Contribution margin analysis: a case study - Financial Manager's Notebook

Healthcare Financial Management, June, 1993 by Judith L. Horowitz

A 250-bed acute care hospital in an urban area currently operates a 25-bed mental health unit. Two years ago, hospital management began considering building a 50-bed freestanding psychiatric facility. Upon completion of the project, the mental health unit would be converted to medical/surgical use. The total cost of the project has been estimated at $6 million.

Hospital management is concerned that changes in the psychiatric/substance abuse market have made the project less attractive than it was when first considered. The hospital's administrator has directed the chief financial officer (CFO) and director of planning to analyze the project and recommend whether the project should be pursued or if the hospital should, instead, continue to operate its existing mental health unit. How should the CFO and the director of planning approach their tasks?

The CFO and the director of planning must first agree on the scope of the analysis and determine what questions need to be answered. Their task is to gain an understanding of the financial implications of building the freestanding facility versus continuing to operate the hospital's existing unit. Therefore, their analysis should detail three financial projections:

* the existing unit's projected financial performance over the next five years,

* the freestanding facility's projected financial performance over the same time period, and

* the projected financial performance of an alternate use of the 25 beds in the hospital that would be vacated by relocating the mental health service to the freestanding facility.

Next, the director of planning should prepare utilization projections for each of the three scenarios. The projections for the mental health service unit should incorporate the latest information on trends in admission rates, lengths of stay, and growth rates of alternative treatment programs, both locally and nationally.

The director of planning then should interview local mental health professionals about trends in the industry and, if possible, interview major payers on the subject of inpatient care for psychiatric and substance abuse disorders. The director also should review utilization trends of other facilities in the area served by the hospital, particularly those facilities used by psychiatrists on the hospital's staff.

The information obtained should be translated for use in two projections (factoring in the hospital's patient base), one projection assuming that the hospital continues its existing unit, the other assuming it expands into the freestanding facility. These projections should list patients by payer class.

Finally, the director of planning should determine--based on a review of historical use, service area demographics, market share estimates, and use-rate trends--whether the hospital can reasonably expect any incremental increase in medical/surgical admissions because it would have 25 more beds available if the mental health service were relocated to the freestanding facility.

While the director of planning prepares use projections, the CFO should prepare financial models to evaluate each scenario. One way to determine which configuration of beds makes the most financial sense is to compare the contribution margins of each scenario to see which makes the larger contribution toward covering the hospital's overhead.

Contribution margin is the difference between the direct net revenues of a program and its direct expenses, prior to the allocation of overhead expenses. Calculating the contribution margin of a program is easiest when a hospital has in place a reliable cost-accounting system that calculates the direct cost of treating patients from a specific unit or in a specified diagnosis-related group or major diagnostic category. But even facilities that do not have the luxury of relying on sophisticated cost-accounting systems can make educated analyses of contribution margins.

To project financial performance for the scenario described, the CFO should consider use by payer type and the expected reimbursement the hospital would receive from each payer. Any changes in reimbursement should be factored into financial projections. Since insurance coverage for inpatient mental health services is changing rapidly, it is also important to assess the impact of other potential changes in reimbursement. The appropriate way to evaluate changes in assumptions such as reimbursement is to run sensitivity analyses.

The CFO also should determine what expenses are directly attributable to the mental health unit. Generally, direct expenses can be defined as those that would not be incurred if the unit ceased operation. Salaries and benefits for staff on the mental health unit should be considered a direct expense, since these expenses would not be incurred if the unit were not operational. In contrast, those expenses that will not vary if the unit is continued or terminated--such as administration, building depreciation, and medical record services--should not be considered as direct expenses, but should be viewed as overhead expenses that the unit contributes to covering. A determination also should be made as to whether expenses associated with support services, such as housekeeping and plant operations, would be reduced if the mental health unit were moved out of the facility. If these expenses are not expected to decrease, then they should not be considered direct expenses of the mental health unit and should not be included in the analysis.