Understanding Economics of the Medical Practice Profit Motive

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Wither the Patient-Assembly Line Product Mentality

By Dr. David Edward Marcinko MBA CMP™

[Editor-in-Chief]

Dr. MarcinkoA cost-volume-profit relationship exists in any healthcare entity and emphasizes the point that the goal of an efficient emerging healthcare organization (EHO) should be profit optimization, rather than revenue or volume maximization.

The profit of any healthcare facility is what’s left after all financial outflows are removed from all financial inflows. This optimization is reached at the point where patient volume, fee per patient, and costs per patient produce highest profit, not the highest revenue.

This is the point of maximum efficiency and is where you want to be. It can be described in the equation below.

The Profit Equation

Medical profit traditionally can be defined by the equation:

Profit = (Price x Volume) – Costs

or P = (P x V) – C

whereas:

Revenue = Price x Volume

or R = PV

Making more Money

To make more money and increase profits, the [physician-executive] doctor must increase price (if possible), increase volume (if possible), or decrease costs (if possible); and ideally the doctor should perform all three maneuvers simultaneously.

Assumptions

If we assume that only costs are under the doctor’s control (a not altogether valid strategy), any strategic financial planning process that ignores them will not be beneficial.

A more efficient doctor addresses cost and volume together; but at some point, more volume does not equal more profit. This point is known as the average cost per patient and should be determined and known for each doctor, service segment, clinic, or hospital.

If visually graphed, the curve would be “U” shaped with both arms extending upward and the hump pointed downward at its most efficient point on the long-range average cost (LRAC) curve.

This tangent is the point of maximum efficiency and this is where the healthcare entity should be, as seen diagrammatically below.

Figs 1 and 2

Working harder by taking on more patients, performing additional procedures, or working additional hours in this scenario will not get the clinic, hospital, or medical practice ahead, only further behind and less economically efficient.

Thus, the main goal for all EHOs is profit improvement, not just revenue improvement …. DO-H!

Doctor-Business

The Cost Volume Relationship

Once the fixed and variable costs of a medical practice or hospital clinic are known, the effects of changes in volume on its cost structure can easily be determined.

This is known as the cost-volume relationship, as seen diagrammatically below.

Figs 1 and 2

Cost-Volume-Profit Analysis

Once a basic understanding of medical cost behavior has been achieved, the techniques of cost-volume-profit analysis (CVPA) can be used to further refine the managerial cost and profit aspects of the office business unit. They can also help illustrate the important differences between the traditional office net income statement and the more contemporary contribution margin income statement.

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Assessment

CVPA is thus concerned with the relationship among prices of medical services, unit volume, per unit variable costs, total fixed costs, and the mix of services provided.

MORE: Negotiating CVPA

Conclusion

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3 Responses

  1. THE “PROFIT EQUATION”

    The profit equation is being put front and center within the banking industry. If anyone is the owner of individual bank stocks (especially smaller or regional banks) then you are seeing first hand how the profit equation is being challenged day over day, quarter over quarter, and year over year.

    Profit = (Price x Volume) – Costs

    That is a pretty straight forward formula. However, within the banking industry costs continue to escalate, volume is stagnant or lower than normal and there is tremendous price pressure around every corner. Online banks offering better rates on cash and cash equivalents and spreads so tight you can’t see any day light pose a tremendous challenge to banks with not as much scale as the global investment banks.

    PRICE: Raising the price on ANYTHING sends your regular bank customers into a rampage. They can get better rates at XYZ bank for the same or lower costs.

    VOLUME: There are already tremendous wait times whether you walk into a Covid restricted branch lobby, are in an online chat que, or listening to the lovely elevator music dialing the bank’s 1-800 number. So getting more volume would be nice, but in a lot of cases this becomes a personnel issue for banks.

    COST: This is likely the biggest culprit in banks that are sucking wind to be kind. Cyber security, online tools, apps, online support, qualified employees, oversight, compliance, accounting, sales people (If you can find any) and the list goes on and on.

    **There are 10-12 examples of banks that their stock chart over a 5 year period are pretty much a 45 degree angle slanted down and to the right. YOY income, revenue, margin, cash on hand are all 20%+ in the red.

    I know this is a challenge within a medical practice – but a more pressing and daunting challenge within banks. Keep an eye out for M&A through 2021.

    JOE

    Like

  2. JOE,
    A nice banking industry metaphor.
    Very informative.
    Thanks.
    Rachel

    Like

  3. Joe,
    Banks have an especially hard time with low interest rates; even negative in Europe?
    Kenneth

    Like

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