. 5
( 21)


Accounts receivable 50,000 Common stock 1,000,000
Supplies 20,000 Retained earnings (10,000)
Gross ¬xed assets 200,000
Total assets $1,020,000 Total claims $1,020,000

Note that Bayshore™s retained earnings have been driven negative by this
transaction. In essence, the equity of the center ($1,020,000 ’ $30,000
= $990,000) is now worth less than the total capital supplied by the
center™s stockholders.
7. Recognition of supplies used. Assume that $2,000 of supplies were
used in providing healthcare services to Bayshore™s patients. The cost of
supplies used is an expense that decreases assets and equity. The expense
is also shown on the income statement, and hence net income is reduced
by a like amount:
Cash $ 750,000 Accounts payable $ 30,000
Accounts receivable 50,000 Common stock 1,000,000
Supplies 18,000 Retained earnings (12,000)
Gross ¬xed assets 200,000
Total assets $1,018,000 Total claims $1,018,000

Note, however, that supplies typically are expended in providing services,
so revenue would be created that increases assets and equity.
8. Payment of accounts payable (advertising bill). Assume that the
center paid its $10,000 advertising bill, which was due in 30 days. (The
supplies bill is not due for 60 days.) The advertising bill was previously
recorded in Transaction 5 as a payable. This payment on an account for
an expense already recognized decreases both assets (cash) and liabilities
Cash $ 740,000 Accounts payable $ 20,000
Accounts receivable 50,000 Common stock 1,000,000
Supplies 18,000 Retained earnings (12,000)
Gross ¬xed assets 200,000
Total assets $1,008,000 Total claims $1,008,000

Payment of a liability related to an expense that has previously been
incurred does not affect equity.
110 Healthcare Finance

9. Payment of accounts payable (supplies bill). One month later, assume
that Bayshore paid its $20,000 supplies bill, which decreases cash and
accounts payable. Recall that the supplies bill was previously recorded
in Transaction 3 as an increase in both assets (supplies) and liabilities
(accounts payable). Furthermore, part of the supplies were used and
recorded in Transaction 7 as a decrease in assets (supplies) and equity:
Cash $720,000 Common stock $1,000,000
Accounts receivable 50,000 Retained earnings (12,000)
Supplies 18,000
Gross ¬xed assets 200,000
Total assets $988,000 Total claims $ 988,000

A payment of a liability related to an asset that has previously been
booked does not affect equity. Equity is not affected until the asset has
been consumed.
10. Receipt of cash from a third-party payer. Assume that $5,000 is
received in payment for patient services rendered from one of Bayshore™s
third-party payers. This transaction does not change Bayshore™s total
assets or, because of the accounting identity, total claims. It does change
the composition of the business™s assets by reducing receivables and
increasing cash:
Cash $725,000 Common stock $1,000,000
Accounts receivable 45,000 Retained earnings (12,000)
Supplies 18,000
Gross ¬xed assets 200,000
Total assets $988,000 Total claims $ 988,000

A collection for services previously billed and recorded does not affect
equity. Revenue was already recorded in Transaction 4 and cannot be
recorded again.

Of course, an almost limitless number of transactions occur in everyday busi-
ness activities. The purpose of this section was to give readers a sense of how
transactions provide the foundation for a business™s ¬nancial statements.

Self-Test 1. What condition must be met when entering transactions on the balance
Questions sheet?
2. What is the effect on a business™s equity account of a payment on a bill
that has already been booked (recorded as an account payable)?
3. What is the effect of the collection of a receivable on a business™s equity
Chapter 4: The Balance Sheet

Another Look Ahead: Using Balance Sheet
Data in Financial Statement Analysis
In Chapter 3, readers were provided an introduction to ratio analysis. In this
section, we continue the discussion using balance sheet data. The debt ratio
(or debt-to-assets ratio) is de¬ned as total debt divided by total assets. Total
debt can be de¬ned several ways, depending on the use of the ratio, but
for purposes here, assume that total debt includes all liabilities (i.e., all non-
equity capital). (An alternative would be to include only interest-bearing debt
in our de¬nition.) Using Table 4.1 data, Sunnyvale™s debt ratio at the end
of 2004 was total debt (liabilities) divided by total assets = $100,747,000 /
$154,815,000 = 0.65 = 65%. This ratio reveals that each dollar of assets was
¬nanced by 65 cents of debt and, by inference, 35 cents of equity.
Sunnyvale™s debt ratio at the end of 2003 was $68,893,000 /
$115,101,000 = 0.60 = 60%. Thus, the clinic increased its proportional use of
debt ¬nancing by 5 percentage points in one year. That information is impor-
tant to Sunnyvale™s managers and creditors. (The consequences of increased
debt utilization are discussed throughout this book.) Also, it should be clear
that judgments about Sunnyvale™s capital structure could not be made easily
without constructing the debt ratio and other ratios; interpreting the dollar
values directly is just too dif¬cult.

Key Concepts
Chapter 3 contained an introduction to ¬nancial accounting along with a
discussion of the ¬rst of three ¬nancial statements”the income statement.
This chapter extended the discussion to cover the balance sheet and the
statement of cash ¬‚ows, with emphasis on the interrelationships among the
three statements. A demonstration of how economic events (transactions)
work their way onto the balance sheet was also presented. The key concepts
of this chapter are:
• The balance sheet may be thought of as a snapshot of the ¬nancial position
of a business at a given point in time.
• The accounting identity speci¬es that assets must equal liabilities plus
equity (total assets must equal total claims). When rearranged, the
accounting identity reminds us that a business™s equity is really a residual
amount that represents the difference between assets and liabilities.
• Assets identify the resources owned by a health services organization in
dollar terms. Assets are listed by maturity (i.e., by order of when the assets
are expected to be converted into cash). Current assets are expected to be
converted into cash during the next accounting period.
• Liabilities are ¬xed claims by employees, suppliers, tax authorities, and
lenders against a business™s assets. Current liabilities ”those obligations
that fall due within one accounting period”are listed ¬rst. Long-term
liabilities (typically debt with maturities greater than one accounting
period) are listed second.
112 Healthcare Finance

• Equity is the ownership claim against total assets. Depending on the form
of organization and ownership, this claim may be called net assets,
stockholders™ equity, proprietor™s net worth, or something else.
• There are two primary interrelationships between the balance sheet and
the income statement. First, the annual depreciation expense shown on
the income statement accumulates on the balance sheet in the
accumulated depreciation account. Second, all earnings from the income
statement that are reinvested in the business accumulate on the balance
sheet in the equity account.
• The structure of the liabilities and equity side of the balance sheet (i.e., the
proportions of debt and equity ¬nancing) de¬nes the organization™s
capital structure.
• Fund accounting is used by organizations that have restricted
contributions. This complicates internal accounting procedures and adds
additional detail to the balance sheet. However, fund accounting does not
alter the basic format of the balance sheet nor its economic interpretation.
• The statement of cash ¬‚ows shows where an organization gets its cash and
how it is used. It combines information found on both the income
statement and the balance sheet.
• The statement of cash ¬‚ows has three major sections: cash ¬‚ows from
operating activities, cash ¬‚ows from investing activities, and cash ¬‚ows from
¬nancing activities.
• The “bottom line” of the statement of cash ¬‚ows is the net increase
(decrease) in cash. Although this amount is useful in verifying the accuracy
of the statement, its economic content is not as meaningful as the
statement™s component amounts.
• Transactions are the primary underpinning of the measurement and
reporting of ¬nancial accounting information. Understanding how
transactions affect the ¬nancial statements leads to a better understanding
of the statements themselves.

This temporarily ends the discussion of ¬nancial accounting. The next chapter
begins our coverage of managerial accounting. However, the concepts pre-
sented in Chapters 3 and 4 are used repeatedly throughout the remainder of
the book. In addition, ¬nancial accounting concepts are revisited in Chapter
17, which focuses on using the ¬nancing statements to assess ¬nancial perfor-

4.1 a. What is the difference between the income statement and balance
sheet in regards to timing?
b. What is wrong with this statement: “The clinic™s cash balance for
2004 was $150,000, while its net income on December 31, 2004,
was $50,000.”
Chapter 4: The Balance Sheet

4.2 a. What is the accounting identity?
b. What is the implication of the accounting identity for the numbers on
a balance sheet?
c. What does the accounting identity tell us about a business™s equity?
4.3 a. What are assets?
b. What are the three major categories of assets?
4.4 a. What makes an asset a current asset?
b. Provide some examples of current assets.
c. What is net working capital, and what does it measure?
4.5 a. On the balance sheet, what is the difference between long-term
investments and property and equipment?
b. What is the difference between gross ¬xed assets and net ¬xed assets?
c. How does depreciation expense on the income statement relate to
accumulated depreciation on the balance sheet?
4.6 a. What is the difference between liabilities and equity?
b. What makes a liability a current liability?
c. Give some examples of current liabilities.
d. What is the difference between long-term debt and notes payable?
4.7 a. Explain the difference between the equity section of a not-for-pro¬t
business and an investor-owned business.
b. What is the relationship between net income on the income statement
and the equity section on a balance sheet?
4.8 What is fund accounting, and why is it important to some healthcare
4.9 a. What is the statement of cash ¬‚ows, and how does it differ from the
income statement?
b. What are the three major sections of the statement of cash ¬‚ows?
c. What is the “bottom line” of the statement of cash ¬‚ows, and how
important is it?

4.1 Middleton Clinic had total assets of $500,000 and an equity balance of
$350,000 at the end of 2003. One year later, at the end of 2004, the clinic
had $575,000 in assets and $380,000 in equity. What was the clinic™s
dollar growth in assets during 2004, and how was this growth ¬nanced?
4.2 San Mateo Healthcare had an equity balance of $1.38 million at the
beginning of the year. At the end of the year, its equity balance was
$1.98 million.
a. Assume that San Mateo is a not-for-pro¬t organization. What was its
net income for the period?
b. Now, assume that San Mateo is an investor-owned business.
• Assuming zero dividends, what was San Mateo™s net income?
• Assuming $200,000 in dividends, what was its net income?
114 Healthcare Finance

• Assuming $200,000 in dividends and $300,000 in additional stock
sales, what was San Mateo™s net income?
4.3 Here is ¬nancial statement information on four not-for-pro¬t clinics:
Pittman Rose Beckman Jaffe
December 31, 2003:
Assets $ 80,000 $100,000 g $150,000
Liabilities 50,000 d $ 75,000 j
Equity a 60,000 45,000 90,000
December 31, 2004:
Assets b 130,000 180,000 k
Liabilities 55,000 62,000 h 80,000
Equity 45,000 e 110,000 145,000
During 2004:
Total revenues c 400,000 i 500,000
Total expenses 330,000 f 360,000 l

Fill in the missing values labeled a through l.
4.4 The following are selected entries for Warren Clinic for December 31,
2004, in alphabetical order. Create Warren Clinic™s balance sheet.
Accounts payable $ 20,000
Accounts receivable, net 60,000
Cash 30,000
Other long-term liabilities 10,000
Long-term debt 120,000
Long-term investments 100,000
Net property and equipment 150,000
Other assets 40,000
Equity 230,000

4.5 Consider the following balance sheet:

BestCare HMO
Balance Sheet
June 30, 2004
(in thousands)

Current Assets:
Cash and cash equivalents $2,737
Net premiums receivable 821
Supplies 387
Total current assets $3,945
Chapter 4: The Balance Sheet

Net property and equipment $5,924
Total assets $9,869

Liabilities and Net Assets
Accounts payable”medical services $2,145
Accrued expenses 929
Notes payable 382
Total current liabilities $3,456
Long-term debt $4,295
Total liabilities $7,751
Net assets”unrestricted (equity) $2,118

Total liabilities and net assets $9,869

a. How does this balance sheet differ from the one presented in Table
4.1 for Sunnyvale ?
b. What is BestCare™s net working capital for 2004?
c. What is BestCare™s debt ratio? How does it compare with Sunnyvale™s
debt ratio?
4.6 Consider this balance sheet:

Green Valley Nursing Home, Inc.
Balance Sheet
December 31, 2004

Current Assets:
Cash and cash equivalents $ 105,737
Investments 200,000
Net patient accounts receivable 215,600
Supplies 87,655
Total current assets $ 608,992
Property and equipment $2,250,000
Less accumulated depreciation 356,000
Net property and equipment $1,894,000

Total assets $2,502,992

Liabilities and Shareholders™ Equity
Current Liabilities:
Accounts payable $ 72,250
Accrued expenses 192,900
116 Healthcare Finance

Notes payable 180,000
Total current liabilities $ 445,150
Long-term debt $1,700,000
Shareholders™ Equity:
Common stock, $10 par value $ 100,000
Retained earnings 257,842
Total shareholders™ equity $ 357,842

Total liabilities and shareholders™ equity $2,502,992

a. How does this balance sheet differ from the ones presented in Table
4.1 and Problem 4.5?
b. What is Green Valley™s net working capital for 2004?
c. What is Green Valley™s debt ratio? How does it compare with the debt
ratios for Sunnyvale and BestCare?
4.7 Refer to the transactions pertaining to Bayshore Radiology Center
presented in this chapter. Restate the impact of the transactions on
Bayshore™s balance sheet using these data:
a. Transaction 2: The $200,000 equipment purchase is made with
long-term borrowings instead of cash.
b. Transaction 3: The $20,000 in supplies are purchased with cash
instead of on trade credit.
c. Transaction 4: The $50,000 in services provided are immediately paid
for by patients instead of billed to third-party payers.


1. Money market mutual funds are mutual funds that invest in safe, short-term
securities such as Treasury bills and commercial paper. Treasury bills are
short-term debt instruments issued by the U.S. government. Commercial paper
is short-term debt issued by very large and ¬nancially strong corporations. All
of these securities are relatively safe investments because there is virtually 100
percent assurance that borrowers will repay the loans when they mature.
2. For-pro¬t ¬rms have to be concerned with both book depreciation, which is
calculated according to GAAP and reported to stockholders, and tax depreciation,
which is calculated according to IRS regulations and used to determine the
¬rm™s income for tax purposes.
3. Adjustments often must be made to the ¬xed asset accounts on the balance sheet
(and to revenues and costs on the income statement) when assets are sold or lose
value. However, such adjustments are beyond the scope of this book.
4. The decision whether or not Sunnyvale should take the extended trade credit
(pay in 30 days rather than ten) is discussed in Chapter 16. In essence, the cost of
foregoing the discount to gain additional credit (¬nancing) has to be compared
to the cost of other ¬nancing alternatives.
Chapter 4: The Balance Sheet

5. An important current liability account for providers with a high percentage of
capitated contracts is incurred but not reported (IBNR) expenses. This account
is not present on Sunnyvale™s balance sheet because its payer mix is dominated
by fee-for-service reimbursement. Under capitation, providers receive payment
before the services are rendered. At the end of an accounting period when the
books are closed, there may still be a large number of expenses related to services
for the capitated enrollees that have not yet been reported in the accounting
system. Many of the expenses will have occurred and been reported, but the costs
of services provided near the end of the period may still be in the accounting
pipeline. If the provider subcontracts out for some services, these services may
have been performed by subcontractors but not yet billed. Even if the services
are provided in-house, the episode of care may straddle into the next accounting
period, thus resulting in a need to estimate the cost of those services. One of the
last accounting entries typically done by capitated providers is to record IBNR
expenses both as a current liability on the balance sheet and as an operating
expense on the income statement. This procedure properly matches the timing
of the costs of services to be provided with the revenue for those services, which
was received up-front.
6. Although long-term debt has a maturity of more than one year, many long-term
debt issues have provisions mandating that a portion of the borrowed amount
(principal ) be repaid in each year. Furthermore, some long-term debt that was
issued in the past may mature in any given year. (The features of long-term debt
are discussed in detail in Chapter 11.) The portion of long-term debt that must
be paid in the coming year is recorded on the balance sheet as a current liability
titled current maturities of long-term debt.
7. Conversion of a not-for-pro¬t organization to for-pro¬t status presents a dif¬cult
legal challenge because not-for-pro¬t assets must be used for charitable purposes
in perpetuity (forever). Thus, the monies received in a conversion must be used
to create a foundation that will continue to perform charitable deeds.
8. Prior to the statement of cash ¬‚ows, a different statement”the statement of
changes in ¬nancial position”was required. The statement of cash ¬‚ows presents
similar information to the previous statement, but in a much more usable format.

AICPA. 2003. Audit and Accounting Guide. New York: American Institute of Certi-
¬ed Public Accountants.
. 2003. Checklists and Illustrative Financial Statements for Health Care Orga-
nizations. New York: American Institute of Certi¬ed Public Accountants.
Bitter, M. E., and J. Cassidy. 1992. “Perceptions of New AICPA Audit Guide.”
Healthcare Financial Management (November): 38“48.
Luecke, R. W., and D. T. Meeting. 1996. “SFAS 124, Accounting for Investments:
The Rules Have Changed.” Healthcare Financial Management (December):
This page intentionally left blank

Managerial Accounting
This page intentionally left blank


Learning Objectives
After studying this chapter, readers will be able to:

• Explain the differences between ¬nancial and managerial
• Describe how costs are classi¬ed according to their relationship
with volume.
• Conduct pro¬t analyses to analyze the impact of input value
changes on both pro¬tability and breakeven points.
• Explain the primary differences in pro¬t analyses that arise when
comparing fee-for-service reimbursement with capitation.

Thus far in the book, we have concentrated on healthcare ¬nance basics and
¬nancial accounting. Now we will change the focus to managerial accounting,
which spans four chapters. In addition to managerial accounting basics, this
chapter covers cost behavior and pro¬t analysis”topics that many consider to
be the cornerstones of managerial accounting. Then, in Chapters 6 through
8, coverage is extended to include cost allocation, pricing, planning, and bud-
geting. After studying these four chapters, you will have a good appreciation
of managerial accounting and its value to health services organizations.

The Basics of Managerial Accounting
Whereas ¬nancial accounting focuses on organizational-level data for pre-
sentation in a business™s ¬nancial statements, managerial accounting focuses
mostly on sub-unit”say, a department”data used internally for managerial
decision making.1 For example, managerial accounting information is used for
routine budgeting processes, allocation of managerial bonuses, and pricing
decisions, all of which deal with sub-units of an organization. Also, manage-
rial accounting data can be compiled for special projects such as assessing
alternative modes of delivery or projecting the pro¬tability of a particular
122 Healthcare Finance

reimbursement contract. In short, the focus of managerial accounting is to
develop information to meet the needs of managers within the organization,
rather than interested parties (mainly investors) outside the organization.
Thus, while ¬nancial accounting information is driven primarily by the needs
of outsiders, managerial accounting information is driven by the needs of
Managers are more concerned with what will happen in the future than
with what has happened in the past. Unlike ¬nancial accounting, managerial
accounting is for the most part forward-looking. Because the past is certain,
while most of the future is uncertain, managerial accounting information
tends to be much less reliable than ¬nancial accounting data. As managers
embark on budgeting and pricing decisions, they often must make many
assumptions regarding factors such as utilization, reimbursement, and costs.
This requirement for assumptions about the future, combined with the fact
that there are no generally agreed-upon rules for managerial accounting,
makes it much more open to improvisation than ¬nancial accounting.
In general, ¬nancial accounting can be thought of as reporting work,
while managerial accounting is best described as decision work. We do not
mean to imply that there is little value in ¬nancial accounting data. Indeed,
as you will see in Chapter 17, ¬nancial statements are key to understanding
a business™s overall ¬nancial status. Still, the managerial decisions that are
made on a daily basis that create this status are in¬‚uenced much more by
managerial accounting data, which focus on individual activities, than by
¬nancial accounting data, which focus on aggregate amounts.
A critical part of managerial accounting is the measurement of costs. In
fact, the concept of costs is so important that it has spawned its own ¬eld of
accounting”cost accounting. Cost accounting generally is considered to be
a subset of managerial accounting, although cost accounting systems also are
used to develop the expense data reported on a business™s income statement.
Therefore, cost accounting bridges both managerial and ¬nancial accounting.
Unfortunately, there is no single de¬nition of the term cost. Rather,
there are different costs for different purposes. As a general rule for healthcare
providers, a cost involves a resource use associated with providing, or sup-
porting, a speci¬c service. However, the cost-per-service identi¬ed for pricing
purposes can differ from the cost-per-service used for management control
purposes. Also, the cost-per-service used for long-range planning purposes
may differ from the cost-per-service de¬ned for short-term purposes. Finally,
as we discussed in Chapters 3 and 4, costs do not necessarily re¬‚ect actual cash
Costs are classi¬ed in two primary ways: by their relationship to the
volume (amount) of services provided and by their relationship to the unit
(i.e., department) being analyzed. In this chapter, we focus on the ¬rst clas-
si¬cation method”the relationship of costs to volume. Our discussion of the
latter classi¬cation method will be deferred until the next chapter.
Chapter 5: Managerial Accounting Basics

1. What are the primary differences between ¬nancial and managerial
2. What is meant by the term cost ?
3. What are the two primary ways that costs can be classi¬ed?

Cost Classi¬cations: Fixed and Variable
We can de¬ne (classify) several types of costs on the basis of their relationship
to the amount of services provided, often referred to as activity, utilization,
or volume. However, such cost classi¬cations require the speci¬cation of a rel-
evant range. In dealing with the future, there is always volume uncertainty”
the number of patient days, number of visits, number of enrollees, number
of laboratory tests, and so on. However, managers often have some idea of
the potential range of volume over some future time period. For example,
the manager of Northside Clinic, a small walk-in clinic, might estimate that
the number of visits next year could range from 12,000 to 14,000 or from
about 34 to 40 per day. If there is little likelihood that utilization will fall
outside of these bounds, then the range of 12,000 to 14,000 annual visits
de¬nes the clinic™s relevant range. Note that the relevant range pertains to
a particular time period”in this case, next year. For other time periods, the
relevant range might differ from its estimate for the coming year.

Fixed Costs
Some costs, called ¬xed costs, are more or less known with certainty, regardless
of the level of volume within the relevant range. For example, the clinic has
a labor force of well-trained permanent employees that would be increased
or decreased only under unusual circumstances. Thus, as long as volume falls
within the relevant range, labor costs at Northside Clinic are ¬xed for the
coming year regardless of the number of patient visits. Other examples of
¬xed costs include expenditures on facilities, diagnostic equipment, informa-
tion systems, and the like. After an organization has acquired these assets, they
typically are locked into them for some period of time, regardless of volume.
Of course, no costs are ¬xed over the long run. At some point of increasing
volume, healthcare businesses must incur additional ¬xed costs for new prop-
erty and equipment, additional staf¬ng, and so on. Likewise, if volume shrinks
enough, an organization likely would reduce ¬xed costs by shedding part of
its ¬xed assets and labor base.

Variable Costs
Whereas some costs are ¬xed regardless of volume, other resources are more
or less consumed as volume dictates. Costs that are directly related to volume
are called variable costs. For example, the costs of the clinical supplies (e.g.,
rubber gloves, tongue depressors, hypodermics, and so on) used by Northside
124 Healthcare Finance

would be classi¬ed as variable costs. Also, some of the diagnostic equipment
used in the clinic may be leased on a per procedure basis, which would convert
the cost of the equipment from a ¬xed cost to a variable cost. Finally, some
health services organizations pay their employees on the basis of the amount
of work performed, which would convert labor costs from ¬xed to variable.

Self-Test 1. De¬ne relevant range.
Questions 2. Explain the features and provide examples of ¬xed and variable costs.
3. How does time period affect the de¬nition of ¬xed costs?

Cost Behavior
Health services managers are vitally interested in how costs are affected by
changes in the organization™s activity (volume). The relationship between
cost and activity, called cost behavior or underlying cost structure, is used by
managers in planning, control, and decision making. The primary reason for
de¬ning an organization™s underlying cost structure is to provide managers
with a tool for forecasting costs at different levels of activity.
To illustrate the concept of cost behavior, consider the hypothetical cost
data presented in Table 5.1 for a hospital™s clinical laboratory. The underlying
cost structure consists of both ¬xed and variable costs”that is, some of the
costs are expected to be volume sensitive and some are not. This structure of
both ¬xed and variable costs is typical in healthcare businesses as well as most
other businesses. To begin our discussion of cost behavior, we unrealistically
assume that the relevant range is from zero to 20,000 tests.
As noted in Table 5.1, the laboratory has $150,000 in ¬xed costs that
consist primarily of labor, facilities, and equipment costs. These costs will
occur even if the laboratory does not perform one test, assuming it is kept
open. In addition to the ¬xed costs, each test, on average, requires $10 in
laboratory supplies such as glass slides and reagents. The per unit (per test
in this example) variable cost of $10 is de¬ned as the variable cost rate. If
activity at the laboratory doubles”for example, from 500 to 1,000 tests”
total variable costs double from $5,000 to $10,000. However, the variable
cost rate of $10 per test remains the same whether the test is the ¬rst, the
hundredth, or the thousandth. Total variable costs, therefore, increase or
decrease proportionately as activity changes, but the variable cost rate remains
Fixed costs, in contrast to total variable costs, remain unchanged as the
level of activity varies. When activity doubles from 500 to 1,000 tests, ¬xed
costs remain at $150,000. Because all costs in this example are either ¬xed
or variable, total costs are merely the sum of the two. (In the next section,
we introduce the concept of semi-¬xed costs.) For example, at 5,000 tests,
total costs are Fixed costs + Total variable costs = $150,000 + (5,000 —
Chapter 5: Managerial Accounting Basics

Variable Cost per Test Fixed Costs per Year
Cost Behavior
Laboratory supplies $10 Labor $100,000
Fixed and
Other ¬xed costs 50,000
Variable Costs

Fixed Variable Total Average
Volume Costs Costs Costs Cost per Test

0 $150,000 $ 0 $150,000 ”
1 150,000 10 150,010 $150,010.00
50 150,000 500 150,500 3,010.00
100 150,000 1,000 151,000 1,510.00
500 150,000 5,000 155,000 310.00
1,000 150,000 10,000 160,000 160.00
5,000 150,000 50,000 200,000 40.00
10,000 150,000 100,000 250,000 25.00
15,000 150,000 150,000 300,000 20.00
20,000 150,000 200,000 350,000 17.50

$10) = $150,000 + $50,000 = $200,000. Because variable costs are tied to
volume, total costs increase as activity increases even though ¬xed costs remain
The rightmost column in Table 5.1 contains average cost per unit of
activity, which in this example is average cost per test. It is calculated by
dividing total costs by volume. For example, at 5,000 tests, with total costs
of $200,000, the average cost per test is $200,000 / 5,000 = $40. Because
¬xed costs are spread over more visits as activity increases, the average cost
per unit of activity declines as volume increases. For example, when activity
doubles from 5,000 to 10,000 tests, ¬xed costs remain at $150,000, but ¬xed
cost per unit declines from $150,000 / 5,000 = $30 to $150,000 / 10,000
= $15. With ¬xed cost per test declining from $30 to $15, the average cost
per test declines from $30 + $10 = $40 to $15 + $10 = $25. The fact
that higher volume reduces average ¬xed cost and average cost per unit of
activity has important implications regarding the effect of volume changes on
pro¬tability. This point will be made clear in a later section.
The cost behavior presented in Table 5.1 in tabular format is presented
in graphical format in Figure 5.1. Here, costs are shown on the vertical
(Y) axis, and volume (number of tests) is shown on the horizontal (X) axis.
Because ¬xed costs are independent of volume, they are shown as a horizontal
dashed line at $150,000. Total variable costs appear as an upward-sloping
dotted line that starts at the origin (0 tests, $0 costs) and rises at a rate of
$10 for each additional test. Thus, the slope of the total variable costs line
126 Healthcare Finance

Cost Behavior

Total Costs

Fixed Costs

Total Variable

(Number of Tests)

is the variable cost rate. When ¬xed and total variable costs are combined to
obtain total costs, the result is the upward-sloping solid line parallel to the
total variable costs line but beginning at the Y axis at a value of $150,000 (the
¬xed costs amount). In effect, the total costs line is nothing more than the
total variable costs line shifted upward by the amount of ¬xed costs.
Note that Figure 5.1 is not drawn to scale. Furthermore, the relevant
range is unrealistically large. The intent here is to emphasize the general shape
of a cost behavior graph and not its exact position. Also, note that total variable
costs plot as a straight line (are linear), because the variable cost rate is assumed
to be constant over the relevant range. Although curvilinear total variable costs
can occur in some situations, we assume throughout the book that the variable
cost rate is constant, and hence total variable costs are linear, at least within
the relevant range. Such an assumption is not unreasonable for most health
services organizations in most situations.

Self-Test 1. Construct a simple table like the one in Table 5.1, and discuss its
Questions elements.
2. Sketch and explain a simple diagram similar to Figure 5.1 to match your
Chapter 5: Managerial Accounting Basics

Cost Classi¬cations: Semi-Fixed
Fixed and variable costs represent two ends of the volume classi¬cation spec-
trum. Here, within the relevant range, the costs are either independent of
volume (¬xed) or directly related to volume (variable). A third classi¬cation,
semi-¬xed costs, falls in between the two extremes. To illustrate, assume that
the actual relevant range of volume for the clinical laboratory is 10,000 to
20,000 tests. However, the laboratory™s current workforce can only handle
up to 15,000 tests per year, so an additional technician, at an annual cost of
$35,000, would be required if volume exceeds that level. Now, labor costs are
¬xed from 10,000 to 15,000 tests, and then from 15,000 to 20,000 tests, but
they are not ¬xed throughout the entire relevant range of 10,000 to 20,000
tests. Semi-¬xed costs are ¬xed within ranges of volume, but there are multiple
ranges of semi-¬xed costs within the relevant range. Because a plot of semi-
¬xed costs versus volume looks like a step function, such costs are also called
step-variable costs.
Table 5.2 and Figure 5.2 illustrate the cost behavior of the laboratory
within the new relevant range and with the addition of semi-¬xed costs. As
shown in Table 5.2, the inclusion of semi-¬xed costs prevents average ¬xed
cost and average cost per test from continuously declining throughout the
relevant range. At volumes above 15,000 tests, the laboratory must add an
additional technician at a cost of $35,000. This causes a jump in total ¬xed
costs (consisting of ¬xed and semi-¬xed), average ¬xed cost, total costs, and
average cost per test. However, once this jump (or step) occurs, average ¬xed
cost and average cost per test again begin to decrease as volume increases.
The jump in total costs is easily identi¬ed on the total costs line shown
in Figure 5.2. Because of the negative impact of this sudden increase in total
costs, the laboratory department head would probably try to avoid hiring an

Variable Costs per Test Fixed Costs per Year Semi-Fixed Costs
Cost Behavior
Laboratory supplies $10 Labor $100,000 Increase in labor costs $35,000
Other ¬xed costs 50,000 above 15,000 tests
Semi-Fixed, and
Variable Costs
Total Total
Fixed Semi-Fixed Fixed Variable Total Average
Volume Costs Costs Costs Costs Costs Cost per Test

10,000 $150,000 $ 0 $150,000 $100,000 $250,000 $25.00
14,000 150,000 0 150,000 140,000 290,000 20.71
15,000 150,000 0 150,000 150,000 300,000 20.00
16,000 150,000 35,000 185,000 160,000 345,000 21.56
20,000 150,000 35,000 185,000 200,000 385,000 19.25
128 Healthcare Finance

Cost Behavior

additional technician when volume exceeds 15,000 tests, especially if volume
is expected to be only slightly above the jump point or is expected to be
temporary. Perhaps new incentives could be put into place that encourage
the current technicians to be more productive. Such an action could lower
costs in general and create a situation in which the average cost per test would
decline continuously throughout the relevant range.
Although semi-¬xed costs are common within health services organi-
zations, they add a level of complexity to pro¬t analysis (the topic covered
next) without adding a great deal of additional insight. Thus, the remainder
of the examples in this book will assume that an organization™s cost structure
consists only of ¬xed and variable costs.

Self-Test 1. What is a semi-¬xed cost?
Questions 2. How does the addition of semi-¬xed costs change a cost behavior graph?
3. What is the impact of semi-¬xed costs on per unit average cost?

Pro¬t (CVP) Analysis
Pro¬t analysis is an analytical technique typically used to analyze the effects of
volume changes on pro¬t. The same procedures can be used to assess the
Chapter 5: Managerial Accounting Basics

effects of volume changes on costs, so this type of analysis is often called
cost-volume-pro¬t (CVP) analysis. CVP analysis allows managers to examine
the effects of alternative assumptions regarding costs, volume, and prices.
Clearly, such information is useful as managers evaluate future courses of
action regarding pricing and the introduction of new services.

Basic Data
Table 5.3 presents the estimated annual costs for Atlanta Clinic, a subsidiary
of Atlanta Health Services, for 2005. These costs are based on the clinic™s
most likely estimate of volume”75,000 visits. The most likely estimate often
is called the base case, so the data in Table 5.3 represent the clinic™s base case
cost forecast. Expected total costs for 2005 are $7,080,962. Because these
costs support 75,000 visits, the forecasted average cost per visit is $7,080,962
/ 75,000 = $94.41.
Focusing solely on total costs does not provide the clinic™s managers
with much information regarding potential alternative ¬nancial outcomes
for 2005. In essence, a single (total cost) amount suggests that the clinic™s
costs will remain constant regardless of the number of patient visits. Similarly,
the base case average cost per visit amount of $94.41 implicitly treats all
costs as variable costs, suggesting that the cost per visit would be $94.41
regardless of volume. Total cost information is necessary and useful, but the
detailed breakdown in Table 5.3 gives the clinic™s managers more insight into
prospective ¬nancial outcomes for 2005 than is possible with a total cost focus.
Table 5.3 categorizes the clinic™s total costs of $7,080,962 into
two components: total variable costs of $2,113,500 and total ¬xed costs of
$4,967,462. These cost amounts are fundamentally different, both in quan-
titative and qualitative terms. The total ¬xed costs of $4,967,462 must be
borne by the clinic regardless of the actual volume in 2005. However, total

Variable Costs Fixed Costs Total Costs
Atlanta Clinic:
Forecasted Cost
Salaries and Bene¬ts:
Data for 2005
Management and supervision $ 0 $ 928,687 $ 928,687
(based on
Coordinators 442,617 598,063 1,040,680
Specialists 0 38,600 38,600 75,000 patient
Technicians 681,383 552,670 1,234,053 visits)
Clerical/administrative 71,182 58,240 129,422
Social security taxes 89,622 163,188 252,810
Group health insurance 115,924 211,081 327,005
Professional fees 325,489 383,360 708,849
Supplies 313,283 231,184 544,467
Utilities 74,000 45,040 119,040
Allocated costs 0 1,757,349 1,757,349
Total $2,113,500 $4,967,462 $7,080,962
130 Healthcare Finance

variable costs of $2,113,500 apply only to a volume of 75,000 patient visits. If
the actual number of visits realized in 2005 is less than or greater than 75,000,
total variable costs will be less than or greater than $2,133,500. (Of course,
this is the primary reason that costs are classi¬ed as ¬xed and variable in the
¬rst place.)
The best way to highlight that total variable costs vary with volume
is to express variable costs on a per unit (cost rate) basis. For Atlanta Clinic,
the implied variable cost rate is $2,113,500 / 75,000 visits = $28.18 per
visit. Thus, the clinic™s total costs at any relevant volume can be calculated as

Total costs = Fixed costs + Total variable costs
= $4,967,462 + ($28.18 — Number of visits).
This equation, the cost behavior model, explicitly shows that total costs
depend on volume. To illustrate use of the cost behavior model, consider three
potential volumes for 2005: 70,000, 75,000, and 80,000 patient visits:

Volume = 70,000:
Total costs = $4,967,462 + ($28.18 — 70,000)
= $4,967,462 + $1,972,600 = $6,940,062.
Volume = 75,000:
Total costs = $4,967,462 + ($28.18 — 75,000)
= $4,967,462 + $2,113,500 = $7,080,962.
Volume = 80,000:
Total costs = $4,967,462 + ($28.18 — 80,000)
= $4,967,462 + $2,254,400 = $7,221,862.

When an organization™s costs are expressed in this way, it is easy to see that
higher volume leads to higher total costs.
Atlanta Clinic™s underlying cost structure is plotted in Figure 5.3. (To
simplify the graph, we assume that the relevant range extends to zero visits.)
As ¬rst illustrated in Figure 5.1, ¬xed costs are shown as a horizontal dashed
line and total costs are shown as an upward-sloping solid line with a slope (rise
over run) equal to the variable cost rate”$28.18 per visit. Unlike Figure 5.1,
the graphical presentation has been simpli¬ed by not showing total variable
costs as a separate line starting at the origin. Of course, total variable costs are
represented in Figure 5.3 by the vertical distance between the total costs line
and the ¬xed costs line.
Note that Atlanta Clinic does not literally write out a check for $28.18
for each visit, although there may be examples of variable costs in which this is
Chapter 5: Managerial Accounting Basics

Atlanta Clinic:
and Costs CVP Graphical

Total Costs

Fixed Costs

69,165 75,000
0 Volume
(Number of Visits)

the case. Rather, Atlanta™s cost structure indicates that the clinic uses certain
resources that its managers have de¬ned as inherently variable, and the best
estimate of the value of such resources is $28.18 per visit.
The cost structure shown in Figure 5.3 could be estimated in several
ways. One way would be to use time-motion studies and interviews with clinic
personnel. However, instead of such an intrusive approach, cost accountants
could plot the total costs of the clinic at different volume levels for the past
several years and then run a regression on these data. In this case, the beta
term (slope) of the regression would be the variable cost rate, $28.18, and
the alpha term (intercept) would be ¬xed costs, $4,967,462.
To complete the CVP model, a revenue component must be added.
For 2005, Atlanta Clinic expects revenues, on average, to be $100 per patient
visit. Total revenues are plotted on Figure 5.3 as an upward-sloping solid line
starting at the origin and having a slope of $100 per visit. If there were no
visits, total revenues would be zero; at one visit, total revenues would be $100;
at ten visits, total revenues would be $1,000; at 75,000 visits, total revenues
would be $7,500,000; and so on.

The Projected P&L Statement
One of the ¬rst steps that Atlanta Clinic™s managers could take in terms of
the 2005 CVP analysis is to project pro¬t (net income), given the base case
assumptions. Such a forecast is called a projected pro¬t and loss (P&L) state-
132 Healthcare Finance

Total revenues ($100 — 75,000) $7,500,000
Atlanta Clinic:
Total variable costs ($28.18 — 75,000) 2,113,500
2005 Base Case
Total contribution margin ($71.82 — 75,000) $5,386,500
Projected P&L Fixed costs 4,967,462
Statement Pro¬t $ 419,038
(based on
75,000 patient
ment. The term pro¬t and loss statement distinguishes this statement from
Atlanta Clinic™s audited income statement. There are two primary differences
between a P&L statement and an income statement. First, P&L statements, as
with all managerial accounting data, can be developed to best serve decision
making purposes, as opposed to following GAAP. Second, P&L statements
can be created for any sub-unit within an organization, whereas income state-
ments normally are created only for the overall accounting entity and major
Atlanta Clinic™s 2005 base case projected P&L statement is shown in
Table 5.4. The bottom line projects Atlanta™s 2005 pro¬t using base case
values for costs, volume, and prices. Note that the format of a P&L statement
for CVP analysis purposes distinguishes between variable and ¬xed costs,
whereas a typical income statement (and P&L statements for other purposes)
does not make this distinction. Also, note that the projected P&L statement
contains a line labeled total contribution margin. This very important concept
will be discussed in the next section.
The projected P&L statement used in CVP analysis contains four vari-
ables”three of the variables are assumed and the fourth is calculated. In Table
5.4, the assumed variables are expected volume (75,000 visits), expected price
($100 per visit), and expected costs (delineated in terms of the clinic™s cost
structure). Pro¬t, the fourth variable, is calculated on the basis of the three
assumed variables.
The Table 5.4 base case projected P&L statement represents only one
point on the Figure 5.3 CVP model. This point is shown by the dotted vertical
line at a volume of 75,000 patient visits. Moving up along this dotted line,
the distance from the X-axis to the horizontal ¬xed costs line represents the
$4,967,462 ¬xed costs. The distance from the ¬xed costs line to the total costs
line represents the $2,113,500 total variable costs. The distance between the
total costs line and the total revenues line represents the $419,038 pro¬t.
As in previous ¬gures, the graph in Figure 5.3 is not drawn to scale because
it will not be used to develop numerical data. Rather, it provides the clinic™s
managers with a pictorial representation of Atlanta™s projected ¬nancial future.

Contribution Margin
The base case projected P&L statement in Table 5.4 introduces the concept
of contribution margin, which is de¬ned as the difference between per unit
Chapter 5: Managerial Accounting Basics

revenue and per unit variable cost (the variable cost rate). In this illustration,
the contribution margin is $100.00 ’ $28.18 = $71.82. What is the inher-
ent meaning of this contribution margin value of $71.82? The contribution
margin has the look and feel of pro¬t because it is calculated as revenue minus
cost. However, because none of the ¬xed costs of providing service have been
included in the cost amount used in the contribution margin, it is not pro¬t.
Rather, the contribution margin is the dollar amount per visit that ¬rst must
be used to cover Atlanta Clinic™s ¬xed costs. Only after ¬xed costs are fully
covered does the contribution margin contribute to pro¬t.
With a contribution margin of $71.82 on each of the clinic™s 75,000
visits, the projected base case total contribution margin for 2005 is $71.82
— 75,000 = $5,386,500, which is suf¬cient to cover the clinic™s ¬xed costs
of $4,967,462 and then provide a $5,386,500 ’ $4967,462 = $419,038
pro¬t. After ¬xed costs have been covered, any additional visits contribute to
the clinic™s pro¬t at a rate of $71.82 per visit. Readers will discover that the
contribution margin concept is used again and again as our discussion of CVP
analysis is extended.

1. Construct a simple P&L statement like the one in Table 5.4, and
discuss its elements.
2. Sketch and explain a simple diagram to match your table.
3. De¬ne and explain the contribution margin.

Breakeven Analysis
Breakeven analysis is applied in many different situations, so it is necessary
to understand the context to fully understand the meaning of the term break
even. Generically, breakeven analyses are used to determine a breakeven point,
which is the value of a given input variable that produces some minimum
desired result. In the speci¬c situation at hand, we will use breakeven analysis
to determine the volume, called the breakeven volume, at which a business
or program or service becomes ¬nancially self-suf¬cient in an accounting
sense. In other words, the breakeven point is that volume that generates zero
accounting pro¬t. Although the breakeven analysis discussed here is actually
part of pro¬t (CVP) analysis, the concept deserves separate consideration.
As mentioned in the previous section, the P&L statement format used
here is a four-variable model. When the focus is pro¬t, the three assumed vari-
ables are costs, volume, and price, while pro¬t is calculated. When the focus is
volume breakeven, the same four variables are used, but pro¬t is now assumed
to be known while volume is the unknown (calculated) value. However, it is
also possible to assume a value for volume and price (or costs) and then calcu-
late the breakeven value for costs (or price). A breakeven point can be obtained
two ways: algebraically or graphically. To illustrate the algebraic approach, the
134 Healthcare Finance

projected P&L statement presented in Table 5.4 can be expressed algebraically
as the following equation:

Total revenues ’ Total variable costs ’ Fixed costs = Pro¬t
($100 — Volume) ’ ($28.18 — Volume) ’ $4,967,462 = Pro¬t.
By de¬nition, at breakeven the clinic™s pro¬t equals zero, so the equation can
be rewritten this way:

($100 — Volume) ’ ($28.18 — Volume) ’ $4,967,462 = $0.
Rearranging the terms so that only the terms related to volume appear on the
left side produces this equation:

($100 — Volume) ’ ($28.18 — Volume) = $4,967,462.
Using basic algebra, the two terms on the left side can be combined because
volume appears in both. The end result is this:

($100 ’ $28.18) — Volume = $4,967,462
$71.82 — Volume = $4,967,462.
The left side of the breakeven equation now contains the contribution
margin, $71.82, multiplied by volume. Here, the previous conclusion that the
clinic will break even when the total contribution margin equals ¬xed costs is
reaf¬rmed. Solving the equation for volume results in a breakeven point of
$4,967,462 / $71.82 = 69,165 visits. Any volume greater than 69,165 visits
produces a pro¬t for the clinic, while any volume less than 69,165 results in a
The economic logic behind the breakeven point is this: Each patient
visit brings in $100, of which $28.18 is the variable cost to treat the patient.
This leaves a $71.82 contribution margin from each visit. If the clinic sets
the contribution margin aside for the ¬rst 69,165 visits in 2005, it would
have $4,967,430, which is enough (except for a small rounding difference)
to cover its ¬xed costs. Once the clinic exceeds breakeven volume, each visit™s
contribution margin ¬‚ows directly to pro¬t. If the clinic achieves its volume
estimate of 75,000 visits, the 5,835 visits above the breakeven point result in a
total pro¬t of 5,835 — $71.82 = $419,070, which matches the pro¬t (again
except for a rounding difference) shown on the clinic™s base case projected
income statement in Table 5.4.
The second method for determining the breakeven point is by graphi-
cal analysis. At breakeven the pro¬t is zero, so total revenues must equal total
costs. On a CVP graph such as Figure 5.3, this condition holds at the inter-
section of the total revenues line and total costs line. This point is indicated by
a vertical dashed line drawn at a volume of 69,165 visits. If a very large sheet
Chapter 5: Managerial Accounting Basics

Total revenues ($100 — 69,165) $ 6,916,500
Atlanta Clinic:
Total variable costs ($28.18 — 69,165) 1,949,070
2005 Projected
Total contribution margin $4,967,430
P&L Statement
Fixed costs 4,967,462
(based on
Pro¬t ($ 32)
69,165 patient

of graph paper were used, the lines could be drawn to scale and the breakeven
point could be read off of the graph.
The logic of the breakeven point illustrated in Figure 5.3 goes back to
the nature of the clinic™s ¬xed and variable cost structure. Before even one
patient walks in the door, the clinic has already committed to $4,967,462 in
¬xed costs. Because the total revenues line is steeper than the total variable
costs line, and hence the total costs line, as volume increases total revenues
eventually catches up to the clinic™s cost structure. Any utilization to the right
of the breakeven point, which is shown as a dark-shaded area, produces a
pro¬t; any utilization to the left, which is shown as a light-shaded area, results
in a loss.
The relationship between breakeven analysis and the projected P&L
statement is important to understand. Based on the clinic™s base case projec-
tion of 75,000 visits, it can anticipate a pro¬t of $419,038. However, man-
agement may worry that the clinic will not achieve this projected volume and
ask the following question: What is the minimum number of visits that are
needed to at least break even? The answer is: 69,165 visits.
To verify the breakeven point, Table 5.5 contains a projected P&L
statement for 69,165 visits. Except for a small rounding difference, the pro¬t
at the breakeven point is $0. (The breakeven point was actually 69,165.4
visits.) As mentioned previously, at breakeven the total contribution margin
just covers ¬xed costs, resulting in zero pro¬t.
This breakeven analysis contains important assumptions. The ¬rst as-
sumption is that the price or set of prices for different types of patients and dif-
ferent payers is independent of volume. In other words, volume increases are
not attained by lowering prices, and price increases are not met with volume
declines. The second assumption is that costs can be reasonably subdivided
into ¬xed and variable components. The third assumption is that both ¬xed
costs and the variable cost rate are independent of volume over the relevant
range, so both the total costs and total revenues lines are linear.
Breakeven analysis is often performed in an iterative manner. After the
breakeven volume is calculated, managers must determine whether the result-
ing volume can realistically be achieved at the price assumed in the analysis. If
the price appears to be unreasonable for the breakeven volume, a new price has
to be estimated and the breakeven analysis repeated. Likewise, if the cost struc-
ture used for the calculation appears to be unrealistic at the breakeven volume,
136 Healthcare Finance

operational assumptions and hence cost assumptions should be changed and
the analysis repeated again.
Both concepts”the projected P&L statement and breakeven analysis
”are consistent with the broader intent of CVP analysis, which is to estimate
relationships between cost, volume, price, and pro¬t. To take this logic a step
further, the base case projected P&L statement and the breakeven point are
only two points on a continuum of possibilities. Instead of asking the number
of visits needed to break even, Atlanta™s managers may ask the number of visits
needed to achieve a $100,000 pro¬t or, for that matter, any other pro¬t. They
know that the clinic will have a $419,038 pro¬t if it has 75,000 visits and that
it will have no pro¬t if it has 69,165 visits. Thus, the number of visits required
to achieve a $100,000 pro¬t is somewhere in between 69,165 and 75,000. In
fact, the number of visits required is 70,558:

Total revenues ’ Total variable costs ’ Fixed costs = Pro¬t
($100 — Volume) ’ ($28.18 — Volume) ’ $4,967,462 = $100,000
($71.82 — Volume) ’ $4,967,462 = $100,000
$71.82 — Volume = $5,067,462
Volume = 70,558.

Self-Test 1. What is the purpose of breakeven analysis?
Questions 2. What is the equation for volume breakeven?
3. Why is breakeven analysis often conducted in an iterative manner?
4. Can breakeven concepts be applied to a pro¬t value other than zero?

Operating Leverage
The change in our analysis from 75,000 visits to 69,165 visits was quite easy.
In fact, the analysis could be entered on a spreadsheet and the results could be
quickly examined at any given volume. This way, “what if” questions could be
answered about the impact on pro¬t of changing volume, costs, or prices. To
illustrate, assume that Atlanta Clinic™s managers believe that positive changes
might occur in the local market for healthcare services that would increase
their volume estimate for 2005 to 82,500 visits”an increase of 7,500 visits
over the original 75,000 visit base case estimate. Table 5.6 contains the clinic™s
projected P&L statements at 69,165 (break even), 75,000 (base case), and
82,500 visits. The ¬rst two columns are the same as previously constructed.
The third column, which represents the 82,500 visit estimate, is new.
Now that P&L statements exist at three different volume levels, the
consequences of volume changes can be better understood. As the clinic™s
forecasted volume moves from 75,000 visits to 82,500 visits, its pro¬t in-
Chapter 5: Managerial Accounting Basics

Number of Visits
Atlanta Clinic:
69,165 75,000 82,500 2005 Projected
P&L Statements
Total revenues ($100 — volume) $6,916,500 $7,500,000 $8,250,000 (based on
Total variable costs ($28.18 — volume) 1,949,070 2,113,500 2,324,850 69,165; 75,000;
Total contribution margin
and 82,500
($71.82 — volume) $4,967,430 $5,386,500 $5,925,150
patient visits)
Fixed costs 4,967,462 4,967,462 4,967,462
Pro¬t ($ 32) $ 419,038 $ 957,688

creases by $957,688 ’ $419,038 = $538,650. This increase is equal to the
additional 7,500 visits multiplied by the $71.82 contribution margin. When
the volume is beyond the breakeven point, any additional visits are “gravy””
that is, the clinic™s ¬xed costs are now covered, so all contribution margin
additions ¬‚ow directly to pro¬t. Similarly, the outcome is known if the clinic™s
projected volume dropped from 75,000 to 69,165 visits. In this case, the
decrease of 5,835 visits multiplied by the $71.82 contribution margin equals
$419,670, which is the loss of pro¬t (except for a rounding difference) that
results from the volume decrease.
The movement from 75,000 to 82,500 visits resulted in a (82,500 ’
75,000) / 75,000 = 7,500 / 75,000 = 0.10 = 10% increase in
volume and thus total revenues. While the top line of the P&L state-
ment”total revenues”increased by 10 percent, the bottom line of the state-
ment”pro¬t”increased by 128.5 percent ($538,650 / $419,038 = 1.285 =
128.5%.) This incredible increase in pro¬t occurs because the clinic is reaping
the bene¬t of its cost structure, which includes ¬xed costs that do not increase
with volume.
If a high proportion of a business™s total costs are ¬xed, the business
is said to have high operating leverage. In physics, leverage implies the use
of a lever to raise a heavy object with a small amount of force. In politics,
individuals who have leverage can accomplish much with the smallest word or
action. In ¬nance, high operating leverage means that a relatively small change
in volume results in a large change in pro¬t.
Operating leverage is measured by the degree of operating leverage
(DOL), which at any volume is calculated by dividing the total contribution
margin by earnings before interest and taxes (EBIT), which for not-for-pro¬t
businesses is merely pro¬t plus any interest expense. At a volume of 75,000
visits, Atlanta Clinic™s degree of operating leverage is $5,386,500 / $419,038
= 12.85. (We have no information regarding the clinic™s interest expense,
so we are simply using its expected pro¬t.) The DOL indicates how much
pro¬t will change for each 1-percent change in volume. Thus, each 1-percent
change in volume produces a 12.85 percent change in pro¬t, so a 10 percent
138 Healthcare Finance

increase in volume results in a 10% — 12.85 = 128.5% increase in pro¬t. Note,
however, that the DOL changes with volume, so the 12.85 DOL calculated
here is applicable only to a starting volume of 75,000 visits.
Cost structures differ widely among industries and among organ-
izations within a given industry. The DOL is greatest in health services
organizations with a large proportion of ¬xed costs and, consequently, a low
proportion of variable costs. The end result is a high contribution margin,
which contributes to a high DOL. In economics terminology, high-DOL
businesses are said to have economies of scale because higher volumes lead
to lower per unit total costs. In such businesses, a small increase in revenue
produces a relatively large increase in pro¬t. However, high DOL businesses
have relatively high breakeven points, which increase the risk of losses. Also,
operating leverage is a double-edged sword: High DOL businesses suffer large
pro¬t declines, and potentially large losses, if volume falls.
To illustrate the negative effect of a high DOL, consider this question:
What would happen to Atlanta Clinic™s pro¬t if volume falls by 7.8 percent
from the base case level of 75,000 visits? To answer this question, recognize
that pro¬t would decline by 7.8% — 12.85 ≈ 100%, so the clinic™s pro¬t would
fall to zero. The data in Table 5.6 con¬rm this answer. At a projected volume of
69,165 visits (a decrease of 7.8 percent from 75,000 visits), the clinic™s pro¬t is
zero. Of course, this volume was previously identi¬ed as the breakeven point.
To what extent can managers in¬‚uence a business™s operating leverage?
In many respects, operating leverage is determined by the inherent nature of
the business. In general, hospitals must make large investments in ¬xed assets,
and hence they have a high proportion of ¬xed costs and high operating lever-
age. Conversely, home health care businesses need few ¬xed assets, so they
tend to have relatively low operating leverage. Still, managers can somewhat
in¬‚uence operating leverage. For example, organizations can make use of tem-
porary, rather than permanent, employees to handle peak patient loads. Assets
also can be leased, especially on a per use basis, rather than purchased. Actions
such as these tend to reduce the proportion of ¬xed costs in an organization™s
cost structure, and hence reduce operating leverage.

Self-Test 1. What is operating leverage, and how is it measured?
Questions 2. Why is the operating leverage concept important to managers?
3. Can managers in¬‚uence their ¬rms™ operating leverage?
4. How does an organization™s cost structure affect its exposure to
economies of scale?

Pro¬t Analysis in a Discounted Fee-for-Service Environment
As noted in the previous discussion, CVP analysis is quite valuable to managers
in that it provides information about expected costs and pro¬tability under
Chapter 5: Managerial Accounting Basics

Total revenues ($100 — 50,000) $5,000,000
Atlanta Clinic:
Total variable costs ($28.18 — 50,000) 1,409,000
2005 Projected
Total contribution margin ($71.82 — 50,000) $3,591,000
P&L Statement
Fixed costs 4,967,462
(based on
Pro¬t ($1,376,462)
patient visits)
alternative estimates of volume. To learn more about its usefulness, suppose
that one third (25,000) of Atlanta Clinic™s expected 75,000 visits would come
from Peachtree HMO, which has proposed that their new contract with the
clinic contain a 40 percent discount from charges. Thus, the net price for their
patients would be $60 instead of the undiscounted $100. If the clinic refuses,
Peachtree has threatened to take its members elsewhere.
At ¬rst blush, Peachtree™s proposal appears to be unacceptable. Among
other reasons, $60 is less than the full cost of providing service, which was
determined previously to be $94.41 per visit at a volume of 75,000. Thus,
on a full-cost basis, Atlanta would lose $94.41 ’ $60 = $34.41 per visit on
Peachtree™s patients. With an estimated 25,000 visits, the discounted contract
would result in a loss of 25,000 — $34.41 = $860,250. Before Atlanta™s
managers reject Peachtree™s proposal, however, it must be examined more

The Impact of Rejecting the Proposal
If Atlanta™s managers reject the proposal, the clinic would lose market share”
an estimated 25,000 visits. The projected P&L statement that would result,
which is based on 50,000 undiscounted visits, is shown in Table 5.7. At
the lower volume, the clinic™s total revenues, total variable costs, and total
contribution margin decrease proportionately (i.e., by one third). However,
¬xed costs are not reduced, so Atlanta would not cover its ¬xed costs, and
hence a loss of $3,591,000 ’ $4,967,462 = ’$1,376,462 would occur. To
view the situation another way, the expected volume of 50,000 visits is 19,165
short of the breakeven point, so the clinic would be operating to the left of
the breakeven point in Figure 5.3. This shortfall from breakeven of 19,165
visits, when multiplied by the contribution margin of $71.82, produces a loss
of $1,376,430, which is the same as shown in Table 5.7 (except for a rounding
Clearly, the major factor behind the projected loss is the clinic™s ¬xed
cost structure of $4,967,462. With a projected decrease in volume of 33
percent, perhaps the clinic could reduce its ¬xed costs. If Atlanta™s managers
perceive the volume reduction to be permanent, they would begin to reduce
the ¬xed costs currently in place to meet an anticipated volume of 75,000
visits. However, if the clinic™s managers believe that the loss of volume is
merely a temporary occurrence, they may choose to maintain the current ¬xed
140 Healthcare Finance

TABLE 5.8 Undiscounted revenue ($100 — 50,000) $ 5,000,000
Discounted revenue ($60 — 25,000)
Atlanta Clinic: 1,500,000
2005 Projected Total revenues ($86.67 — 75,000) $ 6,500,000
Total variable costs ($28.18 — 75,000)
P&L Statement 2,113,500
Total contribution margin ($58.49 — 75,000) $ 4,386,500
(based on
Fixed costs 4,967,462
50,000 visits at
Pro¬t ($ 580,962)
$100 and
25,000 visits at

cost structure and absorb the loss expected for next year. It would not make
sense for them to start selling off equipment and facilities, and ¬ring staff,
only to reverse these actions one year later. The critical point, though, is that
the loss of market share caused by rejecting Peachtree™s proposal can have
a signi¬cant negative impact on the clinic™s pro¬t, which indicates that the
clinic™s ¬xed cost structure should be reexamined.

The Impact of Accepting the Proposal
An alternative strategy for the clinic™s managers would be to accept Peachtree™s
proposal. The resulting projected P&L statement is contained in Table 5.8.
The average per visit revenue of serving these two different payer groups is
(2/3 — $100) + (1/3 — $60) = $86.67. Total revenues based on this average
revenue per visit would be 75,000 — $86.67 = $6,500,250, which equals the
value for total revenues shown in the table (except for a rounding difference).
With a lower average revenue per visit, the contribution margin falls to $86.67
’ $28.18 = $58.49, which leads to a lower total contribution margin.


. 5
( 21)