1. Chapter 5 Understanding Costs Copyright 2015 Health Administration Press

2. After mastering this material, students will be able to  calculate average and marginal costs,  articulate why efficiency is important,  identify opportunity costs,  forecast how costs will change – if technology changes and – if input prices change,  and discuss the cost-quality relationship. Copyright 2015 Health Administration Press2

3. You run a service that provides 200 hip replacements per year.  Variable costs average $12,000 per case.  Overhead costs are $2,000,000.  Your average price is $30,000.  What is your average cost?  Are you profitable? Copyright 2015 Health Administration Press3

4. You run a service that provides 200 hip replacements per year.  Total costs = $4,400,000 = $2,000,000 + $12,000 × 200  Average cost = $22,000 = $4,400,000 ÷ 200 Copyright 2015 Health Administration Press4

5. You are profitable.  Total revenue = $6,000,000 = $30,000 × 200  Total costs = $4,400,000  Profit − $1,600,000 = $6,000,000 − $4,400,000 Copyright 2015 Health Administration Press5

6. Reference Pricing  Blue Cross now pays $22,000 per hip.  Patients pay the difference. – The negotiated price is $30,000. – Patients now pay $8,000.  Your volume has dropped to 110. Copyright 2015 Health Administration Press6

7. Your volume has fallen to 110.  Variable costs average $12,000.  Overhead costs are $2,000,000.  Your average price is $30,000.  What is your average cost?  Are you profitable? Copyright 2015 Health Administration Press7

8. Your volume has fallen to 110, so average costs have risen.  Your total costs are $3,320,000.  Average cost is $30,182 = $3,320,000 ÷ 110 Copyright 2015 Health Administration Press8

9. Your volume has fallen to 110 and you are not profitable.  Your total costs are $3,320,000.  Your total revenue is $3,300,000.  Profits = $3,300,000 − $3,320,000 = -$20,000 Copyright 2015 Health Administration Press9

10. What are you going to do? Copyright 2015 Health Administration Press10

11. Understanding and controlling costs are primary management tasks.  Low-cost producers have an edge.  Managers need to – find out what their costs are, and – reduce them.  Managers need to know – what costs to look at, and – how cost and quality are related. Copyright 2015 Health Administration Press11

12. Managers should be seeking  least costly ways of producing – desired products, and – increased health;  ways to reduce costs (increase efficiency); and  product lines in which – costs are too high to compete, and – costs give them an edge. Copyright 2015 Health Administration Press12

13. WHY COSTS ARE COMPLEX Copyright 2015 Health Administration Press13

14. Why are costs complex?  Costs depend on perspectives.  Insurance complicates calculations.  Opportunity costs may be implicit.  What is fixed depends on the time frame. Copyright 2015 Health Administration Press14

15. Without insurance, cost perspectives matter a little. PharmacyPatientSociety Acquisition$10$0$10 Processing303 Capital101 Price14 0 Travel044 Total cost$0$18 Copyright 2015 Health Administration Press 15

16. Insurance complicates things. Copyright 2015 Health Administration Press PharmacyPatientInsurerSociety Acquisition$10$0 $10 Processing3025 Capital1023 Price14680 Travel0404 Total cost$0$10$12$22 16

17. Accounting and economic costs can differ.  Accounting costs – serve lenders and investors, – must be objective and verifiable, and – must accurately reflect historical costs.  Economic costs – serve managers, and – must accurately reflect opportunity costs. Copyright 2015 Health Administration Press17

18. Accounting Versus Economic Costs AccountingEconomic Revenue$600 Labor$100 Supplies$250 Rent$200 Cost of owner’s time$0$100 Profit$50 Copyright 2015 Health Administration Press18

19. Opportunity cost = value of a resource in its next-best use.  Opportunity costs are usually – explicit, and – easy to measure.  However, what is the opportunity cost of – an hour of nursing time? – an hour of a salaried employee’s time? – obsolete equipment? – a vacant hospital wing? Copyright 2015 Health Administration Press19

20. WHY COSTS VARY Copyright 2015 Health Administration Press20

21. Costs depend on  input use, which depends on – nature and volume of output, – technology, and – efficiency; and  input prices, which depend on – what you buy, and – how you buy it. Copyright 2015 Health Administration Press21

22. Nature and Volume of Output  Economies of scale –Do larger firms have lower average costs?  Economies of scope -Do multiproduct firms have lower average costs?  They may or may not. – Spread fixed costs over a large volume. – Use specialized workers or machines. Copyright 2015 Health Administration Press22

23. Suppose a shared resource has a fixed cost of $50,000. Volume01001,000 Fixed costs$50,000 Variable costs040,000400,000 Total costs50,00090,000450,000 Average total cost?? Copyright 2015 Health Administration Press23

24. What will average total cost be? Volume01001,000 Fixed costs$50,000 Variable costs040,000400,000 Total costs50,00090,000450,000 Average total cost?? Copyright 2015 Health Administration Press24

25. Why is average total cost falling? Volume01001,000 Fixed costs$50,000 Variable costs040,000400,000 Total costs50,00090,000450,000 Average total cost$900$450 Copyright 2015 Health Administration Press25

26. But large or multiproduct firms  may have higher fixed costs,  may have higher variable costs, and  may be less efficient. Copyright 2015 Health Administration Press26

27. Larger firms may not have lower costs. Volume01001,000 Fixed costs$50,000 $200,000 Variable costs040,000500,000 Total costs50,00090,000700,000 Average total cost$900$700 Copyright 2015 Health Administration Press27

28. Some larger firms will have higher costs. Volume01001,000 Fixed costs$50,000 $400,000 Variable costs040,000600,000 Total costs50,00090,0001,000,000 Average total cost$900$1,000 Copyright 2015 Health Administration Press28

29. No sign of scale economies  for hospitals with >100 beds, and  for HMOs with >50,000 enrollees Bigger is not always more efficient. Copyright 2015 Health Administration Press29

30. Why might bigger firms have higher costs?  Higher costs of communicating  Higher costs of management  Slower responses to change  Duplication of effort Copyright 2015 Health Administration Press30

31. The Nature of Output  Lower-quality products should cost less.  Higher-quality products should cost more.  Easier-to-use products should cost more. – If not, why make the less desirable one? – If not, you’ve chosen to be inefficient. Copyright 2015 Health Administration Press31

32. Higher costs do not always mean higher quality.  High costs may be attributable to – inefficiency, – low volumes, or – high markups.  Higher quality may reduce costs.  Insurers are beginning to ask rude questions about cost and quality. Copyright 2015 Health Administration Press32

33. INPUT PRICES AND TECHNOLOGY Copyright 2015 Health Administration Press33

34. Input Prices  Higher input prices – always increase costs, and – may be partly offset by input substitutions.  Lower input prices – always reduce costs, and – may be enhanced by input substitutions. Copyright 2015 Health Administration Press34

35. Total Cost is $648,000. Input PricesNumberTotal Cost Rentals$100,0001 RNs$65,0004$260,000 LPNs$42,0004$168,000 Technicians$30,0004$120,000 $648,000 Copyright 2015 Health Administration Press35

36. What happens to Total Cost if RN wages rise to $70,000? Input PricesNumberTotal Cost Rentals$100,0001 RNs$70,0004$280,000 LPNs$42,0004$168,000 Technicians$30,0004$120,000 $668,000 Copyright 2015 Health Administration Press36

37. Could you make any adjustments in response to higher RN wages? Input PricesNumberTotal Cost Rentals$100,0001 RNs$70,000?$280,000 LPNs$42,000?$168,000 Technicians$30,000?$120,000 $668,000 Copyright 2015 Health Administration Press37

38. Technological Advances  Technological advances always reduce the cost of an activity; otherwise, it would be foolish to adopt technology.  However, total spending may rise. – If the cost of surgery falls from $20,000 to $10,000 but the volume of surgery rises from 1,000 to 8,000, spending rises from $20 to $80 million. Copyright 2015 Health Administration Press38

39. TIME Copyright 2015 Health Administration Press39

40. You spent $10 million on new IT.  It works poorly.  How should the $10 million affect decisions? Copyright 2015 Health Administration Press40

41. The $10 million is a sunk cost.  You can’t undo spending it.  All you can do is ignore it. Copyright 2015 Health Administration Press41

42. Time and Costs  Sunk costs – cannot be changed, and – should be ignored.  Fixed costs – do not change during the decision-making period, and – affect average cost, hence profitability and risk.  Variable costs – change during the decision-making period, and – affect incremental and average cost. Copyright 2015 Health Administration Press42

43. Sunk costs are fixed, but fixed costs may not be sunk.  You leased a 3 Tesla MRI last month. – The lease is $70,000 per month. – The lease does not vary with use. – The lease is a fixed cost.  You can end the lease on 60 days’ notice. – Sunk costs = $210,000 (three months’ lease). Copyright 2015 Health Administration Press43

44. Variable costs depend on output.  Important for pricing and output choices  Costs you can avoid by producing nothing  Example: For a test, a lab needs – $5 worth of supplies and labor per test, and – to lease equipment for $20,000.  The supply and labor costs are variable. Copyright 2015 Health Administration Press44

45. CONCLUSIONS Copyright 2015 Health Administration Press45

46. Costs are complex.  They depend on perspectives.  What’s variable depends on the time frame. – Most things are fixed in the short run. – Most things are variable in the long run.  Accounting and opportunity costs may differ. Copyright 2015 Health Administration Press46

47. But there are clear regularities.  More efficient firms have lower costs.  Higher input prices increase costs.  New technology should reduce unit costs but may result in – better quality or – higher volumes. Copyright 2015 Health Administration Press47

48. Managers need  to understand their costs, and  then reduce them. Copyright 2015 Health Administration Press48

49. Efficiency is a problem.  Many healthcare firms waste resources. – Badly designed production processes – Frequent efforts to fix problems  More efficient firms will – have lower costs, – have higher quality, and – take market share from rivals. Copyright 2015 Health Administration Press49