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VII / VIII

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Preface

My first book, Reengineering the Medical Practice, was published by St. Anthony's in 1994. As it happens, the environment physicians face today - seventeen years later - is strikingly similar to the one we faced then. Fortunately, the principles and strategies discussed in the reengineering book have withstood the test of time and have resulted in increased quality, lower costs, and improved medical practice performance for its readers. These same principles lay the foundation for material discussed in The Medical Practitioner's Survival Handbook.

Whether you practice solo, in a small group, as part of a large network, or in a "supergroup," the same laws of science encountered in your pre-med education can be applied in unique, innovative ways to your medical practice. They will help you to increase quality and productivity while decreasing costs. These strategies make sense in any healthcare environment, but in the current high volume, price competitive market in which payers and employers are seeking to reward efficiency and quality, the potential opportunities to be gained through application of these principles are signifiant. Given the similarity of the 1994 medical arena to that of 2011, I feel that the preface taken from the reengineering book applies as well today as it did seventeen years ago.

Preface from Reengineering the Medical Practice, 1994

Let's face it, medicine is a business, and that business is changing fast, very, very fast. The "tried and true" isn't working today, and by tomorrow, it will fail completely. In this competitive climate, lower reimbursement rates and higher costs have combined to reduce profitability and quality of care. To survive, you will need tools that will help you compete profitably and avoid costly mistakes.

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The good news is that addressing these problems is not a mysterious proposition. It will, however, require a change in the way you do things. Other industries experiencing similar competitive environments have adapted successfully. The bad news is that while major industries have made this transition, many corporations competing within those industries have failed along the way. This is why Reengineering the Medical Practice was written. The same sound business practices employed by businesses that succeeded in the corporate arena can be adapted to work in your medical office or clinic. As the practice of medicine and the entire health care industry change, the skills that have worked so well for you in the past must be augmented with business skills designed to increase quality, improve efficiency, and lower costs. This book will provide you with the business knowledge needed to bridge the gap between today's and tomorrow's practice of medicine.

In every industry, the most successful companies are those which make the most profit. The highest profits are achieved by those with the capability to adapt to change and deliver, in the least costly way, a high volume of those quality features most valued by customers. To understand the type of change necessary for adapting, consider a problem that Ford Motor Company faced in the early 1980s. Ford employed more than 500 people in accounts payable and realized that it needed to cut costs in this department in order to better compete against foreign imports. To address this inefficient process, Ford planned to install a new computer system with the hope of reducing its accounts payable head count by 20 per cent. Compare Ford's hoped for outcome to the reality of Mazda's accounts payable department which, during this same time period, employed only five people! Obviously, Mazda's accounts payable process was not simply an improved version of Ford's; it was an entirely different "species" that had been accomplished through workflow analysis and process re- engineering. Given the fact that all value delivered by medicine is achieved through some type of "process," similar opportunities for improvement are substantial.

This book represents the results of two decades of analysis and study of the successful principles utilized by other industries that have already been through the same competitive changes that medicine is currently experiencing. It adapts those same principles

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for use in attacking the cost, quality, access, and profitability problems currently faced by physicians. The relevant information needed to succeed in a price competitive market is included in this book, and the business disciplines needed to understand and effectively apply these concepts are presented in a language understandable to physicians.

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Chapter 1: Know Your Costs

Revenue and Costs

We've all heard the saying, "It's not how much you make that counts, it's how much you keep." Let us consider this in terms of the medical practice. Although top line revenue for today's typical practice remains relatively high, the amount that drops to the bottom line as profit continues to shrink. This is partly due to lower fees, but doctors today are facing even bigger challenges - high patient volumes and more complex business operations - resulting in overly high costs. These circumstances have propelled the understanding and effective application of efficiency concepts to the forefront of the tools a practitioner must wield in order to achieve ultimate success. As we will see throughout this book, efficiency has a positive impact on quality as well as on profitability; a doctor who focuses on "quality" through efficiency will achieve more profit in the process.

In business, profit results from supplying a product or service that a customer values and is willing to pay more for than it costs to produce. Profit is important to the success of every business and is a reflection of its value. Unnecessary costs can significantly reduce this "value" - sometimes to the point that the business ceases to exist. Before analyzing the business operational areas that impact quality and profit, it is important that we first understand profit from a financial perspective, starting with the profit equation.

The Profit Equation

Profit is defined as revenue minus cost, and revenue is defined as price times volume. Combining these two equations, we arrive at the formula:

Profit = (Price * Volume) - Cost

In a price competitive market, price is often out of our control and is certain to decrease. Volume is out of our direct control and could move either up or down. The only part of the equation under our direct control is cost. Our profit equation reveals that an

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increase in volume, a decrease in cost, or the combination of both, could offset a decline in profit resulting from lower prices. The following is the "winning" strategy when price is declining:

Profit = (Price ↓ * Volume ↑) - Cost ↓

Since volume is not under our direct control, it may decline, and if it does, costs must be aggressively reduced in order to offset this decline and, thereby, maintain or increase profit. While practitioners fear the possibility of failure resulting from an inability to secure contracts that pay reasonable fees, they should also be aware that failure can be caused by obtaining contracts that, while they increase volume, cause costs to increase at a faster rate than revenue. Any strategy that ignores costs is a "losing" one, one that will result in lower profit.

Cutting costs should not be simply a matter of spending less or "doing without." In a medical practice, this type of cost-cutting results in lower quality - especially when patient volume is increasing. The key to success is maintaining, or increasing, quality while simultaneously increasing volume and decreasing costs. This process is not an easy one but is made possible through implementation of efficiency improvements. Efficiency techniques and the tools for their successful implementation will be discussed throughout this book.

Cost Trends Over Time

Over the lifetime of a business, costs tend to follow a "U" shaped curve. At first, they decrease rapidly as volume increases. This is an intuitive concept, and most people understand this relationship as being related to cost-savings resulting from economies of scale. If a practice's annual overhead is $250,000 and only one patient is treated, the total cost of treating that one patient is $250,000. When a second patient is treated, the cost decreases to $125,000 per patient; adding just one patient cuts costs-per-patient in half. When 1,000 patients are treated, the average cost is $250 per patient. At this point, treating one more patient (patient number 1,001) reduces costs by only $00.25 per patient. As you can see,

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cost per patient continues to decline at this point, but at a much slower rate.

Increasing volume helps to reduce costs by spreading overhead over a greater number of patients; however, there are also some new costs associated with any increase in patient volume. With each additional patient, a small, incremental cost related to supplies is incurred, and when a pivotal number of patients is reached, additional personnel may be required to deal with the higher volume. At this point, any additional increase in volume may raise costs enough to actually lower profit. As patient volume reaches beyond office or clinic capacity, costs rise even faster. This phenomenon is related to inefficiencies that occur in a sub-optimal environment (such as one with inadequate treatment space or redundant employees).

The above example is depicted in the "U" shaped cost curve on the following chart:

This curve is common to all businesses and shows clearly how the per patient cost initially drops quickly as patient volume increases and then tends to level off. An optimum point is reached when per patient costs level off to a minimum. This point is different for each practice and reflects over-all office efficiency. To determine

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this actual number for any particular practice, such factors as the number of treatment rooms, types of equipment available, business processes in place, treatment processes utilized, physician skills, and other factors that vary from clinic to clinic must be taken into account. This curve does not reflect revenue; however, no matter what the total revenue is at a given point in time, profit will be highest at the point on the cost curve where per patient costs are lowest.

Remember that the above graph represents average cost per patient. The reason that the speed of the decline of average cost slows, and then stops, is that at some point, the small incremental cost increase (marginal, or variable, cost) for new or additional business begins to "add up." This increase begins long before the average cost per patient begins to increase. The significant thing to understand here is that increasing patient volume beyond some optimal point has the actual potential of reducing the profit margin. There is some point at which more volume does not translate into more profit. The lower the fee, the sooner this point will be reached.

Fixed Costs and Variable Costs

It is essential to understand that there are two types of costs relevant to making decisions regarding volume or pricing: fixed and variable ones. Most data we receive from our accountants gives us only average and total costs. Both average and total cost numbers combine fixed and variable costs together. For most of the decisions we will be making - such as short-term pricing and contracting decisions that will alter patient volume - the variable costs are the ones that are relevant. Variable costs are the existing ones that will change as a direct result of implementing specific decisions.

Fixed costs, on the other hand, are the ones that are not going to be altered by a specific decision. They are a result of previous decisions and are the costs that are not going to change as a result of this new decision. Fixed costs should not be a factor when determining what changes you want to make. Using fixed costs when making short-term, strategic financial decisions leads to poor

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financial choices, especially when the choice involves whether or not to accept a contract that will increase patient volume.

For example: a doctor with a practice grossing $200,000 a year considers signing a contract that will increase the practice by 2,000 visits a year. The contract will add revenue of $25 per patient and, therefore, should increase revenue by $50,000. Before accepting the contract, the doctor needs to determine the cost of treating these additional patients.

The doctor's accountant analyzes the contract and recommends that it be rejected because, as he tells the doctor, "You will lose money." He explains that the practice overhead ($120,000) is 60 percent of total revenues and that the doctor had 4,000 patient visits last year (80 a week). From these figures, he calculates the average cost per patient to be $30 and informs the doctor that with the new contract's revenue of only $25 a patient, s/he would be losing $5 a patient.

While there may be other reasons for rejecting this contract, lack of profitability should not be one of them. Otherwise intelligent people often make this type of mistake. Fixed costs have not been correctly accounted for in making this decision.

Assume that the doctor will be able to accommodate the additional 2,000 patient visits (8 a day) without adding costs for more space or hiring additional employees. Further, assume that there is an average $3 supply cost for each patient ($6,000 for 2,000 patients). For purposes of this contract decision, rent, salaries, malpractice premiums, automobile expenses, telephone costs, and other expenses should not change. In other words, for purposes of this decision, these are all fixed expenses that should not enter into the decision making process because they will need to be paid whether or not the doctor accepts the contract. By considering only relevant costs (the variable ones, i.e. supply costs), the doctor determines that this contract will not produce a loss. Instead, it should increase profit by $44,000. This is demonstrated in Table 1.1.

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Table 1.1: Calculating Contract Profitability

If the doctor determines that treating these additional patients will require hiring one more employee, that employee's salary becomes a variable cost and is relevant to making the decision as to whether or not s/he should accept the contract. (The amount of this new salary would be added to the overhead/changes under contract entry in Table 1.1).

Confusion is created when some costs that we traditionally see as "fixed" become "variable" because of a particular change we are considering. For example, when making a decision regarding change in a practice, rent is usually considered a fixed expense; however, if a contract or merger is being considered which will increase patient volume to the point that the practice will require additional space, any resultant increase in rent is relevant to the decision being made. The amount of the rent increase is added to the variable costs at this point. If the current rent is $3,000 a month and the new rent would be $4,500 a month, the original $3,000 cost remains as a fixed expense while the $1,500 increase becomes a variable expense for purposes of this decision.

Revisiting the Profit Equation

Recall the profit equation: Profit = (Price * Volume) - Cost. From what we now know about costs, we could re-write this equation as follows:

Profit = (Price * Volume) - (Fixed Costs + Variable Costs)

This is the equation for total profit, but most decisions regarding fees and volume are based on predicted marginal (additional) profit. For these decisions, fixed costs are irrelevant and should

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not be included in the equation. The profit equation can be re-written as follows:

Marginal Profit = (Price x Increase in Volume) - Variable Costs

It is important to re-emphasize that the relevant costs for decision making vary with the type of decision being made. In the above contract and volume example, variable costs are the relevant ones. Later, we will see that fixed-costs are relevant when we are making cost cutting and efficiency improvement decisions.

Marginal Profit and Diminishing Returns

Assume that a clinic spends $20,000 for advertising in one year and that this advertising brings in 100 new patients, at an average of $300 per patient. This generates total additional revenue of $30,000. This $20,000 expenditure produces a net gain (profit) of $10,000. The average advertising cost, per new patient acquired, is $200, and the average revenue, per new patient, is $300.

Table 1.2: Marginal Profit from Advertising Cost

Should the clinic have additional slack time in which to see more patients, it might make the strategic decision to increase next year's advertising by another $10,000. Using the available accounting data, this would seem to make sense; however, the clinic does not have all cost data necessary for making this decision. For example, what if, in the previous year, the first $10,000 spent had brought in 80 of the new patients? This would mean that the second $10,000 brought in only 20! Before making any decision, this practice needs to do a cost effectiveness analysis of its advertising expenditure.

This example alerts us to the fact that we should take into account the law of diminishing marginal returns: when making any financial decision, each additional dollar we spend beyond an

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optimum point has a decreasing return. In this case, the first $10,000 spent on advertising brought in $24,000 in revenue whereas the second $10,000 brought in only $6,000. With a loss of $4,000 for the second $10,000, it is clear that spending this second $10,000 was not cost-effective. This conclusion would not be clear if we were to use only total cost and average cost data.

Using the typical accounting data available to managers, this clinic would make the decision to spend an additional $10,000 on advertising - with the expectation of receiving 50 more new patients and $15,000 more in revenue; however, using the relevant numbers (incremental or marginal numbers), an optimal financial decision will be made: spend $10,000 less on advertising than last year. In this case, this year's advertising costs would be $10,000, and the benefit could be predicted to be $24,000 (80 * $300). This decision should result in $14,000 in profit - more than the previous year's $10,000.

Table 1.3: Comparison of Marginal Profit

Compare this with a decision to increase the $20,000 advertising budget by another $10,000 for the next year (a decision that is likely to be made when using only average and total cost data). This would bring the yearly advertising costs to $30,000, with a possible benefit of $33,000 (110 * 300). This produces a profit of only $3,000 as compared to the potential $14,000 in profit to be achieved by reducing the budget by $10,000 in the next year!

Table 1.4: Returns on Diverse Advertising Costs

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Opportunity Costs

When making decisions, there are implied costs to consider that do not appear on financial statements. Every time we make a decision, we are choosing between alternatives, and there are always tradeoffs when choosing one alternative over another. For example, when we choose to schedule a procedure from 8:30 to 10:30, we exclude other types of patient care between those hours. Or, if we add space to our business office, we exclude the possibility of using that same space for patient treatment. Making a decision requires tradeoffs. One measure of the cost of a decision is the amount of profit that might be lost as a result of that decision - profit that would have been earned had an alternative choice been made. This cost is referred to as opportunity cost, and it can be incurred even when no money is spent. Opportunity cost will not show up on a profit/loss statement, but it should be considered when making a decision regarding the use of time, capital, or space.

If someone in a practice is performing one function, it is always at the exclusion of other possible choices. For example, if a back office assistant is drawing blood, he or she cannot be changing a dressing or taking an x-ray at the same time. A dollar amount can always be put on "the best alternative foregone," and obviously, one's time should always be spent on the highest valued opportunity (in some cases, using a doctor's free time may even be the most valued opportunity). Sometimes, choices involving opportunity costs are made "on the spot," and at others, they are the result of extensive analysis and planning. Opportunity costs become most relevant when re-engineering a practice because many of the decisions made during the re-engineering process involve "who does what and when."

In the early seventies, "The $100,000 Practice" was a goal to be achieved. I recall a well-known practice management expert stating, " If your practice is generating $100,000 a year, your time is worth $50 an hour. A $50 per hour doctor should not be doing $10 an hour work." This statement might "sound right" on cursory hearing, but it does not take opportunity costs into account, and adhering rigidly to such advice can result in creating support staffs (who do the "less than $50 per hour" work) that are too large,

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costly, and less efficient than ones that are smaller and better-trained.

There is always potential for making a wrong decision when basing that decision on averages. For example, in the course of a typical day there may be a few hours when a doctor who averages $50 an hour is actually producing $400 an hour and other times when s/he is producing nothing. At the times when there are no opportunities to produce income, the doctor's opportunity costs are zero. At such times, we do not want that doctor to interrupt an assistant who is already performing productive work in order to ask him or her to perform a task (a less than $50 per hour one) which the idled doctor could easily perform (i.e. remove a dressing or even schedule a return appointment from a computer terminal located in the treatment room). If such a need occurs at a time when the doctor's opportunity costs are zero, it is the doctor who is the best person to perform that task at that moment. While some of these tasks may seem to be relatively "insignificant," failure to consider the doctor's opportunity costs in such "small matters" can result in substantial cost increases in a practice and overall inefficiencies. A "micropractice" consisting of one doctor, one nurse, and maximum use of information technology is an extreme example of allocating physician and staff time based primarily on opportunity costs.

Sunk Costs

Sunk costs are the final ones to consider when making strategic decisions. They are different from fixed costs in that they are those costs that will not be changed as a result of making a strategic decision (even over the long-term). For this reason, sunk costs should never be a factor when making such a decision. For example, assume that you purchase a computer system at a cost of $32,000. Four years later, that system needs to be upgraded - at a cost of $16,000. A brand new system, which has the same capabilities as can be obtained through upgrading this old system, can be purchased for $9,000. Should the doctor purchase the new system and scrap the old one - or should he upgrade the old system?

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