BEP and CVP Analysis.
1. Scenario #1 – New Wing Rental.
In order to determine the break-even number of knee replacements, the Finance Director should do several calculations. First he needs to determine the total variable cost. They are equal to $12 500 ($9 500 Supplies + $3 000 sales costs per knee). Knowing the selling price of one knee replacement ($17 000), the Finance Director can now calculate the contribution margin. In order to do that, he needs to subtract total variable costs from the selling price. The contribution margin is $ 4 500 ($17 000 – 12 500). This is the amount that can be applied to cover the fixed costs from the sale of each knee replacement. Next the Finance Director has to calculate the total fixed costs. They are equal to $ 40 500 ($15 500 Wing Rent + 25 000 Surgeon’s Salary). Finally, the break-even number can now be calculated by diving the total fixed costs by the contribution margin. The number of knee replacements that is needed to get a zero profit is 9 ($ 40 500 / 4500). The same calculation can give the Finance Director the number of knee replacements that will generate a profit of $100 000. Total fixed costs ($40 500) plus the desired profit ($ 100 000) divided by the contribution margin equals 32 replacements per month. The actual number is 31,2 ($140 500/ 4500) but it is not possible to do an increment of a knee replacement, so the next even number is used. The calculations are summarized in the table and the graph below:
2. Scenario #2 – New Clinic.
The same calculations should be applied to the second scenario, where a surgeon opens a new clinic. The numbers are different though. Total variable costs are $9 500, that gives a new and higher than the first scenario contribution margin - $7 500. Fixed costs are higher because of the additional employee’s salary. They are $41 500. The break-even number of knee replacements is 6 ($41 500 / 7 500 = 5,53). The target profit of $100 000 can be reached with 19 knee replacements per month ($141 500 / 7 500 = 18,9). The calculations are summarized in the table below:
3. Which scenario is preferable?
The Finance Director should recommend the second scenario because it produces a higher contribution margin and lower break-even point. Higher contribution margin allows the hospital to cover the fixed costs with the lower number of knee replacements and therefore it’s more profitable.
4. Define break-even analysis and its importance in the healthcare industry.
“Healthcare Financial Management” defines break-even analysis as “a point where the total revenue from the operation of the organization covers the fixed and variable costs” (Courtney, Briggs, 2004, p.167). The importance of break-even analysis is hard to overestimate. Without understanding of the minimum level of service that would generate enough revenue to cover all the fixed and variable costs, a health organization will simply face a risk of going insolvent. “Health care organizations must generate revenue to pay for the costs of providing services. Matching revenue generated to the costs of providing specific services is an important element of prudent financial management if the organization is to remain solvent” (Austin, Boxerman, 1995, p.21).
5. Define variable cost.
“A variable cost is a cost that varies, in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, beds occupied, lines of print, hours worked, and so forth” (Garrison, Noreen, Brewer, 2010, p.48).
6. Define contribution margin.
Contribution margin is the difference between the variable costs and the cost of sale of one unit of goods or services.
7. Define fixed costs.
“A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity” (Garrison, Noreen, Brewer, 2010, p.49).
8. Compare and contrast variance analysis and sensitivity analysis.
Variance analysis is a planning tool that compares planned or budgeted activity with the actual results, while “sensitivity analysis examines how sensitive the net present value is to changes in key variables, such as increases in capital costs at the commencement of the project, increases and decreases in projected sales volumes, and increases and decreases in variable costs” (Coombs, Hobbs, Jenkins, 2005, p.274).
References.
Courtney, Mary, Briggs, David, (2004). Healthcare Financial Management. Elsevier Australia.
Austin, Charles J., Boxerman, Stuart B., (1995). Quantitative Analysis for Health Service Administration. AUPHA Press/Health Administration Press.
Garrison, Ray H., Noreen, Eric W., Brewer, Peter C., (2010). Managerial Accounting 13th Edition. McGraw-Hill/Irwin.
Coombs, Hue, Hobbs, David, Jenkins, Ellis, (2005). Management Accounting. Principles and Applications. Sage Publications.
