
ownership of equity are estab-
lished—through exchanges in the market. The cost of equity to
the firm is therefore set by the
views of investors on the risk of the firm and the expected

returns. As with all investments,
higher risks must be associated with higher expected returns, or
there will not be investors.
The challenge to organizations seeking to estimate the cost of
capital for planning and bud-
geting purposes, without engaging in market exchanges, is
where they can find information
on the relationship between risk and returns. In the modern
practice of corporate finance,
there is a model that can be used to estimate the relationship
between risk and returns called
the capital asset pricing model (CAPM). Developed by William
Sharpe (Sharpe, 1964) and
refined and tested by hundreds of economists over the years,
CAPM provides a reasonable
estimate of the expected returns for varying levels of risks and
other market conditions.
The first key idea behind the CAPM is that investors may
allocate their investments between
risk-free assets, like U.S. Treasury bills, and risky assets, like
equity in a particular company.
The second key idea is that investors should be reasonably
consistent and efficient in their
use of information about interest rates, the average return on
investments in the market as a
whole, and the relative risk involved with a particular
investment. The third key idea behind
the CAPM is investors generally hold a portfolio of
investments, with an investment in one
company being only a part of their overall holdings.
The basic equation for the CAPM is written as
E[ri] 5 rf 1 bi 3 (E[rM]) 2 rf )

where E[ri] is the expected return on one particular investment
(indicated by the subscript
i ). The risk-free rate of return is represented as rf , and the
expected rate of return for the
market as a whole is represented as E[rM]. The last term in this
equation, bi (pronounced
smi81240_09_c09_221-244.indd 234 3/10/14 2:23 PM
235
beta), indicates the relative riskiness of one particular
investment as compared to the riski-
ness of the market as a whole. The term in parentheses (E[rM])
2 rf ), the difference between
the expected return for the market as a whole and the risk-free
rate of return, is referred to as
the market risk premium. The market risk premium indicates, on
average, how much higher
returns on equity investments are compared to risk-free rates.
For the risk-free rate, a common data source is the U.S.
Treasury. On October 30, 2013, the
rate of return on U.S. Treasury bills (90 days) was 0.035%,
which is zero for all practical pur-
poses, as it has been since 2009. For an investor considering a
long-term investment, a longer
term risk-free rate would be appropriate. The current rate of
return on U.S. Treasury bonds
(30 years) is 3.64%. Taking a longer-term view, the rate of
return on U.S. Treasury bonds is

usually around 5%. As presented in Figure 9.5, interest rates are
normally higher as the time
period for investment gets longer. The slope of the line for
interest rates over time is called
the yield curve.
Figure 9.5: Risk-free rate yield curve, October 30, 2013
Source: Daily Treasury yield curve rates,
http://www.treasury.gov/resource-center/data-chart-
center/interest-rates/Pages/
TextView.aspx?data=yield.
For the market rate of return, a broad portfolio of investments is
generally selected, such as
the Standard & Poor’s 500 Index. In Exhibit 9.3, the average
annual rate of return on the S&P
500 was almost 15%.
Using CAPM as a way to determine the returns that investors
should expect, having a bi of 1.0
implies that the level of risk associated with the investment is
the same as the market and that
the average return in the market is appropriate. For bi . 1.0, the
stock is riskier than average
Term of Investment
3 month1 month 20 years7 years1 year 3 years 30 years10
years2 years 5 years6 month
In
te
re
s

t
R
a
te
0.0%
4.0%
3.0%
2.0%
1.0%
3.5%
2.5%
1.5%
0.5%
smi81240_09_c09_221-244.indd 235 3/10/14 2:23 PM
center/interest-rates/Pages/TextView.aspx?data=yield
center/interest-rates/Pages/TextView.aspx?data=yield
236

and requires a higher expected rate of return. For bi , 1.0, the
stock is less risky than average
and requires a lower expected rate of return. Most stocks have
betas in the range of 0.5 to 3.0.
In the practice of corporate finance, analysts regularly calculate
bi for companies that have
shares of equity that are publicly traded. The estimation of bi
comes from statistical analysis
of the relationship between the actual returns of companies, as
an approximation for expected
returns, and an index of actual market returns (e.g., the S&P
500), as an approximation for the
expected market returns. Examples of bi for selected large
healthcare insurance and managed
care and healthcare facility companies are presented in Exhibit
9.5.
Exhibit 9.5 CAPM b for large healthcare organizations
b
WellPoint 0.46
UnitedHealth Group 0.57
Cigna 0.69
Aetna 0.82
Humana 0.89
DaVita HealthCare Partners 1.18
Health Management Associates 1.73
Universal Health Services 1.89
Community Health Systems 1.99
Tenet Healthcare 2.43
Source: http://finance.yahoo.com/ (October 30, 2013).
Presently, equity investments in large healthcare insurance and
managed care companies

(the first five companies in Exhibit 9.5) are less risky than the
market as a whole. In contrast,
equity investments in healthcare facility companies are
currently more risky than the market
as a whole.
With Exhibit 9.5 in mind, consider the following example for
the determination of the long-
term return that investors should expect for holding the stock of
DeVita HealthCare Partners
with bi 5 1.18.
E[ri ] 5 rf 1 bi 3 (E[rM ]) 2 rf )
5 5% 1 1.18 3 (15% 2 5%)
5 16.8%
Analyze This
What are the expected returns associated with UnitedHealth
Group and Tenet Healthcare? Why
are these expected returns so different from one another?
smi81240_09_c09_221-244.indd 236 3/10/14 2:23 PM
http://finance.yahoo.com/
237
The CAPM is an approximation and should be used with some
caution. It is widely used and
quite helpful for estimation purposes, but it should not be
considered to be highly precise.

Cost of Equity: Not-for-Profit Organizations
Not-for-profit organizations face a special challenge in the use
of the capital asset pricing
model and other modern finance tools to determine the cost of
equity capital, namely that
there is no market information on rates of return that can readily
be used for analysis. Faced
with this challenge, not-for-profit organizations can take one of
three approaches: pure-play,
accounting-based CAPM, and the accounting net income
approach. The pure-play tech-
nique suggests that in lieu of actual market information on the
risk of equity in a particular
organization, one could use the actual market information for a
firm that appears to exhibit a
similar level of risk and has a similar level of debt. A large not-
for-profit health insurance or
managed care organization might use a b of 0.46 to 0.89, based
on the information in Exhibit
9.5. Similarly, a large system of hospitals might use a b of 1.18
to 2.43. In this later case, the
range of observed bs is quite wide, leaving much uncertainty in
the appropriate cost of equity
capital.
Another option for not-for-profit healthcare organizations is to
develop an approximation to
the use of CAPM based on accounting net income (Smith &
Wheeler, 1989). A statistical analy-
sis of accounting net income, as an approximation for market
returns, would yield estimates
of b that could be used with a traditional CAPM equation.
Statistical analysis of accounting
data can be quite difficult and should not be attempted by
persons who are not well trained

in statistics.
A final option for not-for-profit organizations is simply to use
average values for accounting
net income as the estimated cost of equity capital. The
advantage of this approach is that the
data are readily available. The disadvantage of this approach is
that by eliminating consider-
ation of market rates of return, it considers the cost of equity
capital for an organization all
by itself and, therefore, includes all stand-alone risk. Any
consideration of the advantages of
diversification through use of portfolios is lost.
Given the effort and uncertainly involved with each approach,
use of the pure-play approach
may be the best option for most organizations. In additions to
large firms listed in Figure 9.4
and Exhibit 9.5, there are more than 20 health insurance
companies and managed care orga-
nizations and more than 50 hospital companies with stock price
information.
For Review:
1. How does financial risk add to business risk?
Financial risk is the risk associated with borrowing money and
the requirement to
make interest and principal payments, whereas business risk is
the risk associated
with possible variations in net income. Adding interest to
expenses decreases net
income and adds to business risk.
2. Why would investors choose to hold a portfolio of
investments rather than hold a

single investment?
A portfolio does not change the expected returns as compared to
single investments.
A portfolio reduces the risk associated with investing. Having
the same expected
returns with lower risks is safer for investors.
smi81240_09_c09_221-244.indd 237 3/10/14 2:23 PM
238
Section 9.4Optimal Capital Structure
3. What information does an organization need to have to use
the capital asset pricing
model?
The basic equation for the CAPM is written as
E[ri ] 5 rf 1 bi 3 (E[rM ]) 2 rf )
Therefore, an organization needs to have information on the
risk-free rate, the
expected return for the market as a whole, and the relative
riskiness of the organiza-
tion, as measured by beta. Not-for-profit organizations without
stock information
used to calculate bi may use information from similar
companies that do have stock
information, an approach that is called the pure-play.
9.4 Optimal Capital Structure
Returning to the discussion of financial risk, the use of debt
permits organizations to purchase
more assets and therefore provide more services than they could

by using only net assets. The
use of small levels of debt do not materially affect the credit
rating and interest rates paid
by organizations and do not involve a high degree of financial
risk. Not only does the use of
large levels of debt harm the credit rating and raise interest
rates paid by organizations, but
it involve a high degree of financial risk. Since the costs of debt
are lower than the expected
returns on equity, at least at low levels of use of debt, some
level of debt should be used to
purchase assets. At higher levels of debt, the use of debt affects
the credit rating and interest
rates (the costs of debt) and the degree of financial risk.
Recalling the relationship between
risk and return, the degree of financial risk will affect the
expected rate of return (the cost of
equity). So what level of debt should be used? What is the
optimal capital structure (use of
debt and use of net assets) for a healthcare organization?
To determine the optimal capital structure, one can use the
information on the use of debt
and the cost of debt and the use of equity capital and the cost of
equity capital. For the orga-
nization as a whole, the percentage use of debt and equity must
equal one. Organizations are
financed by either debt or equity. For the cost of debt, a bank
loan rate or a rate determined by
the credit rating can be used. For the cost of equity capital, the
CAPM can be used. Putting all
of this information together permits the calculation of the
weighted average cost of capital
(WACC). The WACC is the overall cost of capital, measured as
the percentage use of debt, at
the cost of debt after taxes, plus the percentage use of equity, at

the cost of equity. The equa-
tion for the WACC is written as
WACC 5 (Debt 4 Total assets) 3 rd 3 (1 2 Tax rate)
1 (Equity 4 Total assets) 3 re
5 Debt ratio 3 rd 3 (1 2 Tax rate) 1 (1 2 Debt ratio) 3 re
For Bixby Hospital, a not-for-profit that has a 0% tax rate, the
current debt ratio is 27.3%,
and the current average cost of debt is 1.7% (interest expense
divided by total liabilities).
However, the current rate that Bixby has been quoted, given its
credit rating, is 5.5%, which
would be the appropriate rate for future decisions. With an
equity ratio (1 2 Debt ratio) of
72.7%, the only missing term is the cost of equity capital. If we
conduct an analysis and find
that the risk of Bixby Hospital is similar to that of DaVita
HealthCare Partners, we may use a
smi81240_09_c09_221-244.indd 238 3/10/14 2:23 PM
239
b of approximately 1.18, which yields a long-term expected
return on equity capital of 16.8%.
Within the WACC equation, the current WACC is
WACC 5 (Debt 4 Total assets) 3 rd 1 (Equity 4 Total assets) 3
re

5 27.3% 3 5.5% 3 (1 2 0%) 1 72.7% 3 16.8%
5 13.7%
With a WACC value of 13.7%, is a debt ratio of 27.3% optimal?
To determine whether the
WACC is the lowest possible cost of capital, it is helpful to
estimate the value of WACC at alter-
native uses of debt. An estimation of the value of WACC at
levels of debt that range from 0%
to 80% for Bixby Hospital is presented in Figure 9.6. The first
thing to note from Figure 9.6
is that the WACC is not highly sensitive to the debt ratio. At the
lowest levels of debt (10%),
the cost of debt is 4.0%, and the cost of equity capital is 14.6%,
resulting in a WACC of 14.0%.
With more debt, the cost of both debt and equity increases, and
the WACC decreases as the
cost of debt remains lower than the cost of equity capital. At the
highest level of debt (80%),
the cost of debt is 14.5%, and the cost of equity capital is
24.1%, resulting in a WACC of 16.5%.
A range of 14.0% to 16.5% is a narrow range of estimates of the
cost of capital.
Figure 9.6: Weighted average cost of capital (WACC), Bixby
Hospital, 2012
The second thing to note from Figure 9.6 is that the minimum
point on the WACC curve is
quite close to the current debt ratio of 27.3%. The WACC
declines only slightly from 14.0% at
almost no debt to 13.7% at the current use of debt. In fact, it is

not until a use of debt of 65%
that WACC increases to more than 15%. Therefore, the current
use of debt is acceptable.
Cost of Equity Capital
WACC
Cost of Debt
0%
10%0% 80%70%30% 50% 60%40%20%
30%
25%
15%
5%
20%
10%
Percentage Use of Debt
In
te
re
s
t
R

a
te
smi81240_09_c09_221-244.indd 239 3/10/14 2:23 PM
240
Spreadsheet Calculation of WACC
The calculation of equations such as the WACC can be
performed by hand or with a calcula-
tor. To ease the task when there are a number of analyses that
must be performed, or when
there are many observations, electronic spreadsheets may be
used instead. A calculation of
the WACC for Bixby Hospital is presented in Exhibit 9.6.
Exhibit 9.6 Spreadsheet calculations of weighted average cost
of capital, Bixby
Hospital, 2012
A B C D E F G
1
Debt
Ratio
Cost of
Debt Tax Rate
Equity
Ratio

Cost of
Equity WACC
2 20.0% 4.30% 0% 16.31%
3 27.3% 5.50% 0% 72.3% 16.80% 13.65% =(A3*B3*(1–
C3))+(D3*E3)
4 40.0% 6.91% 0% 18.77%
5
Analyze This
Using the information in Exhibit 9.6, what are the equity ratios
and WACCs for Bixby Hospital at
debt ratios of 20% and 40%?
Other Capital Structure Considerations
The use of a process of minimizing the weighted average cost of
capital to select the optimal
level of debt is consistent with the trade-off theory of debt.
Making the trade-off between the
low cost of debt and the risks associated with using too much
debt, the point at which WACC
is minimized yields the optimal capital structure. The trade-off
theory is popular because it
suggests a rational and consistent process for decision making.
An alternative theory of use of debt is the pecking-order theory.
The pecking-order the-
ory suggests that organizations have preferences about the use
of equity capital and debt
for financing new projects. Anecdotal empirical evidence tends
to support pecking-order
theory for hospital systems (Smith, Wheeler, Rivenson, &
Reiter, 2000b). Decision making
in not-for-profit healthcare organizations often takes into
account many factors that are not

readily observable, especially the time and managerial expense
associated with acquiring
debt and equity.
The usual order of preference is to first use available cash (cash
and marketable securities,
or assets limited as to use if the project is consistent with the
limitations). Organizations may
wish to first use available cash because it does not involve any
interactions with individuals
or firms outside of the organization, limiting the time and
expense of acquiring new funds.
smi81240_09_c09_221-244.indd 240 3/10/14 2:23 PM
241
Summary & Resources
The second option for funds is typically debt financing.
Organizations may obtain short-term
loans from banks for small, short-term projects and then seek to
issue long-term debt for
large, long-term projects. There is time and expense associated
with obtaining loans and issu-
ing debt, and these costs are well known and work with
established methods.
The last option is to seek new equity capital. For investor-
owned firms, there is often substan-
tially more time and effort involved in new equity offerings,
including, perhaps, reporting to
the Securities and Exchange Commission. Only for very large
firms are methods well known.

For not-for-profit firms, seeking new equity capital requires
solicitation of philanthropic giv-
ing. The philanthropy process is very time-consuming, with
uncertain and difficult-to-measure
results (Smith & Clement, 2013).
For Review:
1. What information is required to calculate the weighted
average cost of capital?
The WACC requires (1) the percentage use of debt, (2) the cost
of debt, (3) the tax
rate, (4) the percentage use of equity, and (5) the cost of equity.
The equation for the
WACC is written as
WACC 5 (Debt 4 Total assets) 3 rd 3 (1 2 Tax rate)
1 (Equity 4 Total assets) 3 re
2. What theory of organization decision making suggests that
one should use the WACC?
The trade-off theory suggests that organizations use information
on costs of debt and
equity and select the best mix based on WACC. The pecking-
order theory suggests
that firms do not use the WACC and generally use equity unless
they cannot support
assets without borrowing money.
Summary & Resources
Chapter Summary
This chapter has introduced many important and difficult topics
central to the application
of modern finance methods to the financial management of

healthcare organizations. The
concepts of uncertainty and risk can be challenging, even to
persons with a good understand-
ing of statistics. An important message in this chapter is that
organizations face a number of
uncertainties. When a point of uncertainty has financial
consequences, such as the number
of patients that may visit on a particular day, then it is a risk to
the organization’s profitabil-
ity. Use of some basic statistical tools is necessary to quantify
the risk for projects or for the
organization as a whole. Given the importance of risk as a
determination of expected returns,
careful calculation of risk is important for financial managers.
Risks will always exist, and there are ways in which individuals
and organizations can seek to
reduce their financial impact. One way to reduce risks is to
diversify by creating portfolios of
investments. As long as all of the investments in a portfolio do
not have exactly the same risk,
average returns can be earned at lower levels of risk.
In addition to the business risk of an organization, there is
financial risk. Financial risk is
the added risk associated with using debt to purchase assets. As
part of long-term financial
smi81240_09_c09_221-244.indd 241 3/10/14 2:23 PM
242
Summary & Resources

decision making, organizations select the appropriate level of
debt to use and, accordingly,
the appropriate the level of equity. The modern finance tool of
the capital asset pricing model
was introduced as a means to estimate the cost of equity,
thereby enabling the calculation
of the weighted average cost of capital to determine the
appropriate level of debt. Having
demonstrated that the precise level of debt may not make a big
difference in the WACC, it may
seem disappointing to work through the process of calculating
the WACC. As will be demon-
strated in Chapter 10, the WACC is also essential as the
discount rate for investment analysis,
and the work will have been worthwhile.
1. Borrowing money permits an organization to acquire more
assets and involves add-
ing financial risk to the already existing business risk. How
much risk is too much?
2. Diversification enables organizations to reduce their overall
risk. Does diversifica-
tion explain the development of chains of skilled nursing
facilities?
3. The capital asset pricing model is commonly used to evaluate
the expected equity
returns for for-profit companies. How valid is it to adopt a for-
profit company’s
equity return as an approximation for a not-for-profit
company’s equity return?
Exercises

1. Eight clinics (A2H) owned by a health system reported their
operating margins in
2012. What is the average operating margin and what is the
standard deviation of
the operating margin?
Clinic Operating Margin
A 4%
B 5%
C 6%
D 7%
E 8%
F 9%
G 10%
H 11%
2. Four clinics (I2L) owned by a health system reported their
operating margins in
2012. What is the average operating margin and what is the
standard deviation of
the operating margin?
Clinic Operating Margin
I 3%
J 5%
K 10%
L 12%
3. If the total dollar amount of operating profit were the same
for clinics A2H and clin-
ics I2L, which set of clinics would be a better investment?
smi81240_09_c09_221-244.indd 242 3/10/14 2:23 PM

243
Summary & Resources
4. Soniat Skilled Nursing, Inc. is preparing financial plans for
2013. The current plan is
a simple extension of activities in 2012. A proposed plan is
similar but includes hav-
ing $500,000 less in liabilities. What are the debt ratio and the
return on net assets
under the current plan and the proposed plan? Which plan would
you recommend
to the owners of Soniat?
Soniat Skilled Nursing Current Plan Proposed Plan
Balance sheet
Total assets $3,200,000 $3,200,000
Total net assets $700,000 $1,200,000
Income statement
Net revenues $11,000,000 $11,000,000
Operating expenses, except interest $10,500,000 $10,500,000
Interest expense $100,000 $70,000
Net income before taxes $400,000 $430,000
Tax expense $140,000 $150,500
Net income $260,000 $279,500
5. Soniat Skilled Nursing, Inc. views its risk as being similar to
Skilled Healthcare
Group, Inc., which is a company listed on the New York Stock
Exchange (symbol
SKH) with a beta of 0.70. If the long-run average risk-free rate
is 5% and the long-
run average market rate of return is 15%, what is the long-run
average expected

return on Soniat using the capital asset pricing model?
6. If the cost of debt to Soniat is measured as the interest
expense divided by total
liabilities, and the cost of equity is determined by CAPM from
Exercise 5, what is
the weighted average cost of capital for Soniat under the current
plan and the pro-
posed plan?
Key Terms
accounting-based CAPM An approach to
estimating the cost of equity in a not-for-
profit organization by using accounting
information in the capital asset pricing
model.
accounting net income approach An
approach to estimating the cost of equity
in a not-for-profit organization by simply
using accounting net income, without using
the capital asset pricing model.
business risk, stand-alone risk The varia-
tion in possible returns (profits) associated
with the uncertain conditions facing the
organization.
capital asset pricing model (CAPM) The
model of the expected cost of equity capital
(return) for an organization, given its risk
relative to the market.
debt covenant A restriction on operat-
ing or financial conditions associated with
a debt agreement that the organization is

required to meet. Failure to meet a debt
covenant can result in a requirement to
immediately repay a debt or other penalties.
diversification The process of spreading
investments across different assets. The
purpose of diversification is to decrease
risk.
smi81240_09_c09_221-244.indd 243 3/10/14 2:23 PM
244
Summary & Resources
financial risk The risk added to an orga-
nization’s business risk through the use of
debt.
firm-specific risk The variation in pos-
sible returns (profits) associated with the
operations and management of one particu-
lar organization.
market risk The variation in possible
returns (profits) associated with the
industry of an organization and the overall
economy.
market risk premium An indicator of, on
average, how much higher returns on equity
investments are compared to risk-free rates.
It is calculated as E[rM] 2 rf .

normal distribution A probability func-
tion of the observations from a popula-
tion where 68% of the observations will
be within one standard deviation, plus or
minus, of the average return, and 95% of
the observations will be within two stan-
dard deviations, plus or minus, of the aver-
age return. When there are large numbers
of observations, the probability function
often exhibits a normal distribution.
pecking-order theory A theory that orga-
nizations have preferences about the use of
equity capital and debt for financing new
projects and generally choose to use equity
before debt.
portfolio A group of assets pooled together
for investment purposes.
portfolio risk The variation in possible
returns (profits) associated with a number
of investments, potentially several firms, in
several industries, in several economies.
pure-play An approach to estimating the
cost of equity in a not-for-profit organiza-
tion by using the actual market information
for a firm that appears to exhibit a similar
level of risk and has a similar level of debt.
trade-off theory A theory that organiza-
tions calculate the weighted average cost of
capital (WACC) and recognize the trade-off
between the low cost of debt and the risks
associated with using too much debt.

weighted average cost of capital
(WACC) The overall cost of capital mea-
sured as the percentage use of debt, at the
cost of debt, plus the percentage use of
equity, at the cost of equity. The point at
which the WACC is minimized represents
the optimal use of debt by the organization.
yield curve The line that depicts the
relationship between interest rates and the
term of a debt as a given point in time.
Suggested Websites
• For data on financial ratios and cost of debt, see Standard &
Poor’s:
• For data on interest rates, see Federal Reserve:
http://www.federalreserve.gov/
• For data on financial statements, risks, and other information
on investor-owned
firms, see the U.S. Securities and Exchange Commission:
• For financial statements and calculation of b, see Yahoo
Finance:
smi81240_09_c09_221-244.indd 244 3/10/14 2:23 PM
http://www.federalreserve.gov/

Capital Investment
Decisions
10
.welcomia iStock/Thinkstock
Learning Outcomes
• Understand the role of financial analysis for capital
investments
• Describe a capital investment process
• Prepare cash flow estimates
• Classify projects for investment analysis
• Conduct cash flow analysis, using net present value, internal
rate of return, and payback
period decision rules
smi81240_10_c10_245-268.indd 245 3/10/14 4:55 PM
246
Section 10.1Financial Analysis for Capital Investments
Introduction

Chamberlin Skilled Nursing, Inc. is concerned about its
viability as a stand-alone skilled nurs-
ing facility. One plan that has been put forward is to acquire
Soniat Skilled Nursing, Inc., a
company with a similar mission and set of services, though in a
different geographic market.
The purchase of Soniat would be a substantial capital
expenditure for Chamberlin. Soniat’s
owners are agreeable to a plan of being acquired, if the price is
right. Determining how much
Chamberlin would be willing and able to pay for Soniat will
require a careful capital expendi-
ture analysis.
Not all capital expenditure decisions are as large and difficult
as purchase of an entire business.
Many capital expenditure decisions are routine and involve the
renovation or replacement of
existing buildings and equipment. In any particular year, there
may be many requirements for
new or replacement equipment, and organizations must make
decisions about which capital
expenditures to make right now, and which to defer to future
years. This chapter provides a
financial framework for capital expenditure decision-making.
10.1 Financial Analysis for Capital Investments
For the day-to-day activity of the organization, planning and
budgeting focus on the oper-
ating budget, as described in Chapter 7. The operating budget
should be consistent with
both short-run and long-run aims of the organization and be
guided by the strategic plan.
It is important to have a good sense of what the aims of the
organization are and how they
translate into services that are offered to the community. In the

short run, the plan includes
expected volumes of services, expected revenues, and expected
expenses. The end result of
short-run planning is a pro forma income statement.
Buildings, clinical space, and medical equipment are all
necessary for providing healthcare
services. For short-run planning, existing facilities are taken as
fixed, which may place capac-
ity limits on the volume or availability of programs or services.
Further, in the short run, many
clinical program offerings may also be fixed. Hiring of
specialized clinical personnel and rear-
ranging clinical space doesn’t happen overnight. In the long
run, plans are open to changing
the assets and programs of the organization. The end result of
long-run planning is the pro
forma balance sheet of the organization.
The asset side of the balance sheet is planned through a process
of capital investment deci-
sion making, or capital budgeting, as the acquisition of assets
requires the use of equity capi-
tal or debt. Capital budgets indicate dollar amounts approved
for the purchase, construction,
or development of assets or programs. In aggregate, total
expenditures for physical assets for
healthcare organizations in the United States exceeded $103
billion in 2011. Expenditures
for buildings for healthcare organizations were more than $45
billion in 2011, of which more
than 80% came from private sources (as opposed to federal,
state, or local governments).
Expenditures for equipment in healthcare organizations were
more than $58 billion in 2011,
of which more than 70% came from private sources (Centers for

Medicare & Medicaid Ser-
vices, 2012). The total amounts of private spending for
healthcare buildings and equipment
over the last decade are presented in Figure 10.1. The recession
and concerns over healthcare
reform have slowed the increase in private capital spending that
occurred in the years leading
up to 2008. Still, $75 billion in expenditures is a lot of money.
Each of these dollars spent on
smi81240_10_c10_245-268.indd 246 3/10/14 2:27 PM
247
Section 10.1Financial Analysis for Capital Investments
buildings and equipment for healthcare organizations was the
end result of a capital invest-
ment process.
Figure 10.1: Private expenditures, healthcare buildings and
equipment,
200222011
Source: Centers for Medicare & Medicaid Services (2012).
Medicare & Medicaid Statistical Supplement. Retrieved from
http://
www.cms.gov/Research-Statistics-Data-and-Systems/Statistics-
Trends-and-Reports/MedicareMedicaidStatSupp/index.html
Each item in a capital budget is a capital investment. The key
idea behind capital investments,
each being an asset or a program, is that there is an expectation
of a cash outflow in the

near term, and net income from the resulting activities
facilitated in the long term. For some
capital investments, like a renovation to expand a clinic,
expenditures may happen quickly,
and net income may be earned in the same year. For other
capital investments, like the con-
struction of a new outpatient building, expenditures may occur
over several years, with sev-
eral more years of creating programs that eventually result in
positive net income. For some
capital investments, there are only expenses without any net
income, as is the case with new
information systems.
As noted in Chapter 8, corporate finance involves preparation of
information for making deci-
sions about asset acquisition and other long-term investment
decisions. Therefore, the analy-
sis of individual capital investments, the capital budget, and the
planned balance sheet are
important products of corporate finance. This chapter will
present the finance contributions
toward capital investment decisions and budgeting. It will
present a framework for consid-
ering capital investments, focusing on cash flow analysis and
decision rules for undertaking
investments. The full capital expenditure budget will then be
developed, with a focus on capi-
tal budgeting in not-for-profit organizations that may face
financing constraints.
Year
10
0

200920082002 2003 2004 2005 2006 201120102007
30
80
50
20
40
60
70
90
100 Equipment
Buildings
D
o
ll
a
rs
(
in
B
il
li

o
n
s
)
smi81240_10_c10_245-268.indd 247 3/10/14 2:27 PM
http://www.cms.gov/Research-Statistics-Data-and-
Systems/Statistics-Trends-and-
Reports/MedicareMedicaidStatSupp/index.html
248
Section 10.2A Capital Investment Process
For Review:
1. What is the focus on capital investment decision making?
Capital investments are long-run decisions. The focus is on the
acquisition of assets or
programs that will involve expenses in the short run and, for
many investments, net
income in the long run. The financial statement of importance is
the balance sheet.
10.2 A Capital Investment Process
Just as organizations develop processes for operating budgets,
processes are required for
capital investments. A depiction of the process for capital
investments is provided in Figure

10.2. All investments start with strategy. A strategy is a pattern
of decisions that organizations
make over time. The key to effective long-run strategy is that
the pattern of decisions is con-
sistent and positions an organization to be unique in the
marketplace. Long-run strategy is
highlighted in the next section. With a strategy in mind, the
next step in capital investments is
to identify assets and programs, collectively called projects, in
which the organization might
make long-term investments. For certain large-scale projects,
such as the purchase of a com-
pany in the same general business, the idea for the capital
expenditure may be a direct result
of the strategic planning process. Chamberlin Skilled Nursing’s
plan for the purchase of Soniat
Skilled Nursing is a direct result of a strategic intent to grow
and diversify its facility hold-
ings. For other projects, the source may be a department’s need
to replace aging or outdated
equipment, or a clinical group’s interest in having more space
or equipment, or offering a new
service. Given the multitude of ways in which individuals,
departments, and groups of depart-
ments might generate ideas for projects, organizations generally
define a process for making
decisions on the use of scarce resources for capital
expenditures.
Figure 10.2: Capital investment process
Strategy
IdentifyMonitor
EstimateDecide

smi81240_10_c10_245-268.indd 248 3/10/14 2:27 PM
249
Step 1: Identify
A traditional capital investment process in healthcare
organizations includes four steps: iden-
tify, estimate, decide, and monitor. The first step is to identify
and classify projects for con-
sideration. For larger healthcare organizations that have a large
number of potential projects,
this step may involve the submission of proposals. At Bixby
Hospital, a capital request form
is required for all potential capital expenditures. The cover page
for the request form is pre-
sented as Exhibit 10.1. The form starts with the identification of
the department making the
request, and the name of the equipment being proposed for
purchase or the title of the proj-
ect being proposed for development. Preparation of a full
proposal may generate substantial
information for decision makers. For purposes of initial review
and ultimate presentation of
an approved project, a brief description is also required.
Exhibit 10.1 Capital request form, cover page, Bixby Hospital,
2012
Department:
Name of Equipment or Title of Project:
Brief Description: (maximum 1 page if attached)

Amount Requested
Cost of Project/Equipment: $
Cost of Internal Installation Costs (current employees): $
Cost of Marketing (if new services): $
Total Amount Requested: $
Purchasing Review of Quotes
for Price Comparison? Date:
Expected Useful Life (Years):
Maintenance Annual Expense: $
Disposable Components
Annual Expense: $
Justification
New Purchase/Replacement:
Disposition of Current Equipment: Trade-in/Parts/Sale: $
Purpose (Patient Care, Productivity, Financial, Other):
Brief Description (maximum 1 page if attached):
Capital Investment Decision
Equipment/Project Approved in Capital Budget
If YES, Total Amount Approved: $
If NO, Brief Reason:
Approvals
Administrator Physical Plant Committee
Biomedical Engineering Committee Supply Chain Committee
Infection Control Committee Regulatory Affairs (certificate of
need)
Marketing and Planning Other
Source: Author.
smi81240_10_c10_245-268.indd 249 3/10/14 2:27 PM
250

An ideal description also classifies each project as being
dependent upon the approval of
other projects, independent of other projects, or mutually
exclusive of other projects under
consideration. Dependent projects should clearly indicate the
nature of the relationships with
other projects and any timing issues. For example, the purchase
of magnetic resonance imag-
ing (MRI) equipment is dependent upon having an appropriate
location in the building. The
space for an MRI requires lead shielding for radio frequency,
vibration resistance, appropri-
ate electrical power, heating, ventilation, and air conditioning,
and plumbing for an MRI cool-
ing unit. If the purchase of the MRI and space renovation are
separate projects for approval
purposes, their connection as dependent projects must be clearly
identified. And space reno-
vation needs to occur first.
Independent projects do not have identified relationships to
other capital expenditures.
Independence among projects doesn’t necessarily mean
independence from other budget
decisions. Purchase and installation of an MRI requires the
hiring of technicians and per-
haps other personnel, which may be dependent upon the
operating budgeting process. An
important note here is that after capital expenditures have been
made, the resulting activity
becomes part of the operations of the organization, and all
financial results become part of
the operating budget. For this reason, approval of capital
budgets often occurs before the
approval of operating budgets, permitting time for the financial
implications of new projects

to be included in the operating budget.
Mutually exclusive projects are those that involve selection of
one proposed project or
another, or neither, not both. Proposals for the purchase of used
MRI equipment and new
MRI equipment, for an existing space, is a case of mutually
exclusive projects. The organi-
zation may select between the two projects. Some instances of
mutually exclusive projects
may be less obvious. A proposed sleep lab and an additional
MRI might each seek to use the
same space in the building. Unless both proposals are quite
specific in their identification of
the space in the building to be used, it may be possible to
approve both projects, purchase
equipment, and then discover that both projects aren’t feasible
because the space has been
approved for two purposes.
Step 2: Estimate
The second step in the capital investment process is to estimate
cash flows and the riskiness
of the cash flows. Again, most capital investments involve the
purchase of equipment or other
assets and expenditures for project development early in the
timeline. The cover sheet of
the form includes amounts for the initial cost of the project,
including amounts associated
with the use of current Bixby employees to install the
equipment or otherwise get the project
started. The cost of current employees isn’t a new expenditure.
The costs of current employ-
ees are included on the form to indicate the opportunity cost of
other activities that those
employees could be pursuing were it not for the new project.

To satisfy good control procedures, healthcare organizations
may have purchasing depart-
ments that coordinate all purchasing activities and obtain price
quotes for all purchases above
a stated threshold. For small organizations, multiple quotes may
be requested for comparison
purposes at a level of $1,000. For large organizations,
thresholds may be $5,000, $10,000, or
more. For the purchase of MRI equipment, it may be required
that several quotes for prices
be obtained for equipment within certain specifications
(magnetic power and other issues).
smi81240_10_c10_245-268.indd 250 3/10/14 2:27 PM
251
Development of estimates of cash flows on the revenue side
involves coordination with mar-
keting and planning personnel. Finance personnel can be
expected to have good insights on
the expenses associated with new equipment and programs.
They can’t always be expected
to have expertise in forecasting the volumes of services
associated with new equipment and
programs. This is the area of expertise of personnel in
marketing and planning.
The riskiness of the cash flows can be incorporated into
analyses in two ways. First, orga-
nizations may prepare alternative forecasts of cash flows to

understand the sensitivity of
alternative assumptions about the functioning of a project on its
cash flows. Second, the dis-
count rate used to evaluate future cash flows may be adjusted to
account for the riskiness of
a project. These methods are discussed further in this chapter.
Step 3: Decide
The third step in the capital investment process is the decision.
Organizations often have dif-
ferent criteria for decision making with new projects, as
opposed to replacement projects. If
the useful and technologically appropriate life span for an MRI
is 10 years (perhaps with a
life span of seven years in depreciation for financial
accounting), an organization nearing the
10-year point may examine the costs of new equipment. If new
equipment will merely replace
existing equipment, there may be little uncertainty about other
cash flows, and the decision
may be made without much additional information.
For new projects, justification for the project must be included.
The ideal justification includes
consideration of how the project enables the healthcare
organization to fulfill its aims and
technical information on the proposed expenditure. Among the
goals of a healthcare organi-
zation are those related to patient care, which would be
justification for new medical equip-
ment or clinical program expenditures. Enabling new or better
ways to treat patients is often
a good justification for medical projects.
Productivity improvement and purely financial reasons are also
reasonable justifications for

new projects. Information system upgrades that permit faster
data entry or retrieval, which
can reduce the time spent by clinical personnel, may be good
projects to improve productiv-
ity. Accounts receivable system upgrades that accelerate
payments may be justified purely on
the basis of positive net cash flows.
Healthcare organizations may also have criteria for project
approval beyond improving
patient care, productivity, and financial results. Other
justifications for project acceptance
may include improving patient satisfaction, improving provider
satisfaction, and providers’
financial results, independent from the finances of the
organization, and improving commu-
nity goodwill. A key aspect of good financial management is to
be clear about the criteria for
project approval. Projects that are proposed on the basis of
financial results, that are actually
accepted to keep one particular provider satisfied, may result in
many wasted hours of analy-
sis during the monitoring phase as they fail to provide expected
financial results.
The final part of the decision-making step is the decision.
Capital investment decisions are
sometimes clearly yes or no, but they more often involve the
use of a scoring system. Based
upon an organization’s mission and strategy, the elements of a
scoring system might include
categories that represent the highest priorities: ensure
patient/employee health and safety,
smi81240_10_c10_245-268.indd 251 3/10/14 2:27 PM

252
improve quality (clinical outcomes, patient satisfaction),
improve productivity, increase vol-
ume and market share, and ensure financial health (Lyons,
Gumbus, & Bellhouse, 2003). Proj-
ects may be ranked by a scoring system and funded starting at
the top of the list and going
down until available funds are exhausted.
If a project is approved, project timing, the dollar amount of the
approval, and the specifica-
tion of any additional constraints on the use of funds are
included in the communication of
the decision. If a project is denied, good management practice
dictates that a brief reason be
provided. In some cases, there may be financial constraints that
led to a denial for the current
capital budget and permit the project to be reconsidered for a
future capital budget. The score
for a project may have been good, but there were other projects
with higher scores. In other
cases, the project may not be viewed as a good fit with the
organization’s strategy, or it may
be determined that it does not provide an adequate financial
return on investment. The score
for a project may be sufficiently low and would never be
funded. In these cases, the project is
simply denied.
Providing honest reasons for project denial may require tact.
Suppose that a project for the

renovation of a waiting area is proposed with the justification of
improving satisfaction with
a particular clinician. A denial of the project does not
necessarily mean that the organization
is not interested in the satisfaction of the provider. It may be
that provider satisfaction is very
important and that in the current year purchases of replacement
medical equipment were a
higher priority. Nobody likes to hear that something, or
someone else, is a higher priority, so
tact is important.
Analyze This
How would you explain to an important physician that a project
to renovate the waiting room
outside of her clinic was denied? What information would you
share with the physician?
Step 4: Monitor
The decision is the end of the third step, and the start of the
fourth step in the capital invest-
ment process. Before budgetary approval, approval by other
aspects of management and
perhaps outside parties may also be required. Department
administrators, who may be held
accountable for the achievement of project goals, must approve
projects. Individual program
managers may be permitted to propose projects, but not without
the approval of the lead
administrator. Once approved, monitoring and control of the
budget falls under the control
of the administrator. Similarly, a host of other managers may be
required before approval.
For example, if a project requires specialized supplies, the
office of procurement or a supply
chain committee may be asked if the plan for supplies can be

provided as stated in the plan
and whether the plan has any implications for current use of
supplies.
For projects that involve large purchases or construction that
fall under the authority of state-
level certificate of need programs, there may be a series of
official approvals that are also
required. Certificate of need programs still operate in many
states as a means to limit con-
struction and purchases of equipment as a means of controlling
the growth in healthcare
costs (Cauchi, 2009).
smi81240_10_c10_245-268.indd 252 3/10/14 2:27 PM
253
Postapproval reviews are a component of the capital budgeting
process in many organiza-
tions and may be used as additional opportunities for decision
making on the continuation
of projects. They may also be used as analyses of the capital
budgeting process itself. Based
upon postapproval reviews, organizations may learn more about
what should be included
on the capital budget request form, so the right questions are
asked early in the process.
Organizations may also learn how to improve on cash flow
estimation techniques. Too often,
projects are approved with no follow-up to determine whether
the capital budget process is

working properly and leading toward a more effective
The finance contributions to the second and third steps are
expanded upon in later sections.
Estimating cash flows is perhaps the most important role for
financial managers, and the
most difficult. Decision making typically involves an
assessment of financial results, even if
they are not the primary justification for a project. Before these
finance contributions are
explained, an explanation of long-run strategy is presented.
Long-Run Strategy
The strategy of a healthcare organization is the plan by which it
intends to achieve its aims.
The term plan does not refer to the operating budget or the
capital budget. A strategy, or a
strategic plan, refers to the patterns of decisions that the
organization will make over time.
The key to effective long-run strategy is that the pattern of
decisions will be consistent and
position an organization to be unique in the marketplace.
Effective long-run strategies often
involve not following what all other organizations are doing but
doing something unique.
Among the decisions to be made in the development of an
organization’s strategy are the
strategic positions to be taken. At least three strategic positions
are available, each with
unique implications for capital budgeting: need-based, variety-
based, and access-based
(Porter, 1996). Briefly, needs-based positioning involves
addressing the specific needs of a
target population. To some extent, most healthcare

organizations adopt needs-based posi-
tioning by focusing on those persons in a population in ill
health. Needs-based positioning
will lead toward decision making based upon having a range of
medical services and address-
ing community needs that go beyond narrowly defined medical
needs to consider the health
status of the community.
As with each strategic position, needs-based positioning
involves making trade-offs among
projects. Needs-based positioning is a challenge for any
organization, as there are limits on
the extent to which the complete set of needs of any population
can be met, even the complete
set of medical care needs. For a healthcare organization
following a needs-based position-
ing strategy, some projects that would provide a higher level of
medical service for a narrow
population may be denied in favor of a project that addresses a
broader population. It can be
difficult to make decisions among clinical areas on the basis of
which is more appealing to a
broader population, as it is not often clear which clinical area is
more appealing, as appeal may
well go beyond frequency of occurrence. One provision of the
Patient Protection and Afford-
able Care Act is that every not-for-profit must conduct a
community health needs assessment
and create a plan to meet these identified health needs. This
assessment can solicit informa-
tion on community interests and need, beyond traditional
medical needs.
Variety-based positioning involves providing specific and
unique services, with a focus on

the quality and effectiveness of the service. By definition,
healthcare organizations adopt
variety-based positioning by providing medical services. The
particular health conditions
smi81240_10_c10_245-268.indd 253 3/10/14 2:27 PM
254
Section 10.3Cash Flow Estimation
being addressed are the differentiating features of different
types of healthcare organizations.
Many organizations, or units within organizations, target a set
of services. Variety-based posi-
tioning may lead toward decision making based upon having a
narrow set of medical services
provided in an outstanding manner.
Access-based positioning places the focus of attention on
access, which can be broadly
defined in healthcare to include affordability, availability,
accessibility, accommodation, and
acceptability (Wyszewianski & McLaughlin, 2002).
Affordability is affected both by charges
and insurance coverage. Availability is affected by the presence
of providers and resources
to meet patients’ needs. Accessibility is the geographic reach of
the organization. Accom-
modation is affected by how patients’ constraints are met,
particularly those related to time
of service and waiting times. Acceptability reflects the
interpersonal relationships between
employees of the organization and patients. Access-based

positioning may be associated with
efforts to develop exclusive contracts with managed care
organizations and efforts to main-
tain broadly based facilities. Advertisements concerning
emergency department wait times
are a reflection of access-based positioning. Even within aspects
of access, healthcare organi-
zations are faced with trade-offs for capital budgeting.
Again, strategy involves patterns of decisions that are
consistent and position an organization
to be unique in the marketplace. Some trade-offs among
positions are necessary and a key
component of strategy. Should the organization focus on the
broad interests of the commu-
nity and health status, on the focused set of services it is
capable of offering, or on the acces-
sibility of those services? The ideal answer might be all of the
above. The feasible answer is
that choices must be made, and it is those choices that reveal
strategy. From a purely financial
framework, organizations should make choices on the basis of
the highest sustainable level
of profitability. It is not obvious how choices should be made
for not-for-profit healthcare
organizations that use other decision-making frameworks. What
is often important is that
independent of selected sets of positions, operational efficiency
results from maintaining a
focus on those positions.
For Review:
1. What are the four steps in the capital investment decision-
making process? Which
step is most important?

The capital investment decision-making process includes
identifying possible invest-
ments, estimating cash flows, deciding on which to fund, and
monitoring results.
These steps should start with and tie back to the organization’s
strategy. All steps
are important.
10.3 Cash Flow Estimation
Cash flow estimation is the tough work of finance and
operations personnel in capital invest-
ing. The definition of a project and careful assessment of the
purchase price and implementa-
tion cost enable a clear understanding of the cash outflows
required to start a project. Further,
requiring a statement on the disposition of current equipment,
through trade-in, disassembly
to sell parts, or full outright sale, may reduce the cash outflow
or generate cash inflow at the
start of a project. Still, Time 0 costs are often a small portion of
the entire series of cash flows
associated with projects.
smi81240_10_c10_245-268.indd 254 3/10/14 2:27 PM
255
Consider a clinic’s proposed project that will cost $300,000 on
renovations to an examination
room that will allow more patients to be seen. The next step in
cash flow estimation is to con-
sider the length of the timeline, which may be specified as part

of the proposal. Suppose that
the timeline is four years. The first timeline shows that
$300,000 may need to be spent right
now, at Time 0.
The next step in cash flow estimation is the net cash flow that
will occur each year during the
lifetime of the examination room project. Part of this estimation
may be enabled by informa-
tion in the request form. Annual expenses associated with
routine maintenance, or a mainte-
nance contract, and disposable components may be prespecified.
The part of this estimation
that requires the most work is the estimation of the volume of
services, the price per unit of
service, and the cost per unit of service, remembering that there
may be both fixed and vari-
able costs.
Perhaps the most challenging aspect of cash flow estimation is
the volume of patients. For
the clinic, marketing and planning personnel may be asked to
conduct an extensive analysis
of patients in the community and the regional trends in use of
services. It was estimated
that an average of 30 patient visits per day would be treated in
the new examination room,
which is 10,950 patient visits per year (30 3 365). The planned
charge for clinic services to
be provided in the new examination room was estimated to be
$100. Discussions with local
insurance companies and managed care organizations revealed
that they would only be will-
ing and able to pay a bit more than 25% of this amount, for an
average revenue of $76 per
patient. Some portion of the amount approved by payers would

be charged to the patient as a
copayment, and all copayments would be collected at the point
of service.
Time 0
($300,000)
Time 1 Time 2 Time 3 Time 4
Analyze This
Of the $76 per patient, a copayment of $20 may be expected. If
only 80% of patients pay their
copayment, what is the expected revenue per patient? How
would you increase the percentage of
patients who pay their copayment?
Revenues and costs for the examination room project can be
displayed on the timeline as
follows:
Element
($300,000)
($300,000)
$832,200
($250,000)
($438,000)
$144,200
$832,200

($250,000)
($438,000)
$144,200
$832,200
($250,000)
($438,000)
$144,200
$832,200
($250,000)
($438,000)
$144,200
Revenue
Fixed Cost
Variable
Cost
Operating
Income
Time 0 Time 1 Time 2 Time 4Time 3
smi81240_10_c10_245-268.indd 255 3/10/14 2:27 PM

256
The first row is the revenue per year. For 10,950 patients at $76
per patient visit, total net
patient revenue is $832,200 per year. This is a simplification of
what a full set of revenues
might be for the new examination room. The number of patient
visits may increase or
decrease, and the revenue per patient is subject to change by
governmental payers and nego-
tiation by insurance companies and managed care organizations.
The second and third rows are the cost of the new examination
room. Costs for operating the
room are estimated to be $250,000 per year in fixed costs
associated with the clinic manager
and other services, and variables costs that average $40 per
patient for all other personnel
and supplies (10,950 patients 3 $40 per patient 5 $438,000).
Costs of salaries and supplies
may also change over time.
The third row is the operating income for each year the new
examination room is used. At
time 0 there is only the initial investment of $300,000. In each
year there is an operating
income of $144,200.
Operating income 5 $832,200 revenues 2 $250,000 fixed costs 2
$438,000 variable costs

5 $144,200
From Chapter 3, the operating margin ratio considers operating
income as a percentage of net
patient revenues:
Operating margin 5
$144,200
$832,200
3 100%
5 17.3%
Each of the values in this presentation can be considered in
analyses that consider alternative
assumptions. For example, the clinic may consider best-case or
worst-case alternatives to the
volume, revenues, and cost assumptions of the new examination
room. Such an analysis may
provide more insight to decision makers on the value of this
project. Still, the initial set of
volume, revenue, and cost projections might be a reasonable
starting set of values for a finan-
cial analysis. The next step is to determine the type of analysis
that will be conducted and the
decision rules for the analysis.
Analyze This
As a worst-case possibility, volume may be only 10,000 patient
visits per year in the new exami-
nation room. If the revenue per patient, fixed cost, and cost per
patient visit projections were
accepted, what would be the total revenues, total costs, and
operating income for the clinic’s
examination room project?

For Review:
1. Who should be involved with the estimation of cash flows?
Finance personnel should be involved with the estimation of
cash flows, particu-
larly the estimation of expenses and revenue per patient.
Marketing, planning, and
clinical personnel should be involved with the estimation of the
number of patients,
which directly relates to both revenues and expenses.
smi81240_10_c10_245-268.indd 256 3/10/14 2:27 PM
257
Section 10.4Decision Rules for Capital Investments
10.4 Decision Rules for Capital Investments
As you have seen, the third step in capital investing is decision
making. After determining
which projects to evaluate and preparing estimates of cash
flows, a decision must be made.
Has a proposal for a capital investment presented a case that
merits approval, or will the
proposal be denied? Making capital expenditure decisions
requires the selection and applica-
tion of a decision rule. Decision rules are criteria for capital
project investments that should
be fair and transparent, leading to a consistent selection of
projects that support the growth
and viability of the organization. The unique contribution of
finance is the assessment of the
financial results of a project.

As introduced in Chapter 8, when the cash amounts are different
among time periods, it is
necessary to separate them and calculate the values for each
one. In the case of capital invest-
ments, there may be negative cash flows associated with the
initial investments. The timeline
and cash amounts each year for the examination room project
are presented on the spread-
sheet in Exhibit 10.2. The investment of $300,000 is in Time 0.
The simple sum of the net
income amounts in time periods 0 through 4 is $276,800. This
simple sum of the net income
amounts in this does not recognize of the time value of money.
Exhibit 10.2 Spreadsheet calculation of cash flows, clinic
examination
room project
A B C D E F
1
2
3 Time
Capital
Investment
Net Patient
Revenues Fixed Costs Variable Costs Net Income
4 0 ($300,000) ($300,000)
5 1 $832,200 ($250,000) ($438,000) $144,200
6 2 $832,200 ($250,000) ($438,000) $144,200
7 3 $832,200 ($250,000) ($438,000) $144,200
8 4 $832,200 ($250,000) ($438,000) $144,200
9 Total ($300,000) $3,328,800 ($1,000,000) ($1,752,000)

$276,800
10
11
To recognize the time value of money, the present value of each
year’s cash flows can be cal-
culated. The inclusion of the cash flow initial investments (C0)
along with the present value of
the net cash flows each year (Ct ) yields the net present value
(NPV) of a project. This is quite
commonly the case, and the equation is written as
NPV 5 a
T
t 5 1
(Ct 4 (1 1 r)t ) 2 C0
where the summation function ( ∑) is taken from the first time
period (1) until the last time
period (T ). For each cash amount, the discounting recognizes
the number of time periods
involved (t). From Chapter 9, the appropriate rate (r) at which
to discount the net cash flows
smi81240_10_c10_245-268.indd 257 3/10/14 2:27 PM
258
Section 10.4Decision Rules for Capital Investments
of each period is the weighted average cost of capital (WACC).
The process of discounting cash

flows recognizes the time value of money and the organization’s
opportunity cost of the use
of funds for investment in projects.
The NPV decision rule is to select projects based upon NPV,
with a requirement that NPV be
greater than or equal to zero. A project that achieves NPV 5 0
provides a rate of return on the
investment of r, the WACC. By using the rule of NPV $ 0, the
organization assures that accept-
ing projects with accurately estimated cash flows contributes
toward financial viability.
The discount rate for the examination room project and the NPV
calculation are presented on
the spreadsheet in Exhibit 10.3. With a WACC for this clinic of
14% (using the methods devel-
oped in Chapter 9), the NPV of the clinic project is $120,157.
This amount reflects the NPV of
net income in years 1–4, less the capital investment. Again,
using the NPV rule to accept proj-
ects with NPV $ 0, the clinic should accept the project and
move forward to allocate $300,000
for renovation of the space and purchase of the equipment,
pending the approval of an overall
budget for capital expenditures and the analysis of all other
proposed projects.
Exhibit 10.3 Spreadsheet calculation of net present value, clinic
examination
room project
A B C D E F
1 Rate 14%
2

3 Time
Capital
Investment Net Patient Revenues Fixed Costs
Variable
Costs Net Income
4 0 ($300,000) ($300,000)
5 1 $832,200 ($250,000) ($438,000) $144,200
6 2 $832,200 ($250,000) ($438,000) $144,200
7 3 $832,200 ($250,000) ($438,000) $144,200
8 4 $832,200 ($250,000) ($438,000) $144,200
9 Total ($300,000) $3,328,800 ($1,000,000) ($1,752,000)
$276,800
10
11 NPV $120,157 5NPV(B1,F5:F8) + F4
The NPV decision rule is useful for making decisions about
individual projects, as well as for
making decisions among projects when they are mutually
exclusive or when there are limits
on the total capital budget for the year. Consider the alternative
uses of the space that may be
considered for the clinic. One use is to increase the size of the
waiting room for a neighboring
service, thereby increasing the number of patients that can be
seen by that service. The wait-
ing room project has an initial investment cost of only
$135,000. Having additional waiting
room space, assuming that there is also sufficient clinical
capacity, will permit 10 additional
patient visits per day (10 visits per day 3 365 days 5 3,650
visits per year) with average net
revenue of $75 per visit and average variable cost of $55 per
visit, with no change in fixed

costs. The NPV calculation for the waiting room project is
smi81240_10_c10_245-268.indd 258 3/10/14 2:27 PM
259
Section 10.5Decision Rules Beyond Net Present Value
Exhibit 10.4 Spreadsheet calculation of net present value,
waiting room project
A B C D E F
1 Rate 14%
2
3 Time
Capital
Investment Net Patient Revenues Variable Costs Fixed Costs
Net Income
4 0 ($135,000) ($135,000)
5 1 $273,750 ($200,750) ($0) $73,000
6 2 $273,750 ($200,750) ($0) $73,000
7 3 $273,750 ($200,750) ($0) $73,000
8 4 $273,750 ($200,750) ($0) $73,000
9 Total ($135,000) $1,095,000 ($803,000) ($0) $157,000
10
11 NPV $77,701 5NPV(B1,F5:F8) + F4
The NPV decision rule indicated accepting the projects with the
highest NPV among projects
with NPV $ 0. The clinic would like to accept both the clinic

project and the waiting room
project, as they each provide net present values in excess of
zero, in fact in excess of $75,000.
With the limitation that the space can only be used for one of
these two projects (mutually
exclusive), the NPV of the examination room project is $42,456
more than the waiting room
project ($120,157 2 $77,701).
For Review:
1. If the net present value of a project is less than half of the
sum of the cash flows from
the project, does this mean that the project is not worthwhile?
The net present value calculations use the present value
function for the cash flows
that occur each year. The net present value of a project will be
lower than the sum
of cash flows whenever the discount rate is greater than zero.
The fact that the sum
of cash flows might be less than half of the net present value is
not important. In the
example of the examination room, the sum of the cash flows
was $276,800, and the
net present value was $120,157, and yet this is a worthwhile
project.
10.5 Decision Rules Beyond Net Present Value
The net present value rule of accepting projects with NPV $ 0
produces consistent results
of accepting projects that sustain or improve the financial
results of the organization. It is
always recommended that NPV calculations be performed and
the results assessed. Three
additional financial decision rules are also often used:
accounting rate of return (ARR),

internal rate of return (IRR), and payback period. These rules
do not improve upon the
NPV rule. Instead, other possible returns provide more
information that may be helpful to
decision makers.
smi81240_10_c10_245-268.indd 259 3/10/14 2:27 PM
260
Accounting Rate of Return
The accounting return, quite simply, is the nominal net of cash
inflows and cash flows. It is
equal to an NPV analysis where the discount rate is zero. It
should be clear that by not taking
into account the time value of money, the accounting return
overstates the values of the cash
flows from projects. Still, the numbers produced by an
organization’s accounting system are
clear and defensible. Using the accounting return, the
accounting rate of return (ARR) is the
average accounting net income per year, divided by the capital
investment, as written in the
ARR equation:
ARR 5 a
T
t 5 1
(Net incomet 4 T ) 4 Investment0
The calculations of the accounting return and ARR for the

examination room project are
presented in Exhibit 10.5. With an accounting return of
$276,800, the sleep center project
has an ARR of 37.7%. In this presentation, the capital
investment is not included as a cash
flow in Time 0. To be consistent with accounting calculations of
net income, the depreciation
expense associated with the capital investment is included for
each year. The depreciation
expense is calculated using the straight-line method of
depreciation, over the four-year use-
ful life of the assets.
Exhibit 10.5 Spreadsheet calculation of the accounting rate of
return, examina-
tion room project
A B C D E F
1
Capital
Investment $300,000
2
3 Time
Net Patient
Revenues Fixed Costs Variable Costs
Depreciation
Expense Net Income
4 1 $832,200 ($250,000) ($438,000) ($75,000) $69,200
5 2 $832,200 ($250,000) ($438,000) ($75,000) $69,200
6 3 $832,200 ($250,000) ($438,000) ($75,000) $69,200
7 4 $832,200 ($250,000) ($438,000) ($75,000) $69,200

8 Total $3,328,800 ($1,000,000) ($1,752,000) ($300,000)
$276,800
9
10 ARR 23.1% 5(F8/A7)/C1
The decision rule for ARR is to select projects that have a
calculated ARR greater than or
equal to the organization’s required ARR (ARRR ), where the
subscript R refers to a particular
organization’s required return. What is the ARRR for this
clinic? The second limitation on
the use of the ARR decision rule, after the failure to account for
the time value of money, is
the lack of an accepted method of determining an organization’s
required ARR. There is no
generally accepted method for determination of ARRR; it would
have to be a decision made
by the board of directors.
smi81240_10_c10_245-268.indd 260 3/10/14 2:27 PM
261
A third limitation of the ARR decision rule is the use of
accounting data. Accounting data fol-
low accrual methods that may result in different values than the
cash method. To the extent
that accrual differs from cash flows, which is potentially the
case depending on the timing of
investments, other costs, and receipts of payments for services,
the results of ARR will differ

from those using NPV methods.
A fourth limitation associated with ARR is that it does not
provide useful results when select-
ing among mutually exclusive projects of different sizes.
Consider again the waiting room
project. As presented in Exhibit 10.6, the waiting room project
has an ARR of 29.1%, which
is larger than the 23.1% ARR on the examination room project.
If the 23.1% return on the
examination room is thought to exceed ARRR, the clinic would
prefer to approve both projects.
Since there is only enough space for one project, one decision
rule must be selected. Again,
the NPV of the examination room project is $42,456 more than
the waiting room project. Irre-
spective of the ARR calculations, the examination room results
in more money that the clinic
can devote to other purposes.
Exhibit 10.6 Spreadsheet calculation of the accounting return
and accounting
rate of return, waiting room project
A B C D E F
1
Capital
Investment $135,000
2
3 Time
Net Patient
Revenues Variable Costs Fixed Costs

Depreciation
Expense Net Income
5 1 $273,750 ($200,750) ($0) ($33,750) $39,250
6 2 $273,750 ($200,750) ($0) ($33,750) $39,250
7 3 $273,750 ($200,750) ($0) ($33,750) $39,250
8 4 $273,750 ($200,750) ($0) ($33,750) $39,250
9 Total $1,095,000 ($803,000) ($0) ($135,000) $157,000
10
11 ARR 29.1% 5(F9/A8)/C1
Limitations notwithstanding, the accounting returns and ARR
are commonly used measures
when describing projects. Postproject reviews may rely upon
accounting information and are
therefore informed by the financial expectations at the time of
approval. Further, communi-
cating an ARR can help persons unfamiliar with corporate
finance. Earning net present value
of $120,157 sounds good, but out of context it may be difficult
to interpret how good this is
for an investment. When stated as a 23.1% accounting rate of
return, it may have an intuitive
appeal beyond the dollar amount.
Internal Rate of Return
The internal rate of return is another return measure that could
be used as a decision rule.
The IRR is the discount rate (r) that results in a NPV of zero.
Using the NPV equation, it is pos-
sible through a process of trial and error to find the value of r
that yields NPV 5 0. Due to the
smi81240_10_c10_245-268.indd 261 3/10/14 2:27 PM

262
potentially tedious nature of trial-and-error calculations,
specialized financial calculators and
electronic spreadsheets include preprogrammed functions to
calculate the IRR. Calculation of
the IRR for the examination room project is presented in
Exhibit 10.7.
Exhibit 10.7 Spreadsheet calculation of internal rate of return,
examination
room project
A B C D E F
1 Rate 14%
2
3 Time
Capital
Investment
Net Patient
Revenues Fixed Costs Variable Costs Net Income
4 0 ($300,000) ($300,000)
5 1 $832,200 ($250,000) ($438,000) $144,200
6 2 $832,200 ($250,000) ($438,000) $144,200
7 3 $832,200 ($250,000) ($438,000) $144,200
8 4 $832,200 ($250,000) ($438,000) $144,200
9 Total ($300,000) $3,328,800 ($1,000,000) ($1,752,000)
$276,800
10

11 IRR 40.0% 5IRR(F4:F8)
The IRR calculated for the sleep lab is 40.0%. Note that this
value is greater than both the ARR
(23.1%) and the discount rate (14%). The IRR is greater than
the ARR because that determi-
nation of accounting income includes depreciation of the
investment as an expense, lowering
net income. The IRR calculation does not include depreciation
expenses. The IRR takes into
consideration the time value of money and, therefore, is a lower
percentage than would have
been calculated by the ARR if depreciation expenses were not
included.
Analyze This
What is the IRR of the waiting room project, using the values
provided in Exhibit 10.6? What is
the relationship between the ARR and IRR for the waiting room
project?
It is important that all investments in
our system have a strong internal rate of
return and net present value with discount
rates of 12215%. We aren’t in a place
where we can afford to “swing and miss.”
Source: Health system financial manager.
The decision rule for IRR is to select projects that have
a calculated IRR greater than or equal to the organiza-
tion’s required IRR (IRRR ), where the subscript R refers
to an organization’s required return. What is the IRRR
for Bixby Hospital? A limitation on the use of the IRR
decision rule, as with the ARR, is the lack of an accepted

method of determining an organization’s required IRR.
If IRRR is the discount rate, as determined by the WACC,
then it is not necessary to solve the NPV equation for r.
The NPV of the project can be calculated directly. The
smi81240_10_c10_245-268.indd 262 3/10/14 2:27 PM
263
other limitation associated with IRR is that it does not provide
useful results when selecting
among mutually exclusive projects of different sizes, just the
same as the ARR.
Since the IRR results in a decision rule that is closer to NPV
than the ARR decision rule, it
is also a commonly used measure when describing projects.
Earning net present value of
$120,157 sounds good, but out of context it may be difficult to
interpret how good this is for
an investment. When stated as a 40.0% internal rate of return, it
may have an intuitive appeal
beyond the dollar amount.
Payback Period
Another alternative decision rule for capital expenditure
analysis is the payback period (Pay-
back). The Payback is that length of time until the net income
earned on a project exceeds the
initial investment. Calculation of Payback requires preparation
of the same cash flows as net
present value and internal rate of return. The calculation of net

income for the examination
room is presented in Exhibit 10.8, along with the calculations of
the cumulative amount of net
income each year. The examination room earns back the initial
investment before the end of
year 2.
Exhibit 10.8 Spreadsheet calculation of payback period and
discounted
payback period, examination room project
A B C D E
1 Rate 14%
2
3 Time Net Income
Cumulative Net
Income
Present Value of
Net Income
Cumulative Net
Income
4 0 ($300,000) ($300,000)
5 1 $144,200 ($155,800) $126,491 ($173,509)
6 2 $144,200 ($11,600) $110,957 ($62,552)
7 3 $144,200 $132,600 $97,331 $34,779
8 4 $144,200 $276,800 $85,378 $120,157
9 Total $276,800 $120,157
10 Payback Time 2 Time 3
The cumulative net income is the net income as of each time
period. In Time 1 cumulative

net income is the net income in Time 1, plus the initial
investment ($144,200 1 ($300,000)
5 ($155,800)). At the end of the first year, the examination
room project has almost paid
back half of the initial investment cost. In Time 2 cumulative
net income is the net income in
Time 2, less the amount that has just been calculated as the
cumulative net income in Time 1
($144,200 1 ($155,800) 5 ($11,600)). At the end of Time 2, the
examination room has
almost paid back the entire initial investment cost. By the end
of Time 3, the project is ahead
by $132,600, and by the end of Time 4, the project has earned
$276,800.
The cumulative net income associated with the present value
amounts followed the same
logic of calculations, with the difference that each year’s net
income is discounted back to
Time 0 using the clinic’s discount rate.
smi81240_10_c10_245-268.indd 263 3/10/14 2:27 PM
264
Summary & Resources
The decision rule for Payback is to select projects that have a
calculated Payback less than or
equal to the organization’s required Payback (PaybackR ),
where the subscript R refers to an
organization’s required return. What is the PaybackR for the
clinic? A limitation on the use of
the Payback decision rule, as with the IRR and ARR, is the lack

of an accepted method of deter-
mining an organization’s required Payback. Wanting projects to
earn back their investments
sooner is a good idea, but it does not result in a clear decision
rule. The other limitation asso-
ciated with Payback is that it does not provide useful results
when selecting among mutually
exclusive projects of different sizes, just the same as the IRR
and ARR.
Analyze This
What is the Payback of the waiting room project, using the
values provided in Exhibit 10.6?
A limitation of Payback that is easily overcome is the failure to
account for the time value
of money. As demonstrated in Exhibit 10.8, the present value of
net income each year can
be substituted for the nominal value. Calculation of the adjusted
payback period follows the
same methods of finding that time period when the cumulative
amount of net income earns
back the initial investment. In the case of the sleep lab for
Bixby Hospital, the adjusted pay-
back period is also before the end of year 3.
Since Payback provides interesting information, it is a
commonly used measure when describ-
ing projects. Again, earning net present value of $120,157
sounds good, but out of context it
may be difficult to interpret how good this is for an investment.
When stated that the project
pays back in the investment in fewer than three years, it may
have an intuitive appeal beyond
the dollar amount.

For Review:
1. Which of the decision rules, net present value, ARR, IRR or
Payback makes the most
sense to you?
Different people will provide different answers to this question.
The NPV calculation
provides a specific dollar amount of value, which may make
sense to many people.
The percentage rates of ARR and IRR will make sense to people
who think about
how investments are often presented. The payback period will
make sense to people
who are concerned about when the investment return will occur.
Summary & Resources
Chapter Summary
This chapter has introduced the concepts and tools required for
effective capital budgeting.
Capital budgeting is the process by which organizations
propose, analyze, and select invest-
ments in long-term assets and programs. Some decisions on the
total level of long-term assets
that can be purchased within a year are made at the highest
levels within the organization.
Due to external constraints imposed by lenders or capital
markets, or internal constraints
imposed by senior managers or the board of directors, many
organizations establish capital
budgets that represent the total amount that an organization
could spend, if there are a suf-
ficient number of worthwhile projects.
smi81240_10_c10_245-268.indd 264 3/10/14 2:27 PM

265
Summary & Resources
Making good capital expenditure decisions is critical to every
organization. Capital expendi-
ture decisions affect the facility and equipment with which to
provide healthcare services,
and they affect the development of new programs. These
decisions affect the capabilities of
the organization for years in the future. As important as it is to
have a strategic vision to
guide annual operating budgets, it is perhaps even more
important that capital budgets fol-
low the strategic plan of the organization. Without a strategic
plan, it is impossible to know
which items to include in the capital budget, other than routine
maintenance and equipment
replacement.
The analysis of individual capital investments requires a
process for how they are to be pre-
sented, analyzed, decided upon, and monitored. There is
substantial variation among health-
care organizations in terms of how they prepare and implement
capital budgeting processes.
Some organizations are formal and rigid in the capital budgeting
process; others are more flex-
ible. It is common in all healthcare organizations to include a
number of nonfinancial dimen-
sions to decision making. This chapter has focused on the
financial dimensions. Measures of
patient satisfaction, provider satisfaction, community goodwill,
and other dimensions enter

into capital budgeting and are beyond the scope of financial
management. Financial manage-
ment can provide the financial factors and then permit general
management to make and
implement final decisions.
Perhaps the most difficult aspect of capital budgeting, beyond
the creativity required to iden-
tify potential projects, is the estimation of cash flows. For plant
renovation and equipment
replacement projects, existing cash flows may be well known.
For new and innovative pro-
grams, cash flow projections may involve many assumptions
and well-researched guesses.
Tools and techniques for the analysis of cash flows are the key
contribution of corporate
finance. Applying tools to account for the time value of money
(from Chapter 8) at the appro-
priate rate (from Chapter 9) permits the calculation of the net
present value of a project.
To supplement analyses using net present value, financial
analysts can calculate accounting
rates of return, internal rates of return, and payback periods for
projects. Each analysis pre-
sents somewhat different information that can inform decision
makers about a project’s value
to the organization.
With good analysis on the contribution of potential projects,
capital budgets can be prepared,
disseminated, and used to monitor and evaluate the financial
aspects of projects, and the
capital budgeting process itself. Good financial analysis of
capital expenditures can be time-
consuming and helpful in assuring the financial viability of a

1. Healthcare organizations face numerous requests for capital
investments each year.
How should they decide which investments to undertake?
2. Which of the decision rules—net present value, ARR, IRR, or
payback—should be
included on a capital request form? Please explain your
reasoning.
3. If two mutually exclusive projects have nearly the same net
present value, and one is
for a cosmetic surgery center and the other is for a pediatric
cancer center, which one
should be adopted and why?
smi81240_10_c10_245-268.indd 265 3/10/14 2:27 PM
266
Summary & Resources
Exercises
1. An outpatient clinic has proposed a new pediatric service that
will require an initial
investment of $400,000. Marketing and planning has estimated
that 30 patients
per day could be seen for each of the 250 days the service
would be open each year.
Insurance companies would be willing to pay $150 for each

patient visit. Fixed
costs are estimated to be $100,000 per year, and variable costs
are estimated to be
$35 per patient visit. The service can operate for three years
before any additional
investments would be required. What are the cash flows for
three years of this
service?
a. What is the payback period for this service?
b. What is the internal rate of return for this service?
c. If the organization’s discount rate is 8%, should the service
be approved?
2. The Department of Dermatology has proposed a new laser
therapy that appears to
be gaining popularity. The cost of the renovation of current
space, along with the
cost of the new equipment, is $2,100,000. Department personnel
estimate that 1,000
patients per year will use the therapy. Since this is for cosmetic
purposes, it will not
be covered by insurance. Each patient will pay, on average,
$250 for the therapy.
The therapy will not affect fixed costs and will add only $25 in
variable costs per
patient. The department thinks that the equipment will last 10
years. The depart-
ment chairman has argued that with a cost of $2,100,000 and net
patient revenues
of $2,250,000 over 10 years, the project should be approved. If
the organization’s
discount rate is 6%, should the project be approved? Explain
your reasoning.
Key Terms
accounting rate of return (ARR) The rate

of return (percentage) derived from divid-
ing the average net income from a project
by the initial investment amount.
capital budgeting The practice of identi-
fying long-term investment opportunities,
estimating cash flows, making decisions
about which to adopt, and monitoring
results.
certificate of need Regulatory structures
in many states that require justification and
approval for new healthcare facilities or
purchases of equipment.
decision rule A criteria for capital invest-
ment project acceptance or rejection. Deci-
sion rules should be fair and transparent,
leading to a consistent selection of projects
that support the growth and viability of the
organization.
internal rate of return (IRR) The rate
of return (percentage) that equates the
investment in a project with the net cash
flows. The internal rate of return is found by
solving the net present value equation for
the rate.
mutually exclusive projects Projects that
involve selection of one proposed project
or another, or neither, not both. Otherwise,
projects are independent, and decisions
concerning the project do not affect deci-
sions on others.

payback period The number of time
periods (years) until the net cash flows
from a project equal or exceed the initial
investment.
smi81240_10_c10_245-268.indd 266 3/10/14 2:27 PM
267
Summary & Resources
Suggested Websites
• For information on healthcare spending, see Medicare and
Medicaid Statistical
Supplement: http://www.cms.gov/Research-Statistics-Data-and-
Systems/Statistics
-Trends-and-Reports/MedicareMedicaidStatSupp/index.html
• For information on state certificate of need requirements, see
the National Conference
of State Legislatures: http://www.ncsl.org/research/health/con-
certificate-of-need
-state-laws.aspx
smi81240_10_c10_245-268.indd 267 3/10/14 2:27 PM
http://www.ncsl.org/research/health/con-certificate-of-need-

state-laws.aspx
http://www.ncsl.org/research/health/con-certificate-of-need-
state-laws.aspx
smi81240_10_c10_245-268.indd 268 3/10/14 2:27 PM
Planning for the future for a company is big, and many
precautions have to be taken to make sure that the investment or
the capital investment is not a total failure. Budgeting can vary
from organization to organization. Some might have a very
strict process, which can only go only one way. Some other
organizations can have a loose process. Each process has to be
geared towards the organization that’s making this investment.
When opening a new department or even extending it , the
number of procedures that will be estimated as well as the
number of patients that will be coming through the door. The
two main budgeting titles would be operating budget and capital
budget. Operating budget has to deal with expenses and
revenue; this budget process takes about four months. The
capital budget deals with the balance sheet, and looks more
closely on with purchased items with borrowed money.
A look below gives us a closer look in the process
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 (Smith, 2014)
My first argument I would use is volume forecast for my
presentation, this is beginning for any budgeting and planning.
Patients are the reason to keep any medical facility a float.
Without an audience of different patients for different
departments then expanding or moving forward with a capital
investment would be pointless. Managers can use data from
previous years and use the growth from keeping up with the
patient flow, evaluating the competitors around the area, as well
as keeping up with clinical and medial advances.
My second argument I would use is the future value. The
future value uses two key factors in my opinion when it comes
to making an investment. The first factor is the money that will
be used to invest, the company can already have that money
ready to go, or the company will have to borrow the money like
getting a loan. The second factor of course is interest, how
much will the company will earn on the investment, or how
much interest the company will have to pay whether it’s a long
term loan or short term loan.
Lastly I would talk about the risk and returns, which is the main
concern for any organization. Obviously you can not account for
all expenses that might come up, but as long as we can cover
our debts in a timely manner and the patient inflow is rising like
it is every month we should be more than fine. The risk we are

taking should nothing compared to the reward, which is a brand
new rooms with state of the art equipment as well as new
doctors that can bring their patients they originally was working
with.
References

Smith, D.G. (2014). Introduction to Healthcare Financial
Management; San Diego, CA; Bridgepoint Education, Inc.
As a department manager, I feel as if our radiology department
is growing and moving faster than ever. In the coming topics we
will discuss our need for more X-ray equipment as well as MRI
machines, CT, and ultrasound.
Executive Summary
In the last couple of years our patient flow has doubled, our
overall reception form the community has been more than
overwhelming. Our staff is growing as well as our department.
As many of our workers are working overtime because of the
patient flow, as the department manager I would like to expand
the radiology department. Expanding our department with one
more MRI machines and also two new X-ray machines with a
brand new CT scanner and new Ultrasound machines as well..
Many hospitals with aging diagnostic imaging equipment
acknowledge that they cannot remain competitive if they
continue to postpone investment in newer technologies.
The Radiology Administrator's Perspective, provides specific
insights about hospital radiology departments' near-term plans
for capital investment in new and replacement imaging
modalities and related capital purchases such as picture archive
and communication systems. The study found that radiology
departments in hospitals in the 100-199-bed range, which
budgeted an average of $1.061 million per site in capital
spending for 2008, have budgeted an average of $1.401 million
per site for 2009, or an increase of more than 32%. Radiology
departments in hospitals with fewer than 100 beds, which

budgeted an average of $538,200 per site for 2008, are planning
capital investments averaging $793,400 per site in 2009. MR
imaging equipment stands out as the modality most likely to be
purchased in 2009, followed by 16- and 64-slice CT scanners.
Other modality acquisitions most likely to be considered high-
priority purchases include digital mammography and ultrasound
equipment.
Service/Equipment description
The goal is to have the most outstanding technology and to
stay above the hospitals, urgent care centers as well as out
patient clinics. All machine from this point on should be GE,
we should start a new contract and move forward with any other
machines they are building to help our radiology department.
Everything state of the art will help us ensure patients with a
better diagnosis and no chance of us missing any irregularities.
The problem is particularly worrisome when it comes to
illnesses such as cancer, heart disease and stroke, where doctors
are looking for subtle or specific markers. Determine your
needs, the volume you expect to put through, your budget, your
space and your timetable," Palmisano said. "We often are asked
by our clients to develop the budget based on our analysis and
experience. Then we make sure our clients have the radiology
equipment that fits their budgets, and which is installed
properly based on their space and medical imaging throughput
needs.
Establishing the team
There are many different roles here that playa a huge part in
making this all come together. The X-ray , MRI, CT, and
ultrasound technologist will have a big role in making this
change be more efficient. The training of the each employee on
the new machines is vital and will need time to prepare the

supervisors as well as some of the senior technologist as well.
Managers
Organization and developing of the events of the unit
Team leaders
Managing various groups
Allocating Resources
Training of new employees
Doctors
New capabilities with the new machines
X-ray, MRI, Ultrasound, CT Technologists
Assist doctors
Educating the community
Learning the new equipment
Technical Team
Launching and organising medical equipment in the field
Drivers and other supporting team
Transport equipment and specialists to the field
References
Smaller U.S. hospitals to invest in imaging. (2008). The Journal
of Nuclear Medicine, 49(9)
Radiology; seek objective guidance to make your radiology
equipment purchase and installation succeed. (2011).
Telemedicine Business Week, , 905. Retrieved from
http://search.proquest.com/docview/909526464?accountid=3252
1
Smith, D. (2014). Introduction to Healthcare Financial
Management. San Diego, CA:
Bridgepoint Education, Inc

Overview of Financial Statements2©Ingram Publishing.docx

More Related Content

Similar to Overview of Financial Statements2©Ingram Publishing.docx (20)

More from gerardkortney (20)

Recently uploaded (20)

Overview of Financial Statements2©Ingram Publishing.docx