Making Capital Budget Decisions, Essay Example

The financial management of health care organizations is one of the most significant areas of concern for the success and survival of the organizations. Health care organizations such as hospitals, physician’s offices, laboratories, and other facilities are somewhat unique in terms of how money flows into and out of the organization. The majority of health care organizations are either for-profit or not-for-profit, which determines (among other things) how they handle revenues and how they are taxed. Many family-practice doctors’ offices are privately owned, for-profit enterprises, while many hospitals are not-for-profit organizations. In either case, however, the individuals who are in charge of overseeing the management and operations of such facilities still have a responsibility to keep an eye on the bottom line. Even a not-for-profit organization, for example, must still manage its revenues well in order to continue operating. With these considerations in mind, the capital budgeting process at a not-for-profit hospital must be handled in such a way that best serves the needs of all stakeholders and the organization’s bottom line. As an administrator at a hospital radiology department, the decision to choose between the purchase of a new MRI or a new digital mammography unit must be made after weighing a wide range of factors.

In this particular case study, the Medical Directors of two different departments within the Radiology Unit have each requested new machines for their departments. One has requested a mammography machine; the other has requested a new Open MRI. Each has made a case in support of their request: the mammography department at the hospital serves, among others, a significant population of low-income residents in the community who have no other access to mammograms, while the MRI Department wants the Open MRI machine because it will help alleviate the fears of patients who are uncomfortable in a traditional closed MRI machine. Both machines are priced at $800,000, which at first glance seems as if either purchase would have the same impact on the organization’s overall financial situation. This is not necessarily the case, however, and there are many other factors to consider when making a determination about which purchase would be the better choice.

For many for-profit organizations, making decisions about purchasing materials or other needed items is somewhat straightforward, in the sense that a calculation can be made about whether investing in a requested item will help contribute to the organization’s profitability. For a not-for-profit organization such decisions are not based on profit, though it is still important to consider whether a particular purchase or investment will create debt and not pay for itself. As noted in the text, “the ultimate goal of managing costs is minimally to break even and not run a deficit. Break-even analysis is the method of determining at what level of volume the production of a good or service will equal the revenues created.” As this statement makes clear, the decision to purchase either an MRI or a mammogram machine must be made while considering whether one or the other will lead to a deficit. As the text continues, “if the unit covers its direct costs (fixed and variable) and makes any contribution to overhead, it is worth keeping, even in the long run.” As the Administrator in charge of the capital budget for the Radiology department, the first thing in would consider is how each department (MRI and Mammography) functions in the context of this break-even analysis.

Unfortunately the information provided in the case study is minimal, and with the primary information being the purchase price of each unit. This is simply not enough information to make an appropriate decision about such an important investment. The first thing that must be done is to gather as much additional information about the situation as possible. This will include a thorough examination of the various costs and revenues associated with each department to determine if the costs of purchasing the requested unit will meet the test of the break-even analysis. Assuming that each potential purchase crosses that hurdle, the next step would be to analyze and compare how each purchase might contribute to the financial circumstances of each department and the organization as a whole.  Because there is so little information provided in the case study, it will be necessary to look at several hypothetical possibilities and scenarios and make draw some conclusions based on them.

The case study includes slightly more information about the mammography department than it does the MRI department. According to the available information, two primary things are known about the mammography department. The first is that it serves low-income women in the area, and the second is that it has won awards for this community outreach effort. This is a significant consideration for a not-for-profit hospital, as not-for-profit health care organizations are generally expected to engage in such community outreach efforts and other activities that benefit the community. The first question to address regarding this situation is whether the mammography department needs a “state of the art” unit in order to continue this mission; another question is whether a new unit is necessary to serve the hospital’s patients who have insurance or some other means of payment. If the purchase of the new unit will better serve these constituencies and will not harm the organization’s bottom line, then that is one point in favor of the purchase.

Continuing under the assumption that this is a not-for-profit hospital (as many hospitals are), the next step in the decision-making process would be to examine the cash flows related to the Mammography department. It may be safe to presume that many of the low-income patients the department serves are covered by Medicaid or some other form of assistance with their health care costs. The fee-for-service rates for reimbursement may be enough to cover a significant amount of the costs involved in making this purchase, and it is also possible that the fee-for-service rates that have been negotiated with other providers will also contribute to a positive effect on the budget. In order to make such determinations, it will be necessary to look at the budgets for previous years and to make predictions about how many patients the department will serve in the next fiscal year and the amount of revenue those visits will likely generate. If these revenues are likely to help the department at least break even, then the benefits of continuing to serve the community may make it worth the costs of buying the machine.

Many of these same questions and considerations apply to the functions of the MRI department, although the case study makes no mention of the MRI department serving low-income patients or winning awards.  The primary argument made by the head of that department is that the new MRI machine will help to eliminate the fears of patients who dislike going in the traditional MRI tube. AT first glance this might not seem like a good enough reason to choose the MRI machine over the mammogram, but once again the case study does not include enough information to make an informed decision. It is possible, for example, that the lack of an Open MRI unit at the hospital is costing the organization in lost revenues, as potential patients are requesting referrals to other Radiology facilities from their doctors, or even refusing to go into the MRI when they have been admitted to the hospital. In these and other cases, the cost of operating the old machine versus the cost of purchasing and operating the new machine must be weighed against each other to determine what effect a new Open MRI would have on the organization’s budget.

Any decision of this type is challenging for financial managers at hospitals. Unlike many businesses, hospitals must make budget decisions based on the fact that accounts receivable often take a long time to be settled. The high costs of health care services, coupled with the fact that most payments come from insurance companies weeks or even months after services have been provided, mean that hospitals are often in the position of covering costs in the present that will not be recovered until sometime in the future. It is often impossible to make a significant purchase of this nature and simply recover the costs in a short time. As the administrator responsible for making this decision, it will be necessary to be both a good manager and a good leader. Appropriate and effective management will entail looking at every aspect of the budget, especially in terms of cash flow and how each department contributes to the bottom line. It may also require the decision-maker to coordinate with the department heads of MRI and Mammography to determine what steps they might be able to take to generate revenue if they are granted their request.

Based on the available information in the case study, it is impossible to make a final decision. It would, in fact, be a sign of irresponsible financial stewardship to choose one over the other with such limited information. As the text notes, “the basic question that any capital budgeting system must ask is ‘Does this asset or project, in a time value sense, at least pay for itself?” There simply is not enough information in the case study to answer this question. In order to get to point where a decision can be made it will be necessary to display effective leadership by engaging the relevant stakeholders in the process of uncovering the needed information. Only then will it be possible to decide which of the two capital investments will best suit the needs of the hospital and the patients it serves.