transitionconsultants-logo

Medical Practice Sales, Appraisal and Financing

Medical Practice Sales, Appraisal and Financing

How to make a medical practice budget – Intro to variance analysis

In this article I will introduce the idea of variance analysis in medical practice budgets. Basic medical practice budgeting has been covered numerous times by various sources. Simple budgeting often is not the issue. A major problem in the process is how to properly analyze the budget after the fact and actually make sense of it. Simply noting whether a budget has been met or not says nothing about the root cause of cost overruns and inefficiencies in a medical practice. Often times we’re left to guess…Is it a certain expense, the staff, payor contracts, etc.? Variance analysis allows the medical practice manager or physician-owner to transform the budgeting process into a powerful decision support tool.

The budgeting basics – Conventional Approach

For this example we’ll use the conventional approach to budgeting. This is where the old budget or historic figures are used as the starting point. This is in contrast to zero-based budgeting where a new budget is started from scratch every year. A zero-based budget is not always practical for a medical practice, thus it’s usually best to start with the prior-years’ actual figures. For a startup medical practice you can simply use estimated figures until you’ve logged the first year. This can also serve as projections for your business plan used to obtain a medical practice startup loan. Below is a very simplified income and expense statement for a medical practice (assuming all fee for service patients at this point) which we’ll use in our analysis. You’ll note that our example looks a little different than a typical profit and loss statement.

Static Budget – Beginning of Year

Our income and expense statement contains patient volume statistics, average FFS (fee for service) patient reimbursement figures, variable cost figures per FFS patient visit/encounter/procedure, and fixed overhead cost.  These are important statistics in variance analysis and it is vital to keep sufficient productivity figures to get the most out of medical practice budgeting. If you don’t have this type of tracking system in place, some of these variables initially will be based on best estimates. To arrive at an average reimbursement, one can divide the actual FFS collections by the corresponding number of patient visits. To figure out variable cost per fee for service encounter one can find the total variable cost by subtracting all fixed overhead expenses (rent, staff, mid-level provider salaries, ancillary equipment contracts, etc) from total expenses. This figure would then be divided by total FFS patient visits to find the variable cost per FFS patient. Variable expenses are commonly associated with per-unit costs such as supplies, which incrementally increase in tandem with increased volume.

Adding the statistics portion to the income statement is important in getting the most out of variance analysis. Each practice will generate these figures a little differently so we won’t cover this in much detail. The important part is for the medical practice manager or physician group executive to get a decent handle on the key stats in order to bring the financial figures into context. The first column entitled Static Budget is our stating point and represents estimated figures at the beginning of the year. An explanation of the Flexible and Actual Budgets is covered in subsequent sections.

 

Static Budget (Estimated Figures at Year Beginning)

Flexible Budget (Actual Year End Visits X Estimated Reimb/Expense from Static)

Actual Budget (Actual Figures at Year End)

FFS Patient Visits

2,000

2,100

2,100

Average FFS Reimbursement

$                             100

$                     100

$                     90

TOTAL INCOME

$                     200,000

$             210,000

$           189,000

       

FFS Patient Visits

2,000

2,100

2,100

Variable Expense per FFS Visit

$                               50

$                       50

$                     60

TOTAL VARIABLE EXPENSE

$                     100,000

$             105,000

$           126,000

       

TOTAL FIXED EXPENSE

$                       90,000

$               90,000

$             90,000

       

TOTAL EXPENSE

$                     190,000

$             195,000

$           216,000

       

NET INCOME

$                       10,000

$               15,000

$           (27,000)

Actual Budget – End of Year

The realized, or Actual Budget reflects after-the-fact results.  Here we are looking at the actual fee for service patient visits, reimbursement per visit, and cost structure. These figures can be obtained from year-end statements from the accounting software combined with productivity statistics in the practice management software or medical billing company reports. The most important aspect of the year end data is to make sure you are comparing apples to apples. The end of year financial and performance data should come from the same source, and be calculated in a similar way, as the beginning of year data used in the Static Budget. This is especially critical if the practice changes medical billing companies or EMR/practice management software mid-year.

Flexible Budget – Variance Analysis

The middle column in the previous table represents our flexible budget for the medical practice. This is represented by actual visits from the year-end measurement applied to the estimated reimbursement and expense amounts from our original (Static) budget. The flexible budget allows us to ascertain the specific causes of gains or shortfalls in our Static budget. This is one step beyond a simple observation of whether the original budget was met or exceeded based our initial estimates. In the next section we will perform a very basic variance analysis in order to become comfortable with the concept; this will be developed further in Part II of this article.

Variance Analysis – Example 1 – Net Income Variance

Net income variance is the difference between our static net income and our actual net income. To understand this in context we will want to know what portion of our variance in profit in the medical practice is attributable to cost overruns (or savings) and what portion is attributable to increased revenues (or declines). Keep in mind the variance entails the total spread of Actual to Static.

Net Income Variance

=

Actual Net Income

-

Static Net Income

(37,000)

  =

(27,000)

-

10,000

Our Net Income Variance is -$37,000. If our actual net income was -$27,000, aren’t we overstating the actual outcome? No, because the Net Income variance measures the entire spread from the initial budget to the actual achieved result. In other words, not only did we fail to achieve the positive net income of $10,000 in our initial estimate but we also took a loss of -$27,000. This is a total negative of -$37,000. The reason we are calculating this variance figure is so that we can dig further and find the root cause(s) of the total variance. This is the power of variance analysis. We are moving from simple observation to a quantitative assessment of causality and magnitude. This allows the medical group management to use logical measurement when implementing cost control and revenue building initiatives. In today’s healthcare environment this is especially critical when negotiating insurance payor contracts or making strategic market moves.

Root Causes of Budget Variances

The next question is: What are the root causes of net income variance? There are two causes: Revenue Variance and Expense Variance. Added together they comprise total Net Income Variance. Individually, they show us what was their respective contribution (either positive or negative) to Net Income Variance. Below is how they are calculated.

Revenue Variance

=

Actual Revenues

-

Static Revenues

                             (11,000)

=

                      189,000

-

                       200,000

         

Expense Variance

=

Static Expense

-

Actual Expense

                             (26,000)

=

                         190,000

-

                       216,000

         

Net Income Variance

=

Revenue Variance

+

Cost Variance

                             (37,000)

=

                         (11,000)

+

                       (26,000)

As we can see, -$11,000 of our Net Income Variance is attributable to a variance in Revenue. Why would this occur? A negative Revenue Variance might indicate that we have pricing weakness in our practice or a cut in reimbursements. In contrast, a positive Revenue Variance might indicate pricing power in our practice or a particular increase in reimbursement. Most medical practices are price takers and not price setters, so the causes of revenue variances likely will be easier to ascertain than expense variances.

Looking back to our initial income statement it appears that our reimbursement per fee for service visit has declined. Thus ~30% of our Net Income Variance is attributable to reimbursement decline. A particular insurance company may have cut rates, perhaps our billing company didn’t submit claims properly, etc. A further analysis of the exact causes can be explored.

Next we will look at the Expense Variance. -$26,000 of our Net Income Variance is attributable to a variance in Expenses. What’s the reason? A negative Expense Variance might indicate poor cost controls or other inefficiencies. Conversely, a positive Expense Variance would indicate that we have effectively tightened our belt and reigned-in costs. ~70% of our Net Income Variance in this case is caused by cost overruns.

These are fairly simple observations (and we’ll dive deeper into root cause analysis in Part II of this article), so what is the take-away? Our net loss was attributable to both revenue and expense problems, but the majority of our budget variances came from lack of cost controls. The power of this type of analysis is that we can begin to break down causality & magnitude. From here, we can begin to root out slow-moving budget variance trends in the medical practice. These trends may not be immediately recognizable but may become festering problems over time. An effective medical practice manager will be able to better control the practice over time in this manner.

Coming Soon….Part II of Medical Practice Budgeting: Price, Volume, Management, Labor, Fixed Cost, & Supplies Variance.

Written by Christopher M. Majdi, MSHCA, CHBC, CBA, CVA.  Mr. Majdi is a licensed medical practice broker and certified medical practice appraiser, assisting private practice doctors and medical practice groups in mergers, acquisitions, and valuations nationwide.

Written by Transition Consultants

Copyright © 2018 Transition Consultants. All rights reserved. | Email us | 1-800-416-2055