Introduction to managerial accounting

1
Revisted- CHAPTER 5 Cost Behavior and Profit
Analysis

• Introduction to managerial accounting
• Cost classifications
• By sub-unit
• By volume
• Profit analysis
• Profit and loss (PL) statements
• Graphical analysis

2
Cost Classifications

• Cost measurement is a critical part of managerial
  accounting.
• In fact, there is an entire field of accounting
  called cost accounting.
• Unfortunately, there is no single definition of
  the term cost. Different costs are used for
  different purposes.
• Costs are classified in two major ways
• By their relationship to the sub-unit.
• By their relationship to volume.

3
Direct Versus Indirect Costs

• Costs that are unique to a sub-unit are called
  direct costs. For example,
• Labor costs of laboratory employees.
• Reagents and other supplies costs.
• Laboratory equipment costs.
• Costs incurred by the business, but not unique to
  the sub-unit, are called indirect (overhead)
  costs. For example,
• Utilities and housekeeping costs.
• General administrative costs.

4
Direct Versus Indirect Costs (Cont.)

• Which costs are easier to measure at the sub-unit
  level direct or indirect?
• Is the direct versus indirect cost classification
  relevant at the organizational level?
• Direct and indirect costs will be discussed in
  greater detail in chapter 6.

5
Fixed Versus Variable Costs

• The relationship between costs and the amount of
  services provided is called cost behavior or
  underlying cost structure.
• If the underlying cost structure is known,
  managers can forecast costs at different levels
  of patient volume.
• Costs are defined as either
• Fixed, which are independent of volume.
• Variable, which depend on volume.

6
Fixed Versus Variable Costs (Cont.)

• In the long-run, all costs are variable, thus the
  fixed versus variable cost classification holds
  only in the short-run, say, for one year.
• No costs are fixed throughout an indefinite range
  of volumes. Thus, the concept of fixed versus
  variable costs must be applied within some
  relevant range of patient volume.

7
Cost Structure Example

Variable Costs Per Visit Fixed Costs Per Year
Clinical supplies 20 Depreciation
30,000 Supplies 5 Salaries
190,000 25 Other
80,000 300,000
Total Fixed Variable
Total Average Volume Costs Costs
Costs Cost 1 300,000
25 300,025 300,025 50 300,000
1,250 301,250 6,025 100 300,000
2,500 302,500 3,025 200 300,000
5,000 305,000 1,525 500
300,000 12,500 312,500 625 1,000
300,000 25,000 325,000 325
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Cost Structure Example (Cont.)

• Consider a volume of 100.
• What are the fixed costs?
• What is the variable cost rate?
• What are total variable costs?
• What are total costs?
• What is the per visit average cost?
• Now consider a volume of 200. What is the value
  for
• The variable cost rate?
• Fixed costs?
• Total costs?
• Average cost?

9
Graphical Cost Structure
What is the slope of the the total variable costs
line? What is the relationship between total
costs and total variable costs?
Costs ()
Total Costs
Fixed Costs
Total Variable Costs
Volume (Number of Visits)
10
Profit (CVP) Analysis

• Profit analysis, also called cost-volume-profit
  (CVP) analysis, is a technique used to assess the
  effects of volume changes on costs and profits.
• Why is such information valuable to health
  services managers?

11
Profit Analysis Example
Atlanta Clinic has forecasted the following cost
data on the basis of 75,000 expected
visits Fixed costs Total
variable costs 2,113,500 Total costs

4,967,462
7,080,962
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Profit Analysis Example (Cont.)

What is the variable cost rate? Variable cost
rate
Total variable costs

Volume
2,113,500

75,000
28.18 per visit.

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Profit Analysis Example (Cont.)

What is Atlantas cost behavior model? Total
costs Fixed costs Total variable costs

4,967,462 (28.18 x Volume).
Thus, at 70,000 visits Total costs

4,967,462 (28.18 x 70,000)
4,967,462 1,972,600
6,940,062.
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Profit Analysis Example (Cont.)

Cost/Volume Summary Volume 70,000 TC
4,967,462 1,972,600 6,940,062. Volume
75,000 TC 4,967,462 2,113,500
7,080,962. Volume 80,000 TC 4,967,462
2,254,400 7,221,862.
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Profit Analysis Example (Cont.)

• What do Atlantas managers learn from the data on
  the previous slide?
• Now, suppose that the average revenue per visit
  is expected to be 100. What does the clinics
  cost and revenue structure look like graphically?

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Graphical Profit Analysis
Revenues and Costs ()
Where are profits and losses? Where is 75,000
visits? Where is the breakeven volume?
Total Revenues
Total Costs
Fixed Costs
Volume (Number of Visits)
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Pro-Forma Profit and Loss(PL) Statement

• The pro-forma PL statement uses cost structure
  information along with the revenue forecast and
  projected volume to forecast profitability.
• Although it looks like an income statement, it
  does not have to follow GAAP.
• Because it is a forecast, it can be influenced by
  managerial actions.

18
Base Case PL Statement
Total revenues (100 x 75,000) 7,500,000 Total
VC (28.18 x 75,000) 2,113,500 Total CM
(71.82 x 75,000) 5,386,500 Fixed costs
4,967,462 Profit 419,038 VC
Variable costs. CM Contribution margin.
19
Base Case PL Statement (Cont.)

• Note that base case total costs equal fixed costs
  plus total variable costs or 4,967,462
  2,113,500 7,080,962.
• Thus, Atlantas average per visit cost is
  7,080,962 / 75,000 94.41.
• What happens to the average per visit cost as
  volume increases.
• Why?

20
Contribution Margin

• The contribution margin is defined as the
  difference between per visit (unit) revenue and
  the variable cost rate.
• It is the amount of each visits revenue that is
  available to
• Cover fixed costs.
• Flow to profit when fixed costs are covered.
• In this illustration, the contribution margin is
  100 - 28.18 71.82.
• What is the total contribution margin?

21
Breakeven Analysis

• Breakeven analysis is performed in many different
  finance contexts.
• Here, it is used to determine the breakeven
  volume, defined as that volume needed for an
  organization (or service or program) to be
  financially self-sufficient.
• In essence, the breakeven volume is that volume
  that produces a profit of 0.

22
Breakeven Analysis (Cont.)

• There are two approaches to volume breakeven
• Pro-forma PL statement
• Graphical analysis

Total revenues - Total VC -
FC Profit (100 x V) -
(28.18 x V) - 4,967,462 0
71.82 x
V 4,967,462
V 4,967,462 / 71.82 69,165 visits.
PL Approach
23
Breakeven Analysis (Cont.)
Note that the PL approach can be recast in a
contribution margin format.
CM x
V Fixed costs 71.82 x
V 4,967,462 V 4,967,462 / 71.82
69,165 visits.
PL Approach (Contribution Margin Format)
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Graphical Breakeven Analysis
Revenues and Costs ()
Total Revenues
Total Costs
Fixed Costs
Volume (Number of Visits)
69,165
25
Breakeven Analysis (Cont.)
Breakeven concepts can be used to determine
the volume needed for any given profit, say,
100,000
CM x
V Fixed costs Profit
71.82 x V 5,067,462 V 5,067,462 /
71.82 70,558 visits.
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Operating Leverage

• Operating leverage is the use of fixed costs
  the higher the proportion of fixed costs in an
  organizations cost structure, the greater the
  operating leverage.
• Operating leverage is measured by the degree of
  operating leverage (DOL), which is defined as

DOL Total CM / Profit.
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Operating Leverage (Cont.)

• The DOL changes as volume changes, so a single
  value is valid only for one volume.
• What is the DOL at 75,000 visits?

DOL Total CM / Profit
5,386,500 / 419,038
12.85.

• What does the DOL tell Atlantas managers?

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Operating Leverage (Cont.)
Using DOL
-10
10
Visits
67,500
75,000
82,500
Profit
-119,612
419,038
957,688
-128.5
128.5

• What does a high DOL mean?

29
Profit Analysis Under Discounted FFS

• Suppose Atlanta Clinic is confronted with a
  situation in which a payor contributing 25,000
  visits wants a 40 discount.
• Atlantas managers might want to drop the
  contract because a 60 per visit payment is less
  than the 94.41 average per visit cost (Slide
  20).
• But, further analysis is required.

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PL Statement With 50,000 Visits
Total revenues (100 x 50,000) 5,000,000 Total
VC (28.18 x 50,000) 1,409,000 Total CM
(71.82 x 50,000) 3,591,000 Fixed costs
4,967,462 Profit (1,376,462)
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PL Statement With Discount Visits
Undiscounted revenue (100 x 50,000) 5,000,000 Di
scounted revenue (60 x 25,000) 1,500,000
Total revenues (86.67 x 75,000) 6,500,000 Total
VC (28.18 x 75,000) 2,113,500 Total CM
(58.49 x 75,000) 4,386,500 Fixed costs
4,967,462 Profit (
580,962)
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Graphical Profit Analysis
Revenues and Costs ()
Old Total Revenues
New Total Revenues
Total Costs
Fixed Costs
69,165
84,928
Volume (Number of Visits)
33
Marginal Analysis

• Think of the situation in a different way.
  Suppose the clinic had 50,000 visits and a new
  payor offered 25,000 additional visits at 60
  revenue per visit.
• These visits are called incremental or marginal,
  because they add to the existing patient base.
• Thus, the marginal revenue on the contract is 60
  per visit.

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Marginal Analysis (Cont.)

• Remember, that the marginal cost of each visit is
  the variable cost rate of 28.18 per visit.
• What is the marginal contribution margin on the
  contract?
• What should Atlanta do?

35
Profit Analysis Under Capitation

• Capitation changes the way in which profit
  analysis is conducted
• Perhaps the best way to see the effects of
  capitation is by graphical analysis.
• We will examine two approaches to graphical
  analysis
• In terms of utilization (number of visits)
• In terms of membership (covered lives)

36
Graphical Analysis Based on Visits
Revenues and Costs ()
Total Costs
Total Revenues
Fixed Costs
Volume (Number of Visits)
37
Graphical Analysis Based on Members
Revenues and Costs ()
Total Revenues
Total Costs
Fixed Costs
Volume (Number of Members)
38
Conclusions

• What do the graphs tell managers about the
  importance of utilization management
• Under FFS reimbursement?
• Under capitation?
• What do the graphs tell about the importance of
  the number of members under capitation?