Boston University School of Public Health

PM735 Health Care Finance

Alan Sager

Notes on Budgeting and Break-even Analysis

1. Budgeting

A traditional macro- and micro-tool for cost control is the budget.

At the macro level of health spending, a nation that is serious about containing costs typically
establish ceilings on annual spending on health care.

Budgets typically detail how much money is available to be spent to cover certain costs—and often
how it might or must be spent. Budgets typically do not include revenue or estimate
surpluses/profits or losses.

When anticipated budgeted costs and anticipated revenue are compared, the result is a financial
analysis. That’s sometimes called a “pro-forma.” This simply means a projection for the future,
one that rests on various assumptions. Often, two or three different projections are prepared, each
resting on different assumptions.

This budgeting process is usually top-down. Politicians, sickness fund managers, and other payers
decide how much they can afford to spend on health care in a given year.

To stay under the ceiling, most other rich democracies establish budgets for individual hospitals—
including the salary income of doctors who work in the hospital. These nations commit to health
care for all, so it’s essential to spend money carefully—lest the promise of health care for all
become a lie. Doctors working in hospitals therefore typically work closely with hospital managers
to stay within the budget and spend money carefully.

At the micro-level, budgets are often built from the bottom-up. A grad student in Boston reflects
on the costs of living and identifies how much needs to be spent on various items monthly. These
costs are summed to a monthly budget of costs and then compared with available income and
savings.

Key elements in budgeting include

a. How much money is available to spend in total?

b. How is that sum set? Does our budget have a hard cap—a fixed or static sum? Or, if we give
more care, do we get more money to cover the cost of that added care? (That’s a flexible
budget.)
c. Is the money in our budget “fungible?” That is, if we don’t spend it on X, do we lose it or do
we have the ability to re-target it from X to Y?

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d. If the money is fungible, are our doctors willing and able to work with us to weed out
unnecessary, low-value, or incompetent care, and use the savings to serve patients who really
need our help?
e. What is our obligation to give needed care? Do we serve a defined group of people whose
health needs are reasonably well-known? Or is our service area undefined, and its people’s
health unknown? Can we turn people away or establish waiting lists if we lack enough money
to serve everyone who needs care this year?
f. How much does it cost us to give each type of care?

Budgeting at the macro- and micro-levels are certainly not the same. But they share a mode of
thinking—that the money is finite and has to be spent carefully.

This mode of thinking is much more common, in the U.S., at the micro-level than at the macro-
level. This is both a symptom of our unwillingness to contain cost and a cause of ever-higher
spending.

It is usually more effective to control spending in advance than to blame someone for higher-than-
desired spending after the fact. But how much can be spent? And how is this decided?

There is no abstractly “right” amount to spend. Rather, the budget usually depends on three things:
a) how much money is available—financially and politically—to spend on health care, b) how
much care is needed, and c) how much it actually costs to deliver various types of care.

What is the purpose of a budget? It tells a responsible party—such as the nation’s minister of
health, or the administrator of a whole hospital, a laboratory, a kitchen, or a maintenance
department—how much money he/she has to spend during a given year.

Today, budgets for hospital departments are usually set in light of available revenue, costs of care
incurred in the past, expected increases in prices that must be paid to workers and suppliers,
anticipated changes in volume, expected efficiencies, and the like.

Static and flexible budgets

Given how fixed and variable costs behave, we can compare two types of departmental budgeting,
static budgeting and flexible budgeting. Static budgeting ignores the effects of changes in volume
on FCU (fixed cost/unit) while flexible budgeting takes this factor into account.

Suppose that a manager of a lab has a static budget but must actually provide all the tests ordered
by physicians. This type of static budget might be called a “soft” static budget. The manager can
easily go over or under budget, depending on the volume of tests ordered by doctors.

A soft static budget can unfairly punish a manager for higher costs that result from providing a
higher volume of care than had been expected. And it can unfairly reward a manager for lower
costs that result from lower-than-expected volumes.

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Smart higher-level managers (the people to whom the lab manager reports) should recognize that
the lab manager is volume-taker and refrain from awarding (or punishing) the lab manager for
spending less (or more) than was budgeted.

Sometimes, static budgets are very tough and do not allow providing a higher volume of tests than
had been expected when the budget was established. This type of static budget might be called a
“hard” static budget. Here, there’s no punishment for exceeding the budget because the manager is
prohibited from spending money that’s not in the budget—so the budget can’t be exceeded and
punishment is irrelevant.

How might you evaluate the performance of a manager who has a hard static budget?

When a lab has a hard static budget, physicians generally adapt and learn to modulate and prioritize
their test-ordering, so their requests don’t engender costs that exceed the hard budget. Hard
budgets are usually imposed on a hospital’s departments when the flow of revenue to the hospital is
finite and unchanging—imposed by the people who control that flow. It won’t vary with the
number of patients served or the severity of their need for care.

Flexible budgeting is usually more fair than soft static budgets because it acknowledges that most
departmental administrators like lab managers in a hospital or food service managers in a nursing
home do not have control over two things—the fixed cost portion of their budget or the volume of
service they must provide. A flexible budget therefore holds them accountable only for their total
variable costs.

Flexible budgeting is usually possible only when the larger organization, such as the hospital, will
obtain more revenue when it provides greater volumes of care.

Budget variances

Performance of the administrator is usually measured by the gap (or "variance") between actual and
budgeted costs. The gap can be favorable (FAV—better than expected—actual costs are under
budget) or unfavorable (UNFAV—worse than expected—actual costs are over budget).

Please avoid calling these variances positive or negative. Calling them positive or negative will
engender confusion and, ultimately, adamantine defenestration.

We can compare the budget variances under two alternative types of budget for a laboratory, a soft
static budget and a flexible budget.

The soft static budget simply assumes 20,000 tests in 2019, an average total cost/test of $2.50,
yielding a total expected cost of $50,000. That static budget of $50,000 is used regardless of the
actual volume of care provided—the number of lab tests actually performed.

Three possible levels of actual tests and actual costs are given. (Under a soft static budget, actual
volume and actual costs seldom behave quite as predicted or budgeted.)

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Soft static budget
actual tests actual costs incurred planned static budget variance
18,000 $47,000 $50,000 $3,000 FAV
20,000 49,000 50,000 1,000 FAV
23,000 54,000 50,000 4,000 UNFAV

This indicates that an administrator enjoyed lower costs than budgeted—seemed to do a good job—
merely because volume of tests was below the budgeted level. The administrator seemed to do a
bad job at the higher-than-budgeted volume. Neither is a fair judgment. The administrator
probably has little control over volumes. (Please think about which managers, in an actual hospital
today, might be able to control volume and which might not.)

If you can’t control the volume of care you must cope with, you’re a “volume-taker.” If you can
control your volume (or someone else’s volume), you’re a “volume-maker.”

Different volumes will be associated with different total variable costs (TVC) and different fixed
costs/unit (FCU). The former is often under the influence of the administrator, but the latter almost
never is.

Flexible budget

The flexible budget is fairer in suggesting both reward and blame. This one assumes total fixed
costs (TFC) of $10,000 and VCU of $2.00.

actual tests actual costs incurred planned flexible budget Variance

18,000 $47,000 $46,000 $1,000 UNFAV
20,000 49,000 50,000 1,000 FAV
23,000 54,000 56,000 2,000 FAV

The flexible budget, then, acknowledges the real world of fixed and variable costs, and gives
administrators different budgets for different volumes of care or service.

This is a better tool in most respects, but it requires more careful planning. Our budget will now
depend on our volume. We therefore have to have good, up-to-date information on that volume,
and expand or contract spending accordingly. This can be a little nerve-wracking.

How to treat semi-variable costs in static and flexible budgets?

Good question!

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Since you will be preparing a budget for a given volume of care, you can include TSVC
appropriately.

In a static budget for 20,000 lab tests, you might need to include the cost of paying two lab
technicians. They are a semi-variable cost to the lab. They would be part of the budget for the
20,000 lab tests.

In a flexible budget, you would consider the fixed, semi-variable, and variable costs of providing
18,000, 20,000, and 23,000 lab tests. Semi-variable costs might well rise as volume of care rises.
You’d budget the semi-variable costs commensurate with each volume, just as you’d budget the
variable costs commensurate with each volume. The budget might well show jumps in total costs
at certain volumes of care—the volumes at which an additional worker’s semi-variable costs are
added to total cost.

2. Break-even Analysis

Total revenue (TR) is the product of the actual revenue per unit of care (RU) and the quantity of
services or procedures (Q).

Total cost (TC) is the sum of TFC, TSVC, and TVC. For simplicity, we’ll ignore TSVC for now.

The break-even quantity (BEQ) is the level of service (the volume of care) at which TR equals TC.
It’s the volume of care at which all actual costs—fixed and variable—are covered by actual patient
care revenue. Exactly. There’s no surplus and no loss.

BEQ is the number of units of care that must be given to cover all costs. It’s just a number, such as
1,100 home care visits per month or 800 hospital admissions per month. It is not an amount of
money.

Break-even revenue (BER) is the revenue at which TR = TC. BER equals the product of RU and
BEQ.

BEQ and BER refer to the same volume of service, the same number of units. The first is the
number of units at which we break even; the second is the TR we are paid at BEQ.

Calculate BEQ like this:

TFC
BEQ = ------------------------
RU - VCU

That is, break-even quantity is determined by dividing total fixed costs by the difference between
price per unit and variable cost per unit.

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How about an example?

Total fixed cost at our nursing home (mortgage, administrator's salary, and maintenance contract) is
$800,000 per year. How many patient days of care must we give to break even, if our variable cost
per patient-day is $180.00 and our actual revenue per patient-day is $200.00? Assume for this
example that all patients pay that actual revenue.

$800,000
BEQ = ----------- = 40,000 patient-days = BEQ
$200/patient-day - $180/patient-day

Notice that the $ sign in the numerator is canceled by the $ sign in the denominator, so we’re left
with patient-days.

And that makes sense because BEQ is a quantity of care, not an amount of money. (It is always
helpful to follow the units of measurement!)

Now, if I said "what is the average daily census and occupancy rate at BEQ?" how would you
reply?

Well, 40,000 patient-days / 365 days =109.6 average daily census (patients on an average day).

Please notice that the days cancel here, leaving you with patients as the unit of measurement for
your quotient of 109.6 patients.

You'd have to ask how many beds the home had to learn the occupancy rate.

 If the home had 125 beds, it could break even at the specified TFC, RU, and VCU.
 It has enough beds—capacity—to accommodate the average number of patients per day it
would require to reach break-even.
 Its average occupancy rate would be 109.6 / 125 = 87.7 percent.

 But if the home had only 100 beds, it could not break even at the specified TFC, RU, and
VCU. There are not enough beds to house the average daily census you’d require to break
even.

This is a reality check! In the real world, it is often interesting and useful to go back and forth
between financial calculations and measures of actual capacity to care for patients.

Once we know BEQ and RU at BEQ, we can multiply these to learn BER, the revenue (and cost) at
which we break even.

TC at BEQ = TFC + TVC = $800,000 + (VCU * Q = $180 * 40,000 = $7,200,000) = $8,000,000

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TR = at BEQ = RU * Q = $200 * 40,000 = $8,000,000

So TC = TR at the BEQ we calculated, which reassures us that our calculation was accurate.

This information allows us to say things like, “at break-even, TFC = only 10 percent of total costs.”

Contribution margin

The difference between RU and VCU is sometimes called the contribution margin (CM) per unit of
care.

CM is the sum that each unit of care contributes toward covering fixed costs.

Think of it like this. Assuming that RU is greater than VCU (if not, we're in real trouble!), the
surplus of RU over VCU is money not needed to cover variable costs. Therefore, this sum is
available to be applied to fixed costs.

A higher RU or a lower VCU increases the CM. Other things equal, a higher CM means we break
even at a lower volume. If you like, try one or two examples for yourself and see how this works.

Conversely, a lower RU or a higher VCU decreases the CM. This means that BEQ is higher.
Again, why not try an example or two?

Please notice the basic point that, if we are going to be able to break even, RU must be greater than
VCU. If VCU is greater, the denominator will be negative, and BEQ will be negative (a positive
TFC divided by a negative CM equals a negative, right?). That means we’d have to give less than
no care in order to break even. Sounds like trouble!

BER

Break-even revenue can be calculated in several ways. First, we can learn BEQ and multiply it by
RU, as we did on page 5.

Or second, we can use this formula:

TFC
BER = ---------------
1 - (VCU / RU)

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That is, break-even revenue equals total fixed cost divided by 1 minus the ratio of variable cost per
unit of care to actual revenue per unit of care.

Thus, the higher the ratio between variable cost per unit and actual revenue per unit, the smaller the
denominator, and the larger the BER. This makes sense-- a higher ratio means a bigger VCU or a
smaller RU, or both. If VCU is almost as great as RU, each unit of care we give generates a
smaller contribution margin, so we must give more care to fully cover TFC.

And again, please notice that if VCU is bigger than RU, we’d end up with a negative denominator,
and a negative BER, which would make no sense at all!

If monthly total fixed cost at our Medicare-certified home health agency is $15,000, our VCU is
$33 per visit, and our average (!) RU is $38 per visit, what is our monthly BER?

$15,000 $15,000
BER = --------------- = ----------- = $113,636
1 - ($33 / $38) 1 - 0.868

We can check this.

At BER, TR = TC. TR = $113,636, according to our calculation.

TC = TFC + VCU(Q). This is the old Y = a + b(X) equation.

TC should = $15,000 + $33 (Q). But what is Q?

We can get it by dividing TR by RU, because TR = RU * Q, so Q = TR/RU, right?

Q then = TR/RU = $113,636 / $38 = 2,990 visits.

TC = $15,000 + $33 (2,990) = $15,000 + $98,670 = $113,670-- close enough, allowing for
rounding errors.

So, TR = TC at BEQ!

Try a few examples to see how changes in VCU and RU affect BER. Remember to divide VCU by
RU before subtracting this quotient from 1.

In all of these break-even analyses, notice that a higher TFC means a higher BEQ and BER, other
things (contribution margin) equal. That's because a higher TFC must be spread over more units,
given a constant contribution margin.

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Please keep in mind the subtle and tricky idea that BEQ and BER are abstractions. They are the
points on a chart where a TR line and a TC line cross. I’ll ask you to calculate BEQ and BER
sometimes.

But other times, I’ll ask you to calculate actual revenue (TR) and actual cost (TC) at a particular
time and place. You would then use the evidence about actual costs incurred (fixed and variable
and semi-variable, say), and actual revenue obtained (RU * Q, right?).

Profit, or surplus, or net of revenues minus expenses

= TR - TC.

This can be
positive (when TR > TC), when we’re providing care at volumes above BEQ
0 (when TR = TC), at BEQ (and BER)
or negative (when TR < TC), when volume is below BEQ.

Some problems will ask how much service you must give to earn a fixed sum (such as $100,000) as
profit. In this instance, just add the demanded profit to total fixed cost in the numerator of the
equation.

In this sense, we think of profit as an additional fixed cost. Use the BEQ or BER equation, but the
answer is not the true no-profit "break-even quantity," but rather a higher level, because it includes
a sum as profit.

If you need to know not BEQ or BER but rather some other component of one of these two
equations, solve the equation algebraically for the component in question.

Don't worry if some of this fails to make sense yet. We'll go over it in class and get some practice
with it.

BEQ and BER are handy tools for financial planning, budgeting, and other purposes.