A strategic approach to allocating capital in healthcare organizations

Healthcare Financial Management, April, 1999 by Catherine E. Kleinmuntz, Don N. Kleinmuntz

Each year, healthcare organizations face the challenge of determining how best to allocate limited capital across a large number of requests for capital investment. Although many of these requests are for routine renovation or replacement of aging facilities anti equipment, the recent trend toward integration in health care has placed an increased emphasis on strategic investments designed to leverage the capabilities of an integrated delivery system (IDS). Such investments include the adoption of an increasing number of high-cost, large-scale information technologies. The challenge facing healthcare organizations to balance replacement needs against strategic opportunities is compounded by declining revenue growth due to unprecedented competitive pressures and by the need to make major changes in the care delivery infrastructure to meet managed care requirements.

Traditional Approaches to Capital Budgeting

Traditionally, capital budgeting in health care has tended to focus on projected financial returns from investments. To justify the commitment of capital resources, a proposed investment must be shown to provide sufficient benefits in the form of additional revenues or reduced expenses. A hospital, for example, might invest in an automated drug-dispensing system if forecasted savings from reduced labor and supplies are greater than the initial outlay for the equipment. Present-value calculations are used to weigh immediate costs against eventual benefits over the life of an investment.(a)

This approach, however, discourages strategic investments in areas where long-term benefits are difficult to measure in financial terms, such as investing in healthcare technologies to improve quality of care or patient satisfaction. Upgrading diagnostic equipment, for example, may be seen as a way to enhance revenues over the long term based on the rationale that patients and physicians are drawn to healthcare organizations that demonstrate a commitment to providing high-quality care. The problem with such an investment from a traditional capital-budgeting perspective is that it is difficult to predict when this benefit will occur or how large it will be. Similarly, capital investments whose objectives are to attract physicians or boost an organization's market share eventually may increase revenues or reduce costs, but are hard to justify solely in terms of short-term financial benefits.

Even when capital expenditures are based on seemingly sound financial projections, the anticipated benefits are not guaranteed. In fact, financial projections often deviate significantly from actual operational performance because healthcare organizations lack a reliable method to account for the strategic drivers of long-term financial performance, such as patient satisfaction, market share, and physician relations.(b)

Some healthcare organizations have attempted to consider strategic factors in capital allocations by rating proposals based on one or two general strategic criteria, such as "institutional fit" or "strategic impact." This approach is difficult even for highly experienced managers because it relies almost entirely upon the managers' judgment and ability to weigh the complex system of tradeoffs among various short-term and long-term financial, strategic, and quality considerations. This process also is prone to bias because of the vagueness of the judgment criteria. Too often, the result is a politicized budgeting process that creates unnecessary and unproductive conflict that may obstruct actions that would be in the best interests of the organization as a whole.

Decision Analysis

Decision analysis enables an organization to construct multiobjective decision models that focus on the most critical objectives consistently throughout the capital-budgeting process.(c) This process can be performed easily by the same team of top managers who would normally evaluate and rank proposals under the traditional capital-budgeting process.

The strategic capital-budgeting method comprises eight steps:

1. Establish evaluation criteria;

2. Classify proposals;

3. Ensure that proposals are complete and easy to understand;

4. Determine costs of proposals;

5. Rate proposals with respect to each criterion;

6. Set strategic priority weights for each criterion;

7. Calculate weighted value scores for each proposal; and

8. Rank proposals by benefit-cost ratios.

Examples used to illustrate this method draw on analyses of capital investment proposals that were performed during the annual capital-budgeting process of a 300-bed, not-for-profit hospital with gross revenues of more than $150 million per year that will be referred to here as Community Hospital.

Step 1: Establish evaluation criteria. The first step is to define the criteria to be used in evaluating each [TABULAR DATA FOR EXHIBIT 1 OMITTED] proposed capital expenditure. The evaluation criteria should reflect the organization's primary objectives for capital investments. By assessing a proposal's relative benefit in terms of each of these objectives, management can judge the extent to which the proposal will help the organization accomplish its overall purpose. Criteria selection, therefore, should be based on a careful consideration of the organization's overall mission, essential strategies, and critical performance areas.